This is another in my series of high-school quality book reports on nonfiction books that I have read recently.
Name of book:
The Federal Estate Tax History, Law, and Economics by David Joulfaian (MIT Press 2019)
Why I read it:
I regard David Joulfaian as the preeminent national expert on the economics of the federal estate tax. He has worked for many years (decades) at OTA, specializing in estate taxation. Over the years, I have read many of his articles and working papers and found them to be insightful as to how the estate tax works and how it may affect behavior. In addition to providing background information to feed my intrinsic interest in this quirky but important tax, I figured that the book would a useful overview of the details of tax from an expert in whom I have a very high level of confidence.
To provide more context, the Minnesota tax is a constant flash point in legislative tax debates, even though it applies only to a narrow group of taxpayers and raises a modest amount of revenue. I found that when estate tax bills were heard in House Taxes Committee (mostly GOP proposals to cut or eliminate the tax), the debate was consistently the most animated and passionate of any. DFLers seem to regard the tax as a symbol of their core value of progressivity, since it applies only to a small number of individuals with the very highest net worths and incomes. It probably also galls them to see proposed tax reductions going to taxpayers who they regarded as the “rich.” By contrast, GOP members seem to despise the tax more than any other, largely (I think) because they view it as profoundly unfair – a second tax on income that has already been taxed, a success penalty (implicit disincentive for work and risk taking), and (maybe most importantly) a way DFLers can claim to raise revenue from the rich.
I found this debate disconcerting from several perspectives – mainly because many of its premises were often ill founded and because the assertions made often seemed disproportionate to the tax’s real role as either a revenue raise or an effective counter to inequality. The Minnesota debate mirrors the federal debate and what is more interestingly to me is why passions about the tax run so high, particularly on the right. Perhaps more importantly, why does that passion seems to resonate so much with the general public, most of whom will never be touched by the tax (either as someone leaving or receiving a bequest) and do not have many firm political values (i.e., they’re not tribal R’s or D’s)? I didn’t really expect the book to help me figure any of that out (e.g., unlike Mike Graetz’s books), but assume that knowing more about the tax would be helpful.
What I found interesting in the book or worth writing about:
The first half of the book (about 100 pp) provides a very good outline of the basics of the federal tax – its history, how this complicated tax actually works and has changed over the years, who pays it, how much revenue has been collected, profiles of the composition of taxable estates, beneficiaries, and so forth. Most of this stuff was pretty familiar to me, but I also found interesting new stuff (or equally likely at my age stuff that I once knew and had forgotten).
The striking behavioral responses to the changes in the law – particularly the acceleration of lifetime gifts to avoid pending estate or gift tax increases – always leap out of the data when you look at the history of collections as Joulfaian’s tables conveniently provide. His dicussion highlights this effect as well.
He provides a nice summary of the now-repealed credit for state death taxes. Jeffrey Cooper’s law review article provides a much more detailed and nuanced history.
The most interesting and useful contributions of the book (to me anyway) are its last three chapters which summarize the research by economists of the effects of the tax – on labor supply and savings behavior (chapter 7) and on charitable giving, lifetime giving v. bequests, capital gain realizations, portfolio composition, and purchases of life insurance (chapter 8), as well as Joulfaian’s own conclusions (chapter 9). Chapters 7 and 8 summarize the best evidence to evaluate the myriad of claims for and against the tax made during political/policy debates. Much of this research and analysis was done by Joulfaian himself or with coauthors (Holtz-Eakin and Rosen in multiple cases).
The evidence for many assertions is ambiguous, at best, and often counter to the anti-tax assertions. I think it is fair to characterize many/most of the assertions made by opponents that the tax dampens work effort or reduces savings (viewed globally) to not be based on evidence but just the claimant’s favorite piece of economic theory (e.g., focusing on substitution effects and ignoring income effects, considering the effects on decedents’ behavior but ignoring them on beneficiaries, and so forth).
It does seem safe to say that repeal of the tax would have some very real negative effects on charitable giving; the size of that effect and which charities it will be hit the hardest is what is at issue.
What disappointed me about the book:
The book could have used better copy-editing. I guess that is not surprising for an academic press, which is likely operating on a shoestring budget. Copy-editing errors seem concentrated in the first part of the book, which covers basic background and history. I noticed few errors in the last three chapters on the behavioral and economic effects of the tax, much of which summarizes the author’s and others’ scholarly work on complicated economic issues, probably because Joulfaian spent much more time reviewing this to make sure it was right, as compared with the first half which just describes the basics of the tax, recounts its history, and presents basic statistics.
I was disappointed with Joulfaian’s two-page summary of the literature on the effects of the tax (state level) on interstate migration (pp. 156 – 157). Given the title of the book, I didn’t expect the book to cover that topic. But when he chose to do so, I thought he should have been more comprehensive. For example, he discusses the Conway and Houtenville’s article without citing or discussing later articles by Conway and Rork which use more sophisticated methods and caveat the conclusions in Conway and Houtenville. In fact, I think their research undercuts his implication that state taxes are most likely to affect migration decisions by individuals with more modest estates (i.e., those below the level at which the pre-EGTRA federal tax applied). My instinct is that the effects on migration are most likely to occur for larger estates (say $3 million and up), but not so large that the tax averse can easily use lifetime gifting to avoid state estate taxes.
SALT connection:
All state estate taxes, as well as their sibling inheritance taxes, rely heavily on the federal tax concepts and enforcement in imposing and collecting tax. In fact, without a federal tax, I expect that states would need to spend more resources to collect less revenue. In fact, I wonder if TCJA’s large increase in the exemption amount will not erode state tax revenues somewhat. A secondary effect is that the federal tax’s deduction for state tax paid reduces the implicit burden of state taxes, making them easier for those affected to stomach.
The obvious SALT question raised by the the book is the absence of state gift taxes (Connecticut being the lone exception, putting aside provisions related to gifts made shortly before death) and what effect that has on the incidence and revenues collected by state estate and inheritance taxes. I briefly discussed this issue in a Tale of Two Billionaires and the MN Estate Tax.
I think this book is a must have for anyone doing research or providing policy advice on states estate taxes – it provides good basic background information on the history and application of the federal tax, as well as a summary of the economics literature on the potential effects of the tax – on labor supply, savings, etc. It is easy to read and well organized. While still working, I would have used it as a reference book or encyclopedia of the economics literature on this quirky tax, especially chapters 7 and 8.
I find the high level of media attention that RIP Medical Debt, a charity that acquires and pays off medical debts, attracts interesting. Its operations raise some intriguing questions that I wish some enterprising econ grad student would tackle. (Perhaps, it should be an investigative journalist, on another theory.) Based on my poking around Google Scholar, I couldn’t find any published research analyzing organizations like it either from the perspective of the incentive to contribute or on the net charitable benefits of contributing to them. I may be missing something, given the limited searching effort I made.
Note: RIP Medical Debt’s formal name is Medical Debt Resolution, Inc., according to its IRS Form 990. I will refer to it as MDRI in the rest of this post.
I searched for other similar charities (again, I did not make much of an effort – just a few Google searches) and was unable to find any. There are charities that help individuals pay for their out-of-pocket medical expenses or pay off medical debt. I think they typically make grants to applicants who satisfy the program’s eligibility criteria. Pan Foundation is one example.
MDRI, by contrast, uses charitable contributions to purchase and forgive medical debts. MDRI has only been around for a short while – not long enough to be evaluated by Charity Navigator. MDRI’s website has a counter displaying the amount of medical debt it has forgiven (about $1.4 billion) when I last accessed it. Pan Foundation’s website claims that it has paid out over $3 billion to more than 1 million recipients to pay medical debts or costs. The two numbers (Pan Foundation’s and MDRI’s) are not remotely comparable for reasons that will become apparent.
As I noted, MDRI has received a lot of media attention. Here are a few examples:
The comedian John Oliver (back in June 2016) created an LLC that purchased $15 million of debt and gave it to MDRI to forgive. One of his angles was to best how much Oprah Winfrey had given away when each attendee at one of her shows received a car. Key difference, of course, is that the cost of forgiving $15 million of debt is a lot lower than purchasing a bunch of cars, if you buy largely uncollectible debts. (What Oliver spent would barely buy one car.) That angle, however, illustrates an interesting element of MDRI’s operations – figuring out exactly what charitable benefits it yields relative to the amount contributed.
The PBS Newshour ran a segment on MDRI and its founders. They were working (unhappily) as medical debt collectors which is what caused them to create the charity. The segment could be easily characterized as a virtual commercial for MDRI, as well as a commentary on the general problem of growing medical debt.
2018 NY Times story reported on two elderly ladies who raised $12.5K to contribute to MDRI to wipe out $1.5 million in medical debt.
Chicago Tribune story reported on a group of churches that raised $38,000 to forgive $5.3 million in debt as a Thanksgiving Day gift.
In February 2020, the Strib ran a story about Lord of Life church in Maple Grove making medical debt forgiveness one of its missions and raising $15,000 to pay off $1 million in debt, again through MDRI.
The extensive media attention has translated into big increases in contributions to MDRI. Its 2018 Form 990 (most recent available) shows contributions increasing from $2.2 million in 2017 to $5.3 million in 2018. Information from the 990 reveals that it paid a little more than 10% of the contributions as salaries to its three top employees, as well as about an equal amount for fund raising and so forth. Less than half of the amount contributed ($2.3 million out of $5.3) went directly to purchase debt to be forgiven (putting aside admin and expenses allocated to the purchases). Guidestar reports that RIP’s budget is now a little over $6 million, so the increase in contributions may have slowed or the Guidestar number may be old, not sure which. The 2019 Form 990 is not due to be filed until later this year.
The Attraction to Contributors
The attraction to potential contributors is obvious (that is what John Oliver was playing on as well as the media stories lauding MDRI): you’re buying a massive amount of gross debt forgiveness for pennies on the dollar. Actually, a penny on the dollar according to MDRI’s website, which claims a ratio of 100:1 – making a $100 contribution will allow forgiving $10,000 of medical debt. Given recognition that growing medical debt is a societal problem, this seems like a marvelous way to multiply the benefit of your contribution. The implication that MDRI apparently wants to create is that the gross amount reflects the impact of your gift. That of course is a fiscal illusion. It’s akin to a retailer who routinely marks up inventory by 100% and, then, has 50%-off sales. The uninformed consumer thinks he or she is getting a bargain, but that may or may not be the case. The percentage discount is simply irrelevant to whether it’s a good deal or not.
My questions
The obvious first question asked of any charity is how much of amounts contributed go to the actual mission versus overhead and other expenses. In the case of MDRI (based on the 2018 Form 990) more than half of the contributions go for stuff other than the amount directly spent on debt purchases. The two founders are well compensated ($450K for their combined salaries), which is to be expected given their obvious PR abilities and how that has translated into contributions. Its 44% ratio of debt purchases to contributions seems low. Focusing on the ratio of fund raising and management is less bad – about 25% goes to those purposes. Large blue chip charities have lower ratios, though. It does mean that one’s contribution experiences a 50% discount before it is used to forgive medical debts. So, that is an important piece of information. But that is not what really interests me.
The more interesting question or issue to evaluate is to what extent the gross amount of debt forgiveness (i.e., the 100X return on the contributions asserted by the MDRI’s website) yields a real benefit to debtors who are deserving of charity.
Put another way: How much of the gross forgiven amount is a fiscal illusion? An obvious secondary question: Is MDRI effectively targeting relief to deserving debtors? The following are my musings about those questions (I would not characterize them as anything approach analysis) which would be good for someone (with more skills and resources than me) to investigate:
A. Benefit to the debtor?
One way to reframe the first question: what is the real value of the debt relief to the debtor who has his or her debt forgiven? We have two numbers to start with (1) the gross amount of the debt and (2) the price that MDRI pays for it.
MDRI implicitly wants you to start with the first number, the gross amount, but that is clearly the wrong. These debts are obviously very difficult to collect, and most are unlikely to ever be collected because:
The provider (hospital, clinic, physician, etc.) has been unable to collect them and probably a collection agency acting on the provider’s behalf has similarly been unsuccessful.
They typically have been sold to one or more collectors.
