What Federal Tax Reform Means for Minnesota

A look at the Minnesota impacts of the House and Senate tax reform bills and some looming policy questions for state lawmakers in 2018.  From our November-December 2017 edition of Fiscal Focus.

When Minnesota Management and Budget released its November forecast showing a deficit of $188 million for the current biennium, the “we warned you” comments from DFLers and “we need to get spending under control” statements from Republicans were not surprising.  However, unlike many past forecast releases, the rhetorical fervor was muted.  Some of that has to do with the relatively small size of the projected deficit and the fact that 2018 is not a budget year.  But everyone also recognizes the February forecast is going to change and perhaps dramatically in light of developments in Washington, DC.  Or as Senate Majority Leader Paul Gazelka said, the November forecast was “obsolete on arrival.”

The February economic forecast from earlier this year anticipated tax reform, but the state’s macroeconomic consultants removed those expectations from the November forecast – likely because months of inactivity made federal action seem doubtful.  Now that the odds favor passage of a federal tax bill, state policymakers are in “wait and see” mode with respect to how Minnesota’s macroeconomic models digest whatever Congress eventually comes up with.  But changes to the federal tax regime raise a host of potential state tax policy issues with which legislators will have to grapple.  And given the nature of the effort and its potential administrative, distributional, and revenue implications for the state, Minnesota tax policy may prove to be a bigger arena of political drama and intrigue than the state budget itself.

A Look at the Impacts on Minnesota Individual Income Taxpayers

We modeled the effects both the final House1 and Senate bills would have on federal and state income tax burdens for income tax filers at selected incomes and filing statuses.  Our modeling is based on taxpayer data that the Department of Revenue provided for our latest Multistate Individual Income Tax Comparison Study (tax year 2014).  This information allows us to model an "average taxpayer" for filer types at various incomes.  The findings from that study establish our comparative baseline, and we modeled tax returns for those filers under both the final House and Senate bills (Tables 1 and 2).

Some important caveats apply:

  • We assume federal taxable income remains the starting point for Minnesota returns and Minnesota’s only policy response is to fully conform to the new calculations of federal taxable income.
  • Since the taxpayer information we have is specific to tax year 2014, our analysis assumes that changes effective for the 2018 tax year were instead effective for 2014.  This creates slightly larger differences between the baseline standard deduction and personal exemption amounts and the new standard deduction, and therefore may slightly overstate the magnitude of tax cuts.
  • Any individual taxpayer at these income levels may have a much different tax burden than this “average” taxpayer.  The most important factors in any variations include 1) the number of dependents claimed, 2) the total amount of itemized deductions a filer claims, and 3) the use of any “above the line” deductions (i.e. income subtracted in the calculation of federal adjusted gross income) many of which would be eliminated in both the House and Senate bills.  Our analysis assumes married-joint filers have two children and head of household filers have one child.
Table 1

Change in Federal and State Income Tax Burdens Under House Plan

Table 2

Change in Federal and State Income Tax Burdens Under Senate Plan

A few observations:

Most people should see a reduction in their federal income taxes.  Statements (or implications) that these bills result in broad based tax increases on low and middle income households are incorrect – at least in the short term.  Those assertions assume that the elimination of the individual rate reductions will happen as scheduled sometime during the 2020s and taxes will rise accordingly.  In the near term, most households get an (often sizeable) federal income tax cut – a conclusion shared by the Brookings-Urban Tax Policy Center, which estimated only 7% of households would see a tax increase in 2019.

State income tax burdens would go up for most Minnesotans but would decrease for wealthier Minnesotans.  A major theme of this federal income tax reform effort is broader bases and lowered rates.  The effort would also broaden the base for Minnesota’s income tax system since more federal income –our starting point for determining Minnesota taxable income – would be exposed to tax.  However, without similar reductions in Minnesota’s tax rates, state income tax burdens would be expected to rise, all things being equal.

However the simple mathematics is complicated (as shown in Table 3) by which of the three categories a taxpayer would fall into:

  • claiming the standard deduction under current law and proposed plan
  • itemizing deductions under current law but claiming the standard deduction under the proposed plan
  • itemizing deductions under the current law and the proposed plan.
Table 3

Change in Federal and State Income Tax Burdens Under Senate Plan

For the $50,000 and $100,000 married-joint filer, (MJF) taxable income changes are identical because for state income tax purposes both are non-itemizers.  The increases in taxable income ($3,800 or $4,200, depending on the plan) result from the loss of four personal exemptions (adding $15,800 in taxable income) minus the incremental value of the higher standard deduction.

