The Price Tax of Minnesota Fairness

From our March-April 2013 edition of Fiscal Focus.  The Department of Revenue's Tax Incidence Study has become the state's "tax fairness bible".  So what does it say about the steps the state would have to take to create tax fairness?  We look into this question and other complicated issues that touch on tax fairness.

In his entertaining “Devil’s Dictionary of Taxation,” Billy Hamilton of State Tax Notes defines tax fairness as, “a concept of taxation that, like beauty, is in the eye of the beholder.” But neither Mr. Hamilton nor the devil had access to the Department of Revenue’s new 2013 Minnesota Tax Incidence Study.

This biennial analysis is much more than a detailed look at the relative progressivity or regressivity of various state and local taxes and the distribution of tax burdens across Minnesota’s households. It has become the state’s “fairness bible” – where the cold objectivity of tax data collides with the heated politics and subjectivity of what a “fair tax system” means.

In fact, of all the useful and important nuggets of information relevant to state and local tax policy the report provides, only one thing often really seems to matter to policymakers: the table of effective tax rates – the ratio of taxes to income – by population decile, which we reproduce below.

Table 1

Minnesota Effective Tax Rates by Population Decile, 2010

  Population Decile State Taxes Local Taxes Total Taxes
  First 18.6% 13.5% 32.1%
  Second 9.0% 5.1% 14.0%
  Third 7.4% 4.9% 12.3%
  Fourth 7.1% 4.6% 11.7%
  Fifth 7.6% 4.4% 12.1%
  Sixth 7.9% 4.5% 12.3%
  Seventh 8.0% 4.2% 12.2%
  Eighth 8.2% 3.9% 12.0%
  Ninth 8.2% 3.5% 11.7%
  Tenth 7.9% 2.4% 10.3%
  Total 8.0% 3.5% 11.5%
Source: 2013 MN Tax Incidence Study

No other table from a government document has been reproduced in more newspapers and blogs or referenced in more hearings than this one. Many present it as slam dunk evidence that Minnesota has a major tax fairness problem. In the process, it can often serve a useful political purpose. Building an argument for higher taxes based on the need for additional government spending can be a laborious slog. Building an argument for higher taxes based on the idea that other taxpayers haven’t been doing their fair share of the lifting is a lot easier.

However, the Incidence Study not only shows how taxes in Minnesota are distributed; by doing so it also allows one to calculate what is needed to achieve the Holy Grail – “Minnesota Tax Fairness” – with as much precision as any such effort could hope to muster.

The theoretical price tag of fairness

The major caveat about calculating a fairness price tag is that there are many ways to reduce the regressivity of the tax system and improve fairness without increasing overall collections. How state and local governments collect revenue is fundamentally independent from how much revenue they collect. But for purposes of the following, we will assume 1) that fairness means flattening the tax incidence curve at higher income levels with higher levels of taxation so that “everyone pays their fair share” and 2) that this should be the aspirational objective of state and local tax policy.

Our first estimate is based on the common interpretation of the table referenced earlier using the following definition of tax fairness: “fair share taxation” demands that higher-earning population deciles pay at least as much of their income in taxes as the immediately preceding decile.1 These conditions would yield a steadily progressive-to-proportional tax incidence curve.

Such an interpretation immediately presents a problem. Thanks primarily to the incidence of business taxes and the sales taxes consumers pay directly to government, households in the second population decile (with about $10,000 – $16,500 in income) face the highest total state and local tax rate in Minnesota, at 14.0%. The price tag of implementing this strictest interpretation of fairness – where 8 in 10 Minnesota households are failing to pay their fair share of taxes – would be about $4.7 billion in new revenues on families with about $16,500 or more of income.

A similar problem exists in the third decile, which also faces a higher effective state and local tax rate (12.3%) than the decile above it (11.7%). If we choose not to use the rates these lowest three income deciles pay as our fairness benchmark, the effective tax rate peaks at the 6th decile (household incomes from about $41,000 – $53,000) at 12.3%. The table below highlights how much additional revenue would need to come from each of the seventh through tenth deciles, both in the aggregate and on a per-household basis, to meet this definition of tax fairness.

