income tax

Good Use for MN tax data


This one of my signature long and boring posts. Now that more than two people appear to be reading my blog, I decided to add a summary so they can move on to something more interesting in 30 seconds or less.

The Tax Policy Center published a report last summer that used Colorado, Minnesota, and New York state tax data to analyze TCJA’s effect on charitable giving. Robert McClelland, Using State-Level Data To Understand How The Tax Cuts And Jobs Act Affected Charitable Contributions, (July 2022) (11 pages); blog post summary. It shows that TCJA did, as expected, reduce charitable giving but the state data shows that the effect is quite a bit smaller than looking at federal tax data alone. Not surprisingly but still useful.

The report showed an unusual effect for two states – the 2018 drop in Minnesota giving was twice as big as in Colorado. I was intrigued and took up the author’s challenge to explore why Minnesota givers appear (probably mistakenly) to be twice as sensitive to tax incentives as Colorado givers. After spending a bunch of time looking for answers and coming up empty, I decided to wait for another year of data. That shows that the effect reversed with Minnesota giving for 2019 increasing quite bit and Colorado giving declining below Minnesota’s new level (measured relative to AGI). I don’t know what is going on, but my best guess (and that’s all it is) is that the 2018 Minnesota data are goofed up (technical term). But I don’t know why or have a good hypothesis for it.

This post is a tedious explanation of what I did, essentially writing up my research notes, a long, tortuous ride that ends in a box canyon with blank walls.

An addendum reprises my previous rants advocating for changes to Minnesota’s tax incentives for charitable giving after TCJA. That won’t happen because of institutional factors in how the legislature makes decisions on stuff like this but I can’t stop myself.


TCJA, the 2017 federal tax cut, dramatically reduced the number of taxpayers who qualify for income tax incentives for charitable giving. It did so by simultaneously increasing the standard deduction and cutting back on itemized deductions (mainly for SALT, home equity interest, and employee business expenses). That means many fewer taxpayers now itemize deductions (about 10% versus close to 30% previously nationally), the main way charitable giving federal tax incentives are provided.

These new itemizers experience a higher after-tax price of charitable giving as a result. For example, an itemizer in the 25% bracket could give her favorite charity $1 at an after-tax cost of 75 cents. If she becomes a nonitemizer thanks to TCJA, the price rises to the full dollar contributed. Econ 101 predicts that increasing something’s price reduces the quantity purchased (gifts given here). But TCJA’s tax cuts provided potential givers with more income to make contributions. So, that could cause more giving. As with many tax changes, economic theory does not provide an unambiguous indication of the behavioral response that will occur. Standard contradictory substitution and income effects are at play.

One would expect the substitution effect to be more powerful with big price changes coupled with modest tax cuts. But that and the magnitude are empirical questions.

So far, researchers have relied on survey or federal income tax data. However, charitable contributions by newly nonitemizers will not show up on federal returns even though many still give. You don’t report contributions if you can’t deduct them. Survey data and reporting by nonprofits are less reliable ways to track charitable giving than contributions reported on tax returns. See this AEI Report, Howard Husack, The Tax Cuts and Jobs Act and Charitable Giving by Select High-Income Households (April 2022), for an example of an analysis that relies on income tax data; it assumes (more or less) that a reported decline in deductions equals a decline in charitable giving.

James Chandler, The Effect of the TCJA on Donations to Medical Charities (2021), uses a different type of tax data, contribution reports on Form 990s. Although medical charities (his focus) are required to 990s, a fair number of others (e.g., churches) are not and more importantly the characteristics of donors must be inferred (i.e., they are not reflected in the tax data).

Robert McClelland, a researcher at the Tax Policy Center, came up with a clever way to use state tax data from Colorado, Minnesota, and New York to assess the first-year effects of TCJA on charitable giving. Using State-Level Data To Understand How The Tax Cuts And Jobs Act Affected Charitable Contributions, (July 2022) (11 pages); blog post summary. Because these states continued to allow many of those who no longer itemize federally to deduct contributions for state tax purposes, they provide state tax data on giving behavior by these new nonitemizers. This was such a clever use of Minnesota tax data that I wish I had thought of it.

He found that:

[C]ontributions fell by much less than indicated on federal forms. In Colorado, a 16 percent decline measured at the federal level was in fact a 1 percent decline when contributions on state forms are included. In Minnesota, a 33 percent decline at the federal level was actually an 18 percent decline using combined federal and state data, and in New York, a 15 percent decline at the federal level was more likely a 4 percent decline. However, given 5.6 percent growth in AGI, the decline represents an even higher reduction in the rate of giving. Regardless, residents of these states retained some tax incentive to donate even as they switch from itemizing to not itemizing on their federal forms.

Robert McClelland, Using State-Level Data To Understand How The Tax Cuts And Jobs Act Affected Charitable Contributions, (July 2022), p. 9.

If you’re interested in the effects of TCJA’s changes on charitable giving, I recommend reading McClelland’s report or his blog post. It suggests TCJA’s effects on giving may not be as dire as a growing body of research seems to suggest (Google Scholar has a fair number of papers).

Colorado and Minnesota mystery

As is evident in McClelland’s quote above, the data show a big difference in the effects in Colorado (1% drop) compared to Minnesota (18% drop). McClelland notes:

We are unsure of the reasons for the large disparity between Colorado and Minnesota. State officials may know additional information about reporting incentives in those two years.

Id. p. 8

On the surface, that suggests that Minnesotans are more sensitive to charitable giving tax incentives than Coloradans. That is, TCJA’s tax price increase caused a much bigger decline in Minnesota giving. Both by filers who remain itemizers and by newly nonitemizers. That seems odd. The difference in response is so striking that I thought I would take up McClelland’s challenge.

One year of data for two states is a small sample, so I waited until the two states posted another year of data (2019 in addition to 2018) figuring that might help clarify matters. Instead, it reversed the effect, deepening the mystery. Colorado’s 2019 reported giving dipped, while Minnesota’s increased.

The rest of this post records my efforts. The short answer is that I don’t have a good explanation. But that won’t stop me from droning on about the blind alleys I explored.

Five avenues seemed to me worth exploring:

  • TCJA’s differential effects
  • State data differences
  • State tax law differences
  • Reporting differences
  • Year-to-year variability or state differences in giving patterns

Differential TCJA effects on the two states

The first possibility that I looked at was whether TCJA’s itemized deduction changes affected the states differently. The big difference in itemized deduction amounts (33% drop for MN versus 16% for CO) suggested looking at that possibility. If TCJA caused a significantly higher proportion of Minnesotans to become standard deduction filers than in Colorado, that could account for some of the difference. That is so, because a higher proportion of Minnesotans would be subject to TCJA’s increased price of contributing than Coloradans. The graph shows the percentages of itemizers in Colorado and Minnesota for 2017 through 2020 using data from SOI Historic Table 2 (two more years of SOI data are available than CO and MN data).

It indicates there may be something to this. Pre-TCJA about two percentage points more resident Minnesota filers (35.5%) itemized than Colorado filers (33.6%). TCJA reversed that. In 2018, about two percentage points more resident Colorado filers (13.5%) itemized than Minnesota resident filers (11.3%). The effect persists in 2019 and 2020 (the further declines in 2020 may be pandemic effects).

As an aside, the likely explanation for that effect is that the SALT deduction cap adversely affected Minnesota filers more because of the state’s higher and more progressive taxes, which concentrate burdens on itemizers with their higher incomes. (If TCJA’s SALT cap was designed to punish high tax blue states, as I suggested here, it appears to have worked.) SALT deductions in 2017 were 6.6% of AGI in Minnesota versus on 4.4% in Colorado. Coloradans deducted one percentage point more of their AGI in mortgage interest (largely unaffected by TCJA) than Minnesotans, providing another part of the explanation.

That does mean that TCJA’s price increase for regular Joe and Jane charitable givers hit Minnesota a bit harder.

Another indicator for this effect is the extent to which the two states deviate in the income distribution of their givers. The standard deduction, as a fixed dollar amount, is an easier hurdle for very high income filers to overcome and itemize, all else equal. SOI data for 2017 – 2020 show that higher shares of Colorado itemized deductions for contributions come from high income filers. For tax year 2017 (pre-TCJA), 3.5 percentage points more of Minnesota’s itemized deductions were allowed to filers with AGIs of $100,000 or less, compared with Colorado. Post-TCJA, the difference persisted but dropped to 2.8 percentage points. By contrast, for the 4-year period, 7 percentage points more of Colorado’s itemized deductions were attributable to filers with $1 million or more in AGI than in Minnesota (41% versus 34% for the post TCJA period). The graph shows the latter data.

These effects could explain some of the 2018 difference that McClelland observes, but it has to be a small part of it and not the real explanation. If Minnesota had experienced the same drop as Colorado, it would have resulted in about 87,000 more itemizers, reducing the differences between the two states by maybe 10% to 15%. The fact that Colorado derives proportionately more contributions from higher income givers likely also accounts from some of the difference.

State data differences

Minnesota’s posted data on charitable contributions (i.e., the data used by McClelland) are incomplete because they do not include the contributions deducted as Minnesota itemized deductions. Colorado’s data, by contrast, has no similar omission. That could account for some of the difference. However, the posted Minnesota data also double count some charitable contributions. So, the combined effects could go in the wrong direction.

Undercounts. The data posted on the Minnesota Department of Revenue’s (MDOR) website show charitable contributions claimed on federal Schedule A, which are inferred from the Minnesota income tax sample. (McClelland used SOI numbers which differ because they are derived from the population of returns listing Minnesota addresses filed with the IRS. The SOI amounts differ from the MDOR amounts because of the sample and residency issues. I regard SOI’s numbers as likely more accurate than MDOR’s.) The Minnesota data undercount charitable contributions because they do not include the Minnesota itemized deduction for charitable contributions for filers who take the federal standard deduction but itemize for Minnesota purposes.

Minnesota’s standard deductions amounts equal the federal amounts, but its itemization rules differ. State income taxes are not deductible, while employee business expenses are deductible. Some taxpayers will claim the federal standard deduction but itemize for Minnesota purposes, That occurs when employee business expenses plus their other itemized deductions, other than state income taxes, exceeds the standard deduction. That results in them claiming their charitable contributions as Minnesota itemized deductions, rather than deducting them under the nonitemizer rules. MDOR’s posted data do not report these amounts. I think these amounts are small because for many filers disallowing the income tax deduction will offset allowing employee business expenses.

Overcounts. Conversely, some federal itemizers claim the Minnesota standard deduction and the nonitemizer deduction for charitable contributions. The typical example is a filer whose state income tax deduction is necessary to put them over the standard deduction amount. Thus, for those filers the Minnesota data on the web (either SOI or MDOR) double counts their deductions (the contributions are reported on both Schedule A and as Minnesota nonitemizer deductions). This effect is illustrated by data for the top income strata which show over 106% of returns claimed itemized and non-itemizer charitable contribution deductions, a legal impossibility.

Since I no longer have access to the HITS microsimulation model and income tax sample, I can’t calculate these amounts and I don’t trust my intuition to say even what the sign of the combined change is if these errors were corrected. Thus, this is a blind alley. If I were forced to guess, I would predict the overcounts are more than the undercounts. But I would have little confidence in that guess.

State tax law differences

Another possibility is that some sort of state tax law effect may be responsible. Both states have slightly different charitable giving incentives and differ in their rate structures (flat v. graduated) and bases. There are more similarities than differences, though.

The Colorado and Minnesota legislatures enacted somewhat similar responses to TCJA. Both states had used federal taxable income (FTI) as the starting point for their taxes, thereby incorporating the federal itemized deduction rules, and allowed nonitemizers to deduct charitable contributions. Both responded to TCJA by adopting its higher standard deduction and maintaining their nonitemizer deduction, which now applies to many more filers. Colorado did so under its rolling conformity law; Minnesota by linking to federal AGI but allowing a Minnesota standard deduction equal to TCJA’s and a itemized deduction for contributions following the federal rules.

There are some key differences in the two states’ taxes that may be relevant to charitable contribution behavior:

Rates. Colorado has a flat rate (4.63% in 2017 and 2018), while Minnesota has a graduated rate structure with higher rates (5.35%, 7.05%, 7.85%, and 9.85%). Most of the new non-itemizers after TCJA would be subject to 7.05% and 7.85% Minnesota rates.

