The Tax Lessons in the 2013 Tax Bill

Besides feeding everyone's spin cycle, a Department of Revenue white paper examining the impact our new tax laws will have on state tax incidence provides some instructive and important lessons on what state tax policy is simply unable to do well.  From our July-August 2013 edition of Fiscal Focus.

Legislators might have wrapped up their annual session back in May, but their actions continue to reverberate in the political echo chamber. In late June, the Department of Revenue released a white paper prepared by the Research division that projects the impact the omnibus bill will have on the incidence of state and local taxes in 2015. The results provided talking point fodder across the political spectrum. DFLers were quick to herald the additional progressivity introduced into Minnesota’s tax system; while Republicans were quick to note no one escaped the economic impact of the majority’s tax policies.

But beyond feeding the political spin cycle, the Revenue white paper provides some instructive and important lessons on what state tax policy is simply unable to do well. Recognizing and appreciating these limitations offers the prospects of better tax and fiscal policy going forward.

Lesson 1: Exporting state tax burdens is difficult to do

In the spirit of “don’t tax you, don’t tax me, tax that fellow behind the tree” it’s enticing to try to figure out a way make nonresidents help pay for Minnesota’s public services. The increase in the tax on car rentals to 9.2% (from 6.2%) may represent such thinking. But as the incidence analysis of the tax bill points out, most of the omnibus bill’s new taxes land on Minnesotans and attempts to use business taxation to export burdens are not particularly successful.

As Table 1 highlights, of the $923 million in additional state and local tax collections forecast for calendar year 2015, almost $800 million (roughly 85%) will come from the pockets of Minnesota residents – either through direct payments to government or indirectly as business taxes result in lower wages, reduced return to capital, or higher prices. Business taxes generally, and the corporate income tax specifically, are often marketed as a way to export more tax liability. But according to the incidence analysis, 90% of the new sales taxes on business purchases and nearly 2/3rds of the expected increase in corporate income tax collections will ultimately be paid by Minnesotans.

Table 1

Impact of Law Changes of Minnesota State and Local Tax Burdens by Tax Type, CY 2014 as Enacted ($millions)

Tax Type Change in Collections Amount Paid by Minnesotans
Income Tax - Rate Increase $542 $492
Income Tax - Alternative Minimum Tax $3 $3
Corporate Tax $171 $107
State Sales Tax - Consumer Purchases $18 $17
State Sales Tax - Business Purchases $209 $188
Local Sales Taxes $15 $13
Cigarette and Tobacco Taxes $215 $203
Estate Tax $55 $47
Property Taxes ($176) ($143)
Property Tax Refunds ($129) ($129)
Impact, All Taxes $923 $798
Source: Minnesota Department of Revenue; tabulation by MCFE.

Tax scholars argue the economic rationale for tax exporting is to pay for the benefits nonresidents receive and the costs nonresidents impose, not political expediency or subsidizing services. But regardless of whether attempts are driven by good policy or instead by opportunism and political gain, the incidence analysis shows that exporting is a lot more difficult than most people believe.

Lesson 2: Improving tax fairness is tough to do - and even more difficult when you also want a lot more money

Making the tax system more progressive was the stated rationale for tax changes this session, and the incidence analysis certainly demonstrates the result. According to the Department, 76% of the additional $798 million in tax burden projected for 2015 will fall on the top 10% of earners – households with more than $146,400 of income. Even this somewhat understates the focus on wealthy taxpayers; $492 million – nearly 62% of the additional burden – will come from the top 1% of earners. Progressivity elements of the omnibus bill include the second highest statutory rate in the nation at the $250,000 of taxable income threshold for joint filers, a new gift tax (which only one other state in the nation – Connecticut – has), and an increase in the alternative minimum tax. At the other end of the taxpayer continuum, lawmakers also enacted a significant expansion of the state’s property tax refund program to further reduce the regressivity of homeowners’ and renters’ taxes.

Table 2

Projected Impact of Omnibus Tax Bill on Tax Burdens by Population Decile, CY 2015

2015 Population Decile Income Range Change in Tax Burden
($000) As % of Income
1 $10,937 and under $28,065 1.56%
2 $10,938 - $19,316  $28,545 0.70%
3 $19,317 - $26,397  $27,271 0.44%
4 $26,398 - $35,600  $23,581 0.27%
5 $35,601 - $46,507  $12,900 0.11%
6 $46,508 - $59,998  $7,385 0.05%
7 $59,999 - $77,704  $6,836 0.04%
8 $77,705 - $101,618  $13,420 0.05%
9 $101,617 - $146,600  $42,557 0.13%
 Detail for 10th Decile
(lower half of decile) $146,101 - $202,407 $29,232 0.12%
Next 4% $202,408 - $510,005 $85,929 0.27%
Top 1% $510,006 and above $492,128 1.41%
10 - Total $146,601 and above $607,290 0.67%
All Households' Income Impact, All Taxes $797,850 0.37%
Source: Minnesota Department of Revenue

With all this considerable “fairness ammunition” fired at Minnesota’s tax system, it’s striking how relatively little these changes have actually moved the progressivity needle. According to the Department, this year’s omnibus bill moves the Suits Index (a measure of tax system progressivity) projected for 2015 from -0.049 to -0.033. That change is only 1/3rd of the way to a proportional tax system (a Suits Index of 0.0) in which everyone pays the same amount of their income in taxes.

