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.
I would not hold my breath. But if you’re interested in reading about its latest reform effort, the NYT is out with a story today (1/30/2020). It’s worth spending a few minutes to read if you’re interested in taxes, property taxes, or the politics of property taxes or just the gaudy valuations of NYC residential real estate.
Anyone who has ever looked under the hood of the New York City property tax system knows that it is a true mess; a walking horizontal inequity if there ever was one. Homes of equal value pay starkly different property taxes with (no surprise) many very valuable brownstones, coops, condos, etc. paying multiples less than homes with often much lower values. For those who get depressed about the complexity of the Minnesota property tax with its 50+ classes, a good anxiety reliever is to spend a short time looking at New York. (My wife Amy is from NY and was living in NYC when we got married, so out of pure curiosity I have paid some more attention than usual to what goes on there tax-wise. And I have been preparing state and city income tax returns for my daughter who lives in Brooklyn – Minnesota is simpler and easier on that front as well, BTW.)
The article, for example, details a Manhattan condo with a value of $538 million (what??) and an annual property tax of $532,000 that would rise to a cool $3 million under the reform (hey, that’s only an effective rate of 0.6%, less than Prop 13’s 1% benchmark, if you ignore its value cap). You can certainly see why New Yorkers don’t like that $10,000 SALT cap, though!
TPC is out with a new research report, State Income Tax Expenditures, by Aravind Boddupalli, Frank Sammartino, and Eric Toder, that compares the tax expenditure budget (TEB) reports of three states, California, Massachsetts, and Minnesota, and the District of Columbia.
It’s a topic near and dear to my heart, on which I spent a fair amount of time during my career at House Research. See here and here. I promoted the idea (internally to legislators) and drafted the bill that required preparation of the Minnesota TEB back in the 1980s.
The TPC Report is well worth reading (only 12 pages long). It illustrates how variable the reporting of tax expenditures is from state to state, despite the fact that the authors picked four reports that are reputed to be among the higher quality of the state TEB reports. States (as well as analysts and Treasury and the Joint Committee staffs) don’t always agree on what a tax expenditure is. Disagreements at the state level are much common than at the federal level. Much of that is attributable disagreements about the baseline or reference tax structure. (I personally disagreed with a number of judgments that DOR has made in preparing its report. I many times have regretted my decision to parrot the very general terms of federal law in drafting the Minnesota statute and not providing DOR more statutory guidance as to what the reference or normal tax structure is. The House Research reports, as a result, deviated from some of the DOR decisions – in particular with regard to the treatment of the sales tax, which I think in principle is to be a broad tax on consumption, while DOR considers it to be a tax on final sales. That decision, for example, causes DOR to treat exemption of intermediate business inputs as tax expenditures, which the consumption tax norm would not.)
The TPC report also illustrates to me how ill-considered it was for Congress to repeal the ACIR. A federal government entity should be regularly doing work of this sort as part of its central mission and could, perhaps, promote some uniformity and consistency with greater authority and credibility. Instead, we’re left to rely on the good graces of the nonprofit sector (as good as TPC is and it is) for making these national comparisons of state practices and to make recommendations for improvements.
A few observations and nits to pick about the TPC Report and its coverage of Minnesota, since I’m pretty familiar with Minnesota’s practices.
Comparative percentages across states. I was modestly surprised that Minnesota had the highest percentage of its income and corporate income tax in tax expenditures – 61% versus a low of 51% for California. Unfortunately, the report dose not say exactly how those percentages were calculated, so I can’t get an impression (much less a clear answer) of the extent to which the differences are real or just a matter of how the reports define and estimate tax expenditures. Specifically, the Report does not indicate whether the adjustment made in its tables to eliminate a few of the very obvious reporting differences were used in calculating the percentages. Minnesota is the only state, for example, that treats the nontaxability of Medicare as a tax expenditure. Was that amount included in calculating the percentages? It is more than $500 million per year. The same goes for single sales apportionment ($379 million), which is excluded from TPC’s tables but is in the Minnesota report as a tax expenditure. Those are only a couple of the larger differences in reporting identified by the report.
As an aside, tax expenditure numbers cannot be summed to get an accurate total (even accepting the individual estimates as accurate), because they do not reflect the interactions if they were simultaneously eliminated. For example, some taxpayers would quickly revert to the standard deduction, while others would be pushed into higher tax brackets, and so forth. Moreover, behavioral responses to repeal are not taken into account at all (at least in Minnesota’s estimates). As a result, the percentage estimates are questionable as absolute numbers, but still could be useful as a comparative matter.
Treatment of Minnesota’s marriage credit. The Report lists Minnesota’s marriage credit as a tax expenditure. No surprise, given that the Minnesota TEB lists it as a tax expenditure. But the Report filters out filing status as a tax expenditure, because of differences among the states in how they treating filing status provisions. Is treating married couples or heads of households as a separate category of taxpayers with lower rates a tax expenditure? States come to different conclusions about that – Minnesota does not consider it a tax expenditure but other states do, so TPC did not included it in its tables. Minnesota’s quirky marriage credit is really an adjunct or alternative approach to rate reductions based on filing status. When Minnesota (in the 1990s) decided to reduce marriage penalties, it could have done so by simply increasing the married joint bracket widths to be twice the single brackets. That is the traditional way to eliminate a “marriage penalty” in the rate structure, but it also confers “marriage bonuses” on couples when one spouse earns all or most of the income. Minnesota chose instead to offer a credit to married couples when the lower earning spouse’s wages, self-employment income, or pension pushed the couple into a higher tax bracket than filing as two singles would. For some unknown reason, DOR treats that as a tax expenditure, but does not treat filing status differences as one. TPC followed that practice in the Minnesota table, but I would not count the marriage credit as a tax expenditure.
Minnesota’s waters edge unitary. The TPC Report (page 6) has a minor mistake in saying that Minnesota allows water’s edge as an election. Minnesota mandates water’s edge combined reporting, a practice that was upheld by the Minnesota Supreme Court (the US Supreme Court declined to review the case). Minnesota could still treat water’s edge apportionment (with worldwide unitary as the reference baseline) as a tax expenditure, but does not. As the TPC Report notes apportionment rules is a topic on which where there is no policy consensus on what the baseline or reference tax base should be.
The Minnesota numbers do not reflect the 2019 tax bill, as noted by the TPC report. That tax bill, because the major changes it made (going to TCJA’s higher standard deduction, its limits on itemized deductions for taxes and mortgage interest, a modest rate reduction, etc.) likely will make some material changes in the estimates in the 2020. There is no way TPC could deal with that but it will be interesting to see how much it changes the numbers – probably by quite a bit for a few provisions.
Differences in using direct versus tax expenditures. A constant issue for policy makers is whether to use a tax expenditure versus a direct expenditure for a new or existing program. The TPC Report is not intended to deal with that issue, but rather is about improved reporting and oversight of tax expenditures. However, it does obliquely engage the point with regard to film production incentives. Most states do that with tax credits. (The Report says that Georgia’s tax credit has an estimated cost of $500 million, which is shockingly high to me and I assume why the referred to it.) The Report correctly notes Minnesota’s on-again, off-again film production incentive is done as a direct expenditure (page 10’s reference to the Snowbate program). However, it passed up the chance to identify a much bigger difference among the reports – Minnesota has a very generous property tax refund program for both homeowners and renters. Minnesota’s FY 2020 expenditures on this program are estimated to be over $780 million. Because this program is administered separately, not as an income tax credit, the Minnesota budget treats it as a direct expenditure. (In the past, it was an income tax credit for renters and senior homeowners, but the state dropped that to realize one-time budget savings by paying/administering it separately which allowed deferring recognition of its cost until the next fiscal year.) Functionally, the program is little different than a tax credit, but it shows up in the regular budget. California’s, Massachusetts’, and DC’s programs are all tax expenditures because they are administered under their income taxes. The TPC Report is about tax expenditure reporting but failing to highlight this big difference seems like a missed opportunity. It clearly distorts financial reporting of spending (and Census reporting of state tax levels) slightly.
I do wonder whether differences in operating and budgeting for these programs – as direct expenditures by Minnesota and tax expenditures by California, Massachusetts, and D.C. – makes any difference in how much review and oversight they get by their respective legislatures. The conventional wisdom is that tax expenditures are hidden spending that is subject to much less scrutiny than direct spending. That seems like a subtext of the TPC Report and is an inference I generally agree with based on my many years working in the Minnesota legislature. But in the context of relatively high profile programs like renters credits and circuit breakers, I have my doubts. This general topic seems like a fruitful area for public finance economists to study. I have often thought the mixed practice of states in providing college savings incentives – both as tax deductions and credits for 529 plan contributions (tax expenditures) and matching 529 plan contributions (direct expenditures) would provide a good natural experiment to study, since there a multiple states offering both types of programs (in some cases both types in one state). Minnesota has alternated between both approaches over the last 20 years.
Bottom line: The TPC Report is a good start at comparing state tax expenditures and is worth reading. It certainly would be nice if states moved to more consistent and robust reporting, as recommended by the Report. The Report shows just how variable and weak that reporting is now even among states with supposedly very good reports. One baby step (not suggested by the report) might be for the financial accounting standards board to require reporting in CAFRs of the refundable amounts of tax expenditures. In my view, it is only through federal mandates (e.g., Census Bureau reporting) or FASB requirements that there will be any consistency allowing reliable cross state comparisons. If any such mandate were proposed for tax expenditures generally (i.e., beyond the refundable portion), the hue and cry of opposition from the states would be deafening and the complexity of writing the rules, mind boggling. Just doing something on the refundability portion would be a daunting task. Pity.
I have previously suggested that TCJA’s $10K limit on the deductibility of state and local taxes would likely stoke demand for tax exempt bonds -i.e., double tax exempt bonds that are also exempt from the investor’s state income taxes. Morningstar reports that in 2019 inflows to tax exempt bond funds and ETFs were $105 billion, an all time record. The next highest year, 2009, was $75 billion.
This, of course, is only indirect evidence that investors were seeking to buy in-state bonds that are exempt from the issuing state’s income tax, but I think that is probably a reasonable inference. If Morningstar broke those numbers down between single state and multistate funds, that would provide more direct evidence. (Most states, like Minnesota, only exempt bonds issued by themselves or their local governments from their state income taxes, so investors need to buy single state mutual funds for their state of residence to get an exemption.) It probably does that for business subscribers, but I don’t have access to that detail unfortunately. The article does report that 90% of the money went into actively managed funds and all of the single state funds (I believe) are actively managed, but of course most of the multistate funds are too.
STRIB has a new story on the MOA Waterpark saga indicating the negotiations between Triple 5 and the city are taking longer than expected.
That is no surprise given the complexities involved and the tight rope that the city must walk, meeting Triple 5’s business demands while satisfying the federal tax law requirements for the use of 501(c)(3) tax exempt bonds. Just to review:
MOA’s interests and role. Triple 5 (MOA’s owner) obviously wants (1) to put as little of its own capital as possible into the Waterpark and (2) the park to be operated as a successful feeder of customers to MOA and its tenants. This has led Triple 5 to retain ownership of the land, leasing it to the nonprofit that will operate the park, and to manage the waterpark through an affiliate (I assume to ensure that it functions according to MOA’s interests). In essence, the park is really just part of MOA’s overall business plan – they hatched the idea to make Phase II work. But MOA’s owners want to reduce their capital costs by borrowing (real estate entities are almost always highly leveraged) the project costs at tax exempt rates, necessitating use of an “independent” nonprofit and governmental bond issuer.
Bloomington’s interests and role. The city’s interests are linked to MOA. The linkage was effectively locked in 35 years ago when the city opted to go with the megamall plan for the site. As the article reveals, MOA is now 10% of the city’s property tax base. But it is a risky 10% given the shaky state of business of operating shopping malls these days. MOA’s success so far is, in part, due to the city’s partnership (paying for the parking ramps and other infrastructure with TIF). But, as I suggested in another post, the city is riding on the back of a tiger – there really is no easy way to get off. It MOA fails, the city will have a big mess on its hands. So it wants the waterpark to succeed; the city is on the hook to build, own, and operate a big parking ramp for the facility. But city also wants to minimize its exposure if the waterpark isn’t successful (i.e., fails to breaks even or worse). Hence, the city’s decision to put as much distance as possible between itself and the tax exempt bonds – i.e., the decision to use an Arizona entity to issue the bonds – which may (or may not) help minimize the halo effect on the city’s own credit if the waterpark’s finances go south. Nevertheless, it probably would prefer MOA put more money into the waterpark, rather than less, because failure of the waterpark part of the project probably has more negative ramifications for the city than MOA having financial trouble with its lenders or a lower return on equity.
Demands of the tax law. By using tax exempt bonds for a 501(c)(3) entity (the Louisiana nonprofit that will own the waterpark), the deal/project must thread a needle that is complicated by its close linkage to MOA, a for-profit business. Federal tax law says the project must be under either a 10-percent “use” or 10-percent”security interest” threshold test to avoid making the bonds taxable. Those tests essentially say a for-profit business (MOA obviously or related entities) cannot constitute more than 10 percent of the security for the bonds (i.e., either pay them or comprise property that bondholders could look to for payment) and use of the project. I assume that the project llunks the use tax because the business arrangements make MOA a de facto user of the park. The security interest test means land rent and management fees must be set at close to fair market amounts (arms length deals) to be sure that MOA is not subsidizing the waterpark with the subsidies that count toward either of the 10-percent thresholds.
Louisiana nonprofit and Arizona governmental bond issuer interests and role. One might assume that these two entities are just sort of straw men or hired service providers that are totally under the thumbs of Bloomington and MOA, the entities that are driving the deal and are putting up the equity capital for the project (to the extent there is any). But I assume that the two entities actually are independent actors (or this won’t work legally) with their own interests. I assume they have their own lawyers and maybe financial advisers. The Arizona bond issuer is responsible for ensuring that the bond issue complies with the requirements of the federal tax law – not just when the bonds are issued but for as long as they are outstanding. That is a big responsibility with important consequences if the bonds flunk (they retroactively become taxable and bond covenants will likely be violated). Among many other things, it means policing the security interest test described above. This will have long term implications for the ongoing operations of the waterpark as I note below. The Louisiana nonprofit has some similar interests, as well as its business reputation.
What doesn’t compute to me. The STRIB story says that the federal tax law limits MOA’s ability to make donations to the waterpark. I understand that if it means that MOA cannot make ad hoc contributions that would establish a pattern of MOA propping up or supporting the parks operation or, worse, be done under a binding legal commitment to subsidize the park under specified conditions. Either would likely be counted against the security interest thresholds. It would seem to me, though, that MOA could make an initial “no strings” contribution or donation to the water park (i.e., the Louisiana nonprofit entity), such as giving it the land outright so (with more equity and no need to pay $2 million in rent) it is more likely to operate in the black. That would not mean that MOA is either securing the project; it’s a one-time fully completed transaction that occurred before operations or financing of the waterpark began. Maybe I’m wrong, but it seems fishy to me.. Rather, I would speculate that MOA chose not to do that because (1) it wants to keep the land on its balance sheet and the rent on its P/L statement and/or (2) if the waterpark fails financially, MOA wants to control or have a say in what happens, which owning the land will allow it to do. I’m guessing it is mainly (1), but some of (2)..
Longer run issues. If the waterpark flops financially or even more likely just struggles a bit, this financing arrangement has important consequences for the city, I think. The strictures of the federal tax law essentially can be argued to insulate MOA and its owners from chipping in to make the park work. That is so because they can argue (accurately!) that doing so may cause the bonds to be taxable. Those limits will not apply to Bloomington, because it is a governmental entity. You can see how that dynamic is likely to play out. Of course, the city’s ace in the hole would be to insist on triggering the goofy MOA sales tax (see here for my discussion of that), which apparently the lawyers think will count as government revenue and not violate the tests.
My policy take-aways:
The lack of a national interest in permitting these sorts of uses of tax exempt bonds for essentially a private, for-profit business operation, even though it is operated through a nonprofit shell seems clear. Congress needs to tighten these rules up so that nonprofit bonds are limited to colleges, hospitals, and other functions with clear public benefits. This is as bad as building pro sports facilities (like US Bank Stadium to name one) with tax exempt bonds.
We can be thankful that these bonds will apparently not be exempt from Minnesota income tax because they will be issued by an Arizona governmental unit.
Bloomington’s ongoing saga in dealing with MOA should be a cautionary lesson for other cities and counties thinking about signing on with private developers for big signature and risky developments. Decades later you may be de facto on the hook to ante up more and more, as compared with leaving real estate development to the private market and providing actual city public services.
This is another installment in my effort to think through the debate over highway funding. WARNING: THIS IS LONG AND BORING; IF YOU DECIDE TO PROCEED, YOU MAY WISH TO HAVE A MUG OF ESPRESSO HANDY.
There appears to be a bipartisan consensus that the state needs more money for highways (and for transit, although Republicans see little need for that, I’d guess), raising an obvious question:
Should the gas tax or tab fees (registration tax) be increased or should revenues from general fund taxes be reallocated to highways? The state has been consistently running general fund surpluses; why not use some of that money?
This question is complicated by Minnesota’s long tradition of using dedicated funding for highways and to a lesser extent and for a shorter period transit. It has done that mainly through constitutional dedications for highways and roads, starting in the 1920s and modified by several constitutional amendments over the years. Constitutional dedications require the legislature to use gas tax and the motor vehicle registration tax (tab fees) revenues only for state highways and for aids to counties and cities for local highways, streets, and roads. Since 2008, the sales tax on motor vehicle purchases has been dedicated to transportation (not just highways, at least 40% must go for transit). The legislature has occasionally supplemented the constitutional dedication with statutory dedications; currently some of the sales tax on auto parts is dedicated by statute to highways and roads. Since it is a statutory dedication that the legislature could always change; the Republicans, as a result, want to write it into the constitution making sure a future legislature can’t.
This practice of using dedicated funds for transportation channels much of the debate into questions of whether the dedicated taxes should be raised or if general fund taxes/money should be redirected to transportation. Obviously, Republicans with their strong tax aversion routinely advocate for redirecting existing taxes. Democrats, by contrast, typically advocate raising the already dedicated taxes – e.g., Governor Walz and House Democrats both supported large gas tax increases in the 2019 legislative session – although they are conflicted by the fact that the dedicated taxes are regressive, violating their norm of favoring progressive taxation.
Given Minnesota’s long tradition of funding transportation heavily through dedicated funds, I see little value in spending time on the merits of that. As an aside, in the lead up to consideration of the Legacy funding constitutional amendment in 2008, I wrote a publication on earmarking taxes, which I subsequently updated in 2015. It discusses these issues in some detail, so I would also be needlessly re-ploughing old ground. In any case, it is a given that almost all of state highway funding in Minnesota will be done through dedicated funds.1
The more important question is whether any increase in funding should come from user fees and benefit taxes or from general tax revenues (e.g., by earmarking existing taxes for highways). I think a strong case can made for providing any increased state funding for highways and roads through user charges or benefit taxes, rather than taking more general revenue taxes and using them for highways. This post explains my thinking.2
As an initial matter, it is useful to state how I think about the difference between a user charge or benefit tax and general tax revenues. Here, I’m talking about functional, economic, or practical distinctions, not legal distinctions. Any tax can legally be earmarked or dedicated and, then, it becomes part of the dedicated fund. But that legal status does not make it either a user charge or benefit tax, even if the tax is somehow closely or loosely related to transportation or whatever function the dedication relates to.
A user charge or a benefit tax should satisfy two criteria:
It needs to be over and above the taxes that generally apply to most similar activities for general government funding and
The amount should be closely correlated to consumption of or benefit from the funded government service.
A true user charge would vary by the amount of the service consumed or used; if you use more, you pay more and ideally would be voluntary. By contrast, a benefit tax just needs to be collected from the group of individuals or entities that particularly benefit from the service.
Note the effects of this definition: Dedicating part of the proceeds of a general revenue tax does not qualify. For example, taking the sales taxes paid by trucking companies and dedicating it to highways and roads is not a benefit tax or user charge. Those taxes are levied on all businesses and individuals to pay for the general cost of government. It flunks criteria #1 and is not charging users or beneficiaries of a government service additional amounts because of that status. This distinction explains why the sales tax on purchases of vehicles or auto part are neither user charges nor benefit taxes. They are just taking or appropriating general tax revenues and legally earmarking them for transportation.
In a separate post, I go through Minnesota’s funding of highways and roads and attempt very roughly to identify how much comes from user charges and benefit taxes versus general government revenues. In broad strokes, the motor vehicle registration tax is a benefit tax and a portion of the gas tax is a user charge. The rest of highway and road funding comes from state or local general revenues – property taxes or state aid that locals opt to use for roads or general sales taxes that have been legally earmarked for highways. Based on my calculations, about 59% of highway and road costs are paid with general revenues. Somebody with better analytical skills, access to and understanding of the data, and more time could estimate a more accurate number; mine is just a back-of-the-envelope effort. I do think it is a conservative estimate of the general revenue share; the actual share likely is higher.
So, why do I think increasing user charges (lets be transparent, the gas tax) is the best way to provide more state funding for highways and roads? I have two prime rationales which are related to each other, in addition to a third, more minor but not inconsequential, reason for liking a gas tax increase. After I describe why I favor a gas tax, I’ll explain why I think the common objections to or concerns about the gas tax should not disqualify it as the principal funding source for additional highway funding:
First, basic economics – it is consistent with fundamental tax principles and helps a market economy function better. The common metrics public finance economists use to evaluate a tax are equity, efficiency, and simplicity. (Unlike the public and most elected officials, those are also the criteria I use in judging whether a tax proposal is sensible. I’ll get to political feasibility issues a little bit later.) My premise in applying these principles is that the gas tax is a rough user charge, a characteristic widely recognized by tax policy experts. It is an effective user charge because the amount of tax paid is strongly correlated with how much one uses highways and roads – the more gas purchased for highway vehicles, the more miles that are driven. (It’s important to also note that the tax is also borne by those who do not own vehicles or purchase gas, because its burden is passed along in the transportation costs embedded in the goods and services that they do purchase. This is actually a large portion of the burden of the tax – about one-third according to the Minnesota Tax Incidence Study.) It’s true that that correlation is not perfect, because of variation in fuel efficiency of vehicles, more all electric vehicles, and the road damage done by heavy vehicles (the latter two concerns I discuss below). But fundamentally it is a workable way to charge for relative road use by most. Moreover, there is a sort of default rule that when user charges are practical and easy to impose, that is the preferred way to finance a government service, unless doing so would undercut the fundamental purpose of the government program. In any case, this is how I apply those three basic tax policy principles to the gas tax:
It’s obvious the gas tax scores well under the simplicity principle: the tax has been around forever, is easily understood (cents/gallon used for roads – what could be clearer?), is easy to collect from a relative handful of taxpayers (petroleum distributors), and one main compliance issue (the exemption of diesel fuel used off road) was fixed 30+ years ago with the innovation of dyed fuel.
The tax increases efficiency because it encourages people to make economic decisions (where to live, what car to buy, etc.) that reflect the costs of constructing and maintaining public roads. The tax makes the market work better – the price of gas (and transportation costs more generally) will reflect more closely the public’s costs to build and maintain roads. This will flow through to decisions about where to live (how long/expensive a commute will I have?), what vehicle to buy, and so forth. If you, as I do, think the market is the best way for a society to decide how to allocate goods and services, a user charge for public highways is the way to go. And the gas tax is now the easiest way to do that.
On the surface, it might appear that the equity principle is a harder nut to crack because the tax is regressive, the metric most often used in evaluating tax fairness. I have two basic responses to that concern. First, user charges, like the purchase of private goods and services, are fair because you’re paying for what you use. Here, it makes sense for the government to be the service provider because we want to provide