Some of the debts may be barred by the statute of limitations (media stories report how collectors sometimes convince debtors to pay barred debts, so that doesn’t mean the debt holders will stop).
Many of the debtors likely have little in the way of assets to seize or wages to garnish.
Some debtors will go through bankruptcy if pressed too hard by collectors.
Based on MDRI’s assertions about the ratio of contribution to gross amounts, it is obviously buying debt that the market considers to have little value to debt collectors. The price MDRI pays is about 1% of the face amount of the debt. If they are being honest about the overhead haircut that applies to contributions, the purchase price actually is closer to a half cent on the dollar. Potential buyers assign virtually no value to this debt, as far as I can tell. All this says to me to ignore the gross value of the debt as largely irrelevant.
The second number (MDRI’s purchase price) reflects a market judgment about that value of the debts based on their potential collectability. This is clearly a better benchmark to start with in determining the value to the debtor. As an aside, the very low price assigned by the debt buying market suggests it is saying in nearly all these debts will not be collected. Given that starting point, what questions should be answered to adjust that value? The following are some of my naïve thoughts and questions.
The following factors (or answers to the questions) suggest that the value of forgiveness to the debtor may be higher than the purchase price, but then, the issue is by how much:
What is the probability that an effort will be made to collect the debt and how much will be spent to do so? This seems like a first order question that the price of buying it is not a very good proxy for. I assume that debt of this type is very expensive to collect because it takes a lot of time and effort; that conclusion is based on both buyers and sellers setting such a low price. The typical debt collector/purchaser or seller will calculate its value using something like this equation: the gross amount of the debt * probability of collection – (the purchase price + cost of collection). In all cases, the cost of collection will be the biggest factor, I assume, given the trivial purchase price relative to gross debt amount. MDRI, by stepping in and buying the debt, allows the seller/debt collector-owner to forgo those expenses, essentially capturing them for the benefit of the forgiven debtor. What is a reasonable estimate of that amount? There must a strong correlation between the probability of collection and the cost of doing so (i.e., the lower the probability of collecting, the higher the cost of doing so).
Forgiving the debt often will boost the debtor’s credit rating. That’s important because it affects a myriad of stuff – price of insurance, ability to rent an apartment, employ-ability, access to and cost of credit, etc. How much is this worth? I have no idea, but it likely varies a lot with the situation of individual debtors. If they have a lot of other debt or other negative factors preventing them from getting a passable credit rating, the benefits may be minor or nonexistent. Does the fact that this debt has such a low market value suggest that most of the purchased debt and affected debtors fall into that category? How could one measure that?
Forgiveness may eliminate a hassle factor for debtors – they won’t be hounded by collectors potentially impacting their ability to go on with the lives etc. How can one assign a value to something as intangible as this? Of course, this won’t apply to orphan debts that no reasonable debt collector would attempt to collect.
The following factors or questions lean in the opposite direction, suggesting the value of the debt (and the benefit of forgiving it to debtor) may be little more than zero (essentially its purchase price in the secondary debt market):
How much of this debt is so worthless that no sensible collector would consider expending any money to collect it? For that debt, there is little to no benefit to the debtor of purchasing it. How can this type of debt be identified? Is it most of the debt MDRI buys?
How many of the debtors have such bad credit ratings for reason other than the medical debt that discharging it will have little to no benefit for them?
How much will MDRI’s debt purchases benefit debt holders rather than debtors? As I see it, the key question is whether the MDRI is paying a price that is a very close representation of the debt’s value to purchasing collectors or not. If it is paying more than that, it is enriching debt collectors; if it is paying less, it is avoiding that and benefiting the debtors. A related question is whether MDRI’s purchases are big enough (or if a bunch of copycat charities are formed) so that its operations will increase prices in the resale debt market? This would have effects that are counter to MDRI’s mission – increasing profits for third party sellers of medical debt, encouraging medical billing and pricing practices (e.g., even more price discrimination that disadvantages uninsured patients) leading to more medical debt. There are typically unintended effects of stuff like this; it’s almost an iron law.
B. How good is MDRI at targeting deserving debtors (purchasing the “right” debts)?
The second set of obvious questions relate to how MDRI selects the debt it purchases or who are the debtors that benefit from its purchases? It says (on its website and in its Form 990) that it uses three criteria (any one of them is sufficient to make the debt eligible for purchase):
Debtor’s income is less than 200% of the poverty level.
Debts exceed 5% of the debtor’s annual income.
Debts exceed debtor’s assets (i.e., the debtor is bankrupt).
I don’t know much about the information that is available to purchasers of a medical debt portfolio, but assume that MDRI can relatively easily obtain information necessary to determine which debtors meet one or more of these criteria (probably an estimate of the debtor’s income is available). The bigger question is what criteria does it use in selecting among the many debts that satisfy its published or formal criteria? In particular:
Do its selection criteria favor purchasing debts where the benefits outlined under the first question (i.e., under A above) are high relative to the price paid for the debt?
Or does MDRI favor buying debt that have a high gross amount relative to the purchase price, so that its ratio of debt forgiven to contributions is very high? The debt buying market to me is suggesting that discharging these debts has less and probably little value to the debtors for the reasons outlined in the second set of factors or questions under A.
Or does MDRI simply randomly buy debts that satisfy its eligibility criteria?
To get a good return for one’s contributions (i.e., a cost effectiveness ratio or something like that), I think MDRI should favor a policy like that articulated in the first bullet. My suspicion is that they follow something more like a policy in the second bullet (most gross debt for the purchase price), because they view that as likely to increase their ability to collect contributions by making it appear that their operations have a bigger headline impact (i.e., the mindless focus on the gross amount forgiven). The fact that they have a website counter for the dollar amount of debts forgiven implies to me that is a big deal to them. It, however, works against their basic purpose if it leads them to purchase a lot of debts that no debt collector would ever try to collect. The benefits of forgiving those debts are low, if not close to nonexistent. My fear is there is a lot that going on. The money would be better spent buying some more “expensive” debt (i.e., with a lower gross amount relative to its price) where the charitable benefits realized by the debtors are larger. At least that is my instinct.
My takeaways
MDRI’s operations provoked some interesting questions. I’m deeply skeptical about how much (if any) charitable benefit its operations yield, but that just may be my inherent skepticism of new and unconventional approaches.
The bigger deal to me is that the mainstream media (including very sophisticated outlets like PBS and NY Times) appear to buy MDRI’s questionable narrative without asking the (to me anyway) obvious economic questions. That seems to be a serious failing in carrying out their mission of informing of the public and avoiding being a party to selling fiscal illusions. MDRI is still tiny and these are “feel good” stories, so maybe I’m expecting too much. Unquestioning references to its operations in publications by academics or academic-linked organizations (see here (p. 3 at fn 18) for a Washington U-linked newsletter) are even harder for me to stomach.
SALT Angle: none that I can think of. As an aside, because MRDI’s forgiveness is treated by the tax law as a “gift” rather than more traditional cancellation of debt (e.g., short sale of a mortgaged home), there is no taxable income. There are an obvious myriad of health care policy and debt collection regulation questions that could be explored, though.
Update
MRDI is back in the Minnesota news in this recent MinnPost story (Andy Steiner, A fundraising campaign by two Twin Cities churches paid off millions in medical debt for thousands of households), which continues the tradition of mindlessly (in my simple mind) focusing on the headline debt forgiveness number as some sort of measure of the charitable benefit. I guess I’m one of the few skeptics about stuff like this out there. In looking at their most recent 990, it appears that both the revenue (contributions) and salaries paid to the highest paid employees went up substantially. The good news is that the salaries went up by a much smaller percentage than the contributions, which nearly doubled – again, testimony to the organization’s impressive media/PR savvy. That means a great proportion of its contributions are buying and forgiving debt. Measuring the actual benefit of that, though, remains a mystery to me.
I’ve taken to writing down some of my thoughts on the books I’m reading – mainly to be more disciplined in thinking and remembering something about the books. This is partially a response to my fumbling to recall when asked about the books I have recently read. Now that I’m retired, I’m reading more and (seemingly) forgetting more. These posts will be the equivalent of a bad high school book report. I’m only doing this for nonfiction books. My daughters instigated a family book club to compel me to read fiction and I’m not writing anything about those books. Any effort on my part to analyze fiction would be a waste of time of all concerned.
Name of book:
The Hundred Years War – The English in France 1337 -1453 by Desmond Seward (Penquin Books 1978).
Why I read it:
I discovered it on Seth’s (my son’s) bookshelf and since my knowledge of medieval history and particularly of the 100 Years War is limited, I considered it as an opportunity to learn something, as well as to provide historical context for the 2020-21 Guthrie production of the Henriad plays.
What I found interesting:
There are too many to list; the following are the ones that now stick out after finishing the book a few weeks back:
I had thought total war (essentially attacking civilians, ravaging farms, industry and so forth as a general tactic) was a modern invention. The armies in the 100 Years War as recounted here were waging close to the equivalent of total war, if only as a financing mechanism (see below). The incongruity of that while simultaneously upholding chivalry as an ideal (limited, of course, to nobles) is breathtaking.
More thought reveals the economic and psychological rationales for chivalry: Many of the top leaders on both sides were related by blood or marriage, as Seward’s family tree charts reveal, and shifting alliances meant one could end up fighting a current ally or allied with a current opponent. In addition to the economics of ransom (see below), that naturally leads to a reluctance to kill or maim leaders who may be relatives, potential relatives (by marriage), or future allies, I guess.
The English had better weapons (long bows were superior to cross bows), tactics, generalship, and soldiers. This, along with a measure of luck, allowed them to prevail for a very long time. Polarization and division of the French also played a role. It took a very long time for the much richer and vibrant French economy (and their ultimate development of superior artillery, i.e., better cannons) to prevail and to push the English back across the Channel.
The demands on top military leaders were much more strenuous then, compared with later periods. They participated directly in the hand-to-hand fighting of the most brutal sort, in addition to setting and implementing strategy and tactics and providing leadership. Modern generals mainly must exhibit the latter – setting strategy and tactics and providing overall leadership – and don’t need to be deft and powerful with a sword or poleax, etc. (Seward points out that wielding a poleax was much more effective against armor than a sword. Wielding either while wearing 50 lbs or more of metal armor is hard to imagine.) The only saving grace, I suppose, was that if you were a prince, duke, count, etc., a smart opponent would be careful to spare your life, rather than forfeit the ransom potential (see below). That wouldn’t mean you’d avoid being maimed or injured, though. Or inadvertently killed in the heat of battle, as happened occasionally.
The agony the French people in the affected areas went through for six or more generations seems unimaginable to me.
I hadn’t realized that the Scots periodically had allied with the French. I guess that shouldn’t have been a surprise given their antipathy for the English. It allowed them to fight the English on the continent as well as on their home turf (a fair amount of that was going on during the war too). Doing so didn’t turn out very well for either them or the French who apparently found them to be less than helpful allies. Seward reports one of the silver linings in the French loss at Verneuil, which ended the Scots’ involvement, was that the French were “rid of the Scots whose insolence was intolerable.” (p. 202)
A lot of interesting names – “Black Prince” (referring to the color of his armor, not his mood or other qualities), “Bastard of Orleans,” etc.
I now have a firmer fix on the Joan of Arc story (lots of mythology has been woven around that), who Lord Talbot and Duke of York really were, and lots more bits of historical trivia.
Falstaff as portrayed by Shakespeare is quite different than his real life version, Sir John Falstolf, as Seward describes him. I guess there is some debate about who Shakespeare was using as his model, if anyone.
What disappointed me about the book:
It’s drily written, almost like a textbook. To be fair, that probably goes with the territory of a short book (under 300 pp) covering 116+ years of war. There simply isn’t space for colorful writing and the necessary detail. I also would have liked him to spend a little more time and effort on how the Black Death interacted with the war.
SALT connection
Seward spends a fair amount of space on tax and finance issues. That’s not surprising, since wars put immense strains on governmental finance and demand both borrowing and taxing. This one was no exception. The fact that it was funded by primitive economies compounded the challenge.
Taxation in those days was basic, at best, and brutally enforced. The French were more effective and sophisticated than the English, but that didn’t help them much or at least not until later in the war.