Non-itemizer charitable deductions. Both states allow non-itemizers to deduct charitable contributions under similar rules. Contributions over $500 are deductible in computing each state’s taxable income. Colorado allows full deductibility, while Minnesota allows one-half of contributions to be deducted. The incentive effect is determined by multiplying the allowable deduction by applicable marginal tax rates. So, Colorado’s full deductibility offsets its lower tax rate. Of course, what we’re trying to explain is the difference in giving responses in the two states by itemizers that TCJA caused to become standard deduction filers. Thus, the relevant question is whether the combined federal and state changes under TCJA and state conformity for that group had a materially different effect on the after-tax price of giving in the two states. The chart shows the changes.

The graph shows how much TCJA increased the after-tax price of Minnesota and Colorado charitable contribution (expressed in cents per dollar contributed) for a filer who was an itemizer in 2017 and a standard deduction filer in 2018 by levels of AGI. It shows substantial increases in the cost of giving – by about 25 cents/dollar in the sweet spot for these types of givers ($90k to $160k). An increase of that size could be expected to reduce giving, obviously depending upon the elasticity.

But the relevant issue is whether Colorado law did something to mitigate this difference that Minnesota’s law did not. The graph shows that the differences for the two states (the area between the two lines) are small and are unlikely to explain the differences in response in the two states, given any reasonable assumption about elasticity. (The obvious question to me: why was the 2018 decline in Colorado giving so small – only 1% – with the large tax price increase? Standard literature on the elasticity, such as Bakija and Heim, would suggest a larger response. It’s also possible, of course, that 2018 was a particularly good year for charitable giving in Colorado with some very large gifts – for the five tax years I looked at, it had the highest concentration of gifts by resident filers with AGIs of $1 million or more by over 2 percentage points.)

Conservation easement credit. Colorado allows a tax credit for donations of conservation easements. It provides a 50% credit (75% on the first $100,000 of contributed value) – in addition to the deduction under the federal and Colorado state taxes. It has many more complicated rules; it can be partially refundable and can be transferred/sold, for example. This tax expenditure evaluation provides more detail. Minnesota has no comparable incentive. The Colorado credit should stimulate more contributions of conservation easements. This should also result in higher Colorado reported charitable contributions (likely itemized deductions in most cases), since claiming the credit does not appear to disqualify use of the deductions. For 2018 and 2019, Colorado SOI reports $16 million and $14 million in credits claimed respectively, implying about $30 million in value contributed per year. That’s a paltry amount compared to the over $4.6 billion in charitable contributions reported on tax returns by Colorado residents. It’s implausible that it explains the difference between the two states.

Conclusion. It is safe to conclude that state tax law differences do not explain the big difference the 2018 data show. They could explain a very small part of the Colorado advantage, at best.

Reporting differences

This is potential cause that McClelland suggested exploring. 2018 was the first year affected by TCJA’s changes. So, it could have disrupted reporting of contributions on state returns.

Both states responded somewhat similarly to TCJA’s enactment. But the timing of those responses was quite different, and that may have differentially impacted 2018 return filing and taxpayers’ understanding of the applicable rules in the two states. There was a lot more confusion and uncertainty in Minnesota than in Colorado. But it is not obvious why that should lead to different charitable contribution reporting.

Colorado. Colorado is a rolling conformity state. CO Rev Stat § 39-22-103 (5.3) (2018), That means when Congress enacts changes in the federal tax law that affect FTI, those changes automatically apply for Colorado state income tax purposes. Decoupling or failing to follow the federal changes would require the Colorado legislature to enact a law. As a result, when Congress passed TCJA in late December 2017, Colorado taxpayers could be almost certain that its rules would apply to their charitable contributions made in 2018 for both federal and Colorado state income tax purposes. Thus, if TCJA’s standard and itemized deduction changes made them nonitemizers, they would know that they no longer qualified for the federal deduction but would qualify for the Colorado nonitemizer deduction.

Colorado taxpayers, I presume, decided whether or not to make contributions accordingly. They had all year to figure it out, subject to the possibility that the Colorado legislature would make changes. The Colorado forms for 2018 reflected that reality.

Minnesota. If Colorado provided certainty to its filers, Minnesota did the opposite. How the state would respond to the TCJA was still unclear when 2018 filing began.

Minnesota is a fixed conformity state. It links the starting point for its tax (FTI in 2017) to the version of federal law at a fixed date. Minn. Stat. § 290.01, subd. 31. (This is required under a Minnesota Supreme Court decision, which held that a 1960s era rolling conformity statute unconstitutionally delegated legislative power to Congress. Wallace v. Commissioner of Taxation, 184 N.W. 2d 588 (1971).) As a result, how the state would respond to TCJA required legislative action. Minnesota had divided government in 2018 (Democratic governor and Republican legislature), which was unable to agree on a conformity bill during the 2018 legislative session. The legislature did not enact conformity to TCJA until May 2019 after tax year 2018 filing was mostly over.

To make matters worse, Minnesota law required that the election to use itemized deductions or the standard deduction must be made consistently for federal and Minnesota purposes. Minn. Stat. § 290.01, subd. 19 (2018). Because the Minnesota tax was linked to the old, pre-TCJA federal standard deduction, this created the prospect that Minnesota taxpayers would need to forgo claiming Minnesota itemized deductions to use TJCA’s standard deduction for federal purposes. For some taxpayers this would have meant paying higher Minnesota taxes to qualify for lower federal taxes. However, the Minnesota Department of Revenue (MDOR) issued a taxpayer friendly revenue notice in September 2018 allowing inconsistent federal and Minnesota standard deduction elections, even though this was incompatible with the text of the law. Revenue Notice 18-01 (Sept. 4, 2018).

Parsing the language of the revenue notice (last paragraph, p. 2) very carefully would suggest that the federal standard deduction election would determine whether a taxpayer qualified to claim the nonitemizer subtraction. That incongruous result (it would have allowed some taxpayers to double deduct some of their contributions – if they used the federal standard deduction and itemized for Minnesota) was not intended, as later revealed by the instructions (p. 12).

The revenue notice eliminated the uncertainty on the issue of consistent standard deduction elections but not the complexity and confusion as to overall status of TCJA’s changes for Minnesota purposes.

Most insiders expected that the 2019 legislature would enact conformity, much of which would be retroactive to tax year 2018 both to provide tax cuts and to mitigate the ongoing complexity under multiyear provisions like cost recovery allowances. The typical taxpayer, however, would not have had a clue about any of that, of course. The 2019 legislature ultimately did precisely that but not until May 2019.

By necessity, the 2018 filing season proceeded on the assumption that Minnesota was tied to pre-TCJA federal law. Forms were constructed and filers prepared their Minnesota returns using their income and deductions under prior federal law. Despite state law linking to FTI, the combination of TCJA and the failure to pass a conformity bill compelled MDOR to construct the forms starting with AGI and providing Minnesota itemized deductions based on pre-TCJA law. See 2018 M1 instructions. Thus, a filer whose itemized deduction were higher than the pre-TCJA standard deduction but lower than the post-TCJA standard deduction would file claiming itemize deductions, including if applicable those for charitable contributions.

The 2019 legislature passed a conformity bill in May that was retroactive to tax year 2018 with regard to the treatment of TCJA’s charitable contribution changes (higher standard deduction, now directly specified by Minnesota law; higher AGI limits, etc.). This did not require most filers to amend their returns. Rather, MDOR recalculated their tax (assuming the filed forms included the necessary information) allowing the higher standard deduction and converting itemized deductions for charitable contributions to the non-itemizer deduction if applicable (i.e., greater than $500).

So, did this complexity and the potential confusion resulting from temporary nonconformity cause Minnesota filers to underreport their actual charitable contributions on their Minnesota returns (or worse to change their contributing behavior)? As a matter of logic, it should not have. There were two basic possibilities, neither of which would have resulted in less favorable treatment of charitable contributions than provided in Colorado:

  1. Legislature does nothing. MDOR’s revenue notice made it clear (as of fall 2018) that this would allow a state itemized deduction under pre-TCJA rules for state law purposes with the old lower standard deduction. This would allow full deductibility for itemizers.
  2. Legislature adopts TCJA’s charitable contribution rules. This is what happened, of course, and variations on it had been proposed in the 2018 legislative session but were not enacted. As noted above, it provides roughly similar state tax benefits to those in Colorado because of the Minnesota subtraction for nonitemizers.

Thus, either of the two likely options would have resulted in about the same tax treatment as in Colorado. No one, for example, proposed or (to my knowledge) even publicly talked about the legislature repealing or curtailing the nonitemizer deduction. In fact, lobbyists for charities had instead proposed expanding it to full deductibility.

But it is certainly possible that the confusion around what the legislature would do and a general failure to recognize that the Minnesota nonitemizer deduction remained in place (or even existed) may have affected giving more in Minnesota than the certainty that prevailed in Colorado. Confusion about how the state would respond was certainly greater in Minnesota and could have been responsible. For example, some/many taxpayers may have simply assumed, based on media coverage of the federal effects of TCJA, that their relatively modest contributions were totally nondeductible and failed to track or report them. (It’s unclear why such an effect would be different in the two states, unless the confusion about a state response in Minnesota factored in.) That could be the explanation and is my best guess but is pure speculation. (FWIW, a MDOR staffer I contacted made a similar conjecture unprompted by me.)

Could MDOR’s re-computation of itemized and standard deductions (i.e., the conversion of reported itemized deductions to nonitemizer deductions) have been responsible? That is not a credible possibility to me. I trust MDOR’s competence and if a mistake like that had been made, it surely would have come to light.

In short, Minnesota’s response to TCJA was much more muddled and confusing than Colorado’s. However, there was never any public discussion or prospect for disadvantaging charitable giving in Minnesota (whatever the response the legislature landed on) than what ultimately occurred, and which is about the same as in Colorado. Thus, it should not have affected giving decisions differentially.

Yearly variations

My last possibility was to explore year-to-year variations as well as differences in giving patterns between the two states. Giving levels vary somewhat from year to year. And it is widely recognized that giving patterns vary from state to state. For example, because of Utah’s strong Mormon ethos it typically has the highest charitable giving relative to income of any state (CNN map) and is likely less responsive to the level of tax incentives.

So, it would be useful to compare giving patterns in Colorado and Minnesota before and after TCJA. Again, what we’re trying to measure is differences in tax responsiveness, not just basic charitable giving tendencies. Unfortunately, the Colorado DOR website has only 5 years of data. It revamped its data starting in 2015 and cautions that earlier data (only 2013 is available on its website) may not be comparable.

The first graph below shows giving by residents as a percentage of AGI from 2015 to 2019 for the two states. The pre-TCJA data show some modest variability (more in Minnesota than Colorado) with the two states showing similar patterns. In two years Colorado is slightly higher and Minnesota in one. The post-TCJA data are confounding with bigger state differences and oscillations between the two years. (Possible inference is that TCJA unsettled charitable giving patterns, at least temporarily.) It’s hard to conclude anything from this, since it implies a bigger response by Minnesotans in the first year and then by Coloradans in the second year.

Decomposing the 2019 effects, giving by itemizers in both states dropped (CO dropped 6%; MN 4%). The difference was that giving by Minnesota nonitemizers increased dramatically (77%), while giving by nonitemizers in Colorado dropped slightly (4%). The large Minnesota jump obviously raises questions about its 2018 data. Both states experienced small declines in the percentage of taxpayers who itemize, although Minnesota’s was larger. The bigger drop could explain some of Minnesota’s increase in nonitemizer contributions but nothing like what occurred. I’m mystified.

Giving reported on Minnesota tax returns has been fairly stable over the last ten years, putting aside TCJA’s impact. The graph below shows 2010 to 2019 data (again as a percentage of AGI). Simple year-to-year variation seems unlikely to provide much explanatory power to understand the two state’s deviations post-TCJA.

Take away

The differences between the two states remain a mystery. A couple factors (differential changes in giving patterns and Colorado’s concentration of more of its giving in the top income strata) could explain part of the big 2018 difference. But adding a year of data further confused things with Minnesota making up all the difference and more. It suggests to me that the responses in the two states were similar and the big dip in 2018 Minnesota giving was an anomaly – either in reporting (most likely) or actual giving. It may be that the failure to enact a 2018 conformity bill with attendant publicity about that and TCJA’s effects sufficiently confused a fair number of filers so they failed to claim the nonitemizer deduction. Illogical, but possible and pure conjecture.


Tangential points that I cannot resist making

Reading McClelland piece, spending more time reading other research on TCJA’s effects on charitable giving, and mucking around with the Colorado and Minnesota charitable contribution data reinforced in my mind the case for reforming Minnesota charitable contribution tax incentives. I am being repetitive since I have made this case before (e.g., here, here, and here) but I couldn’t resist.

