High tax rates ≠ high revenues
Lower tax rates incentivize economic activity and therefore expand the tax base. High tax rates do the opposite
In February 2020, economic forecasts showed that Minnesota’s state government had a projected budget surplus of $1.5 billion for the remainder of this biennium, FY 2020-21, which ends in July 2021. In March, Covid-19 hit the state and the economy was brought to a sudden halt. By May, the surplus had disappeared and the state budget office projected a $2.4 billion deficit for the period ending July 2021. May saw a prolonged period of rioting which left devastation in some sections of the Twin Cities and, however belated it may have been, a bill for their eventual quashing was added to state spending. On July 31st, the state budget office released a planning estimate for the next biennium, FY 2022-23: an additional $4.7 billion deficit.
The state constitution requires a balanced budget each biennium. Lawmakers in St. Paul must ask themselves the question: how will we close this deficit? They will have three options: higher tax rates, lower spending, or some combination of both.
In our new report, Minnesota’s Budget Deficit: Why we should make spending cuts and not raise taxes, we explain why Minnesota’s policymakers ought to choose the second option. In summary:
Minnesota has the fifth highest top rate of state personal income tax in the United States – 9.85 percent on income over $164,400 a year. Only Oregon, New Jersey, Hawaii, and California have higher top rates.
Minnesota doesn’t just tax ‘the rich’ heavily. Our state’s lowest personal income tax rate – 5.35 percent on the first dollar of taxable income – is higher than the highest rate in 25 states.
At 9.80 percent on the first dollar of taxable revenue, our state has the fourth highest state corporate income tax rate in the United States. Only Pennsylvania, New Jersey, and Iowa have higher rates.
Higher tax rates do not necessarily bring higher revenues. Minnesotans actually handed over a larger share of their incomes to the government in the 1990s with top income tax rates of 8.50 percent than they did in the 1970s with rates of 17.0 percent.
There is a much stronger relationship between state GDP and tax revenues than top tax rates and state revenues: for total state tax revenues as a share of state GDP, the mean average is 6.6 percent and the median is 6.7 percent: in other words, there is very little variation in these numbers.
This means that that if policymakers want more money to fund government services, they should look to increase the state’s GDP rather than its tax rates.
The overwhelming balance of academic literature shows that tax hikes negatively impact economic growth. Of 26 papers reviewed by the Tax Foundation, 23 – 88 percent – found a negative impact of higher tax rates on economic growth.
Should the state government attempt to close the deficit using tax hikes, not only will Minnesotans see their net incomes reduced, but their gross incomes will be reduced too. We estimate that closing Minnesota’s budget deficit for FY2021 with tax hikes alone would cost each Minnesotan $3,828 in lost Personal Income by 2025, or $15,312 for a family of four.
In total and per person, and in real inflation adjusted terms, Minnesota’s state government has never spent more money than it is right now: $4,088 per Minnesotan, up 26.6 percent since 2010.
Minnesota’s welfare spending per person in poverty – $30,479 in 2018 – is the third highest in the United States and nearly double the average – $17,127.
If Minnesota’s state government spent the national average amount of welfare per person in poverty in 2018, it would have spent $9.0 billion instead of $16.1 billion – a saving of $7.1 billion. If Minnesota closed its deficit by cutting welfare spending by $2.4 billion, the amount of welfare we spend per person in poverty would still rank us 6th highest in the United States.
If Minnesota closed its forecast budget deficit entirely with spending cuts, we would be returning spending in real, inflation adjusted, per capita terms, to the level of 2016/2017.
As we conclude in the report:
The facts are that: Minnesota’s tax rates are already some of the highest in the United States; hikes in tax rates do not appear to drive increases in tax revenues; tax revenues seem to be driven by economic growth; tax hikes have been shown to retard economic growth; and that in total and per person, and in real terms, Minnesota’s state government has never spent more money than it is right now. Together, these should steer us toward relying on spending cuts to achieve fiscal consolidation.
John Phelan and Martha Njolomole are economists at the Center of the American Experiment.