The Stool Revisited

Minnesota's "unbalanced three legged revenue stool" was one of the more influential and successful policy marketing efforts in state tax history.  With the 2013 tax changes now in place and the 2014 session approaching, we examine the premise of a balanced revenue system, the actions taken in support of this goal, and conclude that our stool is now a rocking chair.  From our November-December 2013 edition of Fiscal Focus.

Google the words “Minnesota Unbalanced Three Legged Stool” and you get about 17,000 results. That alone is a tribute to the public relations success of the metaphor – a revenue system with income tax, sales tax, and property tax legs – that set the landscape for Minnesota tax policy discussions heading into the 2012 elections and the 2013 legislative session. The prop itself, a lopsided stool, was soon covered with autographs of “rebalance enthusiasts” from tax policy listening sessions all around the state and had the look of a Twins jersey after the winter caravan.

It was without question one of the more successful and influential policy marketing efforts in state tax history. What made the messaging so compelling is that the idea of property tax relief came packaged in a higher purpose: restoring needed structural balance to the revenue system. Appeals to sound tax principles served as the wrapping paper for the gift of taxpayer self interest. With the tax changes now in place and the 2014 session looming, it seems an opportune time to revisit the premise itself, take a closer look at the impact of the 2013 changes on this goal, and what it all means going forward.

A Grand Unified Theory of Taxation?

To mix metaphors, does the basic idea of the balanced stool hold water? Mushing local government finance and state government finance together into one big Grand Unified Theory of Taxation sounds intrinsically appealing but isn’t without some conceptual considerations. For starters, local governments are primarily reliant on the property tax leg. Conversely, state government depends largely on the sales and income tax legs. Importantly, neither has particularly strong access to the other’s primary revenue types. Relatively few local governments have local sales tax authority, and almost all of the cities that have been granted such authority have those revenues tied to specific economic development related projects. No local taxing jurisdictions in Minnesota have income tax authority. Similarly, state government revenues from property taxation are very small relative to the size of the general fund budget.

This mutual exclusivity means the three-legged stool communicates as much or more about dependence on government type as it does about revenue system balance. To illustrate, in 1970 property taxes represented 57.0% of the “big three” collections. The next year, legislators passed the legendary “Minnesota Miracle” legislation, a huge transformation of the state/local fiscal system in which higher individual income, corporate income, sales, liquor and cigarette taxes were implemented in exchange for big increases in state aids to local governments and schools. By 1980, property taxes had fallen to 38.7% of total collections. Then, following the state takeover of the general education levy, property tax share fell to an all time low of 31%. In short, the long-term trend in the “big three tax share” really captures the growing role and influence of state government relative to local governments over time.

Then there is the more practical issue of why structural revenue balance is only evaluated on the basis of the “big three” and not the whole complement of state and local taxation. It has always struck us as odd that “pay their fair share” tax arguments include all state and local taxes (including billions in business taxes that individuals don’t actually remit or “pay” to government but are instead imputed to them by statistical models), yet evaluations of revenue system balance are based on only the three largest taxes. Including all taxes puts property tax trends in a much different perspective. As Table 1 shows, property taxes’ share of total state and local taxation hasn’t meaningfully budged in nearly 40 years.

Table 1

Shares of Minnesota's Big Three Tax Collections, Property Tax Share of Total Tax Collections, and Tax Balance Index, FY 1980-2017

 Fiscal YearShare of Total Big Three CollectionsPT Share of Total Taxes Tax Balance Index
 Income TaxesSales TaxesProperty Taxes
 198040.2%21.1%38.7%29.7%81.7
 198142.2%21.4%36.4%28.4%82.0
 198241.8%24.4%33.8%26.4%86.7
 198341.2%23.5%35.4%28.1%85.2
 198440.9%25.6%33.6%27.9%88.3
 198537.6%26.0%36.4%29.9%89.0
 198633.8%27.5%38.7%31.9%91.3
 198736.1%26.9%37.0%30.3%90.3
 198836.8%27.4%35.8%29.7%91.1
 198933.9%28.1%37.9%30.9%92.2
 199035.5%26.9%37.6%31.2%90.3
 199135.5%26.9%37.5%30.6%90.4
 199234.3%27.5%38.2%31.5%91.2
 199335.0%27.6%37.4%30.7%91.4
 199434.0%28.0%37.9%30.9%92.1
 199534.1%28.6%37.3%30.1%92.9
 199635.1%28.5%36.4%29.5%92.8
 199737.0%27.8%35.2%29.0%91.6
 199835.8%28.5%35.6%29.1%92.8
 199938.1%28.7%33.2%29.3%92.9
 200038.1%30.2%31.7%26.8%92.8
 200139.2%29.7%31.1%27.0%91.2
 200235.5%29.5%35.0%29.3%94.3
 200336.7%31.9%31.4%25.6%95.0
 200436.6%30.9%32.5%26.5%95.1
 200538.1%29.7%32.3%26.1%92.9
 200638.7%29.1%32.2%25.9%91.9
 200738.7%27.8%33.5%27.2%91.7
 200839.1%26.6%34.2%28.3%90.0
 200936.1%26.1%37.8%31.3%89.1
 201033.6%26.6%39.8%32.9%89.9
 201136.0%26.3%37.7%31.1%89.4
 201236.5%26.7%36.8%30.5%90.0
 201337.5%26.1%36.4%30.1%89.2
 201438.3%26.3%35.5%28.9%89.4
 201539.2%26.1%34.6%28.3%89.2
 201640.3%25.8%33.9%27.9%88.7
 201740.4%25.9%33.7%27.8%88.8
Note: FY 2014-17 are forecasted based on End of Legislative Session Price of Government Report; FY 1980-2013 based on actual collections.
Source: Minnesota Department of Revenue Tax Research Division

The notion of a balanced revenue system has merit for two primary reasons. First, an over-reliance on a particular form(s) of taxation may cause problems when economic conditions create volatility for those tax receipts. Second, there may be equity and distributional problems that deserve attention created by relying too much on a particular tax. Ironically, the property tax is largely exempt from both of these potential problems. Unlike the other two legs of the stool, property tax collections are determined by governments themselves and extremely predictable. And thanks to Minnesota’s longstanding attention to ability to pay issues through its nation-leading property tax refund programs, equity concerns in property taxation weren’t a problem to begin with.

A Grand Unified Theory of Taxation?

Putting these conceptual issues aside, the data itself does a better job of undercutting the premises of the structural imbalance argument than it does of supporting it. We have written many times here and elsewhere about the distortion created by choosing to use 2010 – the depths of the Great Recession – as the benchmark year for evaluating tax system balance and dependency. It was anomalous moment in property tax and Minnesota budget history featuring a decline in sales and income tax revenues between 2008 and 2010 of over $1.3 billion dollars. This decline led the “big three” to depend more heavily on the far more stable property tax leg – as is generally the case in a recession. A recovering economy will introduce greater balance into the system. In fact, according to the February 2013 economic forecast, the state was projecting that the property tax share of the big three would return in 2014 to the historical norms of the 1980s and 1990’s – long seen by many as Minnesota’s golden era – without any changes in tax policy at all.

Even more interesting is the Department of Revenue’s Tax Balance Index, which measures deviation from the 33.3% “ideal” for each of the three taxes. Minnesota’s state/ local tax system scores a perfect 100 on the Tax Balance Index if each of the three taxes has exactly a one-third share. According to the Department’s data, the state’s best scores on tax balance over 50 years of measurement came in 2003 and 2004 – a period many balanced stool advocates wouldn’t identify as their favorite years of tax policy. Looking more broadly, Minnesota actually scored a 90 or above in 8 of the 12 years since the implementation of the infamous Big Plan which is the common starting point for the “era of concern” regarding property tax levy growth.

Imbalance Revisited

Now that the tax changes are in place, what does the stool look like? As Table 1 indicates, the property tax share of “big three” collections is projected to decline through FY 2017. However, the Tax Balance Index is projected to fall slightly – moving farther away from the one-third/one-third/one-third “ideal” – because of the proportionately greater reliance on income tax revenues. Income taxes are anticipated to account for more than 40 percent of the of the “big three” by 2016, higher than the share of collections property taxes had in 2010, which were the basis for the original “out of balance” arguments.

Ironically, concerns about over-reliance on a particular form of taxation may be a much more legitimate worry going forward. By focusing on the top 2 percent of income earners with the 2013 tax changes, Minnesota disproportionately targeted non-wage income, which is much more volatile and exposed to the business cycle than wages. A 2012 Tax Foundation report on volatility in the sources of personal income1 notes:

Business and investment income is not just volatile from year to year in aggregate, but also within each year from firm to firm and investor to investor. In any one year, almost half of businesses are unprofitable. Depending on the type of business, it is not uncommon to switch between profitability one year and unprofitability the next, e.g. due to large one-time expenses or the fact that new product lines always carry the risk of losses as well as the potential for profits…

It follows then that high-income earner status is volatile and fleeting. For instance, about half of millionaires are millionaires for just one year, largely due to the volatility of capital gains.

According to the Department of Revenue, for those with income high enough to be subject to the new 4th tier rate, nearly 40 percent comes from capital gains and business flow through income.2

The upshot of the tax changes is that the unbalanced stool has now morphed into more of a rocking chair. We have become more susceptible to big revenue and budgetary swings marked by moments of euphoria (see the November forecast) followed at some point by agitated hand wringing.

As a result, the tax changes have created a continuing need for strong discipline in state fiscal affairs. We’ve read encouraging statements by those who supported the tax changes about not becoming too giddy, about refraining from creating new long term spending commitments, and about recognizing the importance of creating a rock solid budget reserve for the inevitable times when the chair rocks backward. Whether these aspirations can withstand the tests of the 2014 election cycle, the full court press of spending lobbies, and quarterly MMB reports containing sunny revenue forecasts remains to be seen.

Footnotes
  • 1 "The Great Recession and Volatility in the Sources of Personal Income", Tax Foundation, Washington DC, June 2012
  • 2 Memo by Dr. Paul Wilson, Director of Research, Minnesota Department of Revenue, May 1, 2013