Fantasy Policy

It was only a matter of time until Minnesota Republicans proposed to repeal the income tax, an article of faith in Republican state fiscal politics elsewhere. Scott Jensen, the endorsed and presumptive GOP gubernatorial candidate, made it happen:

Republican candidate for governor Scott Jensen unveiled a sweeping plan to battle inflation Thursday that includes eliminating Minnesota’s state income tax and cutting government spending.

Strib (6/23/22)

The title of this post may be too pejorative; “aspirational” would be more neutral. While the idea is not realistic for Minnesota, it’s useful to noodle about it a bit. It is likely to be part of the political discourse leading up to November.

Fiscal Reality

• Big money. Income taxes provide 53% of the state’s general fund tax revenues, forecast to be almost $16 billion for FY 2023. Yes, over half of state general fund tax revenues come from the income tax. The reduction in revenues would need to be replaced by a combination of spending cuts and increases in other taxes.
• Spending cuts. Even in austere times the legislature rarely cuts spending. It simply slows down or stops the rate of increase. Cutting spending by just 10% of the reduced revenues would require more than $1.5 billion in reductions (net of the state aid cuts that result in local property tax increases). I’m sure the Jensen campaign thinks it can cut spending much more than that but it is likely more difficult than they realize. For example, cutting human services spending is devilishly difficult because of the 50% federal Medicaid match for much of it. Cutting a dollar of spending saves only 50 cents in state tax burden; it’s a hard sell to either the providers like nursing homes and clinics or to the elderly or disabled beneficiaries who present very sympathetic cases.
• Sales tax increases. The sales tax is the least unpopular tax. Let’s assume that 45% of income tax revenues are made up by increasing the state sales tax rate. That would require an increase from the current 6.875% to about 14%. (The 6.875% rate excludes the now ubiquitous additional city and county and county tax rates. So, the effective rate in most locations would be even higher.) Of course, the rate increase could be mitigating by expanding the base to items like clothing and services. But that is politically difficult to do even at the current rate. Combining it with a rate increase would increase the political degree of difficulty dramatically. A rate above 10% is sure to encourage evasion. The higher the rate, the bigger the incentive to cheat.
• Property tax increases. Let’s assume that 40% of income taxes revenues are made up by cutting state aid to schools, cities, and counties that yield property tax increases. Most state revenues fund services delivered by local governments. Under that assumption, property taxes would increase by more than 50%, a very tough political pill to swallow.
• Other tax increases. That leaves 5% of the revenues to be made up with increases in other taxes, such as the corporate tax, excise taxes (e.g., on cigarettes and alcohol), and insurance or health care taxes. That might be doable, since the corporate and cigarette taxes tend to be easier to increase politically. Conforming to the new federal GILTI rules could yield a lot of revenues depending upon how it is done. An income tax repeal is sure to raise corporate taxes, probably by a lot.

This fiscal reality is why it is unlikely the Jensen campaign will release details on how it will eliminate the income tax any time soon (even to phase-in a major reduction of say 25%). The details would be ugly politically.

Economic Reality

Progressivity reduced

Eliminating or phasing down the income tax would dramatically reduce the progressivity of the state fiscal system, regardless of whether it results in spending cuts or heavier reliance on other taxes. Both, of course, are inevitable if you’re going to eliminate the income tax.

The income tax is more progressive than the property tax and much more progressive than the sales tax. According to the most recent Tax Incidence Study (p. 24), the current Minnesota state and local tax system is close to proportional (Suits index of -0.013). Most income groups pay close to the same share of their incomes in taxes (not true of the very lowest who pay more if you trust the sketchy data for them). Dropping the income tax and replacing much of its revenue with a combination of sales, property, and corporate taxes (all regressive) would change that dramatically. Using my assumption above for the replacement revenues, the current Suits index of -0.01 might go to about -0.145 (0 is proportional; index values range of 1 to -1 with positive numbers being progressive and negative regressive). Minnesota would go from being a high tax state with a proportional tax system to a high tax state with a regressive distribution.

