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First Impressions on Governor Dayton's Budget Proposal

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Yesterday, Governor Dayton offered “the first word” on the budget and released his FY 2014-2015 budget proposal.  In short, he proposed to increase revenues by $2.976 billion (8.5 percent) as compared to the current budget.  The extra revenue pays for $1.64 billion of built-in spending increases and $1.031 billion in new spending and, in the process, erases the $1.09 billion shortfall.    

Here are the topline takeaways:

  • The budget undermines both job growth and economic growth.
  • The budget is weighted entirely toward new revenue.
  • Dayton’s “comprehensive tax reform” violates basic tax reform principles at nearly every step.
  • Instead of reforming the sales tax to fit the new economy, the proposed sales tax primarily raises taxes on families and their employers.
  • The budget ignored long-term risks pensions pose on the state budget.

For those interested in more details, here’s a summary of the budget and more in-depth explanation of the above takeaways.

What’s in the budget?

On the revenue side, the governor offered what he called comprehensive tax reform.  Major revenue raisers include: 1) A new tax bracket for the top 2 percent of earners ($1.1 billion); 2) A snowbird tax on people who live in the state less than six months, but more than 60 days ($30 million); 3) An expansion in the sales tax base to include more products and services ($4.2 billion); 4) A motor vehicle rental tax ($15 million); 5) corporate tax base expansion ($323 million); and 6) an increase in the cigarette tax ($370 million.  These new revenues are, in part, offset by a tax rebate and a few rate reductions.  All homeowners (assuming they pay income taxes) would receive a $500 income tax rebate, which would reduce revenues by $1.4 billion.  In addition, the sales tax rate is lowered to 5.5 percent, reducing revenue by $2.1 billion, and the corporate tax rate is reduced to 8.4 percent, reducing revenue by $319 million. 

Looking to new spending, the proposed budget adds $344 million to K-12 education, $250 million to higher education, $117 million to local aids and credits, $128 million to health and human services, $86 million to public safety and $70 million to economic development. 

Notably, the high-level budget presentation fails to highlight any specific new expenditure reductions.  However, it does cite $225 million in reductions and reallocations, as well as $890 million in cost inflation absorbed by state agencies.  On closer inspection, there do not appear to be any substantial expenditure reductions.

First impressions

Governor Dayton admitted that a lot of people won’t like this budget and predicted we’ll hear people calling this budget a disaster.  How prescient.  After reading a few news reports on the governor’s position on comprehensive tax reform, it seemed the governor might propose a budget that included at least a handful of positives to counter the negatives.  Regrettably, that does not appear to be the case.   Here are some of the major problems.

The budget undermines both job growth and economic growth.  Very little in the budget says Minnesota is open for business.  Yes, the corporate income tax rate and business property taxes are reduced a notch, but it’s just a notch.  Other tax changes are far more damaging.  Adding another income tax tier to the top earners will raise taxes on small businesses and create yet another barrier for all business in attracting top talent.   More damaging, broadening the sales tax base to business to business sales will only increase their taxes.   Notably, these taxes are passed on to consumers in higher prices and employees through lower wages.  Dayton’s own revenue department recognizes this fact.  Thus, contrary to Dayton’s claims, the average Minnesotan is indeed impacted by these tax increases.   

Governor Dayton pooh-poohed the idea that high taxes and high spending impede economic opportunity.  Now it’s true that Minnesota gets high marks in some business climate indexes and very low marks in others.    However, recent research demonstrates that those indexes that give Minnesota low marks—the indexes that stress the importance of lower taxes and lower spending—are the ones that can actually predict economic growth.  Fortunately for Minnesota, low taxes and low spending aren’t the only factors that influence economic growth, but that doesn’t mean we can ignore them.

The budget is weighted entirely toward new revenue.  Dayton claimed to offer a “balanced” approach, but, as already noted, the budget does not include any substantial spending reductions to help balance out the projected $1.09 billion shortfall.  There’s a bit of irony here.  On Monday, a news release from the governor’s office decried “the slash, burn and borrow budgeting approach of the past.”  Yet the budget presentation boasted of “$5.1 billion in cost savings and reductions over 4 years,” which were largely due to the demands of a Republican-controlled legislature.  The governor called this better government for a better Minnesota, but then failed to offer any specifics on how government would do things better and more efficiently through his budget.  

Reducing spending might sound Draconian on the heels of the budget cuts made to balance out those ugly shortfalls of $6.4 billion and $5.2 billion in the past two biennial budgets.  However, the state actually survived the so called Great Recession without needing to make extreme sacrifices.  Thanks to an assortment of budget gimmicks and federal funding, the state was able to increase total spending by 5.9 percent in the 2010-11 budget and by 7.2% in the 2012-13 budget.   Because the state found ways to increase spending, there remains room to make reasonable spending reductions to balance the current shortfall. 

Dayton’s “comprehensive tax reform” violates basic tax reform principles at nearly every step.  Tax reform principles like simplicity, accountability, efficiency and certainty do not fare well under Dayton’s budget.  Our tax system is repeatedly lampooned for violating nearly all of the most basic principles of a sound tax system.  Complexity is the most serious and common charge.  Yet, Dayton’s budget proposal adds new layers of complexity.   Some new wrinkles to the tax code include a 4th rate tier for the income tax, a new income tax rebate added to an already long list of income tax adjustments, and a requirement on clothing retailers to account for items sold priced higher than $100.  Efficiency also suffers.  The state tax system should minimize any distortions on private and local government activity.  People will find new and innovative ways to avoid snowbird taxes and cigarette taxes (e.g., tribal retailers selling cigarettes will be more popular than ever).  In addition, the proposed $500 rebate on property taxes gives local governments an opportunity to adjust taxes upward and, thereby, reducing their accountability to tax payers. 

Instead of reforming the sales tax to fit the new economy, the proposed sales tax primarily raises taxes on families and their employers.  Governor Dayton attempted to heed the nearly universal call from tax policy experts to broaden the tax base and to lower rates, but his proposal fell far afield from what nearly every tax policy expert would advise.  To the extent Minnesota consumers have shifted more of their spending to services, broadening the sales tax base to include these services makes sense, assuming any expansion is coupled with a reduction in the sales tax rate on all products and services.  Doing so should create a more stable revenue source and reduce distortions on how households spend money.  But Dayton’s proposal depends much more on expanding the sales tax to sales between businesses.  This leads to what tax experts call tax pyramiding where the final cost of a consumer product can include a pyramid of sales taxes on all the inputs that went into creating the product.   And in the end, it’s the consumer that ends up paying the price.  

The budget ignored long-term risks pensions pose on the state budget.  It’s not surprising that the governor didn’t mention the unfunded liabilities in state and local pensions.  After all, pensions are supposed to be an off-budget item.  But Dayton was keen to point out how his budget solved long-term structural problems with the budget.  The fact is, pensions pose a long-term problem to the state’s budget.  And any resolution requires taking on the public employee unions, which this governor simply will not do. 

Now the budget debate turns to the DFL-controlled legislature.  Governor Dayton shrewdly left the tough choices to them.   Clearly, the sales tax base expansion is going to need to be trimmed back if it is going to be implemented at all.  It’s up to the legislature to now pick the winners and losers.  Dayton also made no effort to trim spending, which legislative leaders have suggested may be necessary.  And spending cuts will be necessary if Dayton’s revenue proposal proves unworkable, which is quite likely.     

A majority of Minnesotans gave complete control of state government to Governor Dayton and the new DFL legislature.  It will be interesting to watch the legislature react to the governor’s budget.   Will they pay more attention to advancing sound tax policy principles, reducing spending and promoting economic opportunity?   I’m not holding my breath. 

 

Peter Nelson is Director of Public Policy at the Center of the American Experiment.

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