The Enormity of Conformity

When the federal Tax Cuts and Jobs Act (TCJA) was signed into law last December, MCFE and others called it a “once in a generation” opportunity for state tax policy.  That description reflects an objective assessment of the reality of the situation, rather than a subjective evaluation of the TCJA’s merits.  Whatever one thinks of the wisdom of the federal reform, major federal tax changes create a rare and unique window of opportunity for states to critically reexamine their revenue systems and pursue reforms to improve their design, function, and performance.

It’s a challenge substantively, procedurally, and politically – especially in this year’s shortened legislative session.  As of this writing two of the three players have offered their tax proposals which include their federal conformity plans.  With just a few weeks to go in the 2018 session we take a look at where we stand and how well we are taking advantage of the opportunities being presented.

Rhetoric Flipped on its Head

The politics of this year’s tax bill have been influenced by the squabbles of tax debates past.  For years Republicans interested in lowering state tax burdens and reducing the growth of government have been bedeviled by two influential forces: the forecast for state spending and revenues based on current law and findings from the Department of Revenue’s Tax Incidence Study.  Each frames state tax and spending debates in a powerful way that make both of those objectives more challenging to accomplish.

The former, the foundation of the state economic forecast, answers the question, “what will the fiscal situation look like if we don’t change anything” and therefore captures spending increases due to projected demographics, caseload increases, and some inflationary pressures (despite erroneous suggestions that the forecast ignores inflation).  As a result, current law establishes a much higher baseline for evaluating the growth of state government and creates the situation where significant biennial spending increases can be portrayed as spending cuts.  The latter is the official word on the fairness of Minnesota’s tax system – the sine qua non of state tax policy.   Due to the incidence of Minnesota business taxation, the incidence study has remained a Sisyphean rock of reported tax regressivity even though policymakers have created the most progressive individual income tax system in the nation.

Republican lawmakers have been bludgeoned by this issue framing for a very long time.  So in this most unusual year for tax policy, the planets realigned.  Republicans found themselves suddenly able to use both the future effects of current law and a tax incidence analysis to their own rhetorical advantage for a change, which they did with considerable aggressiveness and relish.

House Republicans were more than pleased to point out that according to the Department of Revenue’s own calculations, relative to the projections in the most recent Incidence Study for 2019 (which are based on current law) the governor’s tax proposals would increase the regressivity of Minnesota’s tax system due to the proposed elimination of the provider tax sunset.  In response, the administration argued that considering the effect of reimposing an existing tax is an “academic” way to think about the issue.  Besides, as DFL committee members pointed out, the regressivity of the provider tax itself is offset by the progressivity of the spending it finances – health services for people at lower income levels.  The idea that systematic thinking about tax progressivity should also account for spending and transfers is a valid and important point.  Curiously, however, this habitually overlooked point never seems to get acknowledged when the release of the Incidence Study elicits debates on tax fairness.

The governor’s response to this representation of his proposal was unsurprisingly and unsparingly harsh – even requiring the help of the 7 second delay on a radio interview.  Once again collegiality between the governor and legislators in developing a tax bill appears to be in short supply.  Regardless, one person’s “excrement” will always be someone else’s political spin, and both sides have proven to be quite adept at that.  What ultimately matters is the substance and the implications of the proposals themselves and the prospects for reconciliation.

The Common Ground – Important (But Expensive) Administrative Conformity

Doing nothing this session on the tax front has been properly recognized as a “non-option” because of the resulting administrative complexities and burdens that would create for both taxpayers and tax administrators.  For individual filers non-conformity would be a hassle, but the really problematic provisions are on the business side – especially any non-conformity with federal depreciation/cost recovery (Section 179 expensing) and accounting rules.  A return to full federal conformity to Section 179 expensing is long overdue, especially when conforming to new federal limits on interest deduction.  Conformity to the TCJA’s expansion of the use of cash-based accounting methods for small businesses is a practical must.

