A Feeling of “TCJA Vu”

We’ve experienced this session’s tax conformity debate before.  The ending may be different this time but we'll likely forego an important opportunity.

It’s been almost a year since the 2018 legislative session ended with an acrimonious thud.  The vetoes of the tax bill and the 1,000-page omnibus spending bill were accompanied by a heavy crossfire of bitter charges and countercharges.  Since then new faces and personalities have arrived, and a greater sense of amicability permeates the 2019 session offering hope for a more productive outcome.  However, the same stark philosophical differences about state government tax and spending policies lurk underneath the surface as press conferences and editorials have demonstrated.  With the session’s conclusion about a month away, an uncomfortable feeling of déjà vu is understandable.  Differing conformity responses to the federal Tax Cuts and Jobs Act are a big part of the reason why.

Spring Repeats

The specifics of the conformity proposals have been tweaked since last year, but the overarching policy themes are intact.  For the DFL, the centerpiece of their conformity plan is again securing more revenue.  Like last year's proposal, Governor Walz and the DFL-controlled House seek to use the tax base expansion from federal conformity actions to raise substantial amounts of new revenue to support new permanent spending and to provide permanent targeted tax relief to correct for the TCJA’s perceived distributional inequities.  It tries to compensate for the TCJA as much as conform to it.

Meanwhile, for the Senate Republicans, the central theme of their conformity plan is again holding individual income taxpayers harmless from any action the state might take on conformity.  Importantly, Senate Republicans intend for this hold harmless principle to apply not just in the aggregate, but at the individual level – a difficult, if not impossible, task given the TCJA’s many moving parts and the multitudes of situations individual income tax filers can find themselves in.  Therefore, Senate Republicans again place a heavy emphasis on trying to keep things as they used to be by retaining a considerable amount of old internal revenue code with respect to itemized deductions and enacting the old federal and dependent exemptions into state law – with a major tax relief kicker by lowering the second tier individual tax rate to try to cover all the bases.

Despite the major differences in philosophy and approach, there are some significant areas of agreement among all three players, as the accompanying table shows.  All parties agree on conformity actions which are projected to raise $613 million in FY 20-21.  All parties agree on conformity provisions that would cost about $200 million over that same period.  That leaves around $400 million of consensus new conformity revenue to construct a biennial budget.  Combined with the current budget surplus it’s a large enough sum to suggest some type of “vote while holding your nose” compromise could be constructed.

But even if something can be cobbled together which grudgingly passes everyone’s tax demands and spending tests, this session’s tax bill likely will be less “successful” than what it could have been.  That’s because a significant opportunity presented by federal conformity – simplifying and easing tax compliance and administrative burdens while improving the state’s revenue integrity on good tax policy principles – has received much less attention than it deserves.

Like last year, tax simplicity, compliance, and administrative considerations were overwhelmed by other matters like winners and losers and state budget ambitions.  It would be naïve to suggest such “second tier” tax policy ideas addressing revenue system function, reliability, and integrity would ever replace “who pays and how much” as everyone’s compass points in pursuing a conformity plan.  But both sides’ proposals contain elements suggesting indifference to these objectives, rather than just subordination.

For example, just a few years ago the DFL was expressing concerns about revenue dependency, balance, and stability in a call for state tax reform which employed the prop of an unbalanced three-legged stool to visualize the problem.  Fast forward to the present and the three major revenue-raising legs, comprising $1.1 billion of the $1.2 billion the House is seeking in new revenues, are repatriated earnings (temporary), a new capital gains and dividend tax on the wealthy (highly volatile and potentially avoidable) and GILTI (inherently volatile, quantifiably uncertain, and perhaps constitutionally questionable).  With respect to the $600 to $750 million (depending on the method) DOR estimates could be generated from conforming to the two forms of federal foreign earnings taxation, even the progressive Center on Budget and Policy Priorities of Washington DC has urged caution noting, “States conforming to TCJA international provisions can reasonably anticipate legal challenges taking years to resolve.  Accordingly, states should not build revenue from conformity into budgets.”[1]

Similarly, Republicans’ insistence on trying protecting individual taxpayers by essentially retaining old federal itemizing law has its own consequences.  It would mean a lot of taxpayers now benefitting from the higher federal standard deduction would have to deal with the unnecessary record-keeping hassle, time, and cost of itemizing for state purposes – all for a tiny fraction of the former benefit.  That’s a recipe for more costly tax compliance and inefficient tax administration complicated by larger and more costly state auditing responsibilities and greater tax avoidance potential since Revenue cannot piggyback on any IRS audits for these taxpayers who itemize at the state level only.