There has always been a good case for reforming the Minnesota and federal charitable giving tax incentives – to increase their equity and effectiveness. TCJA strengthened that case because it:

  • Adversely affected giving. This is the obvious emerging consensus from the research. McClelland’s piece shows that it is smaller than simply looking at the federal data would suggest. But it’s still meaningful and a concern for those who believe it is appropriate to encourage charitable giving with tax incentives.
  • Dramatically concentrated tax incentives in the top income strata with its increase in the standard deduction and cap on the SALT deduction. The chart below shows the decline in Minnesota returns claiming the itemized deduction for contributions by income strata, comparing tax years 2017 (pre-TCJA) and 2019.

The change is striking. There are big drops across the aboard, but especially below $500k. Yes, Minnesota’s nonitemizer deduction continues to apply and is claimed much more heavily by the filers in strata below $250k. But they get only half the benefit of itemizers.

My favored fix.  I believe the way to do that is what I suggested in this blog post for a revenue neutral reform option:

  • Replace both deductions. The standard deduction now functions more as a zero-bracket amount (nontax threshold income amount) rather than a proxy for average itemized deductions. Given that, I see little rationale for bifurcating the level of incentive based on whether you use the standard deduction or not. The disallowance of the first $500 in the non-itemizer deduction was intended to represent (I believe) a rough measure of the portion of the standard deduction for charitable contributions. That rationale makes little sense with the much more generous standard deduction; having differing incentives is confusing without a policy rationale to justify the complexity.
  • Limit the incentive to giving over an income threshold (e.g., 2% of AGI or something similar) and a dollar minimum (e.g., $500), so more of the incentive applies at the margin. We don’t need to reward people for what most/many would give without an incentive, and this helps deter people from claiming small amounts they didn’t give because they know they won’t be audited on small amounts.
  • Use a credit so the same percentage incentive applies regardless of the tax rate and income level. Yes, high-income people may be more responsive to incentives, but appearances and equity considerations are more important.
  • Limit the credit to cash contributions, so the state does not amplify the double federal tax benefits for giving away untaxed appreciation. A big side benefit is to keep MDOR out of auditing and contesting valuations of hard to value property like real estate, art, and similar.
  • Disqualify federal itemizers from using the state credit. Given TCJA’s concentration of federal incentives, I would allocate a richer state incentive to those who lost their federal incentive. The way to do that in a revenue neutral proposal is to cut out federal itemizers. This should allow a revenue neutral credit rate of more than 15% to those who no longer qualify for the federal incentives.
  • Impose a maximum credit as a disincentive for big givers to forgo the federal deduction to qualify for a more generous Minnesota incentive. This would be a problem if the credit rate goes to 25% or more, for example. The savings from the cap will allow a higher credit rate under the revenue neutral constraint, a more powerful incentive for qualifying contributions.

My original blog post has more detail on my thinking.

Noncash contributions. One of my hobby horses is to get rid of the deduction for untaxed appreciation. Why should owners get a double tax benefit for giving appreciated assets away (no tax on the gain and its gift reduces tax on their other income), when cold hard cash is almost always more useful to charities? Other than for publicly traded securities, valuation challenges and abuses abound too.

Moreover, this benefit is concentrated at the top, raising equity concerns. The chart shows the percentages of noncash contributions by AGI class for Minnesota in 2019. About 75% of contributions by itemizers with incomes below $500k were made in cash. For those with incomes of $500k or more, about half of their contributions were.  Put another way, the noncash proportion of the top group’s contributions are twice that of the rest of the filers. You can be sure that most of those contributions include untaxed appreciation that gets the double benefit.

SOI data (with more detail for higher income filers) shows the benefits are even more concentrated at the very top.  Figure D in the SOI Report on noncash contributions for tax year 2017, shows that 39% of the noncash donations were made by returns with $10 million or more in income. Foundations and large charitable organizations are the largest beneficiaries of these donations. Id. (p, 5). This is not where Minnesota needs to or should be putting its tax incentives for donations, in my opinion. Federal largesse is sufficient.

Prospects for reform dim

The prospects for enacting a major change along these lines is slim to none. There is little legislative interest (I suggested it several times to legislators when I was working). If there were interest, lobbying would quickly snuff it out. The charity lobby generally opposes changes that take away benefits their constituent members now enjoy. They are happy to lobby for more benefits (e.g., expanding the nonitemizer deduction to 100%), but are unwilling to accept cutting back on existing benefits for a better designed incentive. At least, that was the pattern when I worked for legislature and legislators are loath to cross them.

This is just standard trade association behavior. Governing bodies and representative of trade associations have strong incentives to oppose proposals that create losers among any of their significant constituent member groups (e.g., arts or private higher educational groups that receive many large noncash gifts in this case). Policy collides with interest group politics and dynamics. This is also a big deal in trying to fix business taxation in ways that create winners and losers. Umbrella business trade associations hate mediating conflicts among their members over proposals (no matter how meritorious); it’s easier to just oppose them.

income tax tax administration

The Good, The Bad, and The Ugly

Apologies to Sergio Leone

The Good

Last Thursday, the governor signed federal conformity changes into law (Laws 2023, chapter 1), less than two weeks into the legislative session, lightning speed by legislative standards. I can remember only two similar instances of the legislature acting almost as quickly on a conformity bill in the last 30+ years. In both cases the laws were signed on the last days of January (Laws 2005, chapter 1 on 1/27/05 and Laws 2009, chapter 12 on 1/29/09) and involved relatively inconsequential changes responding to end-of-the-year federal enactments. The 2005 law allowed an extended period to make charitable contributions for Indonesian tsunami relief.

Update and correction: Cynthia Templin, House Fiscal analyst, points out how defective my memory is. Early conformity bills passed in January of 2015, 2017, and 2022. I should actually look this stuff up. Of course, the 2022 legislation (after my retirement) was selective leaving important stuff for later. But things were not really as bad as I recalled.

The need for 2023 conformity changes before the start of the tax filing season was largely due to the previous legislature’s failure to act, of course. Congress did enact some modest changes after the legislature adjourned. Often in the past, it was Congress enacting “extenders” legislation retroactive for the current year. This time it is was self-inflicted by the 2022 political impasse.

The bill is scored as a tax cut of about $100 million for FY 2024 (mostly one-time, though), which I’m sure made it easier to pass and much more consequential than the two examples from the aughts. The Strib billed it as a COVID tax cut (print edition headline: “Walz signs COVID aid tax break”). But aside from the direct effect on state revenues (i.e., the explicit tax cut) it also is an implicit tax cut because of the vast time savings involved (time = money).

It will save tax preparers, taxpayers, and DOR staff thousands of extra hours of wasted time and effort – preparing returns under an out-of-conformity law and redoing them under a revised law that adopts the federal changes. I don’t think thousands is an overstatement when you consider the number of tax filers and how even those unaffected by the federal changes still must click through software questions or read instructions for those who still prepare their returns “by hand.” Even modest per hour assumptions of the value of the wasted time yield millions of dollars of savings.

All those hours wasted doing needless tax preparation and compliance when the legislature fails to pass a conformity bill are an implicit tax increase. It does not show up on legislative spreadsheets or revenue estimates, but it is just as real as an economic matter. That concept, however, was hard to convince legislators of – probably because it is not the sort of thing that shows up on campaign literature (explicit cuts and increases do) and is a long and complicated point to make to voters. Few legislators would attempt to do so during a campaign unless they were speaking to a group of tax preparers.

Delay or total failure has occurred so many times in recent years that I now expect it. That stimulated me to reflect on the why of past failures and whether this year could become the new normal, the real reason I’m writing this. I think the following factors are at play:

  • The large surplus made life relatively easy, given chapter 1 is a big tax cut. In a tight budget, legislators become unwilling to take money off the table early in the process. $100 million is chump change relative to $17 billion. And since the cut is largely one-time, few permanent decisions are being made. That unusual combination is unlikely to reoccur.
  • Unified party control helps. When the GOP controlled one or both houses of the legislature with a DFL governor, they would think (falsely in my opinion) that the governor was responsible for conformity (it was in his budget and the executive branch administers the tax) and, therefore, would make political concessions to get it in a final budget deal. That was rarely, if ever, true. Governors did not consider it much of a political priority as a good government responsibility. Thus, its trade value was minimal in budget negotiations. (Note that Pawlenty was governor with DFL control of one or both houses for the two other examples of early conformity passing. DFL legislators either recognized the value of conformity or the lack of trade or bargaining value, not sure which.)
  • The tax chairs likely are on the same conformity page. During the Lenczewski and Bakk era, this became a factor. Representative Lenczewski was a big advocate for conformity, while Senator Bakk seemingly did not consider it to be big deal. He, being a master negotiator and deal cutter, naturally assumed he could get something for agreeing to conformity in a final deal, even if he favored it. As a result, decisions tended to be delayed. Again, he probably overvalued the trade value but why throw chips away if getting the maximum deal is your default frame of reference.
  • A final factor that militated against passing multiple bills was tax chairs’ distaste for floor fights. Bringing tax bills up to the floor typically leads to the minority offering multiple gotcha amendments for various and sundry tax cuts (to get bad political votes on the record) and long debates for consumption by the viewers of legislative TV (who are those people and why don’t they have anything better to do?). This is an unpleasant process to go through once, much less twice. This distaste/pain looms larger if you think you probably can’t get a deal until May anyway. (As an aside, I always doubted the utility of getting two sets of the same bad votes on the record and why that would matter. But I have never been involved in campaigns.) In this case, the minorities apparently decided not to make the majority run that gauntlet twice. I have no clue why, but applaud the decision to forgo a meaningless exercise.

Is this likely to continue in future sessions? I hope so but would not put money on it. But even one-time victories are a cause for celebration.

The Bad

By contrast, the first action of the U.S. House of Representatives was to repeal the increased funding for the IRS that passed last year in the Inflation Reduction Act. House Republicans use first vote to gut IRS funding boost (Politico 1/10/23). It left in place the funding for increased taxpayer services and some of the IT improvements. (WaPo reports “a little over half [of the original $80 billion w]as targeted for enforcement.” The House GOP bill repeals 7/8th of the funding, so well beyond the enforcement money.) Because Biden is president and the Dems control the Senate, it won’t be enacted into law but is nevertheless a bad thing.

  • Since the big 2022 federal budget deal froze IRS funding (at the insistence of the Senate GOP), if enacted it would return the IRS to starvation funding for purposes of enforcement and system modernization. That is a recipe for more noncompliance and unfairness. One takeaway from the Joint Committee’s report (12/14/2022) on Trump’s tax returns is how under-resourced the IRS is in dealing with the complicated returns of high-income business owners (400+ PTEs to review, a fair number of which had a lot of revenue and magically identical expenses, and one auditor!).
  • It would increase the deficit by more than a $100 billion according to CBO, money that is owed under current tax law. It reflects a common pattern in Congress – Dems enact new spending that is supposedly paid for with revenue increases – GOP feigns concerns about deficits but proceeds to advocate for and repeal the revenues (with support from Dems) without doing anything about the spending. That is what happened to much of the revenues that funded the ACA (remember the Cadillac insurance and medical device taxes?). The fact that the new House GOP rules replaced PAYGO with CUTGO (Politico) reveals that the GOP’s concern about deficits looks the other way when reducing revenues is the proposition. Deficits apparently don’t matter if you’re cutting taxes? Weird asymmetry calculated to curry political favor from those who want government services/benefits but don’t want to pay, contrary to Milton Friedman’s classic aphorism: “To spend is to tax.”
  • It took 15 votes to elect a speaker. By contrast, all but one of the GOP members voted to repeal the IRS funding, and none voted against it. That is sobering (so much for the idea there are GOP moderates when it comes to taxes) and a clear message about where their priorities lie. It is easy to reflexively hate taxes but irrational. Everything (including government services) has a price that must be paid. A measure of honesty would reveal what spending they plan to reduce. Of course, they simply regard the CBO estimate as inaccurate if the past is any guide.
  • Expect the 118th Congress to travel a bumpy fiscal road. Let’s hope they figure out that the debt ceiling must be increased without the need for a financial meltdown lesson. It’s probably too much to expect them to remember what happened in 2011. According to the Council on Foreign Relations:

The protracted and politically acrimonious debt limit showdown in the summer of 2011 prompted Standard and Poor’s to take the unprecedented step of downgrading the U.S. credit rating from its triple-A status, and analysts fear such brinksmanship in late 2013 could bring about similar moves from other rating agencies. “Failure to raise the federal debt ceiling in a timely manner (i.e., several days prior to when the Treasury will have exhausted extraordinary measures and cash reserves) will prompt a formal review of the U.S. sovereign ratings and likely lead to a downgrade,” said Fitch Ratings, which maintains a “negative” outlook on the U.S. triple-A rating.