Why? Part of the reason is due to a critical and under recognized point that the Incidence Study itself makes: changes in the economy that affect the distribution of income can have a much greater effect on changes in the overall level of progressivity or regressivity in the tax system than do tax law changes themselves:

“Although the historical changes in the degree of regressivity are due partly to changes in tax laws, the role of the business cycle may be even more important. During the past two decades, income inequality has generally risen during times of rapid growth and fallen during economic contractions. This concentration of income by itself, with no change in tax law, will increase the measured regressivity of the tax system....

Tax policy can certainly affect the degree of regressivity, but it is difficult to identify tax changes that are large enough to move the Suits index by as much as it has moved over the last 20 years. Trends in income inequality are certainly responsible for much of the pattern shown above.” 1

In other words, in the pursuit of greater progressivity, the state tax system is often swimming against larger and much more powerful economic forces and income trends. The changes enacted this year were destined to fail to make a bigger dent in the pursuit of a tax fairness ideal.

But another reason for the lack of progress on progressivity revolves around the incidence of the newly enacted increases in tobacco and business taxes to pay for additional desired spending. While the new income and estate taxes fall almost entirely on Minnesota’s highest earners, the other tax increases – corporate, cigarette and tobacco, and business sales – land hard on lower income households. In fact, according to the incidence analysis, change in tax burden as a percent of income for households earning $35,000 or less are higher than any group except for the top 5% of earners – i.e. those making $200,000 or more. The impact on the second and third decile of earners is proportionately larger than any group except the top 1% – undoubtedly an awkward finding for many who supported the overall thrust of the bill. What taxes on the wealthy giveth in the pursuit of fairness, taxes on businesses and tobacco taketh away.

Lesson 3: State tax structures are a largely ineffective way to try to address income inequality concerns

For many tax fairness proponents, “ability to pay” is not their only concern. Mitigating growing income inequality through the tax code and redistributing income is another key dimension of tax fairness. The ability of state and local taxes to actually accomplish this objective has been a topic of study, and controversy, for some time.

On the one hand, noted economist Martin Feldstein found that state and local governments cannot redistribute income because of migration effects combined with the finding that gross wages rapidly adjust to more progressive taxation.2 “Attempts at using state taxes to redistribute income,” he concluded, “are based on fiscal illusion.” Such a finding also raises an interesting issue of cause and effect: to what extent do states adopt progressive income taxes to address significant wage inequality and to what extent do states exacerbate wage inequality with highly progressive income taxes?

On the other hand, other studies have concluded that state tax codes can and do mitigate income inequality by compressing before and after tax incomes – albeit far less than the federal tax code is able to do. A Federal Reserve Bank of Boston paper found by far the most income compression from taxation is derived from the federal system.3 On average, income compression achieved by state taxes is equal to only around 12% of the compression achieved by the federal tax code. Any attempts by a state to match federal performance in this area would certainly result in massive tax outlier status. Hence, economists recognize redistributive goals are best left to the federal system.

Interestingly, this study also found Minnesota is first in the nation at reducing income inequality through the state tax code, achieving about 33.7% of the compression brought about by federal taxes – or nearly three times the national average. And this finding is based on the tax policies that existed prior to this legislative session which were resoundingly decried for their lack of fairness.

Do state taxes have an impact on income equality? The evidence suggests a resounding “sort of.” Figure 1 plots state tax system progressivity4 against the percent change in state income equality specifically due to state taxes. The upward sloping line confirms the relationship between income equality gains and more progressive taxation. The “R squared” value communicates a quite strong correlation between the two measures.

Figure 1

More Progressive Tax Systems are Correlated with Larger Proportional Reductions in After Tax Income Equality...

But as Figure 2 shows, state tax system structure appears to be a marginal player in the grand scheme of things. The correlation between state system progressivity and state after tax income equality is much weaker (R squared of 17%). For example, California – featuring one of the indisputably most progressive tax structures in the nation – nevertheless remains a national leader in income inequality.

Figure 2

...But Overall Tax Systems Don't Make Much of a Dent

It is true that incremental revenues from more progressive taxation could be used to support various transfer payment programs to further reduce income equality. But such spending must compete with a wide variety of other critical state supported services mitigating that potential. Moreover, evidence from around the world has shown “post transfer” income equality is actually strongest in places featuring much more regressive tax structures than in the United States. The much larger amounts of tax revenue collected through these more regressive tax structures – especially consumption taxes – combined with attention to the structural progressivity of spending systems that redistribute this revenue is the key to their income equality gains.

All of these lessons encourage a sense of humility regarding what subnational tax systems can actually accomplish with respect to fairness, progressivity, and income equality agendas. With Minnesota now clearly pushing the envelope with the progressivity of its tax system, and with little apparent public appetite for entertaining additional, albeit more regressive, forms of taxation like a broader array of consumption taxes to support more social spending, spending systems and their own progressivity will have to take center stage.

Footnotes
  • 1 2013 Minnesota Tax Incidence Study, pp. 21-22
  • 2 Feldstein and Vaillant, "Can State Taxes Redistribute Income?"  NBER Working Paper No. 4785, June 1994
  • 3 Cooper, Lutz and Palumbo, "Quantifying the Role of Federal and State Taxes in Mitigating Income Equality" Public Policy Discussion Paper No. 11-7, Federal Reserve Bank of Boston, September 2011
  • 4 Reported state suits indexes are calculated by Minnesota 2020 using data from the Institute on Taxation and Economic Policy.  (http://www.revenue.state.mn.us/research_stats/research_reports/2013/2013_tax_incidence_study_links.pdf), page 64.