The problem with Minnesota’s progressive tax system
Minnesota has one of the most progressive tax systems in the country. That is, high-income earners pay higher tax rates compared to low-income earners. According to a recently published study by the Institute on Taxation and Economic Policy (ITEP), Minnesota ranked only second to Washington D.C on income progressivity.
This is mainly because of a couple of reasons. First, Minnesota relies heavily on its income tax system. Second, Minnesota’s income tax system imposes higher tax rates on high-income earners than it does on low-income earners. In addition, Minnesota has refundable tax credits, which reduce or eliminate tax liability for a good portion of low-income earners.
While ITEP claims that this is a point of celebration, it should be a point of concern.
What makes for a good tax system
Economic theory generally agrees that a good tax system possesses, among other things, two important characteristics. A good tax system has a broad base, meaning that it divides the tax burden over a large number of people. A good tax system also imposes low rates, which when coupled with a broad base, ensures that behavioral distortions are minimal.
Minnesota’s income tax system — the backbone of the state’s entire tax system — defies both of these conditions.
The state’s income tax base is narrow and was made narrower in the 2023 legislative session when lawmakers cut taxes for some select individuals. The Minnesota Department of Revenue estimated in 2021, for example, that about 20 percent of income tax filers did not pay income taxes in 2018. That proportion is likely going to be higher given the child tax credit that was created last session, and the expansion of the social security tax exemption limit.
Tax rates in Minnesota are also higher compared to those of most states. The state’s corporate income tax, for example, is the highest among the 50 states as of January 1 this year. The state’s top individual income tax rate is also one of the highest among the 50 states, and the lowest tax rate is higher than the highest rate in numerous states.
Why Minnesota’s progressive tax system should be concerning
All taxes are not created equal. Some taxes are more damaging than others.
Income taxes, for example, are more damaging than consumption taxes. This is because people are generally more responsive to income taxes than they are to consumption taxes.
While people are generally more responsive to income taxes, incomes at the top are even more responsive to high taxes. A progressive tax system, therefore, leads to an outsized decline in productive economic activity such as work and investment, leading to a more negative impact on growth compared to a flat tax system. Researchers at various institutions such as the Congressional Budget Office (CBO), as well as the Organization for Economic Co-Operation Development (OECD) have documented this phenomenon.
Certainly, people choose where to live and do business for other reasons outside of tax, but our interconnected world gives higher-income earners more flexibility to shop around for more favorable tax systems. We have already seen in recent years that Minnesota has been losing high-income, high-skilled workers to other low-tax states and gaining low-income, low-skilled workers from other states.
After the 2023 legislative session, Minnesota’s progressive income system has become a bigger danger to the state’s economy for a couple of reasons:
- It will likely accelerate the emigration of high-income earners from the state. This will likely translate to reduced investment, and growth will suffer. Eventually, everyone will be affected.
- It has put the state budget in a precarious position. Minnesota is now, more than before, even more reliant on the rich to pay for the state’s growing government. This has increased the risk of fiscal imbalances. Case in point, Minnesota has gone from an $18 billion budget surplus to facing a $2.3 billion deficit because of reckless spending.
It should be of concern to every Minnesotan who cares about the future of the state that our lawmakers continue to create a system that is growing more and more reliant on a small segment of the population to fund it, especially considering the rate at which our state government continues to expand. Such a big government cannot be sustainably maintained by drowning the rich in taxes.
Minnesota’s tax system is bad for the state budget, bad for the economy, and ultimately bad for everyone.