A 2012 study by the nonpartisan Government Accountability Office estimated that delays in raising the debt ceiling in 2011 cost taxpayers approximately $1.3 billion for FY 2011.

The stock market also was thrown into frenzy in the lead-up to and aftermath of the 2011 debt limit debate, with the Dow Jones Industrial Average plunging roughly 2,000 points from the final days of July through the first days of August. Indeed, the Dow recorded one of its worst single-day drops in history on August 8, the day after the S&P downgrade, tumbling 635 points.

U.S. Debt Ceiling: Costs and Consequences

I personally don’t think there is any credible case for the claims the Republican sponsors are making for the defunding (preserving the middle class from nasty IRS audits or some such). For what passes for supposedly thoughtful case for the defunding see here: National Review (Nate Hochman) and the counter from the left, New York magazine (Jon Chait). Attributing assertions from a GOP press release to the Tax Foundation is pretty low stuff, especially for a reputable publication like the National Review (Bill Buckley must be turning over in his grave). The Tax Foundation has a conservative tilt but (in my experience) does not make stuff up; they just make sure the stuff they put out skews right. You can trust their numbers but need to be careful about what’s missing or the spin they put on it – typical of most of similar beltway outfits, whether on the left or right.

The Ugly

According to Fox News, Kevin McCarthy has promised a floor vote on replacing the income, corporate, and estate taxes with the Fair Tax, which abolishes the IRS (states would collect the tax). This was apparently part of the deal to get him elected speaker and will obviously be purely symbolic.

The Fair Tax, a national retail sales tax, has long been a favorite among very conservative Republicans nationally and at the state level (versions have been introduced in Minnesota). But it’s largely a collection of talking points and not a practical proposal.

The U.S. does need a broad-based consumption tax to supplement (not replace) existing taxes. Every other major developed nation has one and none of them spend as much on defense as the US. That is the only way we will be able to continue funding our current level of government services. Since the turn of the century when the budget was last balanced, the deficit spending – due to the combination of tax cuts, two wars, and the baby boom tapping into social insurance – is simply not sustainable, even ignoring COVID relief spending. Cutting spending isn’t going to do it under any realistic political scenario (see this Committee for a Responsible Federal Budget piece on spending cuts; for example, 85% of discretionary spending would be cut if social security, Medicare, veterans, and the military are off limits; just imagine what the health care world would look like without Medicaid funding).

The consensus across the spectrum of experts is that it should be a VAT, rather than a retail sales tax with all its problems of enforcement and administration. The rest of the world abandoned retail sales taxes decades ago as suboptimal. For a full bore treatment of the flaws in the Fair Tax you can read this old Tax Notes article by Bruce Bartlett, Why the Fair Tax Won’t Work (available on SSRN). Bartlett is a former deputy assistant Treasury secretary for economic policy during the GHW Bush administration and an engaging and accessible writer.

Bulwark (a conservative, Never Trump site) questions the politics of bringing it up for a vote: Will the House GOP Really Walk the Plank for the Fair Tax?  It’s amusing reading (at least for me).

If one wants to stay optimistic, this could be a baby step forward in the conversation about the need for a national consumption tax. Obviously, it won’t be with the focus instead on abolishing the IRS, its artificially low tax inclusive rate, and other silliness.

The whole idea of turning tax collection over to the states is the height of foolishness. Do we want to rely on likes of Mississippi and Nevada, to take two examples, to collect federal taxes when inattention or outright corruption can curry favor with local voters and businesses? A sure recipe for undermining revenues and national unity. The founders discovered a similar problem with the Articles of Confederation, after all. The power to impose taxes (the prime reason for the Constitution) necessarily involves the ability to collect them, rather than relying on the good graces of semi-autonomous and occasionally hostile state governments (see, e.g., Texas when a Democrat is in the White House).

My sympathies go out to the nonpartisan Congressional staffers who will spend hours working to provide the symbol, complete with drafts, revenue estimates, summaries, explanations, etc. They will also likely be criticized and/or ordered to fix flaws that are revealed, as they inevitably will be by expert commentary and media coverage. If the underlying concept is unworkable – it is – fixing it technically is not possible. Explaining it accurately without implicit disparagement is not easy.

income tax

Cruz: Defund IRS or shutdown gov’t

In a reprise of his 2013 effort to repeal the ACA, Ted Cruz is advocating congressional Republicans shut down the federal government, if necessary, to repeal IRA’s funding of the IRS according to Politico (Benjamin Guggenheim):

What’s happening: Sen. Ted Cruz said Monday that Republicans should hold up next year’s government funding to block an expansion of the IRS, escalating GOP attacks on the agency.

What he said: “I think we oughta fight an epic, knock-down, drag-out fight over stopping the Democrats from funding 87,000 new IRS agents to harass and intimidate and persecute Americans and their political enemies,” Cruz (R-Texas) said on his podcast, echoing an attack line Republicans have repeatedly used against an $80 billion boost in IRS funding included in the Inflation Reduction Act.


‘Behaving like jellyfish’: Cruz said Republicans shouldn’t be cowed by Democrats and the media in a potential government shutdown standoff. Republican Senate leadership has acquiesced too often to Democrats’ demands and should develop a strategy to pick “real, significant fights that matter,” he said.

“I think the American people are pissed with Republicans behaving like jellyfish,” he said.

Dates and figures: The remarks come as Congress returned for its first day of the lame-duck session. Current stopgap funding ensures that the government will keep operating until Dec. 16. It was not immediately clear whether Cruz wants to cut annual appropriations for the IRS, the $45.64 billion in new funding for tax enforcement, or the entire $80 billion, which includes funding to beef up customer service, modernize technology and other operational upgrades at the agency. A spokesperson for Cruz said his office has nothing to add at this time.

Politico 11/15/2022

By most accounts, Cruz is not a favorite of other Congressional Republicans (BBC). He was a prime instigator of the 2013 shutdown targeting the ACA, which is commonly perceived to have not turned out well for his party. He now claims that resulted from his inadequately explaining the rationale to “elite opinion makers.” Huh?

In any case, IRS funding strikes me as a different political animal than ACA repeal:

  • On the one hand, the ACA was the signature policy achievement of the Obama administration and “fixing” health care had been and continues to be a major Dem policy goal. So, it is some thing they were likely to fall on their swords over. Moreover, Republican opposition on multiple from both the Tea Party base and the affluent funders was palpable. The makings of an extended stare-down are plain to see.
  • On the other hand, IRS funding – whatever one thinks of its merits – is simply a means to an end (more overall government funding, keeping the budget deficit down, and so on). Everyone agrees tax collection is a necessary function. They just disagree about the level and specifics. It is not something Dems care about per se; expanded government funding can be achieved in many ways (raising taxes in a variety of ways or cutting “bad” spending under your policy priors). That should also be true for Republicans. Plus, they just finished an election campaign in which they made this an issue across and, as far as I could tell, it failed to gain political traction.
  • In any case, “defund a basic government function (tax collection) or we’ll shutdown government” does not seem like a winning political slogan (not as bad as Defund the Police but similar). Translation: To justify it, you need to get into a longer and modestly complicated narrative and “If you’re explaining, you’re losing” as Ronald Reagan once said.

This is a long way this political naïf saying Cruz’s blustery threat will not be taken up by his fellow Republicans and if it is, the Dems after reflexively resisting for some time will devise a compromise or solution of some sort. Nobody (who has a modicum of rationality) is going to shut down the federal government over this. That’s not to say, there won’t be a shutdown, and this will be on a longer list of Republican demands.

income tax tax administration


Refunds of PTE tax

MMB is out with its October report on revenues. They continue to come in above forecast, a modest $126 million. Of that, $53 million were from the individual income tax.  Most interesting to me, there still isn’t apparent evidence of the unwinding of overpayments as a result of the new pass-through entity (PTE) tax. The presumption is that taxpayers paid individual income tax on that income during 2021 and near the end of 2021 decided it was preferable (b/c it reduced federal tax) to pay the PTE tax, essentially double paying. The overpayment would unwind when they filed their individual returns and claimed refunds for the individual income estimated tax payments.

Extension filing is due in October. So, I presume that the returns are filed.  Because individual income tax revenues continue above forecast, a big uptick in payment of refunds does seem to have occurred.  That does not settle the issue for at least three reasons:

  1. Taxpayers can apply their refunds to their tax year 2022 liability, rather taking the money as a refund. But if they’re going the PTE tax route, I would guess that is somewhat less likely since their payment obligations would be under that tax. You cannot credit overpayments of individual income tax to the PTE tax, which is an entity tax for which there are DOR separate accounts.
  2. Some refunds may not be processed yet. Returns involving large amounts of PTE income are often among the most complicated returns, more of them may be filed on paper, and they take longer to process. So, refunds due the PTE tax switch may still be in the pipeline.
  3. Other factors (actual economics) may be yielding individual income tax revenues to offset a rise in refunds attributable to the PTE tax.

We’ll have to wait until the November forecast to a get a fuller picture, but I’m guessing more of the revenues are real rather than timing related to PTE tax payments as MMB has reported thinking ($1 billion seems too high to me).

Doug Johnson

It is with sadness that I note the passing of former Senator Johnson. I never had the privilege of working in the same house of the legislature with him. He moved from the House to the Senate just as I started working for the House. But I staffed many conference committees of which he was a Senate member or chair. So, I had ample opportunity to observe him in public and private meetings, as well as one-on-one a few times.

He was my favorite Senate tax chair by a wide margin. He obviously cared about and showed respect for people, whether other members, lobbyists, staff, or the unwashed public, and he listened and was generally open-minded to policy, administrative, and practical concerns (not just political). He was very patient in listening and letting people make their points. That often paid off both in gathering support for and improving his proposals.

The published remembrances of him capture well that he was a very effective a legislator. Like most good legislators he was able to somehow juggle personalities, interest groups, competing partisan positions, etc. in putting together support for proposals that met his and his caucus’s policy priorities. This obviously required an ability to read people and convince them, as well as a willingness to bend, to compromise, a characteristic that now seems in scare legislative supply.

The published obits have made much of his bring home bacon for the Iron Range. I think that is somewhat overstated even though it has a sort of statutory recognition (more of a reflection of the widespread recognition and affection he enjoyed). Like most Range legislators, he was proud and protective of the region he represented. As the mining industry/sugar daddy’s local tax largess began to run low (starting in the 1950s), the DNA of Range legislators dictated they fight for state help to maintain the local public services to which they had become accustomed. Their pivotal political positions in the DFL Party and legislature often enabled them to accomplish that. My perception, though, was that Senator Johnson was more tempered and reasonable in that regard than many Rangers. But more importantly I always thought he was more concerned about what was good for the state than the Range. To be fair, in his mind the two objectives were likely in conflict only rarely.

His work in on the 1985 and 1987 tax bills that greatly simplified and improved the individual income taxes, expanding the base and lowering rates in line with the 1986 federal tax reform, were high points. These were balanced proposals that somehow, he (and Governor Perpich, to be clear) managed to pass, despite strong political opposition by various narrow interests who lost special provisions (pensioners, active military personnel, etc.) in the final deals. There was a good deal of political risk involved with the good policy the only payoff.

An underappreciated quality was his attention to and respect for technical, administrative, and practical issues. Many legislators ignore these important considerations when raised by DOR or legislative staff, pooh-poohing them as overstated or easy to overcome. Senator Johnson, to his credit, typically did not. After he retired, he would call me once or twice each legislative session regarding proposals he was working on as a political consultant. He didn’t do so because he wanted to know what I thought about the policy but to check out technical and legal issues, to make sure they would work and there wasn’t a better way to accomplish his goals. I suspect he did the same with DOR staff that he trusted.

Fundamentally, I will remember him because of the kind and delightful person he was, someone who generally cared about people and not just the famous, moneyed, or powerful with whom he had plenty of contact. He was funny and personable. RIP Doug.

Taxing Cannabis

The mid-term election results increase the prospects for legalization of recreational marijuana (beyond the half-measure passed in 2022). If that comes to pass, the legislature will need to decide how to tax it. Of course, it could ignore that and treat cannabis like any other consumption item, subject to the general sales tax. I assume that is unlikely because of the product (as with alcohol and tobacco) has perceived external social costs and because legislators want the revenue. (Colorado and Washington annually collect about a half billion in revenue from their taxes.) Proponents of legalization (e.g., former Governor Ventura) have touted legalization’s potential for generating revenues. I assume that is because they assume a differential (higher) tax will be imposed, not just the sales tax.