The benefits of state and local government services are progressive (think Medical Assistance and social services at the extreme). So, service cuts will almost surely increase the overall state and local fiscal system’s regressivity. Tax geeks rarely talk about the distribution of state and local spending programs, but it is as important or more than tax distribution. Mildly regressive state taxes that fund services are often on net progressive overall. A fact that is often lost on progressives who seem to focus obsessively on tax progressivity, ignoring other important tax principles. Minnesota relies less on fees than most states. Offsetting the lost revenues with higher fees would have similar effects to service reductions.

Nonresidents benefit

Legislators love taxes that export the burden to nonresidents. A saying attributed to the late Senator Russell Long captures it: “Don’t tax you. Don’t tax me. Tax the guy behind the tree.” For state legislators, the guy behind the tree is somebody who lives in another state and can’t vote for or against them. So how would substituting sales and property taxes affect that dimension of taxation (idiotic as it may be from a policy perspective; we’re all Americans after all)? Once again, the Tax Incidence Study (p. 8) conveniently estimates the shares of the various taxes borne by nonresidents. For the income tax, it’s 5.9%, for the sales taxes it is 5.2%, and for the local property tax it is 0.8%. Thus, the net effect of income tax repeal and replacement will be to shift the tax burden from out-of-staters to Minnesotans, if you trust the Incidence Study (I do). The sales tax paid by visitors and property taxes paid by nonresidents who own Minnesota land and homes simply cannot make up for untaxing the income of nonresidents who own Minnesota businesses and investment properties.

Economic growth benefits uncertain

Of course, proponents of repeal (Club for Growth types) will say that is precisely the purpose of repeal. In their view, untaxing out-of-state investors will attract financial capital into Minnesota, juicing the economy. There are multiple problems with that:

• It’s unclear that lack of financial capital is holding back Minnesota economic growth. It is equally or more likely that lack of workers (labor) is a bigger problem. At least many seem to think so.
• Evidence that reducing or eliminating the tax will attract a lot of capital is thin. Much of the lost revenue will be replaced by raising other taxes and it’s not clear that shifting a state tax structure away from income taxation will yield big benefits. The academic evidence is mixed; compare here and here. Therese McGuire, an economist I knew from the 1983-84 Minnesota Tax Study Commission and have great respect for, has done high-quality research on this issue with conflicting results. Her 2003 essay, Do Taxes Matter? Yes, No, Maybe So is a very thoughtful discussion of the ambiguity and difficulty of the issues involved.
• Much of the benefit will go to investment that is already here, not the targeted new investment (benefitting owners of “old capital” rather than attracting “new capital”).
• A more targeted approach could exempt nonresident investors, avoiding upending the Minnesota fiscal system by repealing the entire income tax. That would leave the tax in place on residents. (Even better would be to only exempt new investment. That is tricky technically, raising other issues.) Good luck with passing an almost $100 million tax cut for out-of-staters on the theory that it may induce new investment. Small detail: much of that will be siphoned off by existing businesses owners who sell their businesses to these favored out-of-state investors, generating no new Minnesota investment (buildings, machines, etc.) but exempting the future returns on the sold businesses from taxation. The differential taxation of in- and out-of-state investors would not be sustainable politically in my experience, anyway. When Minnesota tried an experiment of imposing slightly lower property taxes on new commercial developments, it lasted only a short time in the face of withering political attacks by owners of existing buildings.

Revenue growth curtailed

A key characteristic of the income tax is that it has, in economic terms, a positive elasticity. Of all the state major taxes, it is the only one that grows as fast or faster the economy. It has been years (at least as far as I know) since MMB has estimated the elasticity of the various state taxes. But it is widely accepted that sales tax revenues grow more slowly than the economy; in economic terms, it has an elasticity below 1. The property tax is a levy-based tax, so it raises the amount of revenues that the taxing unit (state, city, county, or school district) says. Excise taxes, like the gas, cigarette, and alcohol taxes, are set as dollar amounts per commodities so they decline in real terms when prices go up. They are very inelastic. All that means tax revenues grow at or maybe below economic growth. Repealing the income tax would make the tax system very inelastic; revenue growth would be sure to lag growth in incomes or the economy.

