Price of Government: Personal Income Driving the New Normal

The widely-watched Price of Government serves as a focal point for tax and spending debates. We take a look at how changes in personal income affect this measure. March-April 2010 .

Price of Government: Personal Income Driving The New Normal

In the 1980s the Price of Government (POG) was created to serve as an index or barometer of state and local government spending. Expressed as state and local government own source revenues' share of total Minnesota personal income, it represents the demands government places on Minnesotans. It was established with strong support from Minnesota's business community and remains a simple, easily understood, yet comprehensive measure of the cost of government services in Minnesota.

Predictably, POG now also serves as a focal point for debates over the appropriate levels of government taxation and spending. Clearly, there is no objectively correct answer to this question. Arguments will be made for various levels based on philosophical views of government and taxation. But examining the correlation between POG and state economic performance is understandably irresistible. As Figure 1 illustrates, throughout most of the 90's – a period of robust state economic performance – state and local government actually consumed 10- 15% more Minnesotans' personal income than it does today. 1

This correlation has led to calls for a return to historical POG levels. But even a partial return to would entail some remarkable tax changes. For example, the Department of Revenue's figures indicate that a full return to the 1998 individual income tax rates (6.0%, 8.0%, and 8.5%: with an AMT of 7.0%) would raise an estimated $806 million in tax year 2010. This is a significant sum, but even if a similar sum had been realized for fiscal year 2009 it would have pushed the estimated price of government up very modestly from 15.0% to 15.4%. Total state and local revenues in FY 2010 would need to be over $4 billion higher to attain the POG average of 17.4% which existed through the early and mid 1990s. A total of $ 1.7 billion would be needed in FY 2010 just to get to the 20-year POG average of 16.3%. That sum is roughly equivalent to:

  • the restoration of 1998 individual income tax rates ($806·million)
  • plus an additional 10% annual income tax surcharge ($695 million)
  • plus inclusion of clothing in state sales tax base ($280 million) 2

Income Trends Shaping the POG

Even if the 1998 state and local tax regime were still in place, total POG figures would be noticeably lower than those historically seen in the 1990s. Clearly more than tax policy is at work in the longer-term POG decline. Attention also needs to be paid to changes in the POG's denominator – Minnesota personal income. A closer look at the underlying components making up Minnesota personal income reveals some important trends and shifts. It also suggests that that any efforts to reestablish the POG norms of the 1990s face some powerful headwinds.

Wages and salaries are the workhorse of state personal income growth comprising nearly 60% of the total state personal income. From FY 1991 – FY 1998 wage and salaries grew at an average annual rate of 6.1% ( Table 1 ).

Table 1

Minnesota Price of Government

Minnesota Price of Government
Source: Table 1

1 It is important to note that, in the Price of Government calculations, personal income data lags revenue data. For example, revenues for FY 1991 are compared against personal income for calendar year (CY) 1990. We will make reference to fiscal years rather than calendar years when discussing personal income data for consistency's sake.

Two recessions – one "normal" and one "great" – have taken their toll as average annual salary growth rate has declined to 4.8% since FY 1998. Wage growth prospects coming out of the current recession are questionable at best. In a recent presentation to the Minnesota Chamber of Commerce, Minneapolis Federal Reserve Bank president Narayana Kocherlakota stated he would be surprised if unemployment were below 9% by the end of 2010 or below 8% by the end of 2011. To get a true expansion in employment and in the economy, he noted, the hiring rate has to pick up – and "we have yet to see evidence that it will do so in the immediate future." Moreover, with so much spare capacity in the labor market wage deflation pressures can be expected to continue for some time.

But a structural shift is also complicating the personal income landscape: the growth of personal income that is fully or partially exempt from the income tax:

  • Growth in non-taxable compensation as personal income . Employer contributions toward pensions and insurance are items that are included when calculating Minnesota personal income but are exempt from the income tax. The average annual growth rate for this component of personal income since FY 1998 has been 6.9%: faster than the growth in wages and salaries (4.8%) and in personal income overall (5.2%); moving a larger share of the overall personal income base into this nontaxable category. This continuing trade of wages and salary for other forms of compensation has important implications for price of government going forward.
  • Growth in government transfers as personal income . Government transfer payments to individuals have grown 7.0% per year since FY 1998, the second- fastest growing source of Minnesota personal income. Some components of government transfer receipts, such as Social Security benefits, can be partially taxable in Minnesota. Other components, such as veteran's benefits, worker's compensation benefits, Medicare benefits, and public assistance benefits (assistance to low-income households), are excluded from income and therefore not taxed. Relatively rapid growth in this area of Minnesota personal income is likely to continue driven by retiring baby boomers. Recent presentations by the state demographer and state economist have flagged a compounding issue: anticipated declines in income and sales tax receipts from this population cohort. Tax policies necessary to obtain more tax revenue from this huge and influential demographic would be anything but popular.

These structural shifts, which have shrunk the size of the total Minnesota personal income "pie" that is entirely subject to the income tax, mean that it now takes higher levels of taxation to yield similar revenues than in the past, absent any base-broadening moves.

Finally, competing spending pressures represent yet another challenge to a return to POG historical norms. Since 1998 Minnesota housing costs have risen 26% faster than personal income while consumer payments for health care – both insurance and out of pocket – have risen 46% faster, locking Minnesotans into spending a higher proportion of their income on these items for the foreseeable future. Add in consumer debt (33% faster) as well as the urgent need to reconstruct household retirement savings and it becomes apparent that Minnesotans' ability, on the whole, to pay for tax increases is significantly less than it once was.

Personal Income in the POG Driver's Seat

A 2009 editorial in the St. Paul Legal Ledger noted. "If we simply returned to the POG we had in the roaring 90s, we could go a long ways toward erasing the scary projected budget deficits for the next biennium and beyond." Regardless of the wisdom of this policy, one thing is clear: there would be nothing "simple" about such an effort.

Personal income sets the landscape for public acceptance of tax levels and policies, and personal income trends are not supportive of a return anytime soon. Even a partial return to historical prices of government would require major broad-based tax increases affecting all Minnesotans for which citizens and their legislators have demonstrated little appetite.

Should we go back? Finding the right balance of tax burden and spending on public goods is a challenging task, but as Winston Churchill noted, "a nation trying to tax itself into prosperity is like a man standing in a bucket trying to lift himself up by the handle." What the components of Minnesota's POG tell us is that advocates for greater public sector spending are best served by focusing their energies on the denominator – work to develop policies which support a thriving private sector and levels of personal income growth needed to sustain higher spending.

Footnotes
  • 1 Data for FY 2002 through FY 2013 comes from the February 2010 economic forecast. State and local revenues for FY 1990 through FY 2001 come from the February 2001 economic forecast. Personal income data for Minnesota for FY 1990 through FY 2001 comes from the October 2009 revised data, the same data set used by MMB for FY 2002 through FY 2013.
  • 2 Based on the November 2009 forecast. Courtesy MN DOR Department of Research.