Passing a conformity bill that resolves those issues is a high priority and Governor Dayton and the House have found common ground by including them in their respective proposals.  The problem is the near term price tag.  Together these two administrative provisions represent a $187 million reduction in general fund revenues for the current biennium, or nearly half of the $387 million that “auto conformity” to the TCJA and other federal provisions would raise.  Like the proverbial pig in the python, the revenue impacts would level out over time (the combined total declines to $155 million for the FY 20-21 biennium) but it nevertheless throws a budgetary monkey wrench into everyone’s wishes and expectations.  Essentially lawmakers would have only $200 million “available” from auto conformity plus the $329 million surplus from the February forecast to accomplish other tax and supplementary budget objectives.  That list includes:

• Reducing taxes / tax rates
• Holding as many taxpayers as harmless as possible through conformity actions
• “Balancing” the distributional benefits of the TCJA at the state level
• Increasing spending on a variety of public goods and services

That’s a lot of conflicting ambitions chasing very little money, and the clashes among these priorities remain the source of tension heading into the final days of the 2018 session.

Contrasts in Substance and Purpose

If this brief foray into the state corporate income tax implications of the TCJA has accomplished nothing else, we hope that it has proven beyond a reasonable doubt the truth of our introductory observations: that, “the complexity of the changes embodied in the TCJA raise many technical and challenging issues at the state level, particularly with respect to foreign source income”; that our discussion “may best be viewed as a preliminary effort to identify the issues along with an exploration of some of the controversies they may spawn” ; and that readers should “stay tuned for further developments in this domain.”

                                                “State Corporate Income Tax Consequences of Federal Tax Reform” Special Report, State Tax Notes, April 16, 2018

This is the conclusion of Walter Hellerstein – Distinguished Research Professor Emeritus, winner of the National Tax Association’s Holland Medal for outstanding lifetime contributions to the study and practice of public finance, and a legend in the study and practice of state tax law – in an 18-page, 128 footnote “overview” of the many legal issues, constitutional questions, and looming controversies embedded in state conformity actions with respect to the federal corporate income tax changes.  (Any readers of this special report like us, who are not tax attorneys or tax practitioners, may have come to the conclusion we did: the Minnesota State Board of Investment should immediately figure out a way to establish large private equity stakes in tax law and accounting firms to prop up struggling state pension funds.)

The overarching message is clear: there is extraordinary complexity and uncertainty surrounding the TCJA’s implications on state corporate income tax systems and collections, and banking on these revenues is a fiscally questionable exercise – especially with respect to the TCJA’s international provisions.  Yet this is the foundation on which Governor Dayton’s tax conformity plan resides.

The governor seeks to hold most, if not all, individual income tax filers harmless from federal conformity actions, while at the same time revamping state tax policy to provide additional benefits specifically to taxpayers deemed underserved by the TCJA.  This includes a new personal and dependent credit exemption (about $233 million/year) on top of preserving the old federal personal exemptions and enhancement of the Working Family Credit ($52 million/year).  The governor has also included several notable spending proposals in his supplemental budget such as a special education aid funding increase, expansion of the Voluntary pre-K and School Readiness Plus program and pension aids.  The price tag for these actions is prompting the governor to also call for modifying tax relief measures he opposed in last year’s tax bill – reinstating the inflator in the state general levy and on the cigarette and moist snuff tax rates, increasing the tax rate on premium cigars back to $3.50 per cigar, and freezing the estate tax exclusion at its current level – along with other revenue enhancers.

Nevertheless, the lead draft horse pulling the governor’s tax wagon is state corporate income tax conformity, which is estimated to raise $270 million in the current biennium and $508 million in the out-biennium.  But as the Hellerstein analysis illustrates, the possibility exists of this horse pulling up lame.  The TCJA is a thicket of legal (can we really tax this stuff) and fiscal (can we really rely on this stuff) risks for state corporate income tax policy.  In addition, the state corporate income tax is already the most notoriously volatile revenue source in the state's portfolio.  For the governor to build permanent individual income tax relief and spending changes on this foundation seems to conflict with the self-proclaimed number one priority of his last budget – maintaining the fiscal integrity of the state.

The proposal’s primary (and perhaps most treasured) asset is its political shrewdness, especially in an election year.  It co-opts the Republicans’ lower taxes / “hold harmless” platform while striking powerful fairness themes by having the state step in to “correct” some of the distributional impacts of the TCJA.

