The Case For A Bigger Standard Deduction

Given a federal tax reform process which featured much of the thoughtfulness and deliberative care of a Tic Tac purchase in a grocery checkout lane, Minnesota’s federal conformity challenge last year was predestined to be difficult.  In most years federal conformity bills are passed on a bipartisan basis early in the session and signed expeditiously.  Lawmakers can readily get behind making tax filing and compliance simpler for taxpayers, easier for the state to administer, and less costly for both.  But the TCJA presented anything but a normal conformity context.

Looking back, the immediate comingling of conformity decisions with supplemental budget and tax redistribution issues spelled its doom.  Policymakers subordinated administrative simplicity to matters of winners and losers, “holding taxpayers harmless,” and righting the perceived wrongs of federal action.  There is little reason to expect much different in 2019.  Tax simplicity may get a hat tip from policymakers but these other issues are the ones that drive tax debates.  Besides, simplicity in taxation has never been a hallmark of Minnesota’s tax system, and state policymakers have never been particularly shy about wanting to add complexity into the tax code.  For example, in just the first month of the 2019 session, 44 new income tax deductions, credits, or subtractions were proposed by legislators from across the political spectrum.

At its core, conformity is still a tax administration issue, and making the tax system easier to deal with and less costly for both taxpayers and the state shouldn’t automatically take a back seat to tax levels, fairness, rates, and related matters.  All of which raises the question, what would an income tax conformity plan that emphasized and prioritized ease of filing and compliance, administration, understandability and transparency look like?  One avenue is getting on the TCJA’s core simplification bandwagon and significantly boosting the state’s standard deduction.

Objectives and Tactics

With respect to individual income tax conformity, three primary objectives deserve attention to advance simplicity in tax administration and filing:

1.       Align filing requirements so Minnesota does not impose a filing requirement and tax obligation when the federal government does not.  For decades, if an individual in Minnesota has not had a federal filing obligation, they haven’t had a state filing obligation.  That could change depending on the nature of Minnesota’s conformity response.  This creates both the potential for leakage in the revenue system from historical conditioning and an administrative hassle and public relations headache for the Department of Revenue chasing down non-filers – especially when the return on compliance action would be so low and the taxpayer annoyance factor so high given the tax amounts involved.  The hassle would be exacerbated by the fact that the Department would not be able to rely on the IRS for help with this group of taxpayers.

2.       Minimize the number of taxpayers who itemize on their Minnesota return but not on their federal return.  Because of the TCJA’s most notable simplification feature – the large expansion in the federal standard deduction -- the Joint Committee on Taxation estimates that the number of households itemizing on their 2018 federal returns will decline by 61% to just 18 million – about 12% of filing households.  House Research estimates the number of Minnesota filers itemizing federally will be cut by almost two-thirds, to 13%.  Itemizing at the state level has always been significantly less valuable because the state tax rates are lower than at the federal level.  It makes little sense to have individuals who will now benefit from the higher federal standard deduction hassle with all the record keeping and documentation requirements associated with itemizing for state purposes only when the result will be a small fraction of the former total benefit.  Nor is the cause of efficient tax administration served by more forms, complication, and greater state auditing responsibilities (since Revenue cannot piggyback on any IRS audits for these taxpayers’ itemized deductions) for a dramatically decreased number of filers.

3.       Get off the federal extender rollercoaster.  Most of the TCJA’s individual income tax changes are temporary and expire for tax year 2026.  Odds heavily favor that Congress will engage in its usual practice and renew at least some subset of the provisions at the end of 2026 for short time periods.  That works for the federal government, but it creates political and budget havoc for states that have to balance their budgets.  When that date approaches, the state’s economic forecast will assume that the expiration of these provisions will generate additional income tax revenue.  When these “extender” bills are passed by the federal government, policymakers would be facing a turbocharged conformity agenda that could dramatically alter the state budget picture – all in a political context in which many will see not conforming as a tax increase.  It would be like the current provider tax debate on steroids.  The way to avoid this chaotic future is to have the state take greater control of its own tax destiny.

The tactics to achieve these outcomes are technically simple and straightforward.  First, switch to federal adjusted gross income (FAGI) from federal taxable income as the starting point for calculating state income taxes. This was a point of agreement among all parties last year, primarily to ensure state income taxation remains responsive to household size – an outcome negatively impacted by the TCJA’s elimination of personal exemptions.  (The enhanced federal child tax credit offsets this to some extent but is subject to age and family income tests).  Moving to FAGI allows the state to address this issue with its own modifications while at the same time establishing greater control and predictability over its own tax policy and avoiding the potential chaos of uncertainty over future federal action.

Second, conform as much as possible to the federal government’s increased standard deduction.  This is much more controversial and both budgetarily and politically problematic.  First, it would be expensive – according to data published by the Department of Revenue’s Research Division, the cost of fully conforming to the federal amount would be approximately $2.5 billion for the coming biennium – and would require an 80% reduction in state personal and dependent exemptions to be revenue neutral (independent of any other conformity actions).  No less problematic is the bi-partisan emphasis on attempting to protect Minnesota filers from a tax increase resulting from state conformity actions.  There appears to be a shared assumption that simply retaining all the old federal deductions in state law creates the conditions for meeting that objective.  However, income changes under TCJA provisions will complicate this calculus by affecting the phase out levels of various deductions, the taxability of Social Security benefits, etc.  In short, other moving pieces in the tax system will often undercut these well-intentioned efforts.

But increasing the state’s standard deduction to pursue these objectives is not as heavy a lift as it may seem.  Our most recent individual income tax study features 19 taxpayers who more often than not itemize deductions on their returns.  However, had the TCJA’s provisions been in effect[1], 11 of these taxpayers would have had a greater benefit from the new, higher standard deduction than from itemizing deductions.  As Table 1 shows, for purposes of these taxpayers’ Minnesota returns, their itemized deductions range from 55% to 75% of the federal amount.  These differences stem from the fact that, at the state level, state income taxes are not a deductible expense.

This suggests that the state could create a new higher standard deduction at around 60% to 70% of the federal amount and largely align itemizers for state purposes with itemizers for federal purposes.  Setting the deduction at this lower amount not only seems as though it would help meet the objectives outlined above, but would also have the added benefit of freeing up additional dollars for creating an exemption or credit for purposes of making the system responsive to issues of family size.  It’s even possible that a little money might be left over to take a second simplification swing at some of the income subtractions which have grown like creeping Charlie in the state tax code over the years.

It’s not surprising lawmakers would approach the idea of reducing targeted tax preferences very gingerly.  That’s especially true in Minnesota in light of the new federal limit on state and local tax deductibility which hits progressive income tax states like Minnesota particularly hard.  That change has made state income taxes more competitively and economically relevant and larger limitations on deductibility might add further insult to the injury on those most exposed by the SALT limitation.

But the “hold harmless” expectations are often a chimera in the first place.  And besides, there are real policy, administrative, and taxpayer benefits to be gained by not reflexively subordinating simplicity to other objectives when deciding how to conform.  It would be nice to flip the 2018 experience around.  First explore how simplicity and efficiency in state tax compliance and administration can be supported and advanced given the new federal reality.  With that goal in mind, then debate tax distribution, tax levels, tax rates, and budget considerations to determine how state conformity should fit into the broader tax bill – with the understanding that any small savings taxpayers might realize from Minnesota-only itemizing will often end up in the pockets of the tax professional who is needed to deal with this additional complexity.