Table 2

Amounts Needed to "Pay Their Fair Share"

  Population Decile Income RangeNeeded Tax Revenue ($ millions) Actual Tax Revenue ($ millions) Revenue GapApproximate Tax Revenue Needed Per Household to Achieve Fairness
  Seventh $53,703 - $68,7731,920.0 1,896.7  23.3$89
  Eighth $68,774 - $89,7462,492.2 2,435.1  57.1$221
  Ninth $89,747 - $129,1133,385.2 3,221.1  164.1$639
  Tenth $129,114 and over9,052.9 7,594.9  1,458.0$5,662
Source: 2013 Minnesota Tax Incidence Study, calculations by MCFE

All told, approximately $1.7 billion of new tax revenue would be needed to achieve Minnesota tax fairness. Notably, about 15% of the fairness problem extends well into middle-income Minnesota.

According to information from Minnesota Management and Budget2, a new 9.85% top bracket would put a partial dent in the fairness gap by raising about $550 million annually over the next four years. However, a new top bracket that targets only the top 2% of earners but exempts 95% of the households currently failing to pay their fair share in taxes (the remaining households in the 10th decile plus all households in deciles 7-9) – seems a “fairness” issue in and of itself. Of course, an alternative approach would be to make the necessary changes so that the new fourth bracket encompasses the top decile of earners. While this scenario would still hold 75% of those paying less than their fair share harmless, political support for tax fairness using this solution might be harder to come by.

Other Complicating Questions Regarding Tax Fairness

For many years we have argued on these pages and elsewhere that the Tax Incidence Study presents a much more complicated “tax fairness” story than most people think. Moving from calculations of effective tax rates to subjective assessments of fairness still includes assumptions and normative judgments despite the appearance of mathematical precision.

To illustrate our point, we offer three questions meriting consideration when mining incidence study findings for tax fairness conclusions. These questions involve both the nature of the taxes themselves and how Minnesotans actually think about fairness.

1) Should tax fairness exclude taxes people themselves don’t directly “pay?”

If asked whether Minnesotans are “paying their fair share” in taxes, the average citizen would probably take that phrase very literally. They would respond based on their perception about all the taxes people directly pay to government – either by writing a check, making a purchase, or having it withheld. People judge tax fairness on what they see and feel.

Yet most of the damage done to tax fairness is not caused by caused by taxes which individuals remit directly to government but by significant amounts of hidden business taxation passed on to households through higher prices, lower wages and lower investment returns. The incidence study assigns all this business taxation to its final resting place among households through sophisticated modeling. These business taxes are the primary source of regressivity in Minnesota’s tax system.

Indeed, many tax fairness advocates are highly conflicted by this issue – embracing the findings of the incidence study (that business taxes are regressive) when fairness is the issue but disregarding the concept when the issue of tax revenue adequacy is on the table. Proposals to increase business taxation this session have been marketed as efforts to make businesses “pay their fair share.”3

Intellectual inconsistency aside, such thinking also practically creates a perpetual “fairness problem” for Minnesota’s tax system. Loading up on business taxes simply means that when the next incidence study shows that those collections have landed disproportionately on lower and middle income households, the “fair share” problem will persist even with new income taxes on the wealthier Minnesotans.

2) Should tax fairness exclude purely voluntary taxation?

Many taxes are voluntary and tied to very specific forms of highly discretionary consumption – most notably vice taxes. No one is obliged to engage in these activities and to pay these taxes unless they want to. It raises the question, is it “fair” to accuse the wealthy of not doing their income-proportionate share of gambling, drinking and smoking?

3) Should tax fairness exclude benefits-received taxation?

Other forms of individual taxation in the incidence study, like gas taxes and solid waste management taxes, are imposed on essential goods and services that everyone across the income spectrum must consume at some level. On one hand, these taxes are typically quite regressive. On the other hand, these taxes are mostly dedicated revenues linked directly to the costs associated with the delivery of a particular public good or service. As a result, they have a strong benefits-received dimension to them – the more benefits you receive, the more taxes you pay. Tax policy experts have long argued that the nature of these taxes already embodies the principle of tax fairness.

The fairness of Minnesota’s tax system looks very different – and the price tag of achieving tax fairness changes dramatically – depending on how one answers these questions. If we exclude those taxes that meet any of these three criteria, then what’s left are three major revenue sources (homestead property,4 sales taxes on purchases by individuals and individual income taxes) plus a handful of miscellaneous taxes (cabin property, estate taxes, MinnesotaCare taxes, insurance premiums taxes, and mortgage and deed taxes.) Most of these are highly compulsory forms of taxation remitted by individuals used to support and sustain general government operations and an arguably better base for evaluating “tax fairness.”

