Reaping the Whirlwind of a Misguided Tax Debate

Back in February, the first two House Tax Committee hearings of the 2018 session focused, unsurprisingly, on the federal tax reform enacted in December.  A familiar lineup of Department of Revenue, House Research, and House Fiscal staff provided an overview of the TCJA provisions and insights into their implications for state taxes.  This testimony was delivered in the trademark restrained, reserved, “just the facts, ma’am” manner of agency and professional staff.  Nevertheless, observers didn’t have to work hard to grasp the unspoken message delivered between the lines – failing to adopt some type of federal conformity plan in 2018 would be a huge problem, if not nightmare, for both the Department and taxpayers.

Four months and a vetoed tax bill later those fears have come to fruition, and a tax filing season promising considerable aggravation looms in Minnesota’s future.  How we arrived at this point and the implications going forward is the cherry on top of the sundae of dysfunctional government Minnesota has experienced for some time now.

“You Had One Job”

Absent the TCJA, the 2018 legislative session held the promise of an undramatic but productive affair.  With a budget surplus of “only” $329 million, major tax relief and large new spending ambitions would automatically be held in check.  At the same time, that sum seemed perfectly suited to throw one-time resources at bipartisan concerns demanding immediate attention prior to the next two-year budget cycle – like school safety, opioid abuse, transportation, and senior care.

In theory, this session outlook didn’t need to change with the passage of the TCJA except for one thing: a conformity bill now was absolutely necessary.  To ensure that happened, policymakers could have segregated federal conformity from the supplemental budget / surplus debate and systematically analyzed the federal changes using standard tax policy and budgeting principles within a revenue neutral framework.  They then could have decided whether to conform to each change on a case-by-case basis, and when necessary just how to deviate to mitigate potentially large tax increases and serve tax fairness.  Ideally a “clean” conformity bill would have been assembled cooperatively, perhaps even with the assistance of a fast-tracked blue-ribbon commission or working group which the state is famous for putting together.  As last year’s blue-ribbon pension commission proved, the political cover these outsider dives into contentious topics offer is often far more valuable than the recommendations themselves.

This scenario was blown to smithereens with the announcement of the governor’s tax proposal about a month into session.  The proposal appeared to be driven by three political objectives: 1) ensure that nothing could be interpreted as validating the federal tax reform effort or its motives; 2) correct for the perceived distributional sins of federal reform at the state level; and 3) box the Republican-controlled legislative bodies in using their own tax agenda.  This was accomplished by what might be viewed as an “anti-conformity” agenda:  preserve nearly every single deduction and exclusion under prior federal law within the state tax code to protect the status quo.  Tacking on a quarter-billion of tax relief to low- and middle-income families – all paid for by conformity-related revenue raisers – immediately transformed how conformity would be discussed.

Republicans immediately found themselves in a dilemma.  They could pursue a conformity response focused on revenue system integrity and the objective of simpler and efficient tax administration.  But that could cause some filers, based on their particular set of circumstances, to pay more versus the status quo, with the inevitable campaign literature to follow.  Or they could also make protecting as many taxpayers as possible from any state tax increases priority one, grant additional relief where they could, and focus the political debate on who did all this better.

Not surprisingly the latter was chosen and federal conformity quickly became a supporting actor in a much larger and complex tax relief and budget drama in which major new characters, like $138 million in emergency education aid, were introduced in the final act.

Ironically, it was in the one thing “they had to do” that featured some of the strongest areas of agreement between the governor and the legislature.  With one big notable exception, both sides reached general consensus on how to structure Minnesota’s individual and corporate tax bases in a post-TCJA world.  That included adopting an adjusted gross income starting point, preserving pre-TCJA itemized deductions and personal exemptions as Minnesota provisions, choosing not to conform to the TCJA’s controversial 20% pass through exclusion, but conforming to the majority of the other TCJA business provisions.  This conformity approach could be considered suboptimal in that policymakers passed on the change to significantly simplify and rationalize the state’s individual income tax system (for example, using an enhanced state standard deduction to eliminate state only itemized deductions which are now considerably more trivial economically).  But it was consensus and in the current political environment, that currency alone is worth a lot.

The notable exception concerned foreign earnings.  The governor proposed fully conforming to new foreign income provisions which translated into $400 million in FY 20-21 from both the corporate franchise tax and individual income taxation related to pass throughs.  The legislature settled on less than one-fifth of that total by choosing to conform only to one-time deemed repatriation income on a net basis.  Not only are there significant unsettled constitutional and legal questions surrounding the ability of states to tax foreign earnings, there are also questions about the accuracy of federal estimates on which state revenue estimates are based.  Strangely, for being such a critical fiscal foundation for the governor’s plan, there was remarkably little – if any¹ – public testimony in the tax committees of these issues, the fiscal risks accompanying a reliance on them, or their administrative implications and costs.

