Taking Inventory of the 2015 Tax Bills

Committee deadlines have come and gone, and the 2015 Session’s homestretch has commenced. Some early indications suggested the tax conference committee might be more sedate than usual – based on the Republican-controlled House Tax Committee’s message of political pragmatism. In spite of House DFLers “double dog daring” their Republican counterparts to put forward a tax bill that uses the surplus to unwind the 4th tier of the income tax, Chair Greg Davids has expressed no interest in a highly political and functionally symbolic tax bill that Governor Dayton will not sign.

Yet, not only are there strong differences of opinion between the Senate and House, but their numbers are light years away from each other. Together, this creates the potential for some end of session fireworks. A closer look at the potential content for the omnibus tax bills reveals some likely focal points of discussion as well as messages about the current state of Minnesota’s tax system.

Sales Taxes: The Costanza Effect

In a memorable episode of Seinfeld, George Costanza, frustrated by how his life is turning out, achieves extraordinary professional and personal success by deciding to do the complete opposite of what his sense of good judgment tells him to do. Perhaps in light of the political and public fallout of ill-fated sales tax reform efforts last session, this year’s sales tax bills exhibit signs of a “Costanza effect.”

Two years ago some well intended, principle-grounded (if occasionally deeply flawed) bills attempted to modernize Minnesota’s sales tax and improve state tax policy by broadening bases and lowering rates. Sales tax bills this year reflect a 180-degree turn – the tax policy equivalent of George’s chicken salad on rye. Base broadening proposals are a distant memory replaced instead by sales tax ideas of dubious tax policy merit.

Of biggest concern are the proposals to strip sales taxes raised through auto part and tire purchases from the general fund and dedicate the revenues to transportation funding. The proposal is part of a larger GOP effort to dedicate existing general fund revenue streams for transportation. According to the Department of Revenue, sales tax revenues on auto parts sales alone will be about $384 million for the coming biennium, rising to around $500 million in FY 18-19.

Any popular appeal this idea might have is more than offset by considerable problems with respect to both tax administration and precedent. Since retailers do not record sales tax collections by item, the administrative costs associated with separately tracking and reporting the tax on selected items is prohibitive. As a result, the bill (HF 215/SF 1106) directs Revenue to estimate the percentage of total sales tax revenue attributable to these sales every four years, based on federal data and the department’s consumption models. Which raises the question: if we are going to use (highly) educated guesses to allocate revenues, couldn’t we accomplish the exact same outcome with far less time and effort while preserving future budget flexibility by simply appropriating $384 million from the general fund to transportation in the next biennium?

As problematic as the administrative issues are, the precedent this proposal would create is no less troublesome. Its adoption would likely lead to an avalanche of special interest attempts to dedicate other sales tax streams to their preferred causes. Back to school products to school finance. Mountain bikes to trails and parks. Smoke alarms and carbon monoxide detectors to underfunded police and fire pensions. All such proposals would be no less legitimate and all would face the same administrative and implementation challenges while making the tax system a de facto appropriations machine.

Other bills that head in the opposite direction of the sales tax policy ideal include the usual collection of tax expenditure proposals. Sponsors usually intend to support a special cause, group, or even economic development in a particular area. As of the Easter/Passover break we count 21 bills of this nature introduced this year, which would exempt a range of items from digital products to herbicide sales for invasive species to infant car seats to admission to nonprofit BMX racing tracks. Individually they are mostly very small carve outs of tiny fiscal impact. Collectively, they would join the well over $1 billion of sales tax revenue from consumer goods and services that is already foregone annually for various policy reasons.

Property Taxes: Eyes on the State General Tax

After serving as a focal point of the tax committees in past years, local property taxes have been less conspicuous this year. High profile tax relief proposals have been replaced by the normal assortment of bills pertaining to increases or adjustments in local government aids, classification tweaking, various exclusions for pet property types or property characteristics, and TIF. One notable exception is the push for farm property tax relief. The Republican takeover of the House was the result of a rural tsunami, so unsurprisingly rural legislators of both parties have shown an interest in farm property taxes. Lawmakers have introduced a couple of proposals to reduce property taxes related to school debt on farmland.

On the other hand, legislators have given considerable bipartisan attention to the state general tax. Several bills have been introduced to either reduce the tax, change the tax base, eliminate the automatic inflator, refund the tax in certain instances, enact some permutation of these items, or get rid of the tax altogether. If business tax relief is part of a final tax agreement, the general tax will be a likely delivery vehicle as any business with property in Minnesota would benefit.

As testimony on these proposals highlighted, the state general tax routinely adds 25% to 30% to a business’ property tax bill. Table 1 demonstrates how the state general tax impacts Minnesota’s property tax competitiveness on a regional basis, showing results from our most recent 50-state property tax comparison study with and without the tax. Commercial impacts are greater since Minnesota’s exemption of personal property is more advantageous for industrial (manufacturing) properties. While most everyone agrees that the state general tax is bad tax policy (echoing the findings of the bipartisan 2012 Property Tax Working Group report), it’s clear that revenue losses are the primary barrier to change.

