Session Reflections: About As Good As Could Be Expected

Just when you think we have experienced every possible type of ending to a legislative session in this era of deeply divided government, a new one comes along.  After meeting the agreed upon legislative deadlines in an orderly way entering into the last few weeks of session, the all-important budget target deadline came and went creating a stalemate with time running out.  That triggered the familiar super-secret leader negotiations, subsequent mad rush to assemble and pass large omnibus budget bills, and ultimately the now not-so-special special session.

This year had the look and feel of a “Price of Government”-ish approach to government budgeting: first agree on how much is available to spend, then prioritize and allocate from there until the money runs out.  Of course, a price of government aficionado would recommend leaving more than 36 hours to accomplish that all-important second part.  Like two years ago, it was clear that the agreement framework did not have nearly enough of the specificity and detail needed to move bills to the governor's desk in an expeditious enough manner to meet the constitutional deadline.  But facing the prospect of having to head home over Memorial Day weekend to face some constituent music, legislators put their shoulders to the wheel and finished their work in a brief special session.

In the end it strikes us the result is probably as good as could have been expected given the stark philosophical differences between the parties.  The $48.5 billion general fund budget for FY20-21 is a $1.07 billion (2.3%) increase over current law February forecasted spending for FY20-21 and a $2.9 billion (6.4%) increase over the current biennium’s spending.  That’s slightly more than 3% growth per year over FY 2018-19.  Some have expressed concern that honest budgeting and fiscal responsibility took a hit with the bump in June accelerated sales tax collections and most notably the $500 million raid on the state’s budget reserves to pay for current law spending in FY 22-23.  It’s a legitimate point and demonstrates the state budget is banking on Minnesota’s economy to perform above expectations as we move forward.  But if fiscal responsibility is the concern, this year’s result pales in comparison to what could have been: over $1 billion more in new permanent spending and tax relief backed by $1.1 billion of hugely volatile, litigious, quantifiably questionable, and often temporary new revenue from foreign earnings and high-end capital gains taxation.  This road not taken would have generated the session outcome most likely to trigger flop sweat within Minnesota Management and Budget.

The Continuing Battle of Budget Framing

The accompanying table provides greater detail on changes in the general fund budget relative to the February forecast and therefore presents a state budget picture using a baseline that “holds harmless” all current law spending.  As the budget debate this year showed, agreement on the appropriate frame of reference for presenting budget information is just as contentious as the budget decisions themselves.  For example, while Health and Human Service spending appears to be essentially flatline, the growth over the previous biennium is actually a hefty $1.37 billion dollars, or 10.2%.  In essence, Republicans believe available revenue should frame the budget debate; DFLers argue it’s current spending.  Both sides have valid, albeit irreconcilable, arguments resulting in an ongoing battle of public perception.

Federal Conformity Dust Settles

Compared to last year, lawmakers appeared more receptive to the idea that simplification and administrative matters deserved consideration as they tackled the thorny issue of federal tax conformity.  This is especially true on the individual income tax side as the state adopted full conformity with the federal government’s higher standard deduction.  On the business side, these matters took more of a back seat as tax revenue from base broadening was employed to provide the grease for the agreement.  The federal conformity provisions the state adopted are projected to generate $650 million in revenue for FY 20-21 from pass throughs and C-corps.  Annoyances like the punt on full Section 179 conformity and the intellectual inconsistency with federal reform objectives (like the decoupling of immediate expensing with adopting the new limitations on net interest expense deductions) were casualties of the revenue raising and redistributional demands within the agreement.

It’s been said there are two seasons in Minnesota: winter and road construction.  There are also two tax policy seasons in Minnesota: creation/enactment and “Frequently Asked Questions.”  The Department of Revenue is undoubtedly gearing up for lots of practitioner demands for guidance, understanding and additional clarification regarding interpretation of and compliance with the tax bill.  As one very simple example, various provisions in the tax bill are retroactive to previous tax years.  Legislators understood this was going to cause issues and included language that essentially holds people who have filed harmless from the retroactivity.  One question that practitioners have already raised is how to deal with returns for tax year 2018 that have not yet been filed.  Do they file under the new revised law or under the old law and assume their returns will be adjusted?  Additional federal guidance on TCJA provisions and some possible yet-to-be-recognized language fixes offer further potential administrative challenges.  The political saga may be over, but some behind the scenes conformity-related drama is likely to continue.