The uncertainty (or perhaps conversely as a result of some due diligence done internally by the Department on these matters) may have influenced the Governor’s final compromise offer to strip out the GILTI and FDII foreign income provisions.  That plus some additional concessions put an additional dent in the difference between each side’s conformity elements.  But the revenue and distributional consequences, rather than administrative and tax filing considerations, were the engine pulling the conformity train.  According to an analysis by House Research of the revenue effects on the last year of the forecast window (FY 21) the two sides were about $220 million apart.  Removing temporary provisions (one-time base expansions and those set to expire) the gap declines to about $145 million.  No less importantly, the governor was insistent that individual income tax relief accrue to lower income households while the GOP majorities insisted that relief be directed somewhat more in proportion to total income tax burdens.  As a result, it was a conformity train trying to head down two tracks at once resulting in derailment.

In his press conference following the tax bill veto, the governor acknowledged its implications for the functionality of the tax system stating that failing to conform was clearly not ideal and should have been avoided.  However, in response to the Department of Revenue’s assurances that the agency is prepared to handle the fallout, the governor stated “the sky is not falling” with respect to state tax administration and has expressly stated he will not call a special session to deal with the issue.

Despite these assurances, no one should underestimate the challenge this presents to the Department.  If federal tax conformity wasn’t that big of a deal, the Department wouldn’t have sought a $4 million appropriation over the next two years (also a casualty of the veto) to implement it.  Now the Department faces the prospect of managing non-conformity, an almost assuredly more expensive proposition, with no additional resources.  For that reason, some have speculated that despite the governor’s conviction, a late year special session dealing with conformity may ultimately be necessary.  The problem with that idea is that it would entail a completely unworkable compressed timeline for managing the conformity given the realities of what goes into updating tax filing systems.  For practical as well as political reasons, the conformity door has closed for tax filing in 2019, and filers of all types must brace for the repercussions.

Will the Tax Increases Really Materialize?

One repercussion on everyone’s mind is the prospect for higher state income taxes.  According to the governor’s supplemental budget documentation, “Budget for a Better Minnesota,” presented early this session, if the legislature did nothing to respond to the TCJA individual state income taxes “will increase $59 million for over 300,000 Minnesota families, costing an average of $200 per year.”

To try to obtain more detail and a better understanding of the nature and distribution of tax burden impacts, we modeled the impact of non-conformity again using our household profiles from our Multistate Individual Income Tax Comparison Study.  As a reminder, these profiles let us model federal and state income taxes on an "average Minnesota taxpayer" for different filer types at various incomes.  The usual caveats apply:

• The taxpayer information we have is specific to tax year 2014.  Our analysis assumes that taxpayer attributes at various combinations of incomes and filing statuses have not changed dramatically over the interval between 2014 and 2017/2018, and therefore we modeled “2017 actual” taxes and “2018 projected” using this 2014-specific taxpayer information.
• Any particular taxpayer at these income levels can have a very different tax burden than the “average” taxpayer we model.  The most important factors in any variations include 1) the number of dependents claimed, 2) whether the filer itemizes deductions or claims the standard deduction, 3) the total amount of itemized deductions a filer claims if itemizing, and 4) the use of any “above the line” deductions (i.e. income subtracted in the calculation of federal adjusted gross income.
• Our modeling assumes the most common scenarios for dependents; that married-joint filers have two children and head of household filers have one child.

The accompanying table presents our comparison of 2017 actual versus projected 2018 under non-conformity for several household types – including many of primary concern to the governor.  As the results show, in most cases burdens decline –  primarily because tax brackets, maximum credits, and other inflation-adjusted features of the tax system are assumed to increase by 2%.  Absent these minor year on year structural adjustments, taxes would remain the same for filers whose income does not change for a very understandable reason – Minnesota’s tax code remains unchanged between 2017 and 2018.

So where does the governor’s supplemental budget estimate of $59 million in higher state income taxes on 300,000 filers come from?  That is a function of the increase in the federal standard deduction, Minnesota’s continuing use of pre-TCJA federal tax law, and state law governing election of standard or itemized deductions.  Under the TCJA, many filers who have itemized in the past will find it in their economic interest to take the more generous federal standard deduction in 2018.  For a subset of these filers – those whose potential itemized deduction amounts are higher than the previous standard deduction but lower than the new standard deduction – this filing election lowers their federal tax burden but penalizes them at the state level, since the state standard deduction (calculated under pre-TCJA law) is less than what they could claim if they itemized.  Most of the tax increases from non-conformity are due to this election issue, since the state does not permit individual filers to claim the standard deduction at the federal level and itemize for state purposes or vice versa.  It’s difficult to identify exactly which taxpayers will be hit the hardest by this issue, but our best estimate is that they will fall in the $90k-$160k income range for married-joint filers and the $70k-$100k income range for other filers.