As a result, the legislature would need to enact explicit tax increases to keep funding the current level of government services. Given the difficulty of passing tax increases politically, that aligns with someone who wants to limit or reduce government growth (i.e., small government types) but it will make it more difficult to maintain services. The state’s experience during the aughts when revenue growth lagged would become the norm. One might question whether the public would understand that “tax increases” are simply what is necessary to keep paying a constant share of the state economic output, rather than politicians seeking to grab an ever-larger share? It will create a structural bias in favor of smaller state and local government. Obviously, one’s priors will determine whether you think that is a good or bad thing. It certainly goes against the traditional Minnesota approach of the last half century plus.

Less revenue diversification

The benefits of diversification of an investment portfolio are widely recognized per modern portfolio theory; it reduces risk while increasing risk-adjusted returns. Tax policy wonks conventionally recognize similar benefits of a diversified tax portfolio, the classic three-legged stool of property, income, and sales taxes. The benefits are threefold. First, diversification makes revenue flows both more reliable across the business cycle, as well as increasing growth potential. (The previous section discussed the latter, of course.) Second, there are fairness benefits since each of the taxes alone fails to tax key components of the economy. Dropping the income tax will favor individuals who consume lesser shares of their income and/or who own below average real estate, relative to their incomes. Finally, by compelling higher rates for the other taxes, the inefficiency penalty (deadweight loss) associated with those taxes increases. State sales taxes with their narrow bases and taxation of business inputs (causing pyramiding or double taxation of some items) is particularly distortive. Sales taxes in practice are not your broad-based VAT, a relatively good consumption tax.

Note that this says nothing about the overall level of the combined taxes, which is an independent legislative decision. Rather, it is a structural feature of the tax system as a theoretical matter. Of course, practical and political reality says that it is easier to raise and spend revenue with a diversified tax structure. That reality is, I assume, a big part of the appeal of cutting off the income tax leg of the stool for small government GOPers.

To what end?

The proposal’s premise, of course, is that the income tax is a drag on economic growth, an article of Republican faith (think Club Growth and similar types). If that is true (evidence is mixed), the effect is small. High sales taxes and property taxes are drags on economic growth too. So, we’re talking about the differences in the growth effects of tax types that are small and uncertain. That is the case to the extent that phasing out the income tax means other taxes rise – a surety; it’s just a question of how much. The change would turn the state fiscal system inside out and clearly make it less fair (if you favor progressivity or proportionality) for uncertain benefits, at best. It’s unclear whether the economic pie will grow, but we know lower income folks’ pieces will be smaller.

Service cuts may hinder economic growth

Many government services (think roads, education, public safety and so on) are important to a vibrant state economy. The state does not raise income tax revenues to burn them in a bonfire. They provide services, some of which are crucial to economic growth or to provide amenities that attract the workers who drive growth. Cutting services in ways that do not affect growth prospects is no easy task and may be impossible when the economy is built on expectations of the current mix of services. Quantifying the exact effects are problematic but they are real, rhetoric about wasteful government spending and that much spending is simply redistribution (taking from Peter to pay Paul), notwithstanding. Minnesota’s economy has generally flourished as a high tax and high service state. How much of that is attributable to luck or the quality of public services is unclear. But it is surely some of both, making big cuts in public services risky.

Political Reality

The politics of the proposal are interesting and seemingly contradictory. Here, I’m out of my element. I have never been active politically or involved in campaigns. My observations are strictly those of an amateur who spent his career working with elected officials and their political staffers. Since political appeal and acceptability are key components of any policy, it was a regular topic of discussion in my presence. I may have absorbed some insight by osmosis.