Typical instruments – hearth tax (I assume that this was like the more famous window tax, imposing a fix amount per fireplace in a castle or lesser buildings), head taxes; and export duties. The English resorted to the latter. At the time, the English economy was much more backward than the richer French (much larger both in terms of population and land area, and the French soil was much more fertile than in England). The English mainly exported wool, while the French wine and food. The English controlled Bordeaux during virtually the entire period, so they control some wine production. The export duty on wool hurt English farmers and merchants. Seems hard to fathom now – they hadn’t even gotten to the point of a mercantilist perspective, flawed as that is – but the warlords did whatever was necessary to raise funds to pay for the war.
The really brutal element of public finance was frankly just plunder and pillage – mainly by the invading English, although not exclusively. This can be broken down into two separate styles or mechanisms: One where plundering army/government did not formally control the territory (i.e., hold the walled cities and castles) and the other where it did.
For the first Seward uses the termchevauchee, a term I was unfamiliar with, but which essentially means invading and stripping the countryside of anything of value and often burning or destroying the rest to deprive those in control of access to resources. The government that technically was in control (i.e., one of the factions of the often-divided French aristocracy) would be holed up in their walled cities, reluctant to come out and defend the farmers, villagers, and etc. – they were concerned that in the open they would be beaten by the superior English fighters. By contrast, the English forces did not have the wherewithal to lay siege to and take the cities and castles. So, it was a sort of stalemate. Given that, they would go on a chevauchees through the countryside to self-fund their armies and war effort through plunder.
The second method was patisor protection when one (usually the English in the early years – first 100 year or so – of the war!) took over new territory from the other. Seward describes it: “Every village and hamlet had to pay the troops from the local stronghold dues in money, livestock, food and wine; failure to pay was punished by arbitrary executions and burnings. Travelers had to pay dearly for safe conducts, road-blocks and toll-gates being set up. Profits from patis were pooled; the soldiers paid one-third of their booty to the garrison commander, who remitted one-third to the King, together with a third of his own profits.” (pp., 80 – 81). Profits from chevauchees were similar divvied up.
One can easily see the poor villagers, farmers, and peasants were between a rock (an invading army on a chevauchee) and a hard place (the powers in control of the city extracting patis).
Another typical financing method was ransom, an earlier and more personal version of reparations. The nobles were fine with butchering lesser soldiers (archers etc.), but they preferred to capture, rather than kill, knights and other higher ups, since this provided ransom opportunities. The nobles were held (often for years if they were dukes or better and their governments were unable or unwilling to pay – the English held the Duke of Orleans for 25 years) for ransom. This enriched the victors. A trade or secondary market (?) in ransoms developed – markets in everything, of course.
Seward gets into some of the details of the contractual arrangements that knights and others entered into with each other. Soldiers of fortune – this was a like a business enterprise. Apparently, a fair number of castles and country homes in England were built with the fortunes made from plundering the French countryside and ransoms paid.
All this gives new meaning to the term kleptocracy. Most of these efforts were self-defeating, in the long run, of course. You can only plunder a countryside profitably once every few years. Doing so demoralizes the citizenry and saps efforts beyond subsistence living, I would assume.
Final Takeaway
Reading this makes one appreciate living in a modern society and just how much better things are now. I guess it makes Steven Pinker’s case. Also, it provides useful perspective on complaints about the communal costs of modern society, in particular taxes, when you consider what earlier generations have endured. It will just make me grit my teeth more when people equate what can only be consider benign taxes as “theft” or “stealing.” If only they could be sent backward in time to see what arbitrary governmental finance rising to the level of thievery really looks like.
WaPo is reporting that last week JP Morgan sent a note to its clients saying that there was a 90% chance of a recession, according to market indicators. Events on Sunday (i.e., Saudi Arabia’s oil moves) and movements in the bond market today (the entire Treasury yield curve was below 1% when I wrote this!) provides more evidence for that. Of course, the stock market is imploding, but I regard the bond market moves as more telling. None of this means that it is a sure thing that the economy is heading into a recession, but the probability is much higher than it was a week or month ago. It’s unlikely to be 90%, but that’s probably closer to reality than the 29% or 37% reported in February forecast.
The implications for state budget policy seem obvious. With regard to the projected budget surplus, only two things should be done:
Appropriate money to help prepare for and mitigate the effects of the coronavirus. According to media reports, the legislature is doing that. It should speed things up.
Move the rest of the surplus to the budget reserve or leave it on the bottom line.
If a new budget forecast were done now (well, after a new GII estimate is available), it seems obvious the surplus would be gone and there would a shortfall of some size. It is imprudent, as a result, to spend general fund money or cut taxes – anything that diminishes general fund resources – unless you would be willing to do that without a surplus. Cutting unnecessary stuff would be wiser, but likely politically impossible. Giving the governor authority to unallot without meeting the stringent requirements now in law (i.e., exhausting the budget reserve) would be a good move, but probably would be opposed by DFLers and so will not be seriously considered.
With regard to bonding, by contrast, it is fine to proceed with a robust bill. The lag between passing a bill and ramping up projects means that doing so can’t be justified under a rationale that it will allow taking advantage of the big dip in interest rates. But these extraordinarily low rates may persist for some time (lets hope not, because that means the economy is in bad shape) and although it is counter to one instincts (based on personal/household budgeting rubrics), borrowing and making public capital investments during a recession is a good thing. So we might as well get the projects and bonding authorizations on the books to allow that to happen if the recession is a long one or if low rates persist for other reasons.
On a separate issue, Bernard P. Friel wrote a letter to the editor responding to John James’ and my Strib op-ed on taxing social security. Incongruously (to me, anyway), the Strib made it the spotlight letter on Sunday. His essential point is that state taxation of social security is inconsistent with both the original purpose of social security itself and the 1983 law that subjected benefits to federal taxation. The former was intended to promote the general welfare by providing old age benefits and the latter to shore up the financing of those benefits. He goes on to write “There is nothing in that preamble or in the [social security] act suggesting that part of the benefits provided should be used to reform a state’s tax system.”
This response to our op-ed is a total non sequitur, of course. The purpose or policy behind a federal law does not dictate state tax treatment. Congress is perfectly capable of limiting state taxation and has done so repeatedly (e.g., prohibiting states from imposing individual income taxes on interest paid by Treasury securities, taxing railroad retirement benefits, limiting taxation of railroads, air carriers, and so forth). It has not done so for social security benefits. Consider a counter example: Congress’s purpose in paying civil servants and their pensions in no way relates to state taxation and state taxes on those payments could be viewed as making it more difficult for the federal government to achieve its underlying objectives. But that wouldn’t lead one to conclude that states should not tax federal employee pay or pensions under their income taxes would it? Well, for some years Minnesota did not tax federal salaries (until the late 1930s, I believe) and did not tax federal pensions until the 1970s. This was due to an expansive, old view of intergovernmental tax immunity doctrine. I wonder what Mr. Friel’s views were of those decisions as policy matter?
John and my views are not intended to “reform” the Minnesota tax system. Rather, we seek to preserve the status quo, which has been in place for 35+ tax years. An entirely different matter. We’re trying to prevent “deforming” of the state tax system, something much less ambitious than reform.
I mention all of this only because I used to know Bernie. At least, I assume that the Bernard P. Friel who wrote to the Strib is the same Bernie Friel that I knew as a long-time partner in the bond department at Briggs with several blue chip clients when I started working at the House. I can remember him calling up to lecture me on how TIF law had gone astray when it was being used to subsidize low-income housing and another time on how the Dorsey bond lawyers we’re pushing the envelop in some deal that they had signed off on. I’m glad to see that he is still kicking around and as opinionated and feisty as I remember him. He must have retired over 20 years ago and be in his 80’s.
Note: this post has been updated. The changes corrected various minor errors and did not make any substantive changes. If you previously read the post, there is no reason to re-read it.
The Strib published John James’ and my op-ed on legislative proposals to exempt more social security benefits from taxation. After writing the op-ed and my earlier blog post, I had a couple more thoughts about the topic and this post records them, focusing on two items: revenue volatility and “declining returns” on social security for younger workers. Space limitations, as well as a lack of general interest by newspaper readers, did not make either of these topics appropriate to address in the op-ed.
Revenue volatility. A point that I failed to make in my blog post was that exempting social security benefits from taxation would make Minnesota’s tax revenues more volatile, as well as less elastic (the latter point was made in both pieces).
A little discussed fact is that the last three major states tax changes –the 2013 increases by the DFL, the 2017 GOP tax cuts, and 2019 compromise tax bill – all made Minnesota’s tax revenues more volatile. The combined effects of those changes was to increase volatile revenue sources, while reducing more stable revenue sources.
To my knowledge, no one has tried to measure the resulting effects on volatility. When we’re in a period of steady economic growth (the situation since 2010), interest in volatility or how much revenues rise and fall with the business cycle declines. One way to calculate volatility is with standard deviations (or any of a variety of related statistical measures of variance) or with the cyclical swing index, a measure which a couple of coauthors and I calculated about 30 years ago for some of Minnesota tax revenues [House Research Department publication not available on the Internet].
Here’s why the 2013 – 2019 tax changes increased volatility:
2013 tax increase. The 2013 increase had three main components: (1) adding a fourth rate bracket at the top the individual income tax rate schedule, (2) a cigarette excise tax rate increase, along with indexing the rate for inflation in cigarette prices, and (3) a corporate tax increase implemented by expanding the base mainly to more income related to foreign operations. Two of these changes yield relatively volatile revenues –
The income tax rate increase applies to filers with the highest incomes (> $250K). These filers have a very large share of the most volatile sources of income – capital gains and business income. The volatility of revenues from taxing capital gains is quickly revealed by skimming a few MMB forecast write-ups – both how difficult they are to predict and how much they fluctuate. It’s like tying your revenues to the stock market.
The corporate tax is the most volatile of the state’s major sources of tax revenue. Twice over the last four decades it has experienced 50% drops in its revenues – in the double dip recession of the early 1980s and during the Great Recession. In any recession, it typically declines in nominal terms.
The third change, a large increase in the cigarette excise tax rate, by contrast, yields stable revenues since it is a per cigarette amount and smokers are addicted, dampening down their ability to avoid the increase by stopping or reducing their smoking. (The tax is a declining revenue source, however, because smoking is declining despite its addictive nature.) The 2013 bill did eliminate the fixed dollar feature of the tax by indexing its rate for price increases in cigarettes, making the revenue less inelastic. Most of the money in the 2013 tax bill was in the income tax rate increase.
2017 tax reduction. When the GOP controlled both houses of the legislature in 2017-18, they maneuvered Governor Dayton into signing their 2017 tax cut bill. This bill focused much of its reduction on the most stable source of state tax revenues by reducing the state general tax levy and eliminating its indexing. The state general tax is as a fixed dollar levy that is paid almost without regard to underlying economic conditions. By repealing the indexing of both cigarette taxes and the state general tax, the bill also reduced the elasticity of tax revenues.
2019 tax bill. This was a compromise bill whose principal features were to conform to TCJA’s changes (the 2017 federal tax act) and to enact a modest individual income tax rate cut. The rate cut is pretty much neutral on volatility, although income tax revenues are more volatile than sales tax revenues (so a sales tax rate cut would have increased volatility more than an income tax rate cut). The bigger effect resulted from TCJA conformity. TCJA changes included a substantial number of business base expansions, which were used to help offset its revenue losing provisions (mainly rate cuts and faster cost recovery). Minnesota conformed to these base expansions – in other words, corporate and business income tax increases – and used the revenue to help offset the individual income tax changes. The net effect makes Minnesota’s tax revenues more volatile because of the volatility of taxes based on corporate profits and business income.
Thus, the legislature has been increasing volatile revenue sources and cutting stable ones, while taking some of the elasticity out of the system by repealing indexing provisions that preserve the tax base from eroding with inflation. With regard to the latter, no one seems to be concerned about or attempting to repeal the indexing provisions that protect taxpayers in the individual income tax – suggesting the GOP aversion to indexing is just really a feature of their general tax aversion, not some sort of philosophical principle (e.g., that the legislature should be compelled to vote on any and all inflation adjustments because otherwise tax policy would be on autopilot or something like that).
