Minnesota, It's Your Turn Now

Passage of the Tax Cuts and Jobs Act (TCJA) in December accomplished many things besides restructuring federal taxation.  It proved that politicians’ outrage over abuses of the legislative process have the half-life of carbon-10 once they gain majority status.¹  It breathed new life into the debate about the federal debt.  And it moved the phrase “federal conformity” from the insular world of tax wonks onto the front pages of newspapers around the country.

Minnesota is certainly not alone in having to chart a response in 2018.  But for both substantive and political reasons, the state faces one of the more complex tax policy development challenges to be found anywhere in the nation.  We take a closer look at three high profile topics pertaining to individual income taxation that will be central to the debate about Minnesota’s response over the coming months.

Just How Big an Issue is SALT Deductibility for Minnesota?

The three big individual itemized deductions targeted as potential “pay-fors” of federal reform were charitable contributions, mortgage interest payments, and state/local tax payments, or “SALT”.  The first two, as one tax expert colorfully stated, “are protected by an impenetrable brick wall of raw political power and moral rectitude.”²  That left SALT – more politically vulnerable in part because its benefits are disproportionately skewed toward so-called “blue states” with higher state and local taxes – like Minnesota.

According to the latest IRS Statistics of Income data, a little over one in three income tax filers (about 950,000 Minnesota households) claimed the deduction for state and local taxes on their 2015 federal tax returns, with an average deduction of $12,954.  The provision is relatively important to Minnesotans – in 2015 the total SALT deduction was equal to 6.3% of total adjusted gross income, 10^th highest in the nation.  Yet filers in other states have been much bigger beneficiaries of this policy.  For some perspective, in 2015 the average claimant’s SALT deduction in California, Connecticut, and New York was 42%, 52%, and 71% higher than Minnesota’s respectively.  It’s not surprising that some of the biggest pushback from congressional Republicans on early versions of the reform came from these states.

Preliminary modeling done by the Tax Policy Center and others on the elimination of SALT deductibility – in isolation – projected sizeable tax increases for a lot of Minnesota households.  But the final TCJA had many moving parts including a significant increase in the standard deduction, which reduces the number of filers choosing to itemize their deductions.  That alone renders the SALT issue moot for what is likely to be a substantial number of “former itemizers”.  The new federal rate structure further offsets potential tax increases, and the final negotiated $10,000 cap on SALT deductibility takes some of the sting for any households that will continue to itemize.  And for households with children, the increase in the child tax credit ($400 refundable; $1,000 nonrefundable) also helped address any increases in tax burdens.

Put it all together, and it explains why our earlier modeling concluded an “average Minnesota filer” across all filing types and income levels was likely to see some level of federal income tax relief.³  Some households will undoubtedly experience higher 2018 burdens but it’s difficult to envision a critical mass of taxpayers heading to voting booths armed with torches and pitchforks because of the new limitations on their state and local tax deductions.  Indeed, as taxpayers check their 2018 paycheck stubs, popularity for the tax bill has grown.⁴

The primary impacts of the SALT deduction changes are longer term in nature affecting state and local government finance and state competitiveness.  Simply put the TCJA generally – and the SALT limitations specifically – accentuates state income tax and effective tax rate differentials.

To illustrate, consider the accompanying table comparing total federal and state individual income tax burdens for a Minnesota filer with those for a similar filer in four states without an income tax.  We chose to model a high income married joint filer to capture “senior executive talent” – the type of taxpayer (and payrolls) Minnesota would obviously like to see more of.

The left-most set of numbers (actual) reflects the status quo and shows that total individual income tax collections (federal and state) are $12,000 - $13,000 higher in Minnesota than in states without an income tax.  The middle set of numbers assumes Minnesota fully conforms to the TCJA with no changes in rates or brackets to offset the higher income base.  The total income tax burden for this Minnesota filer declines, but savings at the federal level are offset by higher state taxes.  The net impact is $4,000 of tax relief compared to $6,000 in the rest of the states with no state income tax offset.  As a result, Minnesota’s comparative income tax disadvantage increases by about one-third (12 to 13 percentage points).

The right-most numbers now assume that Minnesota lawmakers are able to hold this filer completely harmless from any state income tax increase as a result of the TCJA.  As the results show, that hold harmless provision only slightly mitigates the growth in Minnesota’s comparative disadvantage.  That’s because the larger TCJA-related federal tax savings – which affects all filers across the country – makes the existence of Minnesota’s current state income tax more economically relevant.

Of course, comparisons to states with no income taxes represent an extreme; relative impacts compared to states with an individual income tax would be more muted.  And to what extent an approximately $1,200 increase in Minnesota’s already existing “comparative disadvantage” would have real world consequences with respect to residency and job-siting decisions is debatable – especially in an overall net income tax cut environment.  But this example illustrates why state income tax policy responses to the TCJA do entail risk.

It’s a risk that seems to be recognized by the Dayton administration.  Its criticism of SALT limitations was couched as concern over the welfare of Minnesota taxpayers.  However, it almost assuredly reflected the recognition that the tax prices of Minnesota government really do matter and that the biggest impact of the reduction of federal subsidies via SALT limitations will be to make these tax prices become much more noticeable among high earners, the state’s recent “go to” source for revenue.  It will be interesting to see if tax influenced residence decisions, migration, and competitiveness concerns gain more attention this year or if confidence in the superior value proposition Minnesota’s public goods and services offer remains as unshakable as ever.