But the story may not end there.  State law governing the itemized/standard deduction election is not crystal clear,² and taxpayers’ inability to make different elections for state and federal purposes results from the Department of Revenue’s interpretation of those statutes.  However, many tax attorneys believe the Department’s interpretation is incorrect and would not stand up to a court challenge.  If the agency alters its position and chooses to allow differential filing elections next year, little, if any, of the tax increase from non-conformity would materialize.  At a recent meeting of the Minnesota Chamber of Commerce fiscal policy committee, Department officials said “[they] are looking into this.”³  Given the demographic profile of those likely to pay more, contemplating the potential interaction of Revenue’s decision with the potential political ramifications is irresistible.

Remaining Questions

Even though the end of session brings closure to the conformity debate for 2018, some questions remain:

Will there be any political fallout from this?  If so, who gets it and what will it look like?

One of the reasons why policy makers focused so intently on providing income tax relief, or at a minimum holding as many taxpayers as harmless as possible, is that any incidental conformity-related tax increases on any subset of filers – regardless of size – would likely become a campaign issue.  During the tax debate it seemed for every article highlighting the implications for tax administration and filing costs, another five heightened citizens’ sensitivity to potential tax changes.

Administrative issues may get their moment in the sun during the 2019 tax filing season as the hassle, cost, effort, and confusion relating to our failure to conform becomes much more tangible.  Then again, it’s likely the business community, rather than individual filers, who will feel the most detrimental effects of non-conformity, and the number of “voting businesses” (a.k.a. persons owning “pass-throughs”) as a percentage of the voting population is small.  And given that the next election takes place before the 2019 filing season opens, it’s doubtful there will be any repercussions for most candidates this year.  Whether any fallout impacts the 2020 races will likely depend in large part on whether and how the state manages to conform between now and then.

What kind of collateral damage will be inflicted on the Department of Revenue?

In the aftermath of the veto Commissioner Bauerly offered encouraging words that the agency and its staff are committed to ensuring all the information, education, and services needed to help taxpayers meet their obligations next year will be available.  But as highlighted earlier, non-conformity represents an unprecedented challenge for the Department.  Resources will be stretched to the limit, stress levels will rise, and come 2019 the agency’s reputation will be in the spotlight.

Revenue faces the dual challenge of ongoing retirements of very experienced professionals while attracting and retaining younger talent.  The stress of preparing for the next tax season during 2018 will likely be exceeded by the stress of dealing with a lot of confused and frustrated taxpayers during 2019.  It’s not questioning the dedication of Revenue’s staff to wonder whether non-conformity and its fallout will take a special toll on the agency over the next year.  It’s also fair to wonder just who would be willing to take on the agency’s leadership responsibilities with the change in administrations and dive headfirst into this context.

How, if at all, will the 2019 debate be any different?

The one thing we can be certain of is that the 2019 debate on tax conformity will feature at least one different player with the retirement of Governor Dayton.  Given what happens in the 2018 elections, the players on behalf of the state House could change, and in the (somewhat unlikely) circumstance that the DFL picks up Sen. Michelle Fischbach’s vacant seat, the Senate players could change as well.  Given the acrimony on tax issues over the last four years – when only one tax bill was signed into law, under protest – the atmosphere at the capitol is almost certain to improve.

In the event of one-party control of the legislature and governor’s mansion, 2019 will probably feature a spirited debate on conformity that results in the issue being wrapped into a low-drama omnibus tax bill, with conformity-related revenues raised and spent on ideological grounds.  The more likely scenario, though, is continued divided government.  In that case, legislators and the new governor will need to decide quickly whether they want to treat conformity separately from other tax and spending issues, or whether they want to continue to weaponize the issue.  If the former prevails, expect the tone and substance of the debate to change.  If the latter prevails, the productivity of the debate will depend largely on how well the parties can work together.

That last point is an important one.  What’s most disturbing about this year’s tax conformity failure isn’t the challenging filing season that individual and business filers are about to experience.  Rather, it’s that this is only one of many examples of dysfunctional governance in Minnesota.  For whatever reason, the arts of negotiation and compromise don’t seem to be practiced as effectively as they used to.  2019 offers the opportunity for a fresh policymaking start – and the conformity debate will be an important signal for whether those arts have been rediscovered or not.