By contrast, the tax on social security benefits is a very reliable and stable revenue source. Since these federal government payments are required by law, they are almost as reliable as collecting treasury bond interest. Not quite – they depend upon the recipient’s other income sources and if the social security trust fund is ever allowed to run dry, the law provides for an automatic haircut in benefits. That is now estimated to occur in about 15 years, but Congress seems unlikely to let it occur because of the political blowback.
Bottom line: exempting social security benefits from taxation does not score well on the reliability element of the revenue adequacy principle. By eliminating a very stable revenue source, exempting more social security benefits from taxation will make Minnesota tax revenues more volatile. No one seems to ever talk or care much about these issues until a deep recession hits and, then, concerns rise. Changes over the last 7 years have tended to make Minnesota tax revenues more volatile. Given recent events related to COVID-19, I would not be surprised if this doesn’t become a topic for legislative discussion sooner, rather than later.
Relevance of “declining returns” on social security for younger workers.
A few people responded to John and my op-ed with disbelief that the 15% allowance actually allows a fair and full recovery of their employee contributions to social security, negating the double taxation argument that is often made. This skepticism is fueled by media coverage about how bad a “deal” social security now is for current workers with “negative returns” for some, particularly those with high lifetime earnings. I can easily see how the typical media stories could lead to the expressed skepticism about John’s and my assertion. So, I decided it would be useful to gather and state my thoughts on it.
It is a case of comparing apples and oranges. The Social Security Actuary’s estimate of the 15% allowance and the estimates of how “good a deal” social security is for today’s workers are measuring or calculating two related but crucially different things. That is apparent by analyzing what each is doing and why.
Estimates or calculation of the “return” on social security. I tend to see estimates of these hypothetical “returns” presented in three different contexts:
The Social Security Actuary has long prepared estimates of “Money’s Worth Ratios” for various hypothetical Social Security participants. Here’s a link to the most recent version that I could find on SSA’s website (published January 2019). You can see in its tables (##1 – 6) how younger workers are paying in more and getting out less than older generations.
Economists evaluating Social Security make similar calculations. Social security is, of course, not a pension plan, but rather a complex social insurance program that by design redistributes income from some groups to others. In addition to retirement income, it provides de facto life insurance and disability protection and is a pay-as-you-go program, not a pre-funded insurance or pension plan. Economists, of course, are interested in measuring exactly what that program does and in evaluating its effects. See here for an analysis along those lines by economists at the Urban Institute. These analyses, like the SS Actuary’s, show declining returns if getting a “return” for your contributions (as well as your employer’s contributions on your behalf) is how you want to characterize social insurance protections. I tend to think of it as society making sure that all of its members have a basic safety net protecting them – whether because of matters beyond their control or simply because they failed to appropriately prepare. The latter, of course, irritates those with more libertarian sensibilities than mine.
When privatization of social security was a hot topic (e.g., during and shortly before the second Bush administration), advocates of it often made a big deal about how workers would be financially better off if they could just keep their money and invest it in private accounts like a 401(k). There are many heroic assumptions in all of that, of course. These sorts analyses were popular publications by right-leaning or conservative organizations like Heritage (see the “A Bad Investment” section).
What all these estimates or calculations have in common is estimating or measuring the sum of three things: (1) employee contributions (e.g., the after-tax employee FICA payments), (2) employer contributions (e.g., employer FICA or the deductible portion of SECA), and (3) some sort of assumed return or present value calculation. Different approaches are used for (3). Advocates for private accounts base their calculations on some sort of assumed investment return (typically a mixture of stock and bond returns) that parallels how individuals might invest a defined contribution retirement account, like an IRA or 401(k). By contrast, actuaries and economists more typically discount the employee and employer contributions to present value using government bond interest rates. In any case, depending upon the assumed rates used, the value of (3) can overwhelm (1) and (2) amounts.
I can illustrate this with an example from my personal life. Before we married, my wife worked for a nonprofit which had no retirement plan. At the recommendation of her tax preparer she annually made traditional (deductible) IRA contributions to reduce her tax liability. These amounted to $8,000 of contributions, which she invested in bank CDs and earned a few hundred dollars of interest. When we married in 1990, the IRA was worth less than $8,400. To get better returns, I recommended that she move the money to a mixture of stock and bond mutual funds. In the 29 years since, the $8,400 has grown to over $240,000. (No Warrant Buffet was investing the money – just me in plain vanilla mutual funds.) The ratio of contributions to current value is 3.5%. This simply illustrates how important the assumed return or discounting to present value calculations are, given the long periods of time involved, and why 15% is not as low a ratio as it may initially seem.
A second factor to consider is that, as noted above, Social Security also functions as a quasi-life insurance policy by providing dependent benefits if the worker dies and as a disability policy, if the worker becomes disabled. Effectively, one could argue, some sort of annual deduction from the contributions should be made to pay for premiums on that insurance. The estimates typically do not do that (particularly those making the case for private accounts), so they overstate how much is being contributed to the pure retirement/pension-like portion of the program.
The Actuary’s estimate of 15%. By contrast, the Social Security Actuary’s estimate of a pension equivalent recovery ratio (i.e., the 15%) looks at only one of the three components – i.e., employee FICA or the nondeductible part of SECA – and, then, must determine how much those raw amounts contribute actuarially to the payment of old age benefits. These are the only amounts on which tax has already been paid. If one has a background in finance, you can intuitively see why these amounts would be so low relative to benefits paid. The important point is that the Actuary, according to the description (p. 16) by the Congressional Research Service, made the estimates for workers entering the work force in 1993 (the year the estimate was made). Thus, the estimate takes into account the declining “returns” documented in the Money’s Worth Ratios. And, as I noted in my original post, there have been no material changes in social security’s tax or benefit rules that would suggest that these calculations are no longer valid. Longevity has increased and interest rates (and inflation) have declined, offsetting factors. It would be good to update the estimates, but in the absence of that, I see no reason to conclude that the 1993 one is still not valid.
Bottom line: The declining “returns” on social security participation for younger workers says nothing about the validity of the Social Security Actuary’s estimate of the 15% ratio. It continues to be the best estimate of the appropriate amount to allow recovery of after-tax employee contributions.
The February forecast was essentially a nonevent, which is no surprise given that only three months had passed since the November forecast with few economic events of note happening in that interval. The projected surplus rose by $181 million. However, most of increase in revenue was attributed to a category that I’ve been watching, corporate franchise tax revenues.
The forecast reversed the situation that I had observed in my earlier post. Corporate revenues for this biennium (FY 2020-21) are now forecast to be higher than in the last biennium (FY 2018-19). The increase is modest ($140 million), compared with the drop of $78 million forecast in November. This is more in line with the underlining GII forecast of corporate profits. I had thought it odd that revenues were forecast to drop in November, even though corporate profits were forecast to continue growing modestly and TCJA conformity should have increased revenues. That anomaly has been wiped away, well mostly.
The forecast write-up explains that the change in forecast corporate revenues is due to the higher payments (both decs and miscellaneous) in the additional quarter of actual data that MMB economists have. I don’t think there is much of anything to make of this. The change that this translates into is due to the power that actual collections have on rebasing MMB’s models. (As an aside, I have always suspected that that is a slight flaw in the construction of the models; they may be too sensitive to the base year data that they use. That is based on the swings that I observe in the estimates resulting from substituting new base year data. The MMB folks disagree with me and they certainly have a stronger basis for that than my intuition, so I have always assumed they are right. But I still have lingering doubts – my stubborn nature or skepticism, I guess.)
A few thoughts:
I’m still trying to figure out whether TCJA is having a noticeable effect on Minnesota corporate tax revenues. One more quarter of collections and a reforecast (that moves the numbers by a not insignificant amount, though) doesn’t really provide much information on solving that puzzle.
Refunds appear to still be running higher than forecast, one of the weird things I had observed to be going on in November. The forecast writeup says that refunds were lower, but the data in the tables show that they were higher by $6 million. Since the writeup says historic credit refunds, all of which are booked as corporate refunds, were down $4 million, the regular refunds must have been up by $10 million above the forecast. At least, I assume that the numbers in the table are correct, rather than the writeup’s assertion.
The big issue for legislators in making supplemental budget decision is whether we’re on the cusp of a recession because of COVID-19 or other factors. This small change in corporate revenues is meaningless in that context. If the economy trips into a recession, corporate revenues are likely to drop by 20% or more even if it is the shallowest of recessions. That would wipe out the forecast increase in corporate revenues ($217 million) and reduce revenues by a least that much in addition. In a deep recession, corporate revenues typically drop by 40%+, knocking revenues back by a lot more. Corporate revenues are a very small piece of the pie, but they’re very volatile.
Even without a recession, I would think corporate profits will decline as a result of the supply disruptions from the efforts to slow the spread of the virus, that is, compared with the levels GII forecast at the end of January. Prudence says to ignore the increased corporate revenues and to go easy on new commitments.
The big exception to that would be to accelerate commitments the state is going to pay no matter what – e.g., conformity on section 179, which is simply an issue of when depreciation deductions are taken – immediately or stretched over six years. Best to get it out the way sooner rather than later, if it can successfully be substituted for permanent commitments.
In a previous post I outlined why Minnesota’s tax incentives for charitable contributions should be reformed. This post outlines how I would do that and why I think the basic features I’m suggesting make sense. Obviously, others with different values or goals may disagree and opt to substitute or replace some or all of those features.
The goals or principles that I looked to for my reform. Before describing its features, it is useful to describe how I decided on or evaluated alternatives for a new Minnesota charitable tax incentive. I was motivated by three basic goals or principles:
Increase giving. A principal goal of any charitable contribution incentive is to encourage more giving than would otherwise occur. That was my primary goal as well. There is empirical evidence that tax incentives do that. See, e.g., Jon Bakija and Bradley T. Heim, How Does Charitable Giving Respond to Incentives and Income? New Estimates from Panel Data, National Tax Journal, vol. 64 (2, Part 2) (June 2011), pp. 615–650 (summarizing the literature as well as estimating elasticities in excess of -1). Larger percentage reductions generally have bigger effects – in other words, a 20% reduction in the cost of giving should yield more contributions than a 10% or 5% reduction. This provides general support for Minnesota providing tax incentives, if one accepts (as I do) the merit of encouraging more charitable contributions.
Political considerations, including fairness. Increasing giving can’t be the only goal of an incentive, though. For example, if empirical evidence suggested that it was most cost effective (i.e., increased dollars of contributions/forgone tax revenue) to target an incentive only to millionaires, we still would not do that because it is inconsistent with our egalitarian values and because implicitly the government/tax money will go to the charities that millionaires prefer. As critics of the current federal structure have argued, limiting the incentives to a narrow group (9% of filers with the highest incomes) is probably not sustainable politically. Thus, an incentive should be widely available (“fair” to the average person) and benefit most charities. Bakija and Heim (see above) fortunately did “not find strong evidence of differences in persistent price elasticities across income levels.” (p. 647) That makes the case easier for using state tax policy to balance out the imbalance in TCJA’s skewing of who gets federal incentives.
Simplicity, understandability, and ease of tax administration and enforcement. All these goals work together. Provisions that are simpler and easier to understand for the public (taxpayers) are also easier for tax administrators to explain and enforce. These factors become more important design features when a state deviates from the federal rules, because the state can no longer rely on the IRS to enforce or national publicity to get the word out on how the provision works.
There are four key features of my proposed fix:
Use a credit rather than a deduction.
Allow the credit only to those without access to the federal tax incentives.
Limit the credit to cash contributions only.
Require a minimum threshold of contributions before the credit applies.
#1: Use a credit rather than a deduction. I would repeal both of Minnesota’s current incentives – the itemized deduction and subtraction for non-itemizers – and replace them with a credit. Several reasons favor using a credit instead of a deduction. A credit provides the same percentage incentive (i.e., the credit rate) to all givers. This is unlike a deduction, which provides a larger tax benefit or incentive, based on what tax bracket the donor is in. Donors with more income and, thus, in higher tax brackets get higher percentage tax benefits. That might not be bad if higher income donors respond more robustly to incentives and there is some evidence for that, but to me it is outweighed by the value of treating all donors alike. A credit allows the flexibility of setting a credit that provides a more powerful incentive than a deduction would. A deduction’s benefit is determined by the tax rate schedule. But for a credit we can set the rate at any level (e.g., 15% or 20%). That allows the flexibility to make a targeted incentive two or three times higher than a deduction, where the typical tax benefit is less 8% of the contribution. My guess is that on a revenue neutral basis, my proposal would have about a 15% credit rate.