The proposal reflects the contradictions, in my opinion, of the Republican base and the party’s resulting politics and policy proposals. The GOP’s key voters are rural (DFLers are barely competitive now in rural Minnesota), white, and working class. Those are the folks that Trump energized, turned out, and rode to victory in 2016. They similarly represent why the GOP controls the Minnesota Senate and (probably) is favored to win the House in November 2022. By contrast, the party’s big funders are still affluent business owners and corporate executives – think Club for Growth types, again. Despite the Right’s railing against “woke capitalism” (e.g., the likes of big tech and Disney), most corporate executives are still Republican. In fact, this study suggests that is more true than previously (WaPo story on the study). Of course, the Right raises immense amounts of contributions from small dollar contributors, most of whom undoubtedly have modest incomes. But the amounts pale compared to that donated by big hitters.

Repeal of the income tax will appeal to the affluent funders who typically have libertarian and limited government values. But the policy effects, depending upon exactly how the lost revenue is made up, would very likely adversely impact the GOP’s rural and working-class voters. This is so because of the fiscal structure of Minnesota state government. That results from the interaction of two related effects.

• Minnesota state government’s main function is to collect tax revenues and redistribute them to schools, counties, and cities to provide services. Over half of those tax revenues come from the income tax, which is heavily paid by higher income households. These include the big Republican funders. The appeal to them of repealing the tax is obvious. They will pay much less in sales and property taxes and will bear little effect of service cuts (e.g., in medical assistance or education). Again, the Tax Incidence Study shows this effect. Ten percent of the state’s households with the highest income pay over half the state income tax (p. 27). By contrast, they pay less than one-third of the sales tax. (For what it is worth, the Democrats have an ever-growing constituency of affluent supporters, as extreme Republican policies (thanks to Trump and others) have driven more educated folks from the Republican Party. But the Dems still typically want to raise, not cut, taxes especially income taxes.)
• Rural areas of the state win big in this exchange of the state collecting income tax revenues and redistributing them to local government. My old employer, the House Research Department, annually compiles these statistics, which are available here. Twin Cities metropolitan area taxpayers pay 69% of the income tax and 65% of the sales tax (back in 2017, the most recent year available). So, substituting sales for income taxes will disadvantage the rural areas of the state very modestly. The tradeoff is much larger to the extent repeal results in state aid cuts, whether that means property tax increases or service cuts. The nonmetro area collects about 45% of state aids while paying less than 35% of state taxes, a 10 percentage point favorable balance of payments. So, if repealing the income tax results in state aid cuts, nonmetropolitan areas of the state, predominantly Republican, will take it in the shorts. And the Twin Cities metro area, which predominantly votes DFL, will keep more of its money (e.g., to pay property taxes to replace the state aid cuts). If Jensen succeeds in repealing the income tax, he will be like the farmer in Aesop’s fable who kills the goose that lays golden eggs for his rural supporters.
• Cynically, to offset this effect legislative Republicans in their formal budget proposals often disproportionately cut state aid for Minneapolis, St. Paul, Duluth and so on, areas always controlled by the DFL. In some cases, they simply zeroed out that aid to make proposals balance. (As an aside, those cities with their problems typically score higher than rural areas on statistical need measures even with their much bigger tax bases, but never mind.) I don’t know if they would go so far as to do that when they have full control, as opposed to setting up negotiating positions for end-of-session deliberations. But that can only go so far to make up for billions in lost revenues. Aid to their rural communities will need to be cut, probably dramatically.

In essence, it appears that the GOP would be sacrificing its voters to benefit its funders. This galls DFL activists. They can’t understand how the GOP can get away with rhetoric and proposals that do stuff like that. The obvious answer is that typical voters do not examine policy analyses and economic effects to see which party’s or candidate’s proposals would benefit their pocketbooks. They vote on partisan loyalty, rhetoric (gee, I’d love to stop paying income taxes), social issues, identity, and similar. Moreover, the political cultural now has much lower expectation about policy details and effects than it did in the past. For a political campaign it is maddeningly difficult, I would think, to tease out and convince voters of complicated fiscal effects of the type involved here. By contrast, repealing a tax has obvious appeal, even if the real effect is that it will cost you dearly. Moreover, if you’re a dedicated partisan, you will discount whatever the other side says and be highly skeptical of media accounts if they don’t align with your tribe’s position. As a result, it’s not at all clear to me that there will be any negative repercussions of a radical proposal like this.