Certainly, some appreciation of these issues can be found in the respective proposals.  But it’s fair to conclude that, with one notable exception, a focus on the unique opportunity the TCJA created to engage in tax code housecleaning to advance simplicity, understandability, ease of compliance (for taxpayers) and administration (for the government) has not been a priority.

Ingredients of a Not-So-Modest Proposal

In an ideal (a.k.a. imaginary) world, a standalone conformity bill separate from the regular omnibus tax bill would have allowed policy makers to first grapple with how to impose and collect state individual and corporate income taxes in a post-TCJA world before tackling the inevitable “how much” and “who” questions.  That was never going to happen because conformity ideas do have revenue ramifications.  Tax decisions are the most powerful form of leverage in end-of-session budget negotiations, and no one would ever want to concede any such leverage in the session’s earliest stages.

But it’s interesting to speculate on what a conformity bill that prioritized the tax system and good tax principles might actually look like.  We consulted with several SALT experts for their thoughts on this matter for both organizing ideas and some specific conformity recommendations.  Here is a synopsis of the most common ideas we heard and some reasoning behind them.

Organizing approach:  Such a bill should be pursued on a principle of revenue neutrality: the proposal should not to try to increase or decrease overall state tax revenues relative to the permanent features of the proposal and prior law.  Attempts at revenue raising or tax cutting would immediately bollocks up the effort and introduce budget considerations that naturally want take precedence.  Moreover, a revenue neutral approach would provide some additional insurance against being stung by inherently uncertain and potentially overstated revenue estimates accompanying new and complex conformity provisions, thus providing an extra measure to protect the integrity of the state’s revenue base.

The principle of revenue neutrality should also be applied within three individual “buckets” of tax revenues affected by conformity – permanent individual income revenues, permanent corporate franchise revenues, and one-time revenues.  This helps ensure that all the various tax expenditures, exemptions, and income subtractions which have been built up in the state tax code over time would get a long overdue review as part of the conformity effort.

Regrading prime areas of opportunity:  Themes and variations abound with respect to specific conformity details and recommendations but a few stand out based on their tax policy merits

  • Full conformity to the federal standard deduction.  As we have written before, full conformity with the TCJA’s higher standard deduction would accomplish two important objectives: 1) it aligns filing requirements so Minnesota does not impose a filing requirement and tax obligation when the federal government does not; and 2) it minimizes the number of taxpayers who itemize on their Minnesota return but not on their federal return (estimates are 93% of state individual income filers would take the standard deduction).  One individual also suggested this standard deduction should be increased even further for the elderly subject to an income phase out (with corresponding reductions to the Social Security subtraction) in recognition that current policy treats equals unequally by favoring one source of income over another and discriminates based on age.

We, in turn, note the underappreciated tax relief benefits that would flow from fully conforming to the federal standard deduction.  Full standard deduction conformity is a centerpiece of the House’s tax plan, and in his remarks on the House floor, Tax Chair Paul Marquart noted that adopting the higher standard deduction would provide a tax cut for over 2 million Minnesotans, resulting in about a 7% reduction in taxes for the state’s median income household as a result.  Moreover, with the House’s preservation of the federal government’s former dependent exemption, a family of four in Minnesota with up to $32,900 in household income would have no income tax liability.  Because of its unique ability to combine administrative benefits with tax relief to lower income households (only those who take the standard deduction benefit from the change), full conformity to the federal standard deduction should take precedence over the other higher profile but more targeted tax relief provisions like the Working Family Credit expansion, property tax refunds expansions, and any increase in the Social Security subtraction. 

  • Rationalize Charitable Contributions.  With Minnesota’s shift to an AGI starting point and the accompanying move to take control over its own itemized deduction rules (agreed to by all parties) having separate charitable deduction incentives for itemizers and non-itemizers doesn’t make sense.  There is an opportunity to rationalize the system with a more powerful charitable contribution credit for those who do not itemize at the state level.  Recommended features included:  1) creating a minimum contribution threshold to receive the credit to focus the giving incentive on the margin where it matters most; 2) setting the credit rate such that the provision is revenue neutral (the loss equals that from the current itemized deduction and nonitemizer subtraction); and 3) limiting the aggregate donations that would qualify for the credit to the standard deduction to encourage the biggest donors to continue to use the federal deduction, thus having the federal government, rather than the state, experience the revenue loss.  It was also suggested that qualifying contributions be cash only to get rid of the compliance and administrative problems in valuing donations of used clothing and other property.
  • Adopt chained CPI.  The benefits of consistency with federal rules and the enhancement of state revenue collections from its adoption are more important than the slowdown in the growth of lower income redistributive programs like the Working Family Credit, (which as our own research indicates is already one of the nation’s most generous).
  • Eliminate both corporate and individual alternative minimum taxes.  Experts noted retaining a Minnesota corporate AMT based on old federal concepts in an environment without a federal analogue is just not practical.  Moreover, there is plenty of proposed corporate base expansion with or without foreign earnings provisions to offset this revenue loss.  With respect to the individual AMT, the TCJA limitation on property tax and home mortgage interest deductions – two of the main drivers of AMT filings – make this an opportune time to simplify the tax by eliminating it.