From all indications, the source of Republicans’ tax-related objections centered on the retention of the provider tax, not the conformity plan; the specifics of the federal conformity strategy itself appear to have had considerable bipartisan support.  Yet it’s difficult not to be a bit wistful of “what might have been” and our failure to take greater advantage of a rare window of opportunity to pursue more ambitious state tax reform geared toward cleaning up and improving the tax system relative to good tax policy principles.

Big Political Benefits from Relatively Small and Diffuse Economic Benefits

This session demonstrated how difficult it is to really move the needle on providing substantive tax relief from conformity base expansions absent bigger structural reforms.  For example, the maximum benefit of the high-profile second tier rate cut (a $361 million revenue reduction in FY 20-21) for a married-joint filer will be $288 for tax year 2019.  The relevant significance of this tax cut on household well-being is mitigated to some extent by the fact that this maximum benefit will accrue entirely to higher income filers whose taxable income maxes out in the third income tax bracket and can take full advantage of the second tier rate cut – between $154,020 and $269,010 for married-joint filers in 2019.  (Legislators ensured little or no benefit would accrue to filers with income in the fourth tier by adjusting the fourth tier thresholds.)  Based on the modeling underlying our income tax comparison study, we estimate the rate cut will yield about $73 of income tax relief for married-joint filers with $100,000 of household income (near the median for couples) and two kids – or roughly $6 per month.  Similarly, the increased Social Security subtraction for the median married-joint senior filer income of $75,000 reduces income tax burdens $32, or $2.67 a month, at a cost to the state budget of $9 million.  The biggest household economic effect in this budget is almost certainly the $100 increase in monthly MFIP benefits, the first such increase since 1986.  That comes with a relatively modest $43 million biennial price tag.

Even if the household economic impact of tax relief is not that significant, the political returns from these decisions are substantial.  Both sides have planted a flag on the all-important ground of having provided low and middle income tax relief.

The Uncertain Future of the State Gas Tax

It’s difficult to put a finger on exactly what the primary objection to a gas tax increase was this year.  Public polling showed state support for a 10 cent increase last year but opposition to an increase this year.  Was it the sheer magnitude of the increase proposed by the DFL, which left ample room for negotiations but also framed the proposal itself as over-aggressive and out of touch?  Was it the cognitive dissonance of raising this tax and other taxes in times of surplus?  Was it the regressivity of the tax?  Was it concern that Minnesota’s infrastructure development is plagued by what Bloomberg News has described as “inefficient project management, an inefficient government contracting process, and inefficient regulation” now plaguing U.S. infrastructure development?[1]  Do the ample number of orange barrels and lane closures slowing traffic around the state suggest to taxpayers we can’t handle more such investment at this time?  Or was it state history showing how swiftly and decisively lawmakers can be punished at the ballot box for supporting a gas tax increase?

The likelihood is that all these and perhaps other factors contributed to its rejection.  But what makes the gas tax debate a bit of a head-scratcher is that the tax itself functions as the platonic ideal of how taxes should work in the eyes of many citizens.  It’s a benefits tax implicitly offering a high degree of fairness (those who use the service pay for it) along with 100% certainty that every dime collected is dedicated to roads and bridges, an area which most Minnesotans seem to believe needs attention.  Moreover, consider the following:

• In today’s dollars the current gas tax is actually one cent lower than it was in 1925 when legislators first enacted a 2 cent per gallon tax.  It’s about half what it was in 1949 in real terms and 15% less than what is was after the tax rate was last increased in 2008.[2]
• When the gas tax was last increased, gasoline and motor oil comprised a 5.6% share of expenditures for Midwestern consumers.  As of 2017 it represented a 3.4% share.
• As a percent of the average nationwide price of gas, Minnesota’s gas tax rate is at or below historical lows, with the exception of the 1970s-era Arab oil embargo and the 2000s-era melt-up in gas prices.
• If the gas tax had been increased by $.01 every year after the last increase in 2008, we estimate the state would have put roughly a $1.7 billion dent in road and bridge needs.  And under this scenario, the average car/SUV driver consuming 600 gallons of gas per year would be paying about $60 more per year in gas taxes today than over a decade ago, or 16 cents more per day.