#2: Allow the credit only to those without access to federal tax incentives. I would restrict those who qualify for the new credit to taxpayers who neither itemize deductions for federal purposes nor who make direct transfers from an IRA to charities, the two basic ways to receive federal tax benefits. I would fence out these individuals for three reasons:
These individuals already qualify for a substantial federal tax incentive (typical federal tax benefit for an itemizer is 22% or more of the contribution) and so are less in need of encouragement from the state. Those who make IRA transfers to charity already qualify for a Minnesota tax benefit in doing so and we should encourage them to make most of their charitable contributions in that way. Denying them the credit would do that.
Focusing the proposed credit on those who do not receive federal tax benefits will allow a much higher credit rate (i.e., a bigger incentive) for the same revenue cost – a reasonable guess is the proposed credit can have a rate of 15% or more, but that would drop by half or more if contributors who get federal tax benefits are included.
It will help right some of the wrongs that Congress did to federal charitable giving incentives in enacting the TCJA.
#3: Limit the credit to cash contributions. To qualify for the credit all the basic federal rules for the itemized deduction for charitable contributions would apply (e.g., the IRS documentation requirements), except that contributions would be required to be made in cash. (I’m open to cutting out contributions to private foundations and/or donor advised funds. But don’t think either limitation would matter a great deal because most of those contributions will qualify for federal tax incentives and be fenced out under my fix.) There are multiple rationales for focusing the credit on cash only. The main ones are:
Cash is the life blood of most charities. Some contributions of property cannot be easily turned into cash (publicly traded securities are the exception). Even if they are directly used in the charity’s mission, such as art donated to a museum, they have much lower utility to the charities than a cash donation which can be used for its highest priorities. Given that reality, the state should not use its scarce resources to incent gifts of property other than cash.
Allowing incentives pegged to the fair market value of appreciated property violates basic tax policy principles by allowing a tax benefit for donating a capital gain that has not been included in income. (Explanation: This would be like allowing someone making an IRA transfer to a charity (which is excluded from income) also to deduct it, reducing the tax on other income. No one would suggest doing that; the deduction of appreciation is a historical quirk that long ago should have been eliminated by Congress.) The benefits mainly flow to the affluent. If the gift is of publicly traded securities, the giver can just as easily sell them as the charity and give the cash if he or she wishes to qualify for the credit.
Property contributions create nettlesome compliance and administration problems for the IRS and the Department of Revenue (DOR). The main ones relate to valuing the property for other than publicly traded securities. For example, a cursory reading of federal tax court cases shows that the IRS is fighting a losing battle with people who overvalue gifts of used clothing even though the statute and regulations have tightened the documentation requirements substantially. Since the credit will not apply to contributions deductible under the federal tax (thus, the IRS won’t care), I don’t want to put added burdens on DOR.
Large contributions (e.g., contributing art or real estate) will qualify for federal tax benefits and, thus, won’t be at issue under the credit in any case.
The many practical and policy problems created by federal law’s allowance of the deduction of the fair market value of property have been documented and described in detail by Professor Roger Colinvaux. The extensive ongoing litigation and IRS administrative efforts related to donations of syndicated conservation easements, much of which relate to valuation games being played by developers and the complicit charities that work with them provide a recent, high-profile example. See Peter Reilly’s blog posts here and here. The IRS has gone so far as to designate some syndicated conservation easements as listed transactions.
#4: Require a minimum threshold or floor of contributions before the credit applies. I would set a minimum level of contributions that must be made each year before the new credit would apply. I would set this at 2% of adjusted gross income or $1,000, whichever is greater. A threshold restriction like this has frequently been suggested by tax policy experts as a way to focus the incentive where it matters – that is, at the margin by not extending the credit to the smaller contributions that many givers would make with or without an incentive. It allows setting the revenue neutral credit rate higher to enhance the incentive where it matters most. A threshold also helps improve compliance, since contributors will be less tempted to claim small amounts on the theory it won’t be practical to audit them. There is no magic to the two numbers that I picked. They are higher than $500 threshold under the current Minnesota non-itemizer subtraction. That will allow a higher credit rate (stronger or more powerful incentive) at the same revenue loss. I think it is important to include a percentage threshold or floor, so the limit rises as income rises. The non-itemizer subtraction does not do that, likely because when it was enacted most donors with higher incomes would be itemizers.
Other more minor elements. I would set the maximum donation that qualifies for the credit equal to the basic standard deduction amount. This is a corollary of not allowing the credit to those who qualify for the federal itemized deduction. Setting the maximum at that level will prevent most taxpayers from forgoing the federal itemized deduction to claim the Minnesota credit if doing so would generate more total tax savings. One needs to always recognize that tax advisors will figure out how to maximize combined federal and state savings and file returns accordingly, even if their clients (the donors) are unaware of it and thus are not modifying their giving behavior in response. In any case, I want to discourage donors from forgoing some federal savings to realize bigger state savings. The underlying goal is to have the federal treasury bear the cost whenever possible.
Overall, I think my proposed fix would help right some of the wrongs done by TCJA’s changes and would help increase charitable giving in Minnesota. For a state with its sterling reputation for charitable efforts, Minnesota should have a state-of-the-art tax incentive for giving. I think the parameters of my proposed reform would be a big step in that direction. I’m sure they could be refined and improved, but the discussion should start now that the 2019 legislature adopted the main TCJA provisions affecting charitable giving.
The NY Times has a story on how the IRS has been slow in issuing guidance for the 2018 expansion of the carbon sequestration credit. Reading the story sparked a few reactions, none of them directly relevant to SALT issues, though.
I must confess this credit had largely escaped my attention. It was originally enacted in the Bush administration as part of 2008 stimulus tax cut and expanded in the Obama stimulus. The 2018 Congress materially expanded it by removing the dollar cap, which had hobbled its use. My excuse for not noticing the 2018 change: It was enacted when I was preoccupied with the TCJA and how it affected Minnesota’s income and corporate taxes. As a result, when the Bipartisan Budget Act of 2018 (the legislation containing expansion of the credit) was enacted in February 2018, I focused exclusively on its changes affecting Minnesota’s tax calculations, mainly changes to AGI or FTI. Changes to federal credits like this one went right by me.
The Times story recounts how the IRS has been slow in putting out guidance on the credit (two years have passed since BBA was enacted and no proposed regs issued), particularly how businesses making the qualifying investments can shift some or all of the tax benefits to others (obviously in return for money) when they don’t have sufficient tax to use all of the credits themselves. Those arrangements involve massive technical complexities, based on my knowledge of the similar issues with other federal credits (e.g., the low-income housing credit and the historic structure rehabilitation credit to name two). Given the demands on the IRS to put out guidance on the myriad of complex TCJA provisions, the slowness seems entirely predictable to me.
In any case, the story stimulated these random reactions:
Hypocrisy or delusion by members of Congress. My instinctive reaction is that Republicans in Congress who are complaining about the IRS’s slowness (the article quotes Wyoming Senator John Barrasso, a Republican) are rank hypocrites. I don’t know the Senator or his position on IRS funding, so this might be unfair. But since 2010 the Republicans in Congress have consistently been cutting or inadequately funding the IRS. After enacting the TCJA, they gave the IRS a small increase in funding, but real funding is still down by a lot (20%) as I pointed out here. Delays of this sort are exactly what they should expect. Before criticizing, they should consider their own responsibility. It’s not like President Trump is any better (see here), but I’m sure he prefers hobbling the IRS given past statements on his attitude regarding paying taxes.
Aversion to refundable credits. Congress and many states appear to have an aversion to refundable business tax credits. Much of the complexity that resulted in the delay in IRS guidance, according to the Times, is attributable to the need for regulations specifying under what terms third party investors (who probably must be cast as equity owners to) qualify for the credit. That complexity could be minimized, if not wholly eliminated, by simply making the credit refundable and paying the amount that exceeds tax to the owner.
I’m not sure what explains that aversion. One theory is that Congress is still smarting from the refundable safe harbor leasing provisions in the very first Reagan tax cut (ERTA 1981). That provision generated immense adverse publicity and caused Congress to quickly repeal the provision a year later in TEFRA. Maybe it was a lesson learned, rather than an irrational aversion to bad political optics. If so, I don’t know what the lesson was. I still think I was correct in advising Minnesota legislators to make a variety of business credits refundable, rather than to require (or allow) elaborate schemes involving “partners” (who are really just disguised passive investors) to lay off the benefit of credits to third parties. The latter approach imposes high transaction costs (money for investment bankers and corporate lawyers) with little difference in results, as far as I can tell. Put all of the money in the target’s pocket who is engaging in the desired behavior, rather than diverting a healthy amount to bankers’, lawyers’, and consultants’ pockets. In any case, the feds and most states almost never provide for refundable business credits, but rather require complex financial and legal arrangements to transfer the benefits of credits or deductions to third parties. Go figure.
As an aside, there may be a legitimate policy question whether to allow a credit or other incentive to nontaxpaying entities at all. If the government simply wants the activity to occur (seems like the case here) that’s not an issue. But it might be if the thought is that only proven successful firms (i.e., those that regularly have profits and pay tax) are reliable enough to provide the desired benefits. Another instance is if the credit generating activity is so ordinary or common that allowing nontaxpayers to get it will create compliance and tax administration issues. The latter was the case with Minnesota’s refundable R&D credit. I see none of those issues if the goal is carbon capture, certified rehabilitation of historic structures, or construction of qualified low-income housing. Who cares if the claimant has tax liability? The goal is the output.
Climate change: asymmetry and more hypocrisy. Stripped to its essentials, the federal government is buying carbon capture; that is, it is paying (via a tax credit) manufacturers a fixed dollar amount for each ton of carbon they sequester. The justification for this must be to minimize climate change and it was passed by a Republican Congress! (Caveat: The act is called the “bipartisan” budget act. Even though the GOP controlled both houses of Congress in 2018, the Senate filibuster required compromising with the Democrats to help pass this. So, the Democrats may have insisted on including the credit changes in the bill. The original credit was enacted by a Democratic Congress. But the senator quoted in the article dissing the IRS is a Republican. Of course, a lefty NY Times reporter may be at fault in picking his comment or seeking it out, I suppose, could be the defense.)
In effect, this is a negative carbon tax (or it may be better to call it a carbon reduction subsidy, I suppose, but that’s not as catchy). If this makes policy sense (and it very well might, in my opinion as someone who feels the country needs to address climate change now in a big way), its enactment makes the case for serious consideration of a carbon tax. What is the difference between the government paying to sequester carbon or charging people for emitting carbon? None as far as I can tell. (Disclosure: I’m a rank amateur when it comes to this stuff. I do know that if we want to get to zero carbon emissions, sequestration is required to accommodate making concrete, steel, etc. which produce carbon emissions.) The rational approach is to see which is cheaper per ton of carbon and do that first. I assume that it is much easier/cheaper to reduce carbon emissions than to sequester them. But then you would not look like you were cutting taxes in doing it, even if you recycled every dollar of the carbon tax as an offsetting tax cut. It shows the asymmetry in preferring tax over direct expenditures, particularly by Republicans. One more example of why we’re rapidly devolving into a world of more and more tax expenditures and suboptimal policy, in my opinion.
Since the mid-1980s Minnesota has taxed social security benefits following the federal income tax rules. The 2017 and 2019 legislatures began chipping away at the practice by allowing a state subtraction in addition to the roughly 60% to 70% of benefits that are exempt from federal tax.
