The good and the not so good in the House tax bill

The Minnesota House passed their omnibus tax bill yesterday and the Senate revealed their tax bill in committee on Tuesday.  So, the positions for all sides in the negotiations over taxes are now on the table. 

On the heels of a substantial increase in taxes and spending from last session, the Senate and the Governor have basically agreed to carry all that forward.  Presented with nearly a $2 billion surplus, each would reduce tax revenues by only $170 million.  By comparison, the House proposes to reduce revenues by around $2 billion.

Because the Governor and Senate tax proposals don’t amount to much, there’s not much to analyze.  In a nutshell, they carry forward irresponsible taxing and spending habits to a future when tax competition between states will be more intense and demand for public services from an aging population will be greater. 

The House, by contrast, passed a number of substantial changes to the tax code that do warrant analysis here.  Overall, the House set tax reductions at a good and proper amount, but they delivered a mixed bag of good and not so good tax policy.  Though not perfect, this mixed bag is far superior to the empty bag proposed by the Senate and governor.  Before diving into the details, it’s a good time to review what sound tax policy looks like. 

Elements of sound tax policy

As University of St. Thomas professor John Spry explained in the tax chapter he wrote for the Center’s Minnesota Policy Blueprint, “Sound tax policy should promote three core principles: economic efficiency and growth, equal taxation of equally situated people, and simplicity.”  Applying these principles, Spry went on to explain what a tax system should generally look like.   

The three guiding principles strongly favor a tax system with low tax rates levied on a broad tax base. That’s the conclusion of the report published by the Minnesota Department of Revenue and the “canonical goal” of sound tax policy. It’s easy to understand why.

Low tax rates and a broad tax base offer few avenues for taxpayers to avoid the tax by changing behavior. Lower rates promote economic efficiency by minimizing decisions to reduce or forgo the taxed activity. A broad base promotes both efficiency and equal treatment of equals by minimizing opportunities to opt for lower- or nontaxed alternatives. A broad base also promotes simplicity by minimizing the complex assortment of loopholes inherent in a narrow base.

With this mind, how does the House tax bill fare?

The two highlights of the bill

On the no-question-this-is-good-tax-policy side of the ledger, the bill entirely phases out the statewide property tax and conforms the estate tax exemption amount to the federal level.  The statewide property tax is an extra property tax on business and seasonal recreational property over and above local property taxes.  Other classes of properties do not pay the tax. 

The tax violates every major principle of sound tax policy.  It reduces economic efficiency by discouraging business investment around the state.  It violates equal treatment by taxing property of the same value differently.  It violates simplicity because the burden of the tax is largely hidden.  Much of the burden falls on consumers and workers who never see a tax bill.  It also happens to be scored as a regressive tax by the Department of Revenue due to this burden on consumers and workers.

Despite a general consensus among public finance economists and the Minnesota Department of Revenue that consumers and workers bear a substantial burden of these business taxes in the form of higher prices and lower wages, the DFL continue to paint these tax cuts as giveaways to “corporations and special interests.”  It’s hard to believe smart DFLers disagree with this general consensus, yet they still pound Republicans any time they propose reducing business taxes. 

In the Blueprint, American Experiment recommends eliminating the estate tax.  It’s a very high tax on a very narrow base, which, as Spry explains, “poses enormous incentives to distort decisions in economically damaging ways.”  These distortions—e.g., changing residence to another state, saving less, investing less, and transferring assets to would-be heirs—all impact the collection of other taxes, especially income taxes, to some degree.  Losses from other revenues might actually be greater than the gains from the estate tax.  While we prefer eliminating the tax, conforming to the federal exemption amount is a very positive move.

Repeals annual inflation-adjusted increases in the cigarette tax

Not only is Minnesota’s cigarette tax the highest in the region, it’s set to increase annually with inflation.  The dramatic price difference between Minnesota and bordering states has already made it difficult for border gas stations and convenience stores to compete, but it has also brought cigarette smugglers into this state.  Repealing the rate indexing, as the House bill proposes, is the least that can be done to address the competitiveness and smuggling problems the cigarette tax created. 

Expands on some legitimate and helpful tax expenditures

Generally, sound tax policy frowns upon special tax credits, deductions, exemptions, subtractions and other special tax preferences collectively known as tax expenditures.  These tax expenditures narrow the tax base, making it more difficult to lower rates.  They also tend to be complex to administer and encourage people to distort their behavior to take advantage of the tax expenditure.  That said, legitimate policy reasons do support the existence and expansion of certain tax expenditures.  In the Blueprint, we recommend reviewing and sun setting all tax preferences for their effectiveness versus lower rates.