Interestingly, legislative GOP candidates in 2020 made a big deal about opposing increases in the gas tax, a Walz proposal. Obviously, that is a very visible tax that is easy to understand and that disproportionately affects rural voters who typically drive longer distances, often in pickup trucks and older vehicles that do not get good gas mileage. It is possible to hold down the gas tax by transferring general fund resources to the highway funds. Repealing the general fund’s largest tax source will make that more difficult. That might give DFLers a messaging opportunity. But it too is a complex narrative that is likely to cause the typical voter’s eyes to glaze over.

Practical Reality

Nine states get along fine without an income tax. The obvious question, then, is why can’t Minnesota do so? Looking at the situation of the states without income taxes reveals why they are not practical models for Minnesota repealing its tax. (Aside: the Kansas state experiment under former Governor Brownback is probably the better analogy. He and legislative Republicans tried a dramatic cut in the state’s income tax, a sort of first step to phasing it out. The result was fiscal catastrophe and the Republicans in a very red state losing the governorship. The voters did not support the service cuts that resulted from the tax cut. Lesson: taxes buy services many voters want.)

The 9 states without income taxes are Alaska, Florida, South Dakota, New Hampshire, Nevada, Tennessee, Texas, Washington, Wyoming. They all have some combination of the following characteristics:

• Many have substantial ability to export their tax burden to nonresidents because of natural resources like oil, gas, and coal (AK, TX, WY) or strong tourism industries (NV and FA).
• Some are rural without major urban areas that demand more services (AK, NH, SD, WY).
• Most have a long-term political culture of providing below average levels of government services. Alaska and Wyoming, two rural natural resource rich states, export much of their tax burden and spend 50% or more than the national average. Of the remaining states, only Washington spends more than the national average, and the other six states spend 15% or less. Minnesota spends 9% more. (All this is based on FY 2019 census data available on the TPC website). The chart below shows the relative amounts.
• None of them ever had an income tax and repealed it. Tennessee had a tax on investment income, which it recently repealed. (NH still has a tax on interest and dividends, so it has an income tax lite.) As they say, you can’t un-ring a bell. Once the government infrastructure is in place to provide a high level of services and people’s expectations are set, it is difficult, if not impossible, to reverse that. Eliminating programs, laying off employees, and similar is not easy to do. Pension obligations and other debt must be paid even if the programs are terminated or cutback significantly.

The only states that come close to mirroring Minnesota’s demographic profile are Washington and Tennessee. Neither are good analogues because they do not have a history of imposing an income tax and providing high services. Tennessee is a classic low service state. Washington is the closest to Minnesota’s situation, but the level of government services provided in low property tax base areas is likely much lower than in Minnesota.

Bottom Line

In my view, repealing the Minnesota income tax won’t happen because of the practical and political realities. But superficially, it’s a signal to the GOP donor base and (maybe) a nice political talking point. Who wouldn’t want to be free of paying income taxes, especially if you assume it won’t affect the public services you get or the other taxes you pay? It requires digging deeper and thinking about consequences, something that too many voters don’t do. They simply reflexively support the candidates and talking points of their party/tribe.

At one level, the proposal is just a dramatic way of saying: “We hate the income tax and will cut it as much as possible.” (Translation: you know what will happen to the big surplus, if they control the legislature and governorship. Whether that is fiscally sustainable is another and more relevant issue.) Whether Jensen’s proposing it helps or hurts his candidacy is beyond my comprehension. It does not inspire confidence in a dedicated centrist and realist like me who expects candidates to take policy details and feasibility seriously in their campaigns.