In a January press conference, the Senate GOP caucus said that a centerpiece of their 2020 tax proposal is to exempt all social security benefits from Minnesota tax (covered by the Star Tribune here). I will begin collecting benefits when I turn 70 in December, so my instinctive, selfish reaction was “Yay” – I’ll be able to use my tax cut and take that long-dreamed spring training trip. (A quick calculation indicated I would save $3,000 in tax on my $45,000 in annual benefits. To provide some context, the Department of Revenue estimates that the subtraction will yield average savings of $1,070 for the 358,000 taxpayers who would benefit. Since the Trump tax cut limited my deduction for state and local taxes to $10,000, a lot less than I pay, that $3,000 would be pure savings to me, no loss of federal tax savings by paying less Minnesota tax!) But my better angels told me to slow down, put aside my selfish interests and think about whether the exemption is good for the rest of the state. After a little thought, it was obvious to me that it was not, and I decided a better option is to ask the Senate Republicans to come up with a better use for the money.
This blog post describes my thinking. It consists of three parts:
The first describes the three reasons why the proposed exemption does not make sense to me: it’s unnecessary, unaffordable, and unfair.
The second part discusses why I think the typical arguments for the exemption do not hold water.
The third part discusses the elephant in the room, politics.
PART ONE: WHAT’S WRONG WITH THE EXEMPTION
Unnecessary. Most social security benefits (about 60% to 70% according to the Congressional Budget Office) are already exempt under the federal rules that Minnesota uses in starting its tax calculations. The federal rules that the determine how much, if any, benefits are taxable are a complicated mess of income thresholds and phase-outs that only an accountant could like and explain. But they result in recipients with the lower incomes paying no tax on their social security, middle income recipients paying some, and high-income recipients paying the most. No one pays tax on more than 85% of their benefits (more on that later).
The 2017 and 2019 Minnesota tax bills expanded the exemption Minnesota carries over from federal law to cover more benefits received by higher income recipients; maybe about 70% to 75% of benefits are now exempt from Minnesota tax. So, the effect of a total exemption would be to cut taxes for recipients with higher incomes (like me!) who don’t need the help. If Warren Buffet or Donald Trump were Minnesota residents, they would qualify. Is that really what we want to do? I don’t think so.
A natural reaction is to support government policies targeted to help the elderly. This sentiment is captured eloquently in a classic Hubert Humphrey quote: “The moral test of government is how that government treats those who are in the dawn of life, the children; those who are in the twilight of life, the elderly; those who are in the shadows of life, the sick, the needy and the handicapped.”
Exempting social security benefits will help many seniors; about 95% of them receive social security although less than half now pay any Minnesota tax on their benefits. So, can a total exemption be justified as general help for the elderly? Even a cursory review of the data and the effects of the exemption make it obvious that is not a good justification for expanding the exemption.
First, national policy has succeeded admirably in pulling seniors out of poverty. The Table compares the poverty rates for seniors, the general population, and children.
It’s clear which of the two groups could most deserve help and it’s not seniors. Seniors’ poverty rates are more than two percentage points lower than for those for the general population (almost 20% lower). By contrast the child poverty rate is 36% higher than for that for the total population. What may be even more telling, Census Bureau researchers have concluded that seniors’ poverty rates may be even lower than the regularly published statistics suggest. See Adam Bee and Joshua Mitchell, Do Older Americans Have More Income Than We Think? (July 2017) (poverty rates for the elderly drop by 2.2 percentage points using more accurate measures of their income). As table indicates, Minnesota is doing better overall (we’re a high-income state) and much better for seniors and children.
Second, expanding the exemption would target its help to better off seniors, not those in poverty or on the cusp of poverty. And the most help (the biggest dollar tax cuts) would go to those higher up the income scale. That follows directly from the structure of the tax rules, which subjects more benefits to tax as one’s income rises. If the goal is to help lower income seniors, a better tax cut could easily be designed at a much lower revenue loss. Many low-income seniors don’t even pay income tax.
Third, if the purpose is to help seniors who are above the poverty line, I question the wisdom of such a policy. But in any case, data from the Pew Research Center indicates that seniors as a group are doing okay. The American Middle Class is Losing Ground (2015)(“The biggest winners since 1971 are people 65 and older. This age group was the only one that had a smaller share in the lower-income tier in 2015 than in 1971.”) The government does not need to send untargeted help to older Minnesotans.
Bottom line: most social security benefits are not taxed now; seniors as a group are doing as well as or better than other age groups; helping well-off seniors is unnecessary. A better strategy is to focus state resources on the younger generation, on whom the state’s future rests, such as expanding Minnesota’s new tax credit for student loan payments.
Unaffordable. DOR estimates that exempting all social security benefits would reduce revenues by more than $400 million per year. But the current cost is only half the story. As more of the baby boom retirement tsunami washes across Minnesota’s fiscal shores, the tab will grow rapidly. The Social Security Actuary (2019 Annual Report of the Trustees) estimates benefit payments will increase by more than 6% annually through 2028 (intermediate alternative, Table IV.A1, p. 40). If we assume that the DOR estimate grows at that rate, the FY 2028 cost rises to over $600 million, illustrating the magic (or horror) of 6%+ compounding, even over just a few years. By the end of the decade, the revenue reduction will likely exceed $1.2 billion per biennium.
Even for the state budget, a billion dollars a biennium is a lot of money. Affordability is a household or personal budget concept that is misleading to use in the context of government budgets. (I used it to get an alliteration for my three points!) For a high priority item, other spending can be reduced or taxes increased. But to accommodate the exemption will require doing either or both – by a lot. Put simply, enacting the exemption will impose a big opportunity cost. Surely, legislators can find a higher priority use for the money – either a better designed tax cut (if you’re a Republican) or needed spending/investments (if you’re a Democrat who sees much more for government to do).
Bottom line: enacting the exemption will create big challenges for budget setting by either party.
Unfair. The exemption favors people with one type of income over others. All else equal, two people with the same income should pay the same tax. Why should retired parents pay less tax than their working children with the same income? Why should someone whose income comes from pensions, 401(k)s, and social security pay less than another senior who has less social security and retirement income and, thus, must work as a Walmart greeter to make ends meet? To pose the question, answers it. Horizontal equity (equal treatment of equals) is a cardinal rule of tax policy; the exemption plainly violates it. Moreover, because the social security of lower-income recipients is already exempt, the beneficiaries will be middle- and upper-income recipients. The exemption is not progressive, if that is your fairness norm. Certainly, we can come up with a fairer way to cut taxes.
Unfairness is an intrinsic problem; it is simply wrong to arbitrarily favor one class of taxpayers. But it gets worse; it will lead to an inevitable queue of others seeking similar treatment. For example, a natural group to line up for their dollop of tax cuts are public safety retirees – police, firefighters, corrections workers, FBI agents, and similar. These high stress jobs provide government pensions that are not covered by social security, because they provide for earlier retirement than social security. But they are subject to income taxation under the standard pension tax rules, no favoritism for these retirees under either federal or Minnesota law. Naturally, these recipients will not consider that fair, if all social security is exempt. They will undoubtedly seek similar or better treatment, after all they put their lives and limbs on the line for the public. Because the social security exemption is fundamentally arbitrary and unfair, legislators will be hard pressed to explain why public safety pensions should not also be exempt. The almost inevitable result will be for the legislature to exempt these pensions sooner or later, narrowing the tax base, increasing the generational unfairness, and expanding the budget challenges. Recipients with private retirement benefits, then, will likely claim they also should be exempt.
A few states have already slid down this slippery slope and exempt all or virtually all retirement income from state taxation, putting the burden of their income taxes squarely on the shoulders of working people and business owners. And it is not as if seniors do not consume much in the way of services funded by the state. Although I don’t have data to cite, a large share of state medical assistance spending goes to pay for long term care costs of indigent elderly. To my lights, it’s reasonable to expect more affluent seniors to bear some of that burden, not just the young.
Bottom line: the exemption violates basic principle of horizontal equity (equal treatment of equals) by favoring those who receive one type of income.
Because a full exemption is unnecessary, unaffordable and unfair, the policy case against it (indeed, even expanding the current Minnesota subtraction) is overwhelming.
PART TWO: “FOR” ARGUMENTS DON’T HOLD WATER
Proponents of the exemption typically make four general points or arguments for it or least they did when I worked at the legislature. As is often the case, each has some basis in fact, but none of them support the exemption when considered carefully. Here’s why:
Point 1: I paid tax when I paid into social security; taxing the benefits is double taxation. This “double taxation” argument is regularly made. Senator Gazelka in supporting the Senate’s proposal said, according to the Strib, “Let’s be one of those states that doesn’t tax our seniors, when they’ve paid all the way through, and then now they have to pay again.” That’s not exactly the double tax argument if you parse his words carefully but it implies it. Double taxation would be good argument if it were true; it’s not. Debunking this persistent urban legend requires digging into the details of the tax rules that apply to defined benefit pensions.
Social security works like a pension plan in which the employer and the employee contribute equal amounts with the employees’ contributions being subject to income tax when they are made, while the employers’ contributions are not. Employee FICA (FICA is the acronym for social security “contributions” – tax to me) is equivalent of the employee pension contribution and the employer FICA to the employer contribution. (Self-employed individuals pay both parts but can deduct an amount equal to the employer share so the income tax treatment is the same; these payments are referred to as SECA.) When the employee retires and receives standard pension benefits, most of the benefits are taxable but a portion are exempt, allowing recovery of the employee contributions without paying tax again. Each year recipients receive Form 1099Rs from the administrator of the pension plan listing the taxable and exempt portions of their benefits.
When Congress was considering imposing income tax on social security benefits, the Social Security Administration concluded it was not administratively feasible to calculate these pension equivalent amounts for each beneficiary. Social Security benefits relative to employee FICA contributions vary widely, depending the beneficiary’s earnings history (the formula is progressive with low earners getting a more generous returns relative to their contributions, for example), marital status, age of retirement, number of dependents, and many more factors. (It’s an gross understatement to say the social security program structure is more complicated than the typical defined benefit pension plan.) So, the percentage of benefits that represents a “return” over and above recovery of employee FICA payments will vary depending upon the recipient’s personal situation. When Congress set the federal tax rules in 1993, the Social Security Actuary estimated for various groups of beneficiaries the average percentages of their benefits that consisted of recovery of employee FICA (the part that would be exempt under the pension tax rules to avoid double taxation). The highest of these percentages that represents return of employee FICA was 15% for single, high earning males (the average for the entire population was 7%). See this Congressional Research Service 2019 publication (page 16) for a little more detailed description. Congress provided that 15% of benefits would always be exempt. That 15% exemption addresses the double taxation argument.
On the surface, 15% may seem very low since employee taxes generate half of benefits, right? But most pension benefits do not consist of the nominal amount contributed but rather are provided by investment return over the long period of time between when contributions are made and benefits are distributed on retirement (typically 20 to 30 years). That’s why investment professionals advise people to start saving for retirement early, to harness the effect of compounding investment returns over long periods of time. Social security is a pay-as-you-go plan, so it doesn’t have “investment return” like a 401(k) or defined plan does. But benefits are still wildly higher than the nominal employee FICA amounts. That money is coming from FICA paid by current workers and employers, as well a trust fund that is credited with amounts of FICA that exceed benefits payments and assumed interest on those amounts, using the rates on treasury securities (note that amounts in trust fund do not affect benefit entitlements unless Congress allows the trust fund to run out of the money and the automatic benefit cuts take effect). In my personal case, I will recover all of my employee FICA tax in less than four years of benefit payments and I am in a “lower return” cohort that does not benefit from the progressivity of the benefit structure. That 4-year payback ignores the value of the disability coverage social security provided to me during my working career, as well as its life insurance-like benefits. You get the idea.
The SSA Actuary estimates are now more than 25 years old. Are they still accurate? I cannot say for sure. To my knowledge they have not been redone. But I have no reason to think they are not still accurate. The social security benefits and FICA rules have changed very little since 1993. Longevity has increased, which should increase the “return on employee FICA” (i.e., the amount of benefits relative to FICA paid) and push down the percentage. But inflation and inflation expectations have both declined and inflation is a factor in the generosity of social security benefits, since they adjusted for inflation. If Congress were to cut Social Security benefits beyond making the tweaks it typically has done or to increase FICA, the 15% assumption should definitely be re-estimated. It probably would be good practice to do a re-estimate and to revise the 15% (it could down as well as up). But, of course, that would require an act of Congress and we all know how unlikely that is.