I have not formulated policy views on how to best tax cannabis and there is no consensus or conventional wisdom. Thus, it is a tricky area,

TPC has a report out on how other states do it, which provides good background information and policy advice. The House bill in the 2021-22 session had detailed provisions on taxation but (I suspect) no one really thought they would get enacted. My experience is that folks do not really focus on and get serious about the policy and practical issues until passage appears imminent. That was the case for the MinnesotaCare gross receipts tax back in the 1990s. If that is true, serious considerations and discussions will need to occur during the upcoming legislative session.

The TPC Report’s introduction frames the inherent tradeoffs as follows:

The underlying goal of marijuana legalization is reducing illegal sales, whereas the main goals of cannabis taxes are raising revenue, addressing the negative consequences of cannabis use not reflected in the purchase price (i.e., externalities), and discouraging the use highly potent products. The challenge of taxing marijuana is achieving those latter goals without creating an overly onerous or complex tax system that jeopardizes the underlying goal of legalization.

Richard Auxier and Nikhita Airi, THE PROS AND CONS OF CANNABIS TAXES, 1 (9/28/22)

In my view, raising revenues (beyond those resulting from avoiding illegal evasion of sales tax) should not be an important goal. Put another way, any special or higher tax should be justified by recovering or compensating for social or external costs of its use. (Broad-based general taxes should be relied on to raise general revenues.) That is the justification for alcohol and tobacco taxes. To me it is very clear that state alcohol taxes, including Minnesota’s, are too low to recover the social costs of alcohol abuse, which by many accounts (here, e.g.) are very large. (FWIW, according to the TPC Report both Washington and Colorado collect more in cannabis taxes than in their combined alcohol and tobacco taxes.) It is simply not politically feasible to do so, because the general population and the industry cast the taxes as burdening nonproblem drinkers who do not impose those social costs. The difficulty with cannabis taxes is, I suspect, that no one has a good fix on what the magnitude of the social costs are. If one assumes they are high and heavy special taxes should be imposed to recover them, you run the risk of simply driving sales back to the black market (i.e., where they are now) and thwarting part of the reason for legalization as well as not collecting the revenue.

As TPC points out, if the feds legalize national sales that will add a new dimension to appropriate state and local tax policy – i.e., the potential for a national market and the resulting tax competition. Its advice to stay flexible and constantly reevaluate is well taken. But once something is enacted, expectations are created and change becomes difficult. So, it is important to get it as right initially as possible.

City sales tax votes

Updating the city sales tax post, the Secretary of State’s website has the results of the city sales tax votes for taxes authorized by the 2021 tax bill. Of the ten new taxes on the ballot, nine were approved and one rejected (those with two votes were for separate project approvals):

  1. Edina – approved (16,646 – 11,345; 14,605 – 13,224)
  2. Grand Rapids – approved (2,457 – 1,746)
  3. Litchfield – approved (1,431 – 1,139)
  4. Fergus Falls – approved (3,375 – 2,230; 3,361 – 2,234)
  5. Maple Grove – approved (18,739 – 15,060)
  6. Moorhead – approved (8,782 – 4,861)
  7. Oakdale – approved (5,766 – 5,425; 6,218 – 4,992)
  8. Staples – approved (438 – 300)
  9. Wadena – rejected (32 – 36)
  10. Warren – approved (333 – 318)

Projects and taxes were on the ballot in cities with existing taxes, as well. Waite Park, which imposes a tax under the St. Cloud area tax, rejected imposition of an additional tax for a public safety facility project, but approved one for a regional trail connection. Voters in St. Cloud, which has a tax, also rejected a municipal athletic facility project. The voters in Cloquet approved two new projects.

Thus, the usual pattern of overwhelming voter approval for most of these taxes and projects continued to hold.

Senator Ann Rest

I don’t know if there is a previous example of an individual who served as chair of the tax committees in both the House and Senate, probably not. Ann Rest’s designation/election as Senate chair will make that happen in 2023. I worked with her for four years when she was chair of the House committee and two additional years as the ranking minority member. The Senate committee will be in good hands, someone who understands and cares about tax policy and administration.

Partisan affiliation as a COVID risk factor

I vowed to not go off topic and write (yet again) about COVID. But this NBER article (Jacob Wallace et al, Excess Death Rates For Republicans And Democrats During The Covid-19 Pandemic) striking findings on excess deaths by voter registration in Ohio and Florida was too interesting to pass on providing a link. I won’t comment beyond observing that data limits prevent robust statistical controls for relevant factors and wondering whether the results extend to other states (Minnesota?). The obvious question is whether this could affect very close elections?

income tax

Donations w/o deductions

Two recent gifts of appreciated property by billionaires to 501(c)(4) social welfare organizations have attracted national media coverage. A primary purpose of both gifts clearly is political (lobbying, affecting campaigns, and similar to promote the donors’ policy agendas) based on the news stories. The gifts illustrate problems with the tax treatment of donations for political advocacy relative to charitable contributions.

501(c)(4)s can be a wide variety of groups, but most attention focuses on advocacy groups like the NRA and Sierra Club (Citizens United also was a 501(c)(4)).  Contributions to them do not qualify for the income tax and estate taxes charitable contribution deductions, which only apply to contributions to 501(c)(3) organizations and governmental entities. Thus, the explicit tax incentives for charitable donations do not apply. But (c)(4)s are exempt from income tax and gifts to them are exempt from gift tax.

They also are subject to fewer restrictions on their political activities than (c)(3)s, which are  “absolutely prohibited” in the IRS’s words from participating in political campaigns and are subject to stringent limits on lobbying. By contrast, (c)(4)s can engage in lobbying and political campaign activities, subject to limits (e.g., political campaigns cannot be their “primary” activity). See the IRS’s description of the limits.

Thus, ordinary contributions for political advocacy and campaigns do not qualify for tax benefits/subsidies (i.e., the itemized deduction for charitable contributions). But through a confluence of factors these billionaires’ gifts qualify for similar tax benefits. It’s unclear whether Congress intended that result, but it is hard for me to see a policy justification for it.

The donations

The two donations were made by the founder of Patagonia (the Chouinard family), an outdoor equipment and clothing company, and by an owner and chairman (Barre Seid) of Tripp Lite, an electronics manufacturer (less of a household name without the ubiquitous clothing labels). The purpose of the former donation was to further environmental efforts (e.g., to limit climate change) and the latter to further conservative capture of the federal and state judiciaries:

The editorial reaction predictably depended on the ideological priors of the commentators. See e.g.:

  • National Review (unhappy with the Patagonia contribution, characterizing it as hypocritical for a socialist to not give the money to the government)
  • Ruth Marcus (unhappy with the Tripp Lite donation, mainly on the basis of too much opaque money in politics)

Based on the media coverage, the donations are similar with some differences. The Patagonia owners retained ownership and control of their voting shares and, thus, control of the company. They did this by transferring and paying gift tax on those shares, a small dollar amount in the company’s overall capital structure (other public companies, Ford and Facebook to pick two, have similar structures). By contrast, the Tripp Lite shares were donated before the business was sold to an Irish entity (another potential tax dodge?). As exempt entities neither will likely owe tax on its income.

Why they work

Even though they do not qualify for the explicit tax incentives for charitable giving, the income and estate tax deductions, these donations provide similar tax benefits to most cash contributions that qualify for the itemized deduction or as a qualified charitable distribution from an IRA.

Income tax

This works under the income tax because the realization requirement does not treat appreciation as income until an asset is sold or exchanged. That longstanding practice is partially for administrative reasons (it avoids nasty valuation issues) and partially for political and practical reasons (mainly liquidity issues for donors). Gifts typically have not been treated as realization events. Instead, the recipient takes the owner’s basis (carryover basis) and is obliged to pay any tax when she sells. A recipient exempt entity is not taxable. So giving an appreciated asset to one, such as a (c)(4), causes the potential income tax on the appreciation to evaporate. The donor gives the income tax on appreciation away without incurring tax. (Note: you can’t do this with ordinary income, like wages, because of the assignment of income rule. Yet, another preference for owners of appreciated capital assets.) Importantly, as noted below, IRS regulations treat gifts to political organizations as taxable realizations, requiring the donor to pay tax as if the asset were sold. When Congress exempted gifts to (c)(4) from the gift tax, it did not apply a similar rule. It is unclear if that was intentional.

But contributors of most appreciated property to charities get a double benefit. They don’t pay tax on the embedded capital gain and the fair market value deduction reduces the tax on other income. It is like allowing a worker to direct some of her wages to be paid to a charity and both excluding those wages from her income and allowing her to deduct them, reducing tax on her other wages. The Chouinards and Seid passed up that double benefit. Their tax bases in the contributed shares was undoubtedly very low (probably close to zero), and that capital gain tax, thus, substantial. So, they gave up a big tax benefit to satisfy their political advocacy ends.

Without knowing much about either, that decision is likely explained by two factors:

  • Most simplistically, the donors valued funding political advocacy more than any activity that qualifies for the charitable tax deduction. On the surface, they would seem to value advocacy by a lot more, since a charitable deduction yields up to 37% of the value of the contributed property (subject to AGI percentage limits). But the value of the tax incentive partially depends upon how much of a bite the income tax imposes on them, the second factor. If they have other ways to avoid the income tax, the implicit value of the charitable deduction drops.
  • The income tax for the typical billionaire is probably not that big a deal. Relative to their incomes, many pay very little; some billionaires also pay little in absolute terms. Many of us tax geeks assumed that was so and the ProPublica stories confirmed it. Current income tax rates are relatively low, especially those applicable to capital gain and dividend income, and billionaires can use Professor Ed McCaffery’s strategy of Buy, Borrow, and Die, along with a variety of other techniques to reduce their tax burden. Because the income tax on them can be avoided in other ways, charitable giving incentives have less value to billionaires.

Size of the tax benefits. To provide some context, the two tables below illustrate the tax benefits for contributions of zero basis property made by top tax bracket taxpayers in Minnesota to a (c)(4) entity (political purpose) versus to a (c)(3) entity (charitable purpose). The Chouinards’ donation will yield more tax benefits than the table shows, because (I assume) they are California taxpayers. California’s top tax rate is higher than Minnesota’s (13.3% versus 9.85%). Seid appears to live in Illinois, which has a flat 4.95% state tax rate. The table shows the donors gave up potential income tax benefits of more than 40% of their donations to promote their political agendas, rather than accomplishing similar ends through activities conducted by (c)(3) entities.

Since a theme of this post is to contrast the treatment of donations by the very affluent and middle income charitable contributors, the second table shows the income tax benefits for cash contributions – for itemizers in the top bracket and 24% federal bracket (typical for upper and middle income filers) and for nonitemizers (almost 90% of filers after TCJA). The two tables show that the Chouinards and Seid received tax benefits for their donations equal to or greater than those received by the vast majority of the population who make cash charitable contributions. Only households with taxable incomes that put them in the 32% federal bracket ($340K+ of taxable income for a married joint filer) who itemize deductions do better.

Tax benefits for contribution of zero basis property
 Avoid cap gain tax23.8%23.8%
 FMV deduction037%
 Avoid cap gain tax9.85%9.85%
 FMV deduction09.85%
Tax benefits for cash charitable contributions
Itemizer top bracket
Itemizer 24% bracket 

Estate tax

The estate tax does not apply because the donor no longer owns the property when he or she dies. Seid is reportedly childless, reducing his incentive (I assume) to leave money to heirs. From an estate tax perspective, the gifting strategy provides equivalent tax benefits to bequests to charities.

Early deaths may reverse the benefits. There is one potential fly in the oinment – something I haven’t seen mentioned in the press, so I might be wrong about it. If the donor dies within three years of making the gift, the estate tax pulls the donation back into the estate. I.R.C. § 2035. (The provision also pulls any gift tax paid back into the estate (none here, of course), to make up for the difference between the tax inclusive and tax exclusive ways the two taxes are computed. Otherwise, one could save tax by making deathbed gifts of all one’s property subject to estate taxation.) If I am correct about application of this provision, I’m sure the donations contain legal limits that would transfer money or property back to the estate to provide the wherewithal to pay the tax or other mechanisms are used to address it.