All this suggests public perception of the tax is somewhat skewed, a conclusion echoed by a paper presented at the annual conference of the National Tax Association[3] a few years ago.  Researchers found most people greatly overestimate how much they pay in fuel taxes.  Half of survey respondents overestimated the magnitude of fuel taxes paid by at least a factor of five.  Seventy-five percent overestimated the amount by at least a factor of three.  Subsequent analysis showed that these misperceptions strongly influenced their views regarding support for more road and bridge revenue.

This suggests the future of highway finance will be as influenced as much by misperception as principle or ideology – indicating that an investment in educating citizens may be deserved.  However, in today’s social media era with the confirmation bias and ”fake news” accusations embedded in it, educational efforts have often become as difficult as passing a tax bill itself.

One thing we do know: Minnesota is now in the minority of states with respect to its gas tax policy.  According to information provided by the Brookings Institute, thirty-four states have increased their gas taxes in the last six years.  Moreover, several states also apply general sales taxes at the state or local level in addition to their gasoline excise tax.  With competition within the general fund guaranteed to increase, the pressure on Minnesota to join other states in raising its gas tax is not likely to go away.

State/Local Relationship:  Welcome Support for Spending Omitted from the Op-Eds

This year, at long last, city and county officials achieved an elusive policy goal: the restoration of the Local Government Aid (LGA) and County Program Aid (CPA) appropriations to their previous highest historical levels (2002).  The purchasing power of this aid has certainly decreased over the intervening years, but the infusion of new general purpose money ($30 million more per year for both counties and cities) is undoubtedly a welcome development.

On the other hand, the failure of another proposal suggests that state government gives with one hand and takes with the other.  Since 1997, local government’s primary pension plan, PERA General, has received nearly $14 million in state aid annually to defray some of the costs employers (i.e., local governments) would otherwise be expected to make.  A bill was proposed this year to lengthen the sunset date for the aid from June 30, 2020 to the earlier of June 30, 2048, or the year after PERA General achieves fully funded status.  That provision was a casualty of the negotiated budget agreement.  Local governments won’t feel the pain now since it will be difficult for PERA to recoup that $14 million from them.  But as an aging population puts pressure on the state’s pension funds, at some point local governments might wish that 23 cents of every new LGA and CPA aid dollar given out this year ($14 million of $60 million) had been directed instead to local government pension support.

In fact, higher state aids to local governments have been subsidizing higher under-the-radar spending for years.  As a prime example: in 2019 cities are receiving $109 million in additional LGA and counties are receiving $73 million in additional CPA relative to 2011 (even before the additional $60 million in the 2019 tax bill kicks in) for a combined total aid increase of $182 million annually.  Since 2011 employer contribution rates for PERA General and PERA Police and Fire have increased 0.25% and 2.55%, respectively.  Based on FY 2019 projected payroll the additional cost for local governments from the higher rates totals $41.43 million for FY 2019.  Divide that total by $182 million in increased aid for 2019 relative to 2011 and you get… 23 cents on the dollar.

So at a time when the State Board of Investment has been routinely blowing away its investment return targets during much of the longest bull run market in history, the equivalent of nearly 25 cents of every new dollar of local government general purpose aid has needed to be redirected out of local service delivery and into pension support.  It’s worth keeping in mind next time the litany of essential services only made possible by LGA graces your editorial pages.

It Lives

There are two things we know about the provider tax: 1) it’s the type of broad base, low rate tax that public finance wonks generally applaud; and 2) that didn’t matter to Republicans who were really upset by its preservation.  News reports suggested the challenge of putting together an HHS budget without it proved rather daunting.  That shouldn’t surprise anyone, especially with several hundred million in Medical Assistance spending poised to parachute into the General Fund if the projections about the Health Care Access Fund’s future without the provider tax were to come true.  That’s a potential general fund competition / demographic combo even the most confident lobbyist should want no part of.  Whether one likes it or not, the provider tax in its slightly diminished form probably can’t be eliminated until some spending or revenue reform is found to avoid the hole in the state budget its repeal would leave behind.

This year’s compromise provides much more than a state budget for the next two years.  It also sets the stage politically for the 2020 elections as both sides will now retreat to their respective corners.  In electing a full slate of representatives and senators, Minnesotans will be choosing between two starkly different visions of state tax and spending policies to guide the state’s future.  Whether that yields a distinct direction or another slog of future compromise remains to be seen.