The spreadsheet itemizing the House tax bill includes about fifty line items devoted to tax expenditures. As discussed below, many of these don’t withstand scrutiny.  But there are many that do advance sound tax policy, including the following:

  • Expand the current Pre-K-12 educational expenses tax credit to private school tuition.  American Experiment continues to advocate strongly for giving low-income parents the freedom to choose a private school by using all or part of the public funding set aside for their children for tuition.  Understanding the challenging politics of this type of “voucher,” we also recommend to at least expand the current K-12 educational expenses tax credit to include private school tuition.  The House tax bill adds private school tuition to the list, increases the credit from $1,000 to $1,500, and increases the income level where the credit begins phasing out.  
  • Increase the child and dependent care tax credit.  In the Blueprint, Mitch Pearlstein recommends family friendly tax reform to keep “taxes lowest for young families making investments in their offspring” and treating “children as a species of investment.”  He argues: “Lowering overall tax burdens on couples who are struggling with the many expenses and other challenges of raising young children would reduce stress on their marriages.”  The House tax bill provides this type of targeted tax relief.   
  • Expand angel investments and research and development tax credits.  Every state in the country hands out tax advantages to retain and attract businesses.  In a vacuum, handing out tax incentives for business investments is bad tax policy, but Minnesota may need to do so in light of what other states are doing.  Any tax incentive for business investments needs to avoid promoting inefficiency and cronyism in the economy.  To do so, a tax incentive needs to be broadly applied to avoid picking winners and losers.  The House bill expands the angel investment and research and development tax credits, which is generally a good option because it’s not narrowly targeted at one industry or company.

There are a few additional sales tax exemptions that would improve the tax code because they exempt intermediate products.  Taxing intermediate products used to create final products creates multiple layers of taxation, otherwise known as tax pyramiding.  Layering taxes makes taxation less transparent, less equitable, and less efficient.   The House bill reduces this pyramiding by providing a sales tax exemption for machinery and equipment used by restaurants and construction materials used to improve resorts and private campgrounds.  The bill also includes sales tax exemptions for construction materials used to build local government and school district facilities.  Arguably, this avoids layering as well because citizens have already been taxed to fund the purchases.

That’s the sum of the main provisions in the tax bill that pass the test for sound tax policy.  For the 2016-17 budget, they amount to $792 million in tax reductions, which grows to $1.504 billion in the 2018-19 budget.   With these good provisions outlined, it’s time to move on to the not so good policies.

Too much going to unsound tax expenditures

Remember, it’s generally a bad idea to load up the tax code with special tax preferences.  It narrows the tax base, keeps rates higher, adds complexity, and distorts behavior.  While the just discussed tax expenditures offer some legitimate reasons to put some holes in the tax code, there should be a very high bar considering tax expenditures violate essentially every principle of sound tax policy. 

Unfortunately, the House tax bill includes a long list of tax expenditures that don’t meet this high bar.  For instance, the bill includes sales tax exemptions for animal shelters and BMX track admissions, as well as income tax credits for contributions to long-term care savings and getting a master’s degree in a teaching field.  These may be good things we want to encourage, but the state shouldn’t be doling out tax preferences for every good intention.

Many of the tax expenditures don’t amount to much, but there are some that account for a substantial amount of revenue.  The bill provides a subtraction for both social security and military pension income that amounts to $288.3 million in the 2016-17 budget and $697.8 million in the 2018-19 budget.  It also includes a special income tax credit for agricultural property taxes used to fund school levies and a refundable credit for student loans.  Combined, these add up to $180 million in the 2016-17 budget and $240.6 million in the 2018-19 budget.

Because these tax expenditures reflect so much revenue, they represent a substantial narrowing of the tax base.  Any decision to narrow the tax base is, in effect, a decision to not lower tax rates or remove other distortionary elements of the tax code.  Lawmakers always have options.  For instance, the revenue reduction from the tax expenditures identified in the previous paragraph could be used to phase in a reduction in the sales tax rate by over a half percentage point. 

When Minnesota already has among the highest income, corporate and sales tax rates in the country, the state can’t afford to narrow the base any further. 

Temporary income tax subtraction narrows the tax base

The House bill also includes an extra subtraction from income tied to 25 percent of the federal personal and dependent exemption.  An individual taking the federal $4,000 personal exemption will get another $1,000 income tax subtraction at the state level.  That would equal about $70 for people in the 7.05 percent bracket.  The subtraction is only available for 2016 and 2017.  However, it’s probably safe to assume the subtraction is intended to continue if future revenues come in high enough to allow it. 

This is the least defensible part of the bill.  There’s some competiveness and fairness arguments to support things like the social security income subtraction and the credit for agricultural property taxes used to fund schools, but no such arguments support this move.  All this subtraction does is further narrow the income tax base, which, as explained above, is rotten tax policy.  There is no principle of sound tax policy to justify this subtraction. 

Movement toward a better tax code is certainly possible

The House position must of course move closer to the Senate’s and the governor’s positions during the course of negotiations.  Despite being a mixed bag, there’s plenty of good tax policy in the House bill to work with as they negotiate.   

The most positive development is that both the House and the Senate have prioritized a reduction in the statewide property tax.  Though the Senate offers only a meager reduction in tax revenues, a reduction to the statewide property tax accounts for over half of it.  

Also there’s some additional agreement on modifications to the child and dependent care credit, K-12 educational expense credit and the research and development credit.  Though other tax changes do warrant a higher priority, these are at least sound proposals.

If the House focuses on those points of agreement and advancing the better elements of their bill, especially the estate tax changes, then the end result should move Minnesota toward a better tax code.