Bottom line: The 15% exemption is probably still a generous approximation for nearly all recipients and in any case, it addresses the double taxation argument in the only feasible way for the states.
Point 2: Exempting social security benefits from taxation will help prevent seniors from moving out of Minnesota. This is a frequently made argument for the exemption. (Snarky aside: it has almost become the default argument used by GOP legislators to oppose any tax change that they don’t like, particularly an increase. In my last sessions working at the legislature, the Ground Hog Day element of its repeated use devolved into a running joke that caused wise cracks and snickers by tax committee legislators on both sides of the aisle. It was almost as if a GOP member failed to make the argument when a DFL bill was up, it wasn’t a real tax committee hearing.)
Reliable and neutral evidence for this effect simply does not exist. Careful, sophisticated econometric studies of migration by the elderly that control for as many of the relevant factors as possible simply do not find any effect of state income taxation of pensions and social security. The best study in my opinion is Karen Smith Conway and Jonathan C. Rork, “No Country for Old Men (or Women)—Do State Tax Polices Drive away the Elderly?” National Tax Journal (June 2012). Although subject to all of the usual caveats that apply any econometric research analyzing complex human behavior, such as migration decisions, the authors conclude “The results from all analyses overwhelmingly find no credible effect of state income tax breaks on elderly migration.” (p. 351).
Of course, various other sources or “studies” suggest otherwise. The recent column in the Strib by the Center of the American Experiment’s (CAE) John Phelan is a good example. The underlying “study” essentially looks at two variable using IRS data – the incomes of people who moved and state taxes. When there is the expected correlation between the two (i.e., more people/income move to low tax states), the results confirm the hypothesis. Of course, a myriad of factors, other than state taxes, affect where people chose to move or whether they do at all – family ties, access to jobs or schools, weather, amenities, and many more. Failing to control for those factors and using a robust dataset (variables that capture these other factors, across time and many states) calls into serious question whether the results mean anything.
A little reflection lends intuitive support to the econometric findings that Conway and Rork (and other neutral academic economists doing other studies) reached. Consider my personal situation from two different frames of reference – whether another state’s income tax exemption for social security would be sufficient to attract me to move or whether Minnesota’s exempting of social security would cause me to stay if I were inclined to move to a low tax state. In both cases, an income tax exemption for social security seems close to irrelevant:
#1. Luring me to Wisconsin: Wisconsin fully exempts social security and although its tax system has some material differences from Minnesota’s, the two states’ overall levels of taxation are close. Thus, all I need to do to exempt my social security from taxation is to move across the border; I wouldn’t need to abandon friends, family, and community etc. to do so because Wisconsin is close. (Please tell I don’t need to become a Packer fan!!) Let’s assume (falsely!) for the sake of argument that that is the only difference in my tax treatment. Would a $3,000/year tax savings pay for me to move to Wisconsin? A little thought says no – it would take many years of $3,000 in savings just to recover the transaction costs – moving expenses, costs related to selling and buying a house (realtors fees etc.), and so forth. The numbers will not pencil out any time soon, especially if I value my time. But you say, what if I were planning to downsize in retirement and move to a new home, thus incurring those transaction costs anyway. Then, the financial calculations become more complex. Now, I must judge whether moving to a more remote, exurban location farther away from entertainment (e.g., longer tips to the Guthrie, Ordway, and Twins games), family, and friends is worth it. Ultimately, it will come down to whether those differences in lifestyle and inconvenience are worth $3,000/year. To me, it isn’t even close, but for others who prefer an exurban or rural lifestyle, it might be enough to tip the balance from rural or exurban Minnesota locations (or it might be an unneeded windfall, if they would have picked Wisconsin locations without regard to taxes).
In any case, it’s one small factor that (to my intuition) is unlikely to affect many people – just those who are looking to move and who have the correct set of preferences to make the tax benefit a decisive difference. But from the state’s perspective, it must pay everybody with social security and for most of them it is irrelevant (me!) – because they are not seriously considering moving, because the tax benefit is not big enough to be decisive, or because they were going to move out-of-state for other reasons. To yield a fiscal benefit to the state seems almost impossible. Recall that the revenue loss is over $400 million per year.
#2. Keeping me from moving to Florida: But what if I am seriously thinking about moving to a low tax state. This is the situation that outfits like CAE (and other small government, anti-taxers) think a large proportion of the population falls into, probably because that reflects their own views and preferences. Again, consider my situation. Florida is a low tax state. My 96-year old mother-in-law lives in Florida and my wife spends a week each month with her to provide care and help take care of her affairs. It would be convenient for us to move down there and we’d avoid Minnesota’s cold winters as part of the bargain. Because Florida has no income tax at all (okay, I’d pay more in sales and property tax but still a lot less than we pay in Minnesota in total) my income tax savings would be more than 4X what the savings would be from exempting my social security from Minnesota tax. So, if I’m inclined to move to Florida would exempting my social security be enough to make a difference? Probably not. If I were the type of person CAE posits most people are, a social security exemption would be thin gruel to say the least. It’s like offering a free hamburger hoping to top or equal an offer of a free steak dinner with all the fixings.
Finally and perhaps most important, how much should we be concerned about skewing Minnesota tax policy to prevent migration of seniors out of Minnesota, if their preferences are for a low-tax, low-public service type of state and local government? My response is very little or not at all for two reasons.
First, if the state is going to get in the business of explicitly competing for residents based on tax policy (seems like a bad idea to me), I think it makes much more sense to focus efforts on young people, the base on which future growth and viability the state relies, not on seniors. Forecasts of workforce shortages won’t be met by keeping seniors here. (If retaining them as workers is the goal, we should exempt their wages, not their social security benefits.) Tax reductions targeted to keep or attract new workers would seem to be the better approach. As an aside, the young are typically much more willing to move than seniors, so they are more likely to be subject to persuasion.
Second, tax policy and tax levels are only half of the fiscal equation in the competition among states to attract residents and businesses. Public services and amenities matter as well. Using $400 million per year in state revenues for either a better designed tax cut or for more public services and amenities would probably be more successful in competing with other states.
Bottom line: High quality economic research and common sense suggest that exempting social security from income taxation will not be much of a factor in keeping seniors in Minnesota. If losing or failing to attract new residents is a concern, there are better ways to deploy over $400 million per year in state resources than exempting social security from income tax – particularly focusing on young people instead.
Point 3: The federal tax rules include fixed dollar amounts, set in 1983 and 1993, and have never been adjusted for inflation. As a result, inflation has caused more and more taxpayers to have their social security benefits taxed, which Congress never intended. The legislature should exempt all benefits or at least exempt most of them to hold tax rules constant with 1983 and/or 1993. There are two responses to this argument.
First, I think that Congress likely intended to allow the dollar thresholds to slowly erode with inflation, providing a gentle transition to taxing social security more like defined benefit pensions, the correct tax policy treatment. Here’s my thinking. When Congress first subjected benefits to tax in 1983, it had already indexed many dollar amounts used in the most important tax parameters for inflation (bracket widths, personal and dependent exemptions, standard deduction, and so forth). So, it clearly knew how to do that and chose not to. By 1993 when the latest change in the social security benefits tax rules were enacted, Congress had indexed more tax parameters for inflation, but chose not to do so for the social security tax thresholds. (The IRS annually issues two revenue procedures announcing the annual inflation adjustments, one for the general provisions and one for retirement plan provisions. The 2019 basic rev proc is 28 pages long for an impression of how many inflation adjustments there are; the 2019 retirement plan adjustment rev proc adds another 4 pages.) Congress ignored calls by AARP and others to increase the dollar amounts or to index them for inflation when it passed several big tax cut bills since 1993 (two rounds of Bush tax cuts and the latest Trump tax cut), as well as many smaller ones. All of this provides good evidence that the failure to index was a feature, not a bug. That speaks for Minnesota not being concerned either.
Second, the Minnesota legislature specifically responded to this argument (made by AARP and others) in enacting the additional Minnesota subtraction for social security benefits in 2017 and expanding it in 2019. The Minnesota subtraction is indexed for inflation. See Minn. Stat. § 290.0132, subd. 26, paragraph (f).
Bottom line: The 2017 and 2019 legislatures have effectively taken care of the indexing problem, if it even is a concern.
Point 4: Minnesota is one of only a few states that tax social security; it should align its tax system with other states. It is correct that 30 of the 43 states with income taxes fully exempt social security benefits. (West Virginia is phasing in a full exemption by 2022, which will increase the number of states with full exemptions to 31.) Two states (New Mexico and Utah) follow the federal rules; the rest (11 including Minnesota) exempt some more benefits than the federal rules, but not all. The practices of other states, however, provide little basis for Minnesota exempting social security. As my mother responded when I whined “but everyone is doing it” – would you jump off a bridge if everyone else was doing it? Do you want to be a lemming? That response is almost as appropriate here; just because most other states succumb to foolish political whims does not mean Minnesota should.
Bottom line: Minnesota prides itself on having smarter policies and making better decisions than other states. This is perfect chance to prove that is really the case.
PART THREE: THE ELEPHANT IN THE ROOM; POLITICS
Point #4 leads to the natural question: if fully exempting social security from state taxation is such bad policy, why do so many state taxes do it and why hasn’t Minnesota? The answer has three elements: Minnesota’s tax policy history, how states legally tie their income taxes to federal law, and politics (the big factor).
Minnesota’s Tax Policy History. When Congress enacted Social Security in 1935, the law did not resolve whether or how benefits would be taxed. As the program began paying benefits, it fell to the IRS to resolve the issue. The IRS analogized to public assistance benefits, paid by the government to the indigent, and ruled that benefits were not taxable under an administratively created “general welfare” exemption. That decision was questionable, particularly as social security developed into a basic building block of the retirement system paying increasingly generous benefits to nearly all seniors based on their wages and self-employment income. But the exemption granted administratively by the IRS persisted until Congress opted to tax up to half of benefits in 1983 as part of a comprehensive fix of social security’s finances. (Revenues from the federal taxation of social security benefits are used to fund social security and Medicare.)
That federal practice led to Minnesota (and I suspect all other states) initially to exempt benefits from its state income tax. When Congress began taxing social security in 1983, Minnesota would have needed to enact a law, adopting the new federal rule. The 1984 legislature failed to do so, continuing the longstanding exemption. I was working for the House as a tax staffer then. As I remember it, no one publicly proposed Minnesota conform to federal taxation. The early 1980s were difficult fiscal times for the state with the legislature raising taxes several times to close budget deficits. But when the potential to conform to the federal taxation of social security came before the legislature in 1984, the severe state budget crises had mostly passed. That permitted the legislature to ignore the issue and allow the exemption to continue.
Governor Perpich in 1983 had appointed a blue ribbon tax study commission (commonly known by its chair as the Latimer Commission), which made recommendations to the 1985 legislature. Its income tax recommendations generally were to increase conformity to federal rules and expand the base of the tax. These recommendations and a growing tax reform push in Washington by the Reagan Administration provided the backdrop for the 1985 legislative session.
The Republicans had taken control of the House by a narrow majority in the 1984 election after having been in the minority for well over a decade. By 1985, the double-dip recession was well in the rear view mirror and economic good times had returned. Enacting a big income tax cut was the new Republican majority’s signature legislative priority; they billed their overall tax proposal as a billion-dollar tax cut (fudging the numbers a bit to get to a cool billion). The Senate and governor’s office were still controlled by DFLers who had higher priorities than a big income tax cut. Contentious negotiations during a long special session resulted in a broad-based income tax cut that implemented many changes, including subjecting social security to Minnesota tax for the first time. Taxing social security was a minor factor in the discussions; the major sticking point was whether to retain Minnesota’s deduction for federal income tax. The ungainly compromise bill allowed taxpayers to chose between two different tax structures – with or without the federal tax deduction. But both structures taxed social security benefits.
Although taxing social security was a low profile issue in the 1985 tax debates, I believe the legislature agreed to it for three reasons: (1) The resulting expansion of the tax base helped offset the revenue loss from the cut in the rates (a plus for the House Republicans, since a rate cut was their main goal). (2) The Latimer commission and national tax reform discussions created a political climate or consensus accepting it as an improvement in policy. (3) Minnesota then had an exclusion for pension income, which had a strong constituency pushing for its expansion as part of the tax cut. The most vocal and active proponents of expanding the exclusion were retired government employees who were not covered by social security. A prime argument they made was that private sector retirees did not pay any tax on their social security benefits. Adopting the federal rules helped indirectly to counter that argument, but more importantly proponents of a tax cut wanted to maximize the rate cut, rather than providing targeted benefits to narrow groups of recipients, such as pensioners.
1987 was the first legislative session after Congress’s enactment of the landmark 1986 Reagan tax reform. In response, Governor Perpich and legislature (both houses were controlled by Democrats in 1987) opted to dramatically simplify the state income tax by moving into very close conformity with the new federal tax rules. One of the most difficult decisions in doing so was to repeal the old pension exclusion. Amendments to strip its repeal from the bill failed by very narrow votes. The 1985 decision to tax social security benefits was one factor that enabled the legislature to repeal the preference for pension-source income. Government pensioners without social security coverage could no longer cleanly argue that they were being treated unfairly compared to social security recipients, even though only a very small portion of social security benefits were then subject to tax. Although votes on repeal of the pension exclusion were heavily along party lines (with most Republicans voting to keep the pension exclusion), the Republicans did not make this a big campaign issue in the 1988 election to my knowledge.
The 1993 federal change that expanded social security taxation to the current treatment set off a difficult discussion in the 1994 Minnesota legislature. Governor Arne Carlson did not include conformity in his tax proposal. Probably not coincidentally, he was up for election in the fall. By contrast, no senators in the DFL-controlled Senate were scheduled to be on the ballot and the Senate tax bill did provide for conforming. After much hand wringing and discussions in conference committee, the final tax bill included conformity to the federal social security tax, but it was phased in over three years (full conformity for 1997) and was paired with expanding the elderly exclusion for lower income seniors, particularly those who derive less of their income from exempt social security. The phase-in and permanent enhancement of the elderly exclusion were included at the insistence of the governor, probably to help neutralize the change as potential fall campaign issue (it never was made one as I remember it).
Legal structure linking state law to the federal income tax. States link their income taxes to federal law in two different ways. Static conformity states, like Minnesota, tie their taxes to a version of federal law in effect at a specific time. That requires a static conformity states’s legislature to enact laws to adopt later federal changes. By contrast, rolling conformity states have laws that automatically adopt federal changes without the need for any action. According to the Tax Foundation, there are 18 rolling conformity states. Rolling conformity likely represents a commitment or preference by the state to follow federal law for reasons of simplicity or similar. (Minnesota could only become a rolling conformity state by amending its constitution, since the Minnesota Supreme Court held a 1960s era law that did so unconstitutionally delegated the legislature’s power to Congress.)
The effect that this structure has on the likelihood of adopting federal changes, including those of problematic political popularity, should be obvious. The fact that it does not require action by the legislature makes it much easier to maintain conformity. Inertia is powerful force in politics, as well as physics. Some rolling conformity states likely allowed the 1983 and 1993 federal decisions to tax social security to apply to their state laws. One would expect more of these states to tax social security. The table below bears that out – 10 of the 13 states that tax some social security are rolling conformity states.
State
Rolling conformity
Politics
Colorado
Yes
Purple
Connecticut
Yes
Blue
Kansas
Yes
Red
Minnesota
No
Purple
Missouri
Yes
Red
Montana
Yes
Red
Nebraska
Yes
Red
New Mexico
Yes
Blue
North Dakota
Yes
Red
Rhode Island
Yes
Blue
Utah
Yes
Red
Vermont
No
Blue
West Virginia
No
Red
Compiled from various sources by autthor
Politics. The obvious reason, though, that most states do not tax social security is simple and obvious. The politics are compelling. Nobody likes to pay taxes. Seniors are more likely to vote and actively participate in politics than younger voters. They have time to lobby legislators and they are well organized.
Although the policy case for taxing benefits is compelling (at least to me), the countervailing arguments, as described above, are easy to make. Each of them are superficially plausible and easy to state. The responses are complex and require some thought and understanding of pretty complex tax rules; they are cannot be easy for a legislator to quickly put across while door knocking or at a community meeting. Moreover, human nature inherently seeks to rationalize or find justifications for positions that you already hold and/or are in your self-interest. It’s basic human psychology to look for and find confirmation of what one already believes is true and/or to screen out or ignore countervailing facts, especially if it is in your own interest. That puts a putative debunker at a decided disadvantage.
Given the politics and the previous decades of exemption, it seems likely that many static conformity states, unlike Minnesota, never taxed social security. Two of our bordering states, Iowa and Wisconsin, are both static conformity states that for a time did follow the federal rules. But within the last decade or so both exempted all social security benefits from taxation (Iowa still imposes its minimum tax on them in some instances). Last year, North Dakota followed Minnesota and enacted a subtraction for some benefits for lower income filers. Similar trends have occurred nationally, as states increasingly abandon taxing social security. Last year, in addition to North Dakota’s changes, the West Virginia legislature enacted a phase-in of a full exemption. Campaigns by senior groups to expand the exemptions are likely going on in all the states that still tax benefits (based on my quick Googling of a few states).
Minnesota has managed to tax social security for so long, I believe, largely because both political parties (but especially the GOP, the party of small government and tax cutting) have restrained themselves from overtly politicizing the issue. Elected Republicans agreed to imposition of the tax in 1985 and its extension in 1994. The 1985 House was controlled by Republicans and Arne Carlson, a Republican (back then, anyway), was governor in 1994. The GOP House majority from 1999 through 2006, despite supporting and enacting several large tax cuts, and Governor Pawlenty, an inveterate tax cutter, both refrained from proposing social security tax exemptions. I assume that is because they recognized doing so for the poor policy that it is: there simply are many better ways to cut taxes, if you think state government is too big.
Indeed, this should not be a partisan issue. As is evident from the table above, the states that still tax social security do not have any one partisan profile. Some are red states, others blue and purple. (I assigned my partisan leaning judgments based on the 2016 presidential election results. If the contest was reasonably close, like Minnesota’s was, I made it a purple state with no clear partisan dominance.)
More recent experience – based on positions taken by the House GOP, Senate GOP, and Jeff Johnson, the GOP candidate for governor in 2012 and 2016 – appears to reflect a decision to abandon that quiet bipartisan consensus and make it a high profile partisan issue. I don’t expect the 2020 legislature to seriously consider enacting a full exemption, since Governor Walz is on record opposing it and given its fiscal effects will likely hold fast to that. But if the GOP persists in making it a headline partisan issue for the long run, it is very likely that Minnesota will expand and ultimately fully exempt social security. The political dynamics are too compelling, based on what has happened in other states. If I’m correct, fiscal reality will require some combination of higher taxes on others and lower levels of government services, a result that is good for nobody other than higher income recipients of social security like me.
Although I don’t expect Senator Gazelka to ever read this, I hope that he and his GOP Senate colleagues rethink their position and recognize that taxing my social security (and most others as well) makes perfect sense. As nice as an extra $3,000/year would be in my pocket, there are many better ways to deploy that money, either as tax cuts or spending.
If one feels compelled to cut taxes on seniors, expanding the elderly exclusion so that all lower-income seniors, regardless of their sources of income, are treated more equally would be better. I personally would counsel channeling attention to helping the younger generations. My generation has saddled many of them with crushing student loan debt and the economy seems to be providing diminished opportunities for the average person to do even as well as their parents. If ever there was a proposal for which the response “Okay, Boomer” is deserved, this is it in my mind.
Postscript: a senior wag might respond to my plea to tax my benefits: “If you feel that way, don’t claim your savings but let me get mine!” Implicitly, I guess, the idea is that’ll eliminate my supposed ethical qualms. Non sequitur responses like that are frequent responses to similar commentaries – e.g., Warren Buffet’s pointing out that lower tax rates apply to his income than to that earned by his secretary often yields comments that he should, then, write a check to the government – and are snarky and off point. This is about what is good tax policy, not how I or anyone else should use our money.
TPC is out with a new research report that compares tax expenditures before and after the TCJA – both using JCT’s and OTA’s numbers from their respective tax expenditure budgets (TEBs). CRS did a piece back in 2018 that also estimated the effects of TCJA on tax expenditures, but it has much less detail that the new (1/22/2020) TPC Report.
The results are mostly as you would expect with dramatic drops in the amounts for the SALT deduction (-81.5% JCT; -85.3% OTA) and home mortgage interest (-65% JCT; -64% OTA). As the Report points out, this results from a confluence of factors – (1) direct restrictions on the deductions (big deal for SALT, less so for mortgage interest), (2) the increase in the standard deduction (big factor for both), and (3) TCJA’s rate reductions.
#1 and #2 will affect the Minnesota tax expenditures as well, since the 2019 tax bill adopted TCJA’s limits on the deductions and more importantly, TCJA’s higher standard deduction amounts. The effects on the Minnesota TEB will be smaller, since the SALT limit just affects property taxes and Minnesota’s 2019 rate cut was minuscule compared to TCJA’s. But it does give an impression of what is likely to occur.
The business tax expenditures are also relatively predictable (at least for someone like me who spent too much time poring over the JCT’s TCJA estimates back when I was still working). In the future, I will be watching for evidence of the extent to which the federal estimators missed in their bill estimates for two TCJA provisions (both of which my intuition tells me their estimates were too low): (1) the new deduction for qualified business income (I fear that something like the experience with the domestic production deduction estimates may occur for QBI; there is an interesting 2017 NY Times article documenting that debacle) and (2) the foreign provisions, particularly the GILTI tax. By tracking tax expenditure estimates one can infer how much the JCT or OTA economists think actual experience is deviating from their original estimates of the impact of the legislation. It is, however, like looking at shadows on the wall of Plato’s cave – at best an imperfect image.
The Report notes that there was one big increase in an individual, nonbusiness tax expenditure, that is, the higher child credit amounts (+126% JCT; +142% OTA). One weird effect, which is not discussed in the report but occurred to me as I read it, is that TCJA’s repeal of the dependent exemption allowances eliminated a tax feature that was part of the reference or baseline tax base. The resulting increased revenue was, then, used to increase the child credit, a tax expenditure. (Of course, you can’t explicitly connect the two but the implicit connection seems obvious to me.) So, even though revenues would have remained constant (approximately) tax expenditures went up by the big amounts noted above! This is similar to enacting a new tax expenditure or increasing an existing one and offsetting the revenue with a tax rate increase. Some of us have advocated for exactly that to help legislators recognize what they are doing when they support tax expenditures: i.e., implicitly increasing someone else’s relative tax. (As an aside, OTA considered the allowance of dependent exemptions for students aged 19 and older a tax expenditure; I don’t believe JCT considered any of the dependent allowances to be tax expenditures.)
The swap of the dependent exemption for a child credit increase triggered two observations or reflections on my part:
First, the swap reveals the gray area or ambiguity around the edges of the definition of what tax expenditures are. I assume that the policy purposes behind the two provisions (and Congress’s intent in making the swap – my second point) are not that much different. So it seems a bit of a stretch to characterize one as social policy spending and the other as a fundamental feature of the baseline or reference tax system. This shows the malleability of the tax expenditure concept and makes it easier to understand the inherent skepticism with the concept by some – at least in some of these borderline contexts. That, I should say, is not a skepticism that I share – particularly the more virulent versions expressed by some anti-tax types who never see a tax expenditure they don’t support or like because it is also a tax cut (looking at you Grover Norquist).
Second, the swap reminds me of a major frustration that I have with the way TCJA was passed by Congress; the process was nearly devoid of discussion of policy rationales for many of its changes. I may have missed it, but I don’t recall ever seeing or hearing a reason expressed for the swap of the dependent exemption allowance for an increase in the child credit. I can guess why they might like a credit better than an exemption allowance. But why do 17 and 18-year old children count for less or nothing (after the special $500 credit transitions away) than those 16 and younger? I get how there could be rationale for cutting off dependents who are in college, but older high school children and dependents who are adults but disabled is harder to divine. The law still does require parents to provide support for 17 and 18-year old children, I believe, and based on my experience they’re no cheaper to support than 16-year olds.
SALT Speak - Joel Michael's Blog 