That has presented a bit of a strategic and public relations challenge for the Republican controlled legislature.  Unsurprisingly, the House response also placed a heavy emphasis on protecting as many potential voters as possible from state increases but features two major strategic differences.

First, the House bill features substantially less reliance on taxation of international business income.  The House bill captures only about one-third of the deemed repatriation income as the governor’s bill does by choosing not to add back the participation exemption.  The House also does not conform with either the federal global intangible low-taxed income (GILTI) or foreign derived intangible income (FDII) provisions.

Second, the House places a much stronger emphasis on what might be called “bucket integrity.”  In contrast to the governor’s proposal which uses large amounts of business tax revenues to pay for individual income tax relief, the House features substantially less redistribution and approaches conformity by keeping revenue generated by a particular tax within that tax area.  That includes phased-in tax rate reductions (ultimately down to 6.75% for the second tier of the state income tax and 9.06% for the corporate income tax) in response to the broader bases created in both the individual and corporate income tax systems.  But as in the governor’s proposal, some questions about fiscal sustainability can be raised as some ultimately defined amount of repatriated income is being used to help fund permanent rate cuts.

An Opportunity Missed?

It’s been said the difference between tax relief and tax reform is that true tax reform requires someone to be a “loser.”  Ironically, the strongest point of agreement between the House and Governor Dayton’s proposals – minimizing the number of taxpayers whose state individual income taxes increase as a result of Minnesota’s response to the TCJA – comes at the expense of reform opportunities that could improve the efficiency and function of Minnesota’s income tax system.

One example is the retainment of itemized deductions and other exclusions and subtractions for state income tax filers – a feature of both the governor’s and House proposals; although the governor’s proposal takes it to the extreme.  Not being able to itemize on state returns isn’t that unusual – prior to the enactment of the TCJA 12 of the 37 states using federal adjusted gross income as the starting point of individual income returns did not allow itemized deductions.  Post TCJA, there are even more reasons why preserving itemization deserves reconsideration and a reexamination of other exclusions and subtractions deserves attention:

• While the hassle of itemizing remains unchanged, the cost/benefit relationship of itemizing is greatly reduced.  For those who itemize at the state level only, the value of tax savings from itemizing is only a fraction of that realized on federal returns, but the time and recordkeeping demands are the same.
• Incorporating old federal itemizing rules into state law won’t actually provide the tax increase protection people think it will.  This is because, according to legislative staff, the AGI changes under TCJA provisions can cause recalculation of the myriad of phase-outs or various deductions such as the amount of allowable itemized deductions, taxable Social Security benefits. and so forth.
• Phase-outs of itemized deductions and exemption allowances undermines transparency.  These features in both the House and Governor’s proposal effectively create hidden tax rate increases.
• Other mechanisms exist to address policy purposes while also improving simplicity and fairness of the system.  Much of the taxpayer harm from lost deductions can be offset by repurposing those dollars into beefing up the state standard deduction.  Likewise, incentives like charitable contributions can be supported without tying the benefit provided to the level of income earned perhaps through flat percentage credits like those offered by Utah and Wisconsin.

It’s also worth noting the cognitive dissonance with other policy objectives and espoused principles that can result.  For example, reflexively preserving old federal tax law in the state tax code preserves many itemized deductions that disproportionately benefit higher income households.  It's difficult to understand how the governor and progressive advocates can argue in the state's conformity response to fully protect a state subsidy (deductibility) for local property taxes paid on very expensive homes and at the same time express concern about the wealthy not paying their fair share. 

For years simplicity, administrative efficiency, reliability, and stability in revenue systems have taken a distant back seat to fairness issues and levels of taxation in Minnesota tax policy debates.  What’s interesting is that the common ground between Governor Dayton and the House – notably the changes to business depreciation/accounting rules, converting the starting point for income taxation to adjusted gross income, and making features that expire federally permanent in the state – are rooted in those politically useless yet essential principles.  If policymakers really do want to take full advantage of the “unique opportunity” federal reform presented, they need to make sure those ideas are front and center in any compromise agreement.