For the $150,000 and $250,000 MJF, the higher standard deductions being proposed would exceed the total itemized deductions these filers claim under the current tax regime, so we assume they switch to taking the standard deduction under both the House and Senate proposals.  However, the higher standard deduction creates less incremental value for these taxpayers than it does for our lower-income examples.  With less incremental value to offset the loss of the personal exemptions, the result is a larger increase in taxable income.

For the $500,000 and $1 million MFJ, Minnesota taxable income declines for two reasons:

  • for the Senate plan only, 23% of pass-through business income (which both of these taxpayers have) is exempted when calculating taxable income
  • for both the Senate and House plans, the interaction between the federal changes and the state’s existing limitation on itemized deductions and personal exemptions (which we assume the state leaves in place) actually exempts more income from state taxes. 

The second bullet point above illustrates one of the many consequences this reform effort would have that may not be immediately apparent.  Under current state law, high income earners must phase out the value of their personal exemptions and itemized deductions similar to the Pease limitations at the federal level.  However, the limitations cannot reduce total itemized deductions below the amount of the standard deduction.  The increase in the standard deduction under both House and Senate proposals effectively raises the “floor” for these limitations – as best seen in the married-joint filer with $1 million, where the $12,000 decline in Minnesota taxable income under the House plan is exactly equal to the total increase in the standard deduction.

Family/Household Size Matters.  As Table 3 shows, taxable income declines for our single and head of household examples by around $900 to $1,300, illustrating how household size/filing type influence whether one wins or loses under this reform.  The higher standard deduction (roughly $9,000) for the head of household filer with one dependent outweighs the effect of losing two personal exemptions worth $7,900.  Similarly, the single filer loses a personal exemption worth $3,950 but more than makes up for it with the higher standard deduction.  The opposite effect occurs in larger families as the loss of personal exemptions more than offsets the larger standard deduction.  For example, all else equal, we calculate that doubling the number of school age kids from two to four for the $150,000 MFJ filer boosts the projected state income tax increase under the House plan by 125% (to $1,004).

Overall, House and Senate bill impacts are fairly comparable with one major exception pertaining to wealthy filers.  The most notable difference between House and Senate versions occurs in taxable income /state tax relief at the $500,000 and $1 million filer profiles.  That is a consequence of differing approaches to the treatment of pass-through income.  The House plan provides tax relief to filers with pass-through income by capping the tax rates that apply to it – but provides that all such earnings be fully accounted for in federal taxable income.  The more generous Senate plan, however, provides relief by exempting 23% of such income from taxation.  This difference has implications for state income taxes, since any exemption has the potential to flow through to Minnesota taxable income calculations, while the House’s plan to deliver relief through a rate cap limits the impact strictly to federal taxes.

Looming Policy Questions for Lawmakers

Corporate income tax reform will also offer much for state lawmakers to think about.  An arguably larger issue for lawmakers than any budget consequences would be the challenging administrative and compliance issues arising out of a major overhaul of corporate taxation – all compounded by a proposed January 1, 2018 implementation date.  From reports we have read, the “need for speed” has created a disaster zone of unsettled and ambiguous implementation, compliance, and administrative matters featuring unanticipated consequences and costs leading one former U.S. Senate Chief Tax Counsel to declare the January 1 implementation date “insane.”

Put it all together and if Congress enacts a tax reform package, Minnesota’s House and Senate tax committees have some big discussions awaiting them and some big decisions to make.  They include the following:

How should Minnesota think about and approach federal conformity?  Minnesota has historically addressed federal conformity matters expeditiously and in a bipartisan manner.  But federal conformity decisions serve three masters – the state budget, efficient tax administration and compliance, and the politics of tax burden distribution.  The scope and scale of this particular reform effort will create many more tensions and trade-offs than usual.

For example, since 1987 Minnesota has been one of a handful of states that uses federal taxable income as a starting point for individual tax returns, which simplifies Minnesota tax filing.  However, with the elimination of personal exemptions and eventual phase out of supplemental credits, federal tax burdens would become relatively unresponsive to household size.  Given this and Minnesotans’ sensitivity to fairness concerns, the state may look to return to federal adjusted gross income basis as a starting point and create its own set of personal exemptions and deductions.

Minnesota will not be able to conform to every federal provision from a budget standpoint and will probably not want to conform to every federal provision from a policy standpoint.  And given all the uncertainty surrounding the ultimate implementation and execution of this tax bill, “how” to conform is also up in the air.  As former House tax chair Ann Lenczewski noted in a recent panel discussion before the MCFE board, the state would be well advised to form one of its infamous “blue ribbon task forces” to help the state navigate this critically important issue.