Gift tax

This works under the gift tax because gifts to (c)(4)s are exempt from the gift tax (I.R.C. § 2501(a)(6)). Congress exempted those gifts from gift taxation in 2015. JCT Blue Book, JCS1-16 (March 14, 2016) pp. 333-35. Before that change, these gifts were likely taxable gifts. See this 2012 CRS publication, John R. Luckey and Erica K. Lunder, 501(c)(4)s and the Gift Tax: Legal Analysis (August 10, 2012), for background information on the legal issues. The IRS in 2011 started to enforce the tax but backed off in the face of political opposition. Congress enacted the exemption to prevent IRS from changing its mind, I assume.

Gifts to political organizations (political parties and similar entities under I.R.C. § 527(e)(1)) were already exempt (I.R.C. § 2501(a)(4)) and it was generally thought that the 2015 Congressional change put these gifts on equal footing. But and it is a big but, donations of appreciated property to a political campaigns or other section 527 entities are taxable realizations by the donors triggering capital gain tax. Treas. Reg § 1,84-1. Congress did not apply it to donations to (c)(4)s. Of course, many (c)(4)s do not mainly engaged in political advocacy, so that may have been a factor in Congress’s decision. In any case, gifts to 527s and to (c)(4)s are treated very differently. Here is how Arnold & Porter described it in a client newsletter after 2015 enactment of the exemption:

A donation of appreciated stock to a political organization is a taxable transaction. For transfers of stock to political organizations, the Code treats the donor as having sold the stock to the political organization. The donor pays tax on the difference between the fair market value of the stock at the time of the transfer and the donor’s adjusted basis in the stock. The donor will pay tax at capital gains rates for stock held for more than one year or at ordinary income rates for stock held for one year or less. However, the transfer is not subject to gift tax.

Arnold & Porter Private Client Newsletter, Donations of Appreciated Stock to Social Welfare and Political Organizations (March 25, 2016).

The newsletter highlighted the tax advantages created by the 2015 Congressional change in the gift tax. (It points out that the (c)(4) needs to wait a year after realizing the income before making the political expenditure to avoid paying corporate tax on the income, so timing issues must be paid attention to.) The Patagonia and Tripp Lite gifts are exactly what one should expect from the 2015 change. I assume knowledgeable Congressional staffers (e.g., at Joint Committee or in the House and Senate drafting offices) informed the staffs of the relevant members or of the tax writing committees. Whether the members consciously chose not to apply the realization rule is unclear. I suspect that they did and were okay with it (there were Republican majorities in both houses who were generally favorably inclined toward the rule in Citizens United) but that is just idle speculation.

What’s wrong with this picture?

These donations reveal policy problems with the income tax and its incentives for charitable giving. Nothing new.

  • Political limits on charitable tax incentives effectively don’t apply to rich business owners. The law prohibits claiming the itemized deduction for contributions to entities that lobby too much or engage in campaign activity. Seid and the Chouinards got an equally valuable benefit from their donations. This is so because the typical charitable giver (i.e., of cash) avoids paying income tax on the income they give away (at most, assuming other itemized deductions equal the standard deduction or a QCD is made). Seid and the Chouinards, by contrast, got the same benefit (no tax on the appreciation in their shares which probably have close to a zero basis) for contributions for political advocacy. Whatever one thinks about the limit on lobbying and political activity, that seems fundamentally unfair to have one set of rules de facto for wealthy business owners and another for the rest of the population. Even if one accepts that capitalism allows the successful to speak with a much louder voice than the average Joe or Jane, that does not justify the government further amplifying their voices via special tax rules.
  • Uber generous tax incentives for charitable gifts of appreciated property aren’t enough to overcome the preference for political advocacy. Charitable contribution rules are exceeding generous for large donations of the appreciated property with very low bases. That generosity is not enough to induce big givers like the Chouinards or Seid to focus on charitable ways to achieve their political ends (e.g., through education, direct environmental efforts rather than political advocacy, and similar).
  • Should we subsidize political advocacy and speech? An underlying philosophical question is whether the government should subsidize political speech. The current system is flawed because it does that only for holders of highly appreciated (or tax depreciated but still valuable) assets, mainly benefiting the rich. But some might argue that the speech restrictions on charities should be relaxed, providing more egalitarian incentives for political speech. I don’t think so. High levels and steady growth in campaign expenditures (data available at websites like belie the need to subsidize more political speech. I certainly don’t think we need to subsidize the speech/contributions Tim Miller describes in this NYT op-ed to treat the little guy the same as big spenders.
  • Realization rule results in under taxation. These events are one more manifestation of how the realization rule, in its current form, creates holes in the tax base for wealthy business owners. (Stepped up basis on death is a bigger issue.) A rule justified by administrative convenience and liquidity concerns should not drive such a large hole in the tax for the uber rich. It’s an easy step to treat gifts to (c)(4) entities as realizations. Liquidity and valuation issues just don’t cut it in this context.
  • The uneven application of charitable giving tax incentives invites cynicism. To the extent public is paying attention, these events encourage populist opposition to the income tax and undercut support for charitble giving incentives. It certainly looks like one set of rules applies to the wealthy and another to everyone else.

Potential fixes

Steve Rosenthal at Forbes suggests two obvious fixes:

  • Yank the gift tax exemption for donations to (c)(4)s. That would essentially reverse the 2015 change or impose limits when conditions are present (e.g., political activity of the entity).
  • Treat the gift as a realization (i.e., making the donors pay tax as is done for contributions to 527(e)(1) orgs).

The gift tax solution is more direct and would impose a higher rate (40% gift tax rate versus the applicable long term capital gains rate, typically 23.8% for high income filers). Without a lot of careful thought, I prefer the second approach:

  • It provides symmetry with the treatment of gifts to political entities, since that is the rule for contributions to 527 organizations.
  • It has a wider reach. The gift and estate tax exemption amount is $12 million ($24 million for a married couple). The taxes apply to only a small percentage of the population. Using the gift tax mechanism will enable the near rich with appreciated assets to still use the technique. Few will but why allow it for those so inclined?
  • I have a residual concern that the current version of SCOTUS may consider the gift tax approach to violate the First Amendment. It looks like a direct tax on political speech (assuming 501(c)(4) gifts = political spending = speech). It appears to be content based and targeted at a type of speech especially protected by the First Amendment, political speech. A Court whose composition is even more likely to be inclined toward Citizens United style thinking could easily get there. The income tax treatment looks more neutral to me. See this CRS publication for a contrary analysis that concludes gift taxation would likely survive a First Amendment challenge because it would not be considered content based. As an aside, I do wonder if the current Court would reach the same result as Cammarano v. U.S. 358 U.S. 498 (1959) (upholding disallowance of lobbying as business expense deduction). I have always considered its holding a bit off; if the spending qualifies as an ordinary and necessary business expense, taxing it does not deny a subsidy but rather imposes a penalty. That assumes the norm is a net business income tax, making a special tax rule disfavoring a constitutionally protected form of business activity (disallowing business expenses for political advocacy) questionable. The economic and tax sophistication of the 1950s era SCOTUS left something to be desired.
  • It would reenforce my policy priors regarding the income tax (i.e., consumed income should be taxed and giving money for political advocacy is consumption).
  • It has slightly more SALT benefits. Adding it to the income tax base will potentially benefit state income tax bases. By comparison, few states have estate taxes and only Connecticut has a true gift tax. Imposing the federal gift tax, of course, is likely to deter a fair number of contributions and, thus, indirectly augment state income tax bases.

Is Congress likely to do anything about this? Of course not. It’s Congress after all. They take action on stuff like this only if there’s a bipartisan consensus to do so or if one side is in control and considers it to give them some political advantage (satisfy their base, pay for something, etc.). Neither applies here as far as I can tell. Of course, if you want to know what Congress is going to do, you’re better off flipping a coin than asking me. Something should be done, as well as a more general fix for the charitable contribution incentives, which seems even less likely.

income tax

Senate retirement legislation

The Senate released (9/8/22) the legislative language for its version of the retirement changes passed by the House, Section-by-section summary; text of bill; JCT revenue estimate. This language is the product of the June markup session. I assume it will appear on the Senate calendar at some point soon.

I have blogged about this here. As smarter and more knowledgeable people than me (Professors Hemel and Doran) have pointed out, these types of changes largely benefit the affluent and financial services industry, not the average income people that Senator Wyden refers to in his press release: “we are making significant progress for millions of low- and middle-income workers, who are far less likely to have adequate retirement savings. These workers frequently have physical, demanding jobs, and often depend solely on their Social Security income.”

That is supposed to happen by providing incentives for employers and employees to participate in the plans. The track record for actually increasing participation by folks with ordinary incomes is lackluster at best. The Senate version includes matching contributions, which I have not seen done before (other than by states for their 529 plans). That will present some administrative challenges. Will be interested to see if that survives and how it is done mechanically, although my hope is the legislation fails to pass altogether.

As fiscal payfors, both bills rely on moving more retirement plans to the Roth structure – allowing Simple IRAs and SEP IRAs to be done as Roths and moving catchup contributions to the Roth structure. That makes their overall effects revenue neutral within the 10-year budget window. Moving from the traditional defined contribution or DC structure to Roths just delays the revenue loss from those accounts or accelerates the revenue collection, a gimmick to get around budget rules, shifting the cost to later generations, etc.

I think we should be moving in the opposite direction on a policy basis. The Roth structure is more regressive than traditional IRAs and 401ks because accounts with higher investment returns, all else equal, pay lower tax rates on a lifetime basis. Investment returns are likely strongly correlated with having higher incomes and account values, hence the regressivity. Some enterprising economist should study this to quantify the effect. But measuring life time incidence is empiricially challenging and is rarely done as a result.

The Senate bill does contain a modest fix to the problem of syndicated conservation easements as one of its payfors. The change limits the charitable deduction to 2½ times the investor’s tax basis. But that limit only applies for 3 years. After that the sky’s the limit once again. This is what passes for reform in Congress. What’s wrong with limiting the deduction to one’s tax basis in the land permanently? That’s a more principled approach (my take from 2 years ago).

Aside: I do recognize that the 2.5X limit is an improvement over the status quo. Promoters of syndicated conservation easements market them as providing tax savings equal to or greater than the investment. That requires phony valuation multiples based on the investor’s marginal tax rate (i.e., 1/t where t is the investor’s marginal tax rate). So, an investor in the top 37% bracket would require a multiple of 2.7X, just above the 2.5 threshold. Despite the IRS making these deals listed transactions, they are still being done! Note that this would have no effect on how Trump, as alleged by the NY attorney general (Politico story), abused conservation easements. His abuse is the old fashioned-approach of existing land owners wildly overvaluing the easements. More comprehensive reform is needed.

Given the bipartisan support in both the House and Senate, the chances of passage of some changes is high. The Senate bill differs from the House bill in material ways (e.g., it delays the major RMD changes until outside of the budget window and the House implements them more quickly). So, those differences will need to be resolved and time is running out. The Senate (typically slow in processing legislation) still must pass this. So, there may be hope the effort dies. But bipartisan changes like this often pass in lame duck sessions. Members mistakenly think of this stuff as reform, many want to look bipartisan, interest groups are strongly behind it (that should be a warning in and of itself), etc. I see this passing in late November or December as part of package of extenders and/or a FY2023 budget deal (Congress seems likely to kick that down the road until after the midterms).

As I noted in a previous post, the RMD changes result in an automatic hit to state revenues – no state action necessary to conform because Minnesota has no RMD rules, Federal rules are enforced with an excise tax, essentially a penalty (i.e., no state conformity or revenues). So, the Senate’s delay until next decade would put off that revenue loss. That also would eliminate the asymmetry problem with revenue offsets for the RMD changes in the House version. The RMD changes reduce federal revenues. The federal bill offsets the lost revenues from the RMD change with revenue raisers. A state conformity bill will score conforming to those provisions to extent they increase FTI, as most do, as raising state revenues (while ignoring the RMD revenue loss that occur automatically), which the legislature offsets by including tax cuts in a conformity bill. Otherwise, the bill would be a tax increase. The overall effect of the automatic reduction from federal passage of RMD changes and a conformity bill typically results in a net state tax cut. The effect, of course, is very small.

Bottom line. Some version of this is likely to pass. The principal effects will be more assets in Roth plans, affluent account holders keeping assets in retirement accounts longer to pass on to their heirs, larger budget deficits, and little help for middle and lower income households who are failing to save adequately for retirement. In short, little good and the opposite of what Senator Wyden’s press release claims. But it will pass on a bipartisan basis and members of Congress will congratulate themselves for enacting bipartisan “reform.” Minnesota will suffer a small reduction in its tax revenues because of the RMD changes.

income tax tax administration

IRS funding yet again

IRA’s $80 billion in additional funding for the IRS is attracting media attention, in addition to and probably because of the partisan GOP opposition I’ve noted previously. That’s a lot of money and it should get some scrutiny.  Much as I think restoring agency funding to the 2010 level plus making up for deferred investment in the agency’s IT infrastructure is ample justification, public discussion and debate is in order.