What About Those Foreign Earnings Provisions?

The centerpiece of the conformity debate – certainly in a budget sense --  is Minnesota taxation of foreign earnings.   Entire forests have been clearcut to opine, editorialize, analyze, scrutinize, debate, and pontificate on the intricacy, constitutional legitimacy, and revenue-raising justifications of state conformity to deemed repatriation and GILTI.    Less commentary has been offered on whether the cause of simplicity and ease of state tax compliance and administration are better served by conforming or not conforming to these provisions.

While “more federal conformity yields greater simplicity” is a maxim that holds true in most circumstances, that’s not the case with respect to foreign earnings.  Not conforming is superficially straightforward  - the subtraction of two lines from federal taxable income on a state return --  but non-conformity can affect other state return calculations making them more complicated.  However, this annoyance factor pales in comparison with the complexity conformity creates in order to avoid multiple levels of taxation between the foreign jurisdictions, the U.S. federal government, and U.S. states.  This results in the need to apportion income and/or apply a coordinated tax credit and is especially true with respect to GILTI.  

Most foreign earnings are not displaced domestic income, and Minnesota can’t ignore the fact that markets. profits, and taxes exist out of the United States.  Income apportionment is critical in order to pass constitutional tests and presents a challenge for both taxpayers and tax administrators in dealing with potentially hundreds of legal entities in numerous countries. The challenge might be reflected by the fact that the majority of states with a corporate income tax are decoupling from these international provisions.  For the states that are imposing, or potentially imposing, corporate income tax on either repatriated income or GILTI more than 2/3rds have not issued new guidance on how to apportion such income.[2]  It is worth noting that GILTI is a minimum tax intended to ensure that between the foreign jurisdiction and U.S. federal government, 13.125% tax is applied to foreign earnings.  Without an apportionment and/or foreign tax credit mechanisms, multiple taxation of the same foreign income is exacerbated.  Moreover, as the conformity experiences of some states in 2018 has shown, translating GILTI calculated at the federal level to the state level can be problematic for many other reasons including differences between federal and state rules.[3]   As legendary tax scholar Walter Hellerstein has noted, the important question of whether states should embrace the taxation of this income should be accompanied by a consideration of the question “are the costs worth the benefits.”  As he concludes, “the apparent benefits of conformity and increased revenue may well be offset by the costs of conformity and the controversies over the inclusion…”[4]

Sentenced to Another Year? 

With only a few weeks left in the session and the set up so similar to last year, it’s not unreasonable to foresee an ending in which deeply divided government results in a more-or-less status quo budget passing (allowing 2020 to be a referendum on the state’s direction) with federal conformity again kicked to the curb.    An alternative would be to embrace the opportunity to rescue something positive out of the situation by pursuing a revenue neutral conformity plan that improves Minnesota’s tax system on good tax policy principles.  However, both time constraints and the apparent lack of political interest to do this makes this the longest of longshots.

Theory says good tax policy is guided by a consideration of many different, and often competing, principles which should be weighed and evaluated against each other.   Politics, on the other hand, often is guided by a single memorable, appealing, but restricting message, or as G.K. Chesterton once said, “the clean and well-lit prison of one idea.”    One thing is certain: our increasingly partisan and ideological approaches to tax policy is making a jail break more and more difficult.

[1] Michael Mazerov, CBPP, in presentation to the National Council of State Legislators Task Force on State and Local Taxation, March 23, 2018.

[2] “Where in the World is Factor Representation for Foreign Source Income,” Frieden and Donovan, State Tax Notes April 15, 2019

[3] “Differing State, Federal Rules Could Cause GILTI Glitches” Law 360,  April 24, 2019

[4] “Should States Embrace GILTI?”, State Tax Notes, March 18, 2019