Taxes and Their Replacement

Heading into the homestretch a look at where the House and Senate tax bills overlap and why the American Rescue Plan is an afterthought in building a budget.

If one only considers the numbers, there would seem to be some cause for optimism for a timely resolution to the 2021 session.   We have a $1.6 billion surplus – very much on par with past biennial budget sessions -- and a healthy budget reserve.  MMB reports general fund revenue collections are up $563 million through March from a February forecast that was released just 30 days earlier.    Meanwhile, thanks to the federal government, about $6.3 billion is now showing up in Minnesotans’ bank accounts.  Another $8 billion of additional federal COVID recovery relief is on the way to help juice the economy.    We are currently projected to have a surplus of $940 million to end the current fiscal year.  Smart money would take the over.

But politics, not numbers, dictate the outcome.  Divided government is once again generating budget and tax proposals reflecting two profoundly different perspectives on the state of state government.   If lawmakers can’t reach an agreement, it would be the fourth consecutive biennial budget session to require a special session.  The constitutional deadline is May 17.   Smart money would likely take the over on that too.

A Look at the Common Ground

The Senate has now passed its omnibus tax bill setting the stage for the tax conference committee.   As expected, it is much more modest in both its taxing and tax relief ambitions than the House counterpart. The out-biennium tells the tale – a $1.2 billion difference in general fund impact.   Over three-quarters of the Senate’s FY 22-23 total revenue impact of $533 million comes from a single provision – full (uncapped) conformity with federal exclusion of PPP loans from income, largely a one-time hit.  Most significantly it holds true to the Senate’s no new taxes commitment.  

For legislative bodies that seem have little in common on tax matters, there are some notable areas of agreement.   Table 1 captures the extent of shared provisions between them.

Notably absent from the Senate bill is federal conformity pertaining to the all the other federal COVID response acts and federal extenders.   The tab for full conformity across these other federal acts (excluding a few specific areas of purposeful decoupling) is around an additional $143 million.  The difference between the Senate and House PPP conformity proposals is $168 million.  Thus, full federal conformity could be paid for by the House’s capped subtraction.  

That is worth noting because in all the discussion and press coverage surrounding PPP something has largely escaped recognition.   By excluding both the loan income and the expenses paid with the loan income, an extra benefit is provided to any businesses who were fortunate enough to have received a PPP loan but also had other income on which they had to pay tax.  How often this occurred is not known.  But conforming does create an implicit tax fairness issue compared to an identical company that didn’t receive a loan but had to reduce expenses or spent down working capital to avoid laying off workers.  A numerical cap doesn’t address this problem since 2020 profitability isn’t necessarily related to the size of forgivable loans.  But capping it would pay for a lot of other important and beneficial business conformity actions.

An $8 Billion Non-Factor

According to MMB, Minnesota is expected to receive $7.955 billion from the latest infusion of federal recovery aid, the American Rescue Plan (ARP).   The eagerly anticipated and more “flexible” pot of money in the plan-- state and local recovery funds – totals $4.881 billion of which $2.577 billion goes to the state[1] and the remainder to city, county, and other local units of government.   The remaining difference goes to 27 specific spending areas headlined by $1.32 billion to Minnesota elementary and secondary schools.

Although such revenues might be expected to influence on tax committee thinking and budget making in general, ARP has only been an occasional talking point on the need (or not) for more money.   That’s because the distribution of these funds is almost assuredly to be handled by the Governor alone outside of the budget development process and after the session adjournment date.   The fact that the legislature only serves in an advisory capacity on federal funds under current law has been a sore spot among lawmakers.   Now billions loom on the horizon for the Governor to spend as he sees fit.  It’s theoretically possible that in the remaining weeks the House, Senate, and the Governor could come to an agreement on some of this spending as part of a budget deal.  However, that would undoubtedly require some form of acquiescence on each sides’ most valued positions – change to emergency powers/Legislative Advisory Commission law on one side and the no new taxes commitment on the other, which is not going to happen. 

Even if it did, ARP’s inclusion in the budget development process would be compromised by the lack of federal guidance.   In late March MMB reported that necessary Treasury guidance for the use of state and local recovery funds was not available and was not expected to be available for several weeks.  Of particular concern is the interpretation of a provision preventing states from using the funds “to either directly or indirectly offset a reduction in the net tax revenue.”   It is now been several weeks and the only guidance issued from Treasury has been to declare the use of relief to pay for conformity actions are permissible under this offset provision.   It's not clear to us if any state tax cuts would jeopardize state recovery funds on a dollar-for-dollar basis or the whole apportionment.  Assuming the former, and based on our review of the House and Senate tax bills, conservatively $269 million in federal aid could be forfeited by adopting the full suite of tax credits, exemptions, and exclusions in the omnibus bills.  Further guidance is not expected until after adjournment.  

The knowledge that recovery funds are coming may be having some indirect impact in state finance areas where there is a clear, but currently unquantifiable, substitution effect.   For example, neither the House or the Senate bills include a general LGA increase which we might suspect was influenced by the knowledge that a significant tranche of federal support is forthcoming to cities and counties to replace lost revenues and fund different types of service delivery.

But with federal aid functionally on the sidelines at present, each side deeply rooted into their historical positions (lots of taxes on the wealthy and big business vs. no new taxes, period) and the opportunity for non-budget issues like police reform to hold the budget hostage, we have all the makings of a messy, contentious, and frenetic end culminating in intimate backroom negotiations among the triumvirate.

In other words, the usual Minnesota finish.

[1] The state also receives an additional $179 million specifically for water, sewer, or broadband capital investments.