The graph below represents the incidence curve for this set of taxes, based on our calculations from data in the 2013 Tax Incidence Study. Again ignoring the first decile, we see a remarkably progressive Minnesota tax system. The 0.57% drop at the very top represents what remains of the state’s fairness challenge. Our calculations suggest that to achieve tax fairness under these circumstances we would only need roughly $420 million from the top 10% of Minnesota’s income earners.

None of this alters the fact that there are other, equally important, considerations that ought to go into deciding whether it’s wise to make Minnesota one of the highest individual income tax states in the nation. Chasing the elusive goal of tax fairness to the exclusion of everything else that makes up a good tax system – like stability, competitiveness, and accountability, may have undesired consequences.

But this exercise does demonstrate that determining tax fairness will always remain a highly subjective exercise open to interpretation even with a high quality tax incidence study at the fingertips. Or in the words of Billy Hamilton’s alternative definition of tax fairness:

“The fundamental requirement of a good tax system, and a concept best appreciated by those who manage to exclude themselves from that to which the question of fairness applies.”

Most telling is the variation in property tax burdens among income equals across the state. To illustrate, Table 1 compares the median property tax burdens (after PTR) for one income cohort – the $45.000 to $65.000 household income range – across all 20 regions. For these incomes (which includes the state median income), property taxes in the metro region consume almost 50% more household income than in greater Minnesota at the median. Similar results are found for all income strata. Also of note is the geographical difference in the proportion of homeowners experiencing what might be called "property tax stress" (tax burden >5% of income after PTR). The frequency of homeowners above this threshold in the metro region is over four times that of greater Minnesota.

Figure 1

2010 State and Local Taxes by Population Decile: Total Less Business, Voluntary, and Benefits-Received Taxes

Table 1: Notes
  • Property Tax Burden After PTR

Implications for State Aid Programs and Property Tax Relief

Such findings have important implications for current state aid debates and for finding the best mechanisms for property tax relief. Advocates of state aid to cities have long argued that LGA creates greater fairness in property taxation across the state. In 2007, the year of this study, Minneapolis and St. Paul received approximately 30% of the LGA pool. But of the remaining amount, 93.2% went to communities in Greater Minnesota while only 6.8% went to cities in the metro region. Comparing this aid distribution to the findings highlighted above, it's difficult to understand just what kind of fairness is being accomplished. It is certainly not the tax fairness principle of "horizontal equity" – treating equals equally. The significant geographic disparities in homeowner effective property tax rates are attributable to many factors but are undoubtedly influenced by LGA. If ensuring adequate services at reasonable tax prices is the goal of LGA, then this report suggests many metro area cities are also "needy" and the LGA formula is in need of serious overhaul.

LGA cuts – past, present, and future – have triggered a firestorm of criticism, especially among city officials in greater Minnesota and their advocates. It's been argued that critical service cuts are inevitable because local citizens simply cannot afford the property tax increases needed to fully make up for aid cuts. One recent report on the damaging effects of LGA cuts in greater Minnesota was titled "Bleeding Communities Dry." Are greater Minnesota taxpayers at or already beyond the tolerable threshold of property tax affordability? It might be worthwhile to ask metro homeowners whose property tax burden is commonly 40% more than their outstate counterparts on equivalent income.

More fundamentally, this report once again brings an important philosophical debate regarding property taxation into sharp relief. There are two potential paths to assure good local public services at reasonable tax prices. The first is to let local governments control their own property tax destiny and establish whatever levy they determine necessary to deliver on their citizens' desires and expectations concerning public services. The state assists in this goal by providing targeted relief based on ability-to-pay. The other path involves the direct subsidization of city services through state aids and credits. Some of this subsidy may accrue to property tax payers; some may accrue to the public sector (e.g. more public sector jobs or higher compensated jobs). But any property tax relief that actually materializes will be shared equally among rich and poor in the community. It's ironic that in a state which values fairness in its tax system above all else, so much effort is invested in advocating and defending the more regressive approach.

  • 1 We exclude the first-second decile transition because the Department of Revenue encourages users of the study to disregard findings for the first decile due to the anomalous nature of its households and incomes.
  • 2 Supplemental Budget Summary Update #1, Minnesota Management and Budget.
  • 3 "Dayton Says Tax Plan Intended to Force Businesses to Pay Fair Share", Minnesota Public Radio, March 6, 2013
  • 4 Net of homeowner property tax refund