The NPR 1A talk show hosted a program with an all-star cast – Nina Olson, the former Taxpayer Advocate who always has good insights and sensible things to say (and probably would have made a good IRS commissioner); Richard Rubin, a long time Wall Street Journal reporter on the tax beat; John Koskinen, former IRS commissioner (appointed by Obama), and Natasha Sarin, assistant secretary of Treasury (and the coauthor with Larry Summers of multiple articles about using IRS funding to raise revenue that I have blogged about). The show was a disappointment. I don’t think I learned anything new. It covered old ground and was basically pitched to the general public, necessarily a low common denominator audience. I don’t have any particular criticisms, but I felt I wasted a half hour.

By contrast, I learned a variety of stuff from Howard Gleckman’s TPC podcast interview of Koskinen. Of course, that is because TPC’s target audience is wonkish types like me who are interested in tax and fiscal policy. I don’t think Koskinen has inside information, so it’s unclear how reliable or authoritative he is. But he did head the IRS for one term. Some points and my reactions:

  • Congress’s last-minute deletion of the Service’s authority hiring and compensation flexibility. He didn’t offer information on why this happened (like me, he probably doesn’t know or maybe doesn’t want to say) but opined that it was a big deal, especially the ability to hire more quickly.
  • 87,000 new employees. This has been a headline and flash point for the partisan opposition (e.g., the erroneous implication that they will all be auditors and carrying firearms per Chuck Grassley and others). Since the IRS is projected to lose up to 50,000 employees to retirement, Koskinen suggested that it would really mean more like 25,000 to 35,000 new employees. That seems off to me. I assume that the base budget will cover replacing existing employees and the additional funding used for new employees. My guess is that some budget staffer(s) came up with the number and that it is not tied to a specific management/business plan and may not reflect reality. Although the partisan sniping about this is off base, it is what to expect when you put out specific numbers.
  • Source of the $80 billion amount. Koskinen made the point that the $80 billion number came from the administration’s proposal and included implementing and administering the expanded information reporting on financial institution flows, a variation on former IRS Commissioner Rossotti’s idea. Congress deleted that but the $80 billion number in the administration’s proposal did not change. See this CRS FAQ on the idea for background info. I don’t know how much implementing and administering it was scored to cost and IRS probably could implement it under its administrative authority. But I would be shocked if the Service tried to do that after Congress explicitly rejected it. That would court a Congressional slap down.
  • Ramping up taxpayer service. Koskinen felt that taxpayer service could be quickly ramped up – i.e., hiring more people to answer the phone (an abysmal 11% of calls were answered during the 2021 filing season). I had wondered about how feasible it is to do that given the labor market, training requirements, and so for. But I assume that is something a former commissioner who does not have a partisan agenda should know and be candid about.
  • Tax complexity. He validated my instincts that tax complexity is not the problem and that simplifying the tax code (although a very good thing to do: see here for a summary of why) would not right the ship. He pointed out that IRS successfully administered the monthly payment of child credits, a clear achievement. That’s a little off because it’s not an auditing complexity but rather an administration complexity. Nevertheless, it took a lot of resources and expertise to pull off. In my opinion, the points made by a variety of people about complexity being the core problem (see e.g. Clive Crook) are largely a smoke screen and likely intended to make opposition to the funding increase appear less unreasonable, a deflection. (Crook’s picking on the complex retirement rules, something I whole heartedly agree with as a policy matter, seems odd. I haven’t heard that noncompliant retirement plans are a big source of the tax gap. Stuffing of founder stock or other unconventional assets in IRAs is a compliance problem but I doubt it contributes much to the tax gap estimate. I would guess that the mindboggling complexity/ambiguity of subchapter K would be a better target. The IRS barely audits partnership returns, probably for a variety reasons, one of which is likely their complexity and ambiguity.) Even magically assuming the simplest tax code, failure to report income for which there is no information reporting or overclaiming business deductions (allowable under the simplest of tax income tax systems) will always be compliance problems. If Crook had picked on the TCJA (QBI, interest disallowance, etc.) I would be much less skeptical that his hands are clean and he’s not trying to suck up to the GOP opponents of funding increases. This problem can only be fixed by refunding the IRS to normal levels. Major simplification would be complementary icing on the cake and good for other reasons as well.
  • Lack of funding continuity. In making clear the management problems with stop-and-start funding, Koskinen pointed out that one year during the Trump administration the agency’s administration and modernization budget was cut by 50%. I had not heard that before.

FATCA compliance

Reading the recent Senate Finance Committee Report on the “shell bank” loophole in FATCA – the Obama era federal law intended to reduce evasion by hiding income in foreign bank accounts – revealed this nugget about how lack of funding has reduced FATCA’s effectiveness that I had missed (not regularly reading TIGTA reports):

According to a recent TIGTA report, as a result of significant IRS budget cuts following the enactment of FATCA, the IRS “has not come close” to building out its original FATCA compliance roadmap and has instead taken “limited or no action” on a majority of planned activities. This has led to significant underreporting of foreign bank accounts by U.S. taxpayers and billions in lost revenue. For example, IRS data identified more than 330,000 U.S. taxpayers from 2016 to 2019 that failed to file required forms to report foreign bank accounts with a balance more than $50,000.70 The IRS has failed to act on this information, leaving at least $3.3 billion in uncollected revenue on the table.

The Shell Bank Loophole, p. 17 (undated) [footnotes omitted].

The report focuses on the $2 billion tax evasion case against Robert Brockman who died last month (WSJ paywall). Outright failure to report income will not stop no matter how simple the tax code is.


If you want to laugh and/or cry (I couldn’t decide) here’s a link to Senator Rick Scott’s letter advising people not to apply for IRS jobs because when the Republicans take over Congress and cut IRS funding you’ll get fired. It reads like it was produced by some politico comms who are Babylon Wannabees but aren’t funny, a sort of Animal House writers’ room that controls a US Senator’s media releases. Example quote:

The IRS is making it very clear that you not only need to be ready to audit and investigate your fellow hardworking Americans, your neighbors and friends, you need to be ready and, to use the IRS’s words, willing, to kill them.

Scott letter (August 16, 2022)

Hyperbolically “defunding the police” in favor of “an IRS super-police force” is its conclusion. Explanation: IRS CID agents, a tiny subset of its workforce, can carry firearms and therefore use deadly force, a fact that was stated in the original IRS job posting. That gave Scott’s comms license, I guess. I had one instance in my legal career to deal with two CID agents, seeking info on a legislator. They were not packing heat, unless their guns were in their attache cases or strapped under their pant legs.

Does Senator Scott think stunts like this convince people to vote Republican? Who is he trying to appeal to anyway? Scott is a professed conservative who presumptively should respect institutions and norms. Tax collection is a core government function and ensuring most people pay close to what they legally owe is a matter of fairness and respect for the rule of law. I get that some frat boy comms likely thought this was funny. But a 20% cut in the IRS’s budget and cutting audits of the top 1% by upwards of 75%, which is what was done, is a recipe for encouraging noncompliance.

Aside: Unlike flying undocumented immigrants to Martha’s Vineyard or busing them to NYC and DC, it’s pure rhetoric and at least does not make flesh and blood human beings into Theatre of the Political Absurd stage props. Politics has moved beyond what a normal guy like me can understand. I don’t think I’m just another old man yelling at the neighbor kids to get off my grass; this just seems stupid and mean (w/ regard to the immigrants).

This TPC blogpost is an antidote to some of the misinformation that is being put out about the IRS funding FWIW. Or see this opinion (Sense and Nonsense About the IRS’s Funding Increase From Congress) at Bloomberg by former commissioner Rossotti.

Update 10/6/22

Punchbowl News yesterday had an update on GOP campaign spending in competitive midterm congressional races targeting Dems’ support for the IRS funding, including those involving nonincumbents (??). It reports $12 million in spending since August 1 on 24,000 airings. That doesn’t seem like that much given typical campaign spending these days, but I am naif when it comes to campaign spending. The ads, of course, come with the usual doses of misinformation – e.g., that 87,000 agents will be hired to target the middle class. Political business as usual.

income tax tax administration

Quick thots

I was out of state for much of the last two months (vacation and family medical emergency) and wasn’t paying as much attention as usual to ongoing developments. The following are quick reactions to a few random developments over that period – nothing of consequence and nothing that I have given careful thought to (dangerous, I know).

Student loan debt forgiveness

President Biden issued an executive order forgiving up to $20,000 in student loan debt for lower income borrowers, fulfilling a campaign promise. I’m not going to weigh on the underlying policy. I have mixed feelings – how America pays for higher education is in need of a permanent fix; this isn’t it, but good arguments can be made for and against an ad hoc partial student loan jubilee to address past problems. (Full disclosure: all three of my children graduated from college while incurring no student loan debt but I do not begrudge government help for those whose financial circumstances required them to do so and are now saddled with more debt than a reasonable ability to pay it. 1(B) of this post and Susan Dynarski’s NYT op-ed provide some useful context, I think.)  But there is a Minnesota tax angle.

As I blogged about ad nauseum in the context of PPP loans, the general rule is that loan forgiveness generates taxable income. Absent a special statutory provision, student loan forgiveness would be taxable. Congress in the American Rescue Plan Act (ARPA) addressed that by exempting the income. This TPC blog post by John Buhl has the details.

The Minnesota angle:

  • Higher conformity price tag. The 2022 session meltdown and failure to enact a tax bill means Minnesota has not conformed its income tax to the ARPA loan forgiveness provision. That means the Biden executive order (assuming it survives likely court challenges (NYT paywall)) raised the cost of a Minnesota conformity bill by a material amount. Of course, the state likely will have a large surplus after the November forecast, so paying for a larger conformity price tag should not be a problem except the usual competition for scarce budget resources is always fierce no matter how big the surplus.
  • Political fallout? Republicans nationally have opposed the Biden order (e.g., see this Axios story on ads), mainly arguing it is unfair to those who paid their loans back or didn’t incur debt at all. Given the nationalization of partisan issues, I assume Minnesota Republicans will fall in line if they haven’t already. That raises an interesting political question as to whether that opposition will carry through to opposing the favorable Minnesota tax treatment – if they don’t think the forgiveness is a good idea, then exempting the income also should be a bad idea? Of course, Republican DNA finds it hard to not like any kind of tax cut, so who knows? Stay tuned to the 2023 session.

As an aside, it is useful to point out that the student loan debt forgiveness does not involve the extra twist that PPP loan forgiveness did – there is no double benefit. PPP loans were required to be used to pay tax deductible expenses (payroll etc.) and the issue was whether those payments should be allowed to reduce tax on other income (business profits) in addition to not taxing the forgiveness itself. (Congress and the legislature said yes.) The student loan forgiveness is just a straightforward exemption of the income, like the expanded rules for home mortgage debt write-downs after the Great Recession.

Update – lawsuit filed using state taxation to assert standing. In a weird twist, Indiana’s taxation of the forgiveness is being used as the basis for asserting standing in a lawsuit challenging the forgiveness executive order. Federal law does not recognize taxpayer standing to challenge illegal spending (unlike Minnesota law). As a result, a plaintiff must be found whose personal interests (not as a taxapayer) are adversely affected, The plaintiff in the lawsuit claims he is because the forgiveness will trigger a $1,000 Indiana tax bill on his $20,000 in forgiveness. WaPo story. To finesse the fact $20,000 is greater than $1,000 (i.e., is he net to the good which doesn’t seem adverse to me) he says he would qualify forgiveness of his debt anyway under the Public Service Loan Forgiveness program and (I presume although the story does not say) Indiana (like Minnesota) exempts that forgiveness from taxation.

Clever argument if the loan forgiveness is not voluntary (i.e., you don’t need to apply and cannot opt out). That strikes me as implausible. The story quotes a White House spokes person that he could opt out. But Larry Tribe, the Harvard law professor and author of a standard treatise on con law, is quoted in the article as saying the argument is “not beyond the realm of possibility.” Seems highly implausible to me but standing is a malleable and inscrutable concept that seems to regularly morph. My guess is the suit wll be dismissed.

Corporate AMT

The Inflation Reduction Act (IRA) is now law. One of its major revenue raisers is a reenactment of a corporate alternative minimum tax based on book (i.e., accounting) income, about $20 billion/year (JCT estimate). This is a rerun of an idea from the 1980s that did not last long and is down the list of what I would have done (the global minimum tax or raising the corporate rate were better corporate tax revenue raisers).