To FAGI or Not to FAGI?

One of the immediate issues facing lawmakers this year concerns the starting point for determining Minnesota taxable income.  When Minnesota adopted federal taxable income (FTI) as its starting point 30 years ago it did so out of ease of compliance for taxpayers and tax administrators.  Today, because of the TCJA’s overhaul of the standard deduction, itemized deductions, and exemptions, the merits of continuing to use FTI deserve to be called into question.

The chief advantage of retaining FTI as the starting point for determining Minnesota taxable income continues to be the administrative and compliance benefits it offers.  The primary concern with the changes – that FTI no longer provides any sensitivity to family size – does not automatically disqualify its continued use.  Minnesota could address the issue by creating its own dependent exemption, deduction, or credit.  However, the revenues raised from federal base expansions are insufficient to offset the state’s cost of conforming to the higher standard deduction and replacing the dependent exemptions making revenue neutral conformity impossible without tapping business tax base expansions as a source of revenue.  Plus, family size adjustment is just one of several tweaks to FTI lawmakers may deem important in responding to federal reform.  At some point it simply makes more sense to build the house you want to live in than go through the trouble and hassle of retrofitting an existing one to fit your needs.

The most common alternative starting point is federal adjusted gross income (FAGI), which is used by 31 of the 41 states (including the District of Columbia) with a broad-based income tax.  The primary benefit of returning to FAGI as a starting point is that it would enable Minnesota to develop its own desired package of standard deductions, itemized deductions and family size adjustments.  Tax experts, however, have identified several other good tax policy reasons why a transition back to FAGI has considerable merit:

• A state standard deduction offers the opportunity to rationalize or eliminate income subtractions in the state tax code which have proliferated in past Minnesota legislative sessions.
• It offers an avenue for rationalizing charitable contribution rules, which currently provide different incentives based on the income tax brackets taxpayers find themselves in.  Replacing itemized deductions and the non-itemizer subtraction with a well designed credit would advance the cause of tax fairness.
• Adopting a Minnesota-specific standard deduction and itemized deduction rules would avoid future budget balancing turmoil resulting from the expiration of the federal changes at the end of 2025.  Since MMB forecasts are based on current law, it will have to build that expiration into its revenue projections.  Having our own permanent standard and itemized deduction rules would eliminate the uncertainty surrounding this future expiration and the headaches accompanying the nature and timing of federal extender bills which will almost certainly be a distinguishing feature of the 2026 tax system.

The primary disadvantage of this change is that it would require the state to develop an agreed-upon package of standard deductions, itemized deductions and family size adjustments in a short session, in an election year, in an environment where bad blood and distrust have been defining features of the policymaking landscape.  Under normal circumstances delivering on this agenda would be a challenging task; under current legislative dynamics it appears herculean.

The 20% Pass Through Deduction

In a sea of base expansions, the TCJA’s 20% deduction for owners of certain pass through businesses stands out as a major contraction of the income tax base.  Aside from being one of the strangest forms of industrial policy favoritism the federal government has ever cooked up, the state price tag for full conformity (preliminarily estimated at about $1 billion over four years) makes it difficult to adopt these provisions and pursue income tax rate reductions in response to tax base expansions.  Then there are the considerable administrative issues and incentives surrounding its implementation.  Or as Deputy Assistant Treasury Secretary Dana Trier bluntly commented at a recent meeting of the American Bar Association “this is going to be a feast for tax planning.”

For these and many other reasons the provision scores poorly on the general principles of good tax policy.  But could conforming to this tax provision make Minnesota a more attractive location for business investment or increased business activity?  If the state is going to violate core tax principles of neutrality and equity, we should at least do it intelligently in a way that yields economic returns.  A new publication from Minnesota House Research (Evaluating How to Cut Business Taxes) provides a framework for us to judge how well or poorly this provision would accomplish this task (see accompanying table).

The fundamental problem behind this idea is that it’s practically impossible to meaningfully distinguish between wage income and business income.  As author and tax scholar Daniel Shaviro notes, “Business income IS wage income insofar as it reflects the labor of the business owner.  Anything else that we want the owner to do, such as reinvesting or whatever, can be addressed via rules aimed at that particular activity.”⁵  That would include conforming to the federal treatment of capital investment expensing, which would be a much better use of any dollars made available for reducing business tax burdens since such investments are linked to the long-term economic interests of the state.

Inaction is not an option

These three issues are a sample of the topics the tax committees will be discussing this year.  Our accompanying article in this issue highlights the extraordinary fiscal and legal complexity associated with how to respond to the TCJA’s changes to the corporate income tax regime.  If one contextual issue is working in our favor, it is that our decisions will likely not be made under the overhang of a budget deficit.  That’s a luxury not afforded to about half the states.

As the 2018 session approaches, there is really only one option that should be completely off the table – doing nothing.  The administrative implications for taxpayers and the state of continuing to operate off the old tax code are too great to ignore.  Even though the current political environment is ripe for having discussions about how to respond to the TCJA infected with all manner of partisan politics, it’s imperative that lawmakers find a path forward.