How should the state use any additional tax revenues that materialize?  It’s not clear how state revenue collections from individual and corporate tax reform would shake out in the end, if for no other reason than state responses to federal reform will influence that outcome.  However, there is reason to believe – at least in the near term – that features like corporate base broadening and deemed repatriation could result in some sort of a “windfall” for state coffers.  There appear to be three general options:

  • Treat any revenue enhancements as a one-time gain and spend it accordingly.  Once upon a time repatriation of foreign earnings was seen as a potential pool of federal infrastructure funds.  Minnesota might consider that playbook and use any supplemental revenues from reform to put a dent in the state’s transportation and water infrastructure needs.
  • Pursue concurrent state level tax reform.  Lowering federal rates will make Minnesota’s high individual and corporate rates much more economically and competitively relevant.  Revenues might be used to simply buy down state rates or – taking a chapter from ghosts of Minnesota tax reform past – used to buy off “losers” in a more comprehensive tax reform effort.
  • Bank it for the likely shift of federal spending responsibilities coming to state government.  Paying for these tax cuts has to come from somewhere.  From all indications, “somewhere” will include federal funds to the states.

Will state government pursue its own version of “tax planning?”  One of the major concerns expressed about this pending legislation is that it could offer significant opportunities for tax planning and “work arounds” by businesses and individuals to minimize tax liability.  But as over a dozen tax scholars note in a paper entitled, “The Games They Will Play: Tax Games, Roadblocks, and Glitches Under the New Legislation,” taxpayers aren’t the only ones being afforded tax planning opportunities.  State governments have their own ways to get around new limitations for state and local tax deductions and largely undo the policy intent of Congress of raising revenue from the elimination of SALT deductibility.  Here are three possible strategies that have been suggested:

  • Impose taxes on pass through entities and credit those taxes on individual tax returns.  Under this strategy (only possible in the House version) something like a new “unincorporated business income tax” could be imposed “above the line” (i.e. before arriving at adjusted gross income) and deducted.  To hold the individual largely harmless, a credit could be given at the individual level for taxes paid at the business level.
  • Make charitable contributions to state and local governments and have the state provide a 100 percent credit for gifts made to the state and local government against individual taxes owed.  
  • Restructure state income taxes as employer-paid payroll taxes with the result being very similar to preserving the individual level deduction to begin with.2 To the degree states want to preserve progressivity in their income tax systems, they could offer refundable credits at the individual level to filers, targeting the progressivity of the combined system to the degree they desire.

As these experts point out, states in a relatively straightforward manner could entirely negate the effect of the House or Senate proposal with respect to state and local income taxes paid on wage income.  It will be interesting to see if state governments pursue strategies that preserve and maximize their self interest just like their taxpayers do.

Given all the uncertainty about federal tax and spending decisions over the next few months, the bipartisan disregard for the November forecast is understandable – and probably warranted.  But with a short legislative session looming, legislators are faced with the prospect that much of our current income and corporate tax regime may soon be as “obsolete” as that November forecast.


Footnotes

[1] Our House modeling updates a previous analysis by incorporating additional detail and features included in the final bill.

[2] An example of how this would work comes from the University of Chicago’s Daniel Hemel in “The Repeal of SALT Deduction for Income Taxes May Not Raise a Cent”  Medium.com November 9, 2017

“Illinois now imposes a flat income tax of 4.95%. Of the next $100 I earn in wages, $4.95 will go to the state and $95.05 will go to me (before federal taxes). Now imagine if instead the state imposed a 5.208% payroll tax on employers. My employer would pay me $95.05 and then pay 5.208% x $95.05 = $4.95 to the state. The employer would still have a $100 federal income tax deduction: $95.05 in wages + $4.95 in state payroll taxes. (It’s a little funny to make this a first-person example because my employer, the University of Chicago, is tax-exempt.) My federal taxable income would be $95.05, the same as if I could claim the SALT deduction. Everyone is just as happy as before — except that partial repeal of SALT has raised zero for the federal government. Actually, it’s raised less than zero — for two reasons: First, state income taxes currently aren’t deductible for Social Security and Medicare tax purposes, so if Illinois shifts to an employer-side payroll tax, the federal government would collect slightly less in Social Security and Medicare taxes from employees in Illinois. Second, the deduction for state income taxes currently isn’t available to folks who claim the standard deduction, but those taxpayers would benefit from my proposed workaround too.”