But the silver lining is that it will give Minnesota a path out of its linkage to the pre-TCJA federal corporate AMT. The feds have not used that tax for five years now. Legislators must have viewed repealing the old minimum tax as an unacceptable benefit to profitable C corps or they couldn’t agree on how to deal with the lost revenue.  But administering and complying with a complex tax based on obsolete federal law grows increasingly untenable with each passing year. Enacting a Minnesota minimum tax based on IRA’s new minimum tax would be preferrable if only from a compliance and administration standpoint. Since Minnesota has not conformed on bonus depreciation (the major preference that will be nicked by the new federal AMT), it’s unclear whether conformity would mainly be a matter of appearance. Careful analysis of corporate returns will be needed. If conformity with the book income AMT is largely a fig leaf to permit deep sixing the old AMT, so be it.

IRA’s funding of the IRS will provide a revenue bonus to the state that should grow over time, although probably very little for several years given how long it takes to ramp up enforcement. CBO’s estimates of the revenues keep shrinking (down $23 b). The reasons are that Congress withdrew the hiring and compensation flexibility for new hires (no idea why) and the stupid Biden tax pledge that Yellen promises to stick by. Ugh.

On a related issue, GOP opposition to the IRA appears to be totally focused on demonizing the IRS funding. See Howard Gleckman’s TPC blog post characterizing the nature of the political debate. The over-the-top and outright false characterizations that elected officials get away with is appalling (former chairs of the Senate Finance Committee should be held to higher standards of conduct; I expect it from Ted Cruz). Much of the funding just restores IRS enforcement to 2010 levels; I think the increase over the real 2010 levels may only be 5% by 2030 (can’t find where I saw that now). Double ugh.

July revenues – nothing to see here

The MMB report on July revenues, in a change from relentlessly above forecast monthly collections, shows that they are about on target (up a modest $64 million). Sales tax up and everything else flat.

The only point perhaps worth noting is that evidence of unwinding of overpayments by owners of pass through entities (PTEs) is still MIA. That probably doesn’t mean much but who knows. The hypothesis is that many owners of PTEs double paid – first by making individual income tax declarations for the income during 2021 and, then, when the 2021 legislature created the PTE entity option (allowing unlimited deduction of the state taxes paid for federal purposes) by paying the PTE entity tax as well. MMB has said the amount may be $1 billion. That will unwind when the PTE owners file their 2021 individual returns and claim the credit for the PTE entity tax. Most of that money would typically show up in September and October because of the due date for extension returns (October 15th). But given the amounts at stake, some earlier filings could be expected, especially with short term interest rates rising. But a host of other factors involved with individual income tax collections could be masking the effects.  August, September, and October collections will tell the real story (probably muddled by other factors if history is any guide).

Childcare facilities as exempt schools

The Minnesota Supreme Court has held that a childcare (er, early childhood education) facility qualified for a property tax exemption under the constitutional and related statutory provisions exempting “academies, colleges, universities, [and] all seminaries of learning[.]” This reversed a tax court ruling that denied the exemption.

Back when I was working, I tried to stay away from property tax issues as much as possible (too often unsuccessfully) and do not consider myself an expert on them. So, I won’t weigh in on the merits of the decision although I have read it a couple times. I will make a few random observations, though.

This same plaintiff was unsuccessful in an attempt at a property tax exemption claiming to be as an institution of purely public charity about 15 years ago. That case spurred a legislative effort to clarify the statutory rules for qualification as an institution of purely public charity. A main pressure point was the requirement for meaningful support from donations or contributions, rather than service revenue (fees paid by parents or the government). The legislative changes diluted that requirement. That is irrelevant under the exemption for schools. In fact, I don’t think they even need to be nonprofits. At least, it’s not an explicit requirement in the statutory or constitutional language and the Supreme Court has said as much in dicta (“The profit or nonprofit character of the institution is immaterial to a determination of whether or not an institution is a “seminary of learning.” Graphic Arts Educational Foundation, Inc. v. State).

The plaintiff, congruent with the basis of its claims, in the meantime changed its name from “childcare” to “early education” center. Contrary to Shakespeare, an early education center may smell more like a school than a childcare center.

I am sure that the authors of the constitutional language and attendees at the constitutional convention (the relevant language dates to the original constitution) did not think that they were exempting entities that largely cared for children under the age of 5. They likely were thinking more along the lines of traditional teaching of the 3 R’s. Of course, if you’re not an originalist (I’m not), that probably isn’t that important. The actual distinction – what characterizes the collection of entities enumerated in constitutional language and how does that align with what is done in pre-K settings – should matter, though. Both the Supreme and Tax Courts agreed (but not the county) that the nature of its program was educational. The dispute was over whether it was sufficiently “general” and “could readily assimilate” into the public schools, the other two prongs of the test, whatever they may mean.

I suspect the case will cause more childcare centers to seek exemption as schools. That will be a headache for assessors, who will likely require apportionment of the portions of the facilities that are devoted to infant and toddler (earlier than age 3, maybe) care. Goodhue County failed to do that until the case was on appeal (too late). In the larger scheme of things, I doubt this will be much of a hit to the property tax base. But that is a pure guess.

The exemption for schools is not one that the constitution authorizes the legislature to clarify or modify (unlike that for institutions of purely public charity). So, it is unclear how much the legislature, rather than litigation, can clarify this.

Empirical economic research has concluded that early childhood education yields material positive social benefits. Retired federal reserve economist Art Rolnick has been making this case for years now in a variety of Minnesota forums (here, e.g.). So, devoting more public resources to the effort can be easily justified. But I am skeptical that using the property tax under rules devised and enforced by judges is an optimal way to do that.

income tax tax administration

Fund the IRS

In a miracle of sorts, the phoenix-like revival of a much-slimmed down Build Back Better bill, now called IRA, has passed Congress (NYT paywall), and will provide a ten-year infusion of $80 billion to the IRS. IRA refers to Inflation Reduction Act (confusingly since IRA = Individual Retirement Accounts for most of us). I doubt it will materially reduce inflation in the near term (that’s CBO’s view as well), so the name is probably misleading. (The big direct attack on inflation – Medicare authority to negotiate drug prices – is delayed until 2026 and then phases in slowly.) Inflation reduction appear to be what got Joe Manchin onboard, although the real policy motivation of Dems lies elsewhere (ACA changes, negotiating prescription drug prices, climate change, yada yada). But so be it; whatever it takes.

Increased funding should help IRS to:

  • Modernize its antiquated tax processing system and customer service. Implementing big IT system changes is never easy – for government or in the private sector – so the service improvements are neither likely to be quick nor sure. But they are sorely needed.
  • Improve enforcement. This is the prime motivation, to yield revenues. Improvements here will also be a slow process because it takes years to hire and train revenue agents, implement new IT systems to improve compliance, etc. And the legislation does not include tools, like expanded information reporting. As I have repeatedly emphasized, better IRS enforcement and compliance will redound to the benefit of the states, since compliance with state taxes is closely linked to compliance with federal taxes. In many instances, plugging leaks in the federal tax will automatically plug leaks in state taxes.

IT modernization is needed

This WaPo op-ed (paywall) by Catherine Rampell lays out in excruciating detail how the IRS processes paper income tax returns and why modernization is crucial. It’s worth looking at for the pictures alone. I knew that the process was archaic and locked in the mid-20th century but did not really have an idea of how much so. I knew that the IT systems were old (e.g., some routines still use COBOL and some hardware uses Windows XP) and that data are typed in by IRS employees. But I had no idea how manually intensive the process was, including cutting open 3 sides of large envelops with a “nibbler,” candling envelops to make sure items are not left in them, marking returns up with red pens, hand renumbering lines when prior year returns are submitted, etc. It’s no wonder that processing a paper return often takes six months or more:

A single lap through this facility’s Pipeline is about a quarter-mile. The IRS warns on its website that the whole process can take six months or more. And that’s if no errors are detected.

Why does the IRS need $80 billion? Just look at its cafeteria (Washington Post, 8/9/22)

All this reveals just how crazy it was for Congress in the CARES Act to require thousands of amended returns that need to be filed on paper to claim NOL carrybacks. Supposedly that was to get money quickly to businesses with pandemic-caused losses and cash flow problems. It simply gummed up paper processing for everyone else without getting money to the businesses in a timely manner.

Predictable response from the right

The fiscal reason for the increased IRS funding is obvious: per Larry Summers and others, to raise revenue by restoring pre-2010 IRS enforcement resources, the point at which GOP Congresses put the agency on starvation wages while it was increasingly saddled with more responsibilities under the ACA, TCJA, etc.

It was no surprise that right wing commentators and politicians’ response was to decry the funding increase as hiring and unleashing 87,000 tax auditors (the administration’s estimate of the total number of hires, including IT and customer service employees who will ultimately be added by the legislation) on poor unsuspecting middle-income folks. A sample of two from WaPo, which are more measured and accurate than the nut jobs on cable shows, points out the political risks:

Janet Holtzblatt at TPC has a measured take on it and good advice for the IRS and administration (unlikely to be taken, of course): If the IRS Gets $80 Billion, Will Its Agents Come Gunning for You? She points out that the administration has not handled the PR aspects of this very well and there are some legitimate questions to be answered, despite the desperate need for the funding. Jacob Bogage, Democrats’ $80 billion wager: A bigger IRS will be a better IRS (WaPo, 8/6/22) also provides good context.

Will Dems suffer at the 2022 midterms as result of increased IRS funding? Hard to know since I haven’t seen polling on it and the election is still months away. But given how easy the rhetoric is to hurl, it won’t help them and might be the straw that breaks the camel’s back in some close races. They are likely to lose one or both houses of Congres anyway, so passing up the opportunity for partisan political reasons would have been foolish. In any case, they would have had to come up with alternative funding, which may have created even greater political liabilities or could not have cleared the Manchin/Sinema hurdles.

Addendum on Cato’s Take

A blog post at Cato (Chris Edwards, Senate Bill: IRS Funding Hypocrisy, 8/5/22) makes the point – legitimate as far as it goes – that the IRA’s increased tax compliance funding is hypocritical because its expansion of various energy credits for EVs and so forth increases complexity and noncompliance opportunities. It has a graphic to illustrate how this works. The closing paragraph makes the more general and much more questionable point:

Senate bill supporters don’t seem worried about growing tax‐​code complexity. They assume the bill makes sense because the $80 billion of IRS funding is supposed to raise $204 billion in government revenues. But that ignores the added costs and loss of civil liberties imposed on individuals and businesses. More aggressive IRS enforcement will mean more paperwork, more lawyer fees, more time wasted on tax planning, more anguish and uncertainty, less privacy, and less personal financial security. Government will win, but society will lose.

Chris Edwards, Senate Bill: IRS Funding Hypocrisy

My take:

  • Having just read a book on the Panama Papers, the idea that the tax gap is heavily a function of illegal use of tax expenditures is, at best, a stretch and more likely a flat-out distortion. Even the simplest tax (because of the necessary allowance of business expenses, including capital cost recovery) is necessarily complex, putting aside outright evasion (much of the reason for offshore entities). As an aside, I wonder where he stands on the differential rates for capital gain income, a feature that drives some of the most challenging complexity with debatable policy justifications for it. Verifying whether one purchased a qualifying EV is probably child’s play, by contrast.
  • My preference would be to stop littering the tax code with tax incentive carrots and to rely more on Pigouvian taxes, such as a carbon tax, to reduce carbon emissions. Because of its heavier reliance on market-like mechanisms, a Pigouvian tax would be more cost effective and efficient (in the economics terms). However, the Dems’ reliance on tax incentive carrots is understandable as political matter – the consistent drumbeat of anti-tax rhetoric on the Right (by the likes of Grover Norquist and probably Chris Edwards) is what drives, in my opinion, the use of tax credits and incentives. It’s the natural result and what they should expect because of the direction in which they have driven the political debate. It’s an illusion, of course. Handing out tax credits means revenues will be collected through implicitly higher rates on others.
  • There is a small group that cheats on their taxes. Crimping enforcement efforts, as has been done, simply emboldens them and increases their numbers as prospects for getting caught drops. Complexity has, at most, a minor role in this.
  • Suggesting that expanded tax compliance funding (as a general matter after what the GOP-controlled Congress has done to IRS resources) is a challenge to civil liberties is the definition of over the-top-rhetoric coming from a putative Think Tank. Good grief, get a grip.
income tax

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.
Source: US Census Bureau and Tax Policy Center

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.