Individual and Corporate Income Taxes: Tax Expenditure Ideas are Alive and Well

One of the interesting curiosities of tax policy in Minnesota has long been the conflicted and bifurcated thinking regarding the ability of taxes to affect behaviors. Policymakers are frequently skeptical that general tax policy influences either individual or business decision-making – the debate over the fourth income tax tier provides all the evidence one could want of this. At the same time, policymakers often place great faith in the notion that aligning economic incentives with outcomes matters when they want to advance a very specific social or societal outcome. This leads to all sorts of proposals to tweak the tax code in relatively tiny (but often administratively problematic) ways to incentivize certain decisions or reward desirable actions.

Such proposals abound (again) this year; as of this writing we count 45 bills attempting to incentivize or reward very particular actions. Unsurprisingly, the majority of these proposals are individual and/or corporate income tax credits, deductions, or subtractions. To illustrate, here is a partial list of behaviors income and corporate tax expenditures introduced this session would encourage:

• Hire veterans
• Train employees
• Sell equipment to beginning farmers
• Sponsor school lunch programs
• Sponsor workforce housing development
• Sponsor school angel funds
• Hire ex convicts
• Sponsor Pre-K programs
• Implement renewable energy systems
• Give to community foundations
• Preserve old barns
• Complete a masters degree (teachers)
• Sponsor minority teacher programs
• Make home modifications for disabled residents
• Keep retired military veterans in state

Ironically, several of these proposals would provide benefits that would likely accrue more to higher income/wealth households, undercutting the much-heralded progressivity advancements made in Minnesota’s tax system over the last few years.

In contrast to these relatively low impact, targeted initiatives, two tax expenditure proposals – with a stronger “relief” ambience about them – would have substantially larger fiscal impacts. The first would reduce or phase out taxation of Social Security income; the second would set a 7.85% maximum tax rate for active pass-through business income. The former comes with a price tag of about $120 million in the upcoming biennium (increasing to $326 million in the out-biennium) while the latter is priced at $355 million for FY 16-17. With the House Tax Committee chair’s name on both proposals, these are prime candidates for the $2 billion House leadership has allocated for tax reductions.

From a policy standpoint these bigger proposals present some challenging issues. Ever-blunt David Brunori of State Tax Notes comments that there is simply “no theory of taxation” under which age alone should exempt a person, adding that “it doesn't square well with either the ability to pay or the benefit theories of taxation.” As we have noted before, this preferential treatment is unlikely to score too well on horizontal equity considerations either. It’s not difficult to dream up working families with similar incomes that pay much higher effective tax rates. The business pass-through rate reduction is symptomatic of a larger issue – that our tax system has a long history of favoring pass-through entity structures. An ideal tax system would neither favor nor disfavor particular organizational choices.

Estate Taxes: Is Chasing Some Wealthy Away “Worth It”?

Legislators have also spent considerable time on Minnesota’s estate tax this session. A year after repealing the state’s short-lived gift tax, policymakers, with bipartisan interest, are focusing their energies in two areas: providing portability of unused spousal exemptions and increasing the amount of estate value exempt from taxation from the current $1.4 million for 2015 deaths (scheduled to increase to $2.0 million by 2018). More often than not, proposals to increase the exclusion amount would conform to federal law, which provides for a $5.43 million exclusion for 2015 deaths and increases annually with inflation; with other proposals offering a more modest increase. These proposals do come with a cost – bills to conform to the federal exclusion amount are projected to cost about $150 million in FY 2016-17 and $170 million in FY 2018-19; the cost of providing unused exclusion portability between spouses is as yet unknown.

Proponents of these changes point to a number of reasons for doing so, including difficulties some small businesses have in passing ownership from one generation to the next while maintaining viability, the high costs of complying with two different sets of estate tax rules, and the disincentive Minnesota provides to the wealthy to stay in the state during their retirement years because the state’s exclusion amount is substantially lower than most other states that have an estate tax. Opponents’ concerns generally fall into one of three areas: reducing the highly progressive estate tax would mitigate some of progressivity improvements the state made to its tax system in 2013-14, that the estate tax operates as a “backstop” to the income tax by imposing a tax on earnings – especially capital gains – that are not realized during an individual’s lifetime and which would be passed along to heirs tax-free, and that other priorities – especially K-12 education, human services, and broad-based tax relief – should have a higher claim on the state’s surplus.

By all indications, neither chamber’s tax plan will be unveiled until the end of April, making for a frenetic end to the 2015 session. But when all is said and done, the ideas and positioning leading up to the conference committee may eventually turn out to be far more significant than the end result. That’s because, with all legislators up for reelection in 2016, the process matters as legislators and candidates look to fire up their bases. As a commentator on tax policy said many years ago, even if bills don’t get passed, they may create a different, and no less desirable, result – political contributions.