2016 Session "Everything Just Got a Little Harder"

Like a television drama returning from a summer hiatus, Minnesota lawmakers will begin the 2016 legislative session with budgetary and political plot lines intact.  Last session, with the tax bill and transportation finance tied up in knots, $865 million was left on the bottom line after accounting for reserves.  By the November forecast, that projected surplus had swelled to just $1.2 billion (not counting an approximately $600 million increase in the budget reserve).  But the recently-released February economic forecast downgraded economic growth projections and the resulting surplus now sits at $900 million – almost identical to where we were as this biennium began.

Similarly, legislative leaders are sticking to their scripts.  DFLers are emphasizing interest in various spending initiatives like an expanded Working Family Credit, LGA enhancement, and rural broadband; Republicans are emphasizing tax relief for businesses and individuals; and everyone is seeking a transportation funding solution.  Yet the revised forecast and downgraded economic growth projections throw a little cold water on everyone’s agendas.  Or in the words of Senate Majority Leader Tom Bakk, “Everything just got a little harder.”

Forecast Summary

The accompanying table presents how the perspective on this biennium has changed since the legislature adjourned last year.  The resources carried forward from the prior biennium grew by nearly $700 million, largely because revenues during FY 2015 came in higher than expected.  However, projected tax revenues for FY 2016-17 are now down $363 million from the July 2015 estimates.  Reductions in individual income tax and general sales tax projections (down $205 million and $220 million respectively) are partially offset by $62 million of projected increases in all other tax revenues.  This decline in projected taxes is largely mitigated by a $310 million decline in projected expenditures and transfers.  Health and human service spending is the big driver in this change – with a projected half-billion-dollar plus decline more than offsetting anticipated spending increases in most other areas of state government.

The ratcheting back of expectations of economic growth over the last three months similarly impacts the FY 2018-19 out-biennium.  The planning estimate for those years now shows a structural balance (forecast biennial revenues minus projected biennial spending) of $1.18 billion, down $861 million from the November forecast.  That estimate does not include the effects of inflation on state spending, which is either foolish, responsible, or something in between depending on who is offering the commentary.¹ The (very) unofficial MMB estimate of $1.7 billion for inflation during FY 18-19 is derived simply by applying projected changes in the Consumer Price Index onto to the entire general fund, something all legislative leaders seem to agree significantly overstates inflationary impacts.  Nevertheless, potential impact of inflation is another factor to weigh – especially for any proposals that would impact the FY 18-19 budget.

Taxes

The good news:  all the raw material for the “conference committee bill that wasn’t” remains on the table ready for action.  The conference committee has been reconstituted (with Rep. Gene Pelowski replacing the now-departed Rep. Lenczewski) and the discussion will start from there.  The bad news: legislative rules restrict the discussions to items that went through the process in either the House or Senate in 2015.  New provisions from 2016 will be considered only if there is nexus with something already in either the House or Senate’s 2015 omnibus bill.  And with such differences in the House and Senate omnibus bills it’s difficult to see how the process benefits at all from starting at the beginning of session rather than near the end of it.

As is always the case, whatever each side deems essential cargo will determine the fate of the conference committee’s final product.  News reports have suggested optimism about progress on state property tax relief, a prominent feature of the House’s tax bill, but the new forecast presents cloudier skies.  That same overcast also hovers over other tax-related priorities – notably the Senate’s interest in providing additional aid to cities and counties and the House’s interest in exempting Social Security benefits from income taxes.  It will be interesting to see if and to what extent state initiatives in this shortened session are subordinated to local interests.

There is also the question what new tax proposals legislators will consider and whether they can find their way onto a 2016 tax bill.  As usual, a time-sensitive slate of federal conformity issues stare legislators in the face from day one.  Aside from the bigger ticket “wish list” items like Section 179 expensing, there are many smaller investment provisions of potential interest to the business community plus a number of conformity concerns of interest to individual filers, such as deductions for educator expenses, mortgage insurance premiums, and some specific types of charitable contributions.  However, House Tax Chair Greg Davids has already stated his preference that any “second” tax bill this year be one that all parties can agree to – meaning that if one even appears, it will be about as controversial as motherhood and apple pie.  Federal conformity could move through the process as a stand-alone bill, but given discussion in the House Tax Committee it appears that the players involved would prefer to wait until May to adopt it.  This would ensure that all taxpayers file using the same federal laws, and allow DOR the opportunity to adjust tax returns after-the-fact.

The House’s list of “pre-filed” bills offers a window of insight into other tax initiatives on legislators’ minds heading into the shortened session.  Notable proposals include the elimination of the scheduled 2019 repeal of the Minnesota Care provider taxes; a reduction in the percentage of C/I growth metro-area cities under 15,000 contribute to the Fiscal Disparities program (with the state backfilling lost revenues); and, oddly, a DFL-authored bill to have the Department of Revenue study replacing the state’s current individual income tax with a flat tax on income or consumed income.  From the “this was predictable” file, another bill seeks to “reamend” the state Constitution to redirect the constitutionally dedicated 3/8^th cent sales tax to roads, bridges, and clean water infrastructure.  Most of the pre-filed bills, however, are the ubiquitous, low profile, targeted tax expenditures introduced every session providing some form of favorable treatment to some preferred behavior, activity, or type of taxpayer.

That said, one introduction from the first day particularly worth following is HF 2681 – a multi-faceted piece of legislation that looks a bit like a miniature omnibus tax bill.  It conforms Minnesota’s income tax law to 2015 federal tax law changes and establishes a process for prospective federal conformity going forward.  It includes a number of small business tax relief and assistance measures.  And it also addresses a few of the procedural protections for taxpayers highlighted in our November/December 2015 issue of Fiscal Focus – most notably the establishment of a program for private letter rulings.

Related to the issue of improving consistency and predictability in tax enforcement and administration, one final tax issue practically guaranteed to make a very visible return this year is residency determination for income taxation.  “Factor testing” in determining Minnesota “intent” or “domicile” residency – especially as it relates to the impact of employing Minnesota-based lawyers, financial planners, and accountants – has received considerable attention with the passage of the fourth income tax tier.  

Two recent developments guarantee that residency issues are not going away anytime soon.  In mid-February, the Minnesota Supreme Court reversed a Tax Court ruling and now allows the Department of Revenue to consider all days spent in Minnesota in a year in determining physical  presence residency (over 182 days + an abode in MN).  This means that both days spent in the state as a non-resident as well as days spent as a resident are totaled when determining physical residency for income tax purposes.  Two weeks earlier, the Department issued its long anticipated “Revenue Notice #16-01: Income Tax – Domicile Consideration – Location of Attorneys, Certified Public Accountants, and Bank Accounts”, which was greeted with a giant raspberry by business practitioners.  Frustration and aggravation has not abated, perhaps best captured by practitioners’ expressions of disagreement over what was more amazing – publishing something with no explicative or decision-making value, or that it took well over a year to do it.  With language in both the House and Senate tax bills addressing this concern, expect a redoubled effort to push for a legislative solution.

Bonding

Bonding is always a keenly-watched topic in even-numbered years.  Passage of a bonding bill requires a 60% supermajority which almost always means the minority caucus needs to put up votes for the bill.  Negotiations involve two contentious dimensions: the overall size of the bill and the specific projects within it.  Governor Dayton has proposed a $1.4 billion package with a strong clean water focus.  Republican leaders have suggested something around $1 billion would be more amenable (which is more or less in the historical range of past bonding years) centered on roads and bridges.  DFL legislative leaders envision something closer to the Governor with Greater Minnesota projects being one theme of emphasis.  Whatever number is finally agreed to, it will require a substantial winnowing of the estimated $3 - $4 billion in bonding requests.

Transportation Finance

Despite the encouraging comments from transportation finance chairs, and the insistence of all legislative leaders that transportation is unequivocally a top priority for the session, all indications are that last year’s complications are alive and well.  Republicans are adamantly against gas tax increases and want to tap the general fund for transportation – both using one-time money as budget conditions permit and structurally by dedicating general sales tax revenues from auto repair parts.  They are also cool to big ticket transit spending and new transit financing options.  DFLers are much more amenable to gas tax increases, but ice cold to any lasting dedication of existing general fund resources for roads and bridges.  And it’s clear DFLers expect transit to have a significant presence in any transportation finance package looking beyond the current biennium.  Combine this with the fact that these positions continue to be intertwined with unresolved tax matters and any compromise will have some political fallout ahead of the November elections, it’s difficult to see a breakthrough forthcoming this session.  Our accompanying article in this issue takes a closer look at the transportation finance stalemate.

Pensions

Largely ignored in all the biennial budget squabbles are some very significant developments in public pensions.  In 2010, with pension funds reeling from the Great Recession, the legislature enacted a major package of sustainability fixes including both contribution increases and reductions/freezes in cost of living benefit adjustments (COLA) to restore fund health.  Just six years later, with the S&P 500 now up over 165% from its Great Recession lows, another round of sustainability fixes looms.

The focus this time is on the plans for teachers statewide (TRA) and for state employees (MSRS).² MSRS will be proposing to increase both employee and employer contributions and to reduce the annual COLA to 1.75% going forward.  TRA is proposing to boost employer contributions (for the third time in ten years) and also lower the annual COLA to 1.75% but keep employee contributions unchanged.  TRA is also asking for a fresh 30-year amortization period to pay off its $6.7 billion in unfunded liabilities.

Together, the proposed changes in employer contributions represent an opportunity cost of $84 million in FY 2017 – resources that would be directed toward additional pension support and away from the delivery of services that the state and school districts provide.  Testimony from school district representatives made it abundantly clear that they have no capacity to absorb their share of these costs without impacting their operating budgets, and they want the state to appropriate general fund money to cover this additional expense.  For anyone who still may believe that pension costs are not significant in the grand scheme of governmental budgets, school representatives also testified that if they had to assume this additional expense, it would consume 25-50% of the increase in basic education formula aid appropriated with such effort and drama last session.

What’s prompting the need for more fixes?  The message being related to beneficiaries, legislators, and the media is that longer life expectancies are driving up costs.  The plans’ experience studies are showing that public employees are living longer than expected– two years longer on average – which must be factored into pension financing.  Collecting an additional two years of monthly benefits is certainly a significant cost issue. When the MSRS actuaries calculated the impact on the General Employees Retirement Plan, the longer life expectancies increased total liabilities by approximately $700 million.  State pension plans deserve to be commended for pursuing prompt action on this issue.

But everything is relative, including the impact of longer lifespans.  To put this issue into better perspective, the accompanying chart uses data from the pension plans’ actuaries to isolate and quantify how specific factors have affected the unfunded liabilities of the state’s major pension plans from 2006 through 2015.  Positive numbers mean that the factor has generated increases in unfunded liabilities during this period; negative numbers mean the factors have reduced unfunded liabilities.  For example, lower-than-expected salary growth and changes in plan provisions (most of which reflects the sustainability fixes of 2010) together had a positive effect on plan health by lowering unfunded liabilities by nearly $10 billion dollars.  The sum of all the bars equals the net increase in unfunded liabilities over this period: $9.6 billion.

 

The specific impact on fund health of public employees living longer than expected over the last decade can be seen in the bar labeled “mortality.”  $631 million is a lot of money and hardly a rounding error.  But it pales in comparison to other factors.  For starters, the state has set contribution levels into these pension funds at woefully inadequate levels – they have been $5.5 billion inadequate, to be precise.  Although both employer and employee contribution rates have gone up, FY 2015 marks the 12th consecutive year contributions to the pension plans – on an aggregate basis – failed to meet the required amounts.  It is especially interesting to compare the impact of “changes in plan provisions” (generally, the highly-praised and relentlessly-referenced sustainability fixes of 2010) with the impact of contribution policy.  90% of the roughly $6 billion in one-time benefit the 2010 sustainability fixes provided has been undercut by failing to make necessary contributions.  What plan and benefit changes giveth to sustainability, state contribution policy essentially taketh away.

Then there is the Sears Tower – investment income.  This time period obviously captures the devastating effects of the Great Recession, but it also captures the decent to excellent market years before and after.  Interestingly, the State Board of Investment reported a respectable annualized return of 7.8% for the ten years that ended on June 30, 2015.  This makes the $11.3 billion increase in unfunded liabilities over this same period just from missing investment expectations very much worth contemplating.  Part of the disconnect is attributable to “smoothing” practices – some of the recent gains have not been realized yet.  But it also vividly demonstrates the extraordinary impacts even small deviations from investment expectations can have on pension health.

Going forward those deviations may not be so small.  At least the plan’s own actuaries think so.  In their GASB compliance memo to plan officials, they note “according to our most recent experience study, the probability of achieving the 8% assumption is only 37%.  The study further indicates that to have a 50% chance of achieving the assumed earnings rate, the rate would have to be lowered to 6.97%.”

In short, the “living longer” repercussions for pension fund health are undoubtedly real.  But it is also proving to be a bit of a scapegoat and convenient distraction from the far more influential policies and historical practices that are triggering the need for contribution increases – and creating significant risk and exposure for beneficiaries, taxpayers and government services alike.

Given all this, and other tax relief and spending ambitions, it’s easy to understand why legislators might be so disappointed to see $300 million disappear in smoke.  Many different Capitol veterans have uttered the phrase “all or nothing” to describe the 2016 session.  It reflects a sense that either all the pieces of the puzzle will come together expeditiously or will quickly dissolve leaving the November elections to chart the future path.  By all accounts, the prognosis for putting these pieces together – reaching meaningful agreement on these issues (and others) – is not good.  If that’s the case, voters tired of reruns may head to the polls in November in search of a different channel.