Exempt Social Security from state income tax? Good politics. Bad policy

This op ed originally appeared in the Pioneer Press on March 36, 2023.

Milton Friedman once said, “I am in favor of cutting taxes under any circumstances and for any excuse, for any reason, whenever it’s possible.” As much as it pains me to disagree with one of the greatest social scientists of the last century, it is possible for a tax cut to leave the tax system in worse shape. The current proposal to exempt Social Security income from state income taxation is a case in point.

Economically speaking, the best tax system levies low rates on broad bases. Exemptions and credits go against this and ought to be used sparingly, if at all. So, if Minnesota state government is going to tax individuals’ incomes, why should it exempt income from Social Security?

The only answer I’ve really had to this question is that this income was already “taxed” when the individual’s Social Security was withheld from their paycheck and that it is being taxed a second time when Social Security pays out and the state government taxes that.

But this isn’t true.

Rhetorically, Social Security withholdings might be called a “tax,” but economically they function as an individual’s contribution to a “collective” form of national defined benefit plan. As a result, Social Security income is effectively taxed only once, when it is paid out, as an earned benefit, like payouts from a 401k.

If we are going to exempt income from Social Security from state income taxation, why, then, do we not also exempt income from 401ks or other such schemes?

Exempting income from one particular source of retirement income and not others goes against horizontal equity in the tax system, the notion that taxpayers who have the same income should pay the same amount in taxes.

It is disappointing to see the GOP using what little leverage it has in St. Paul — the ability to block a bonding bill — to push bad policy like this. With a $17.6 billion budget surplus forecast, Minnesota’s overtaxed citizens certainly should receive some relief. We at the Center of the American Experiment have advocated for leaving the entire structural surplus with the Minnesotans it is forecast to be taken from in the form of permanent cuts in income tax rates.

With the $1.3 billion this policy is forecast to cost in the current biennium, estimates from the Minnesota Department of Revenue show that we could cut the bottom rate of state income tax by 0.8 percentage points, to 4.55%, providing relief to all Minnesota’s taxpayers, not just those who derive income from Social Security. In their “Give It Back” plan, Republicans proposed a one-percentage-point cut in the bottom two income tax brackets — to 4.3% and 5.8%. By increasing the after-tax return on economic activity, such rate cuts can be expected to increase such activity in a way that increasing the after-tax return on Social Security contributions made years ago will not. Tax-rate cuts are the policies the GOP should be using its leverage for.

I get more emails about the taxation of Social Security income than about any other issue, so I understand the political appeal of this measure. But good politics often makes for bad policy, as the sorry state of the federal budget amply demonstrates. That is the case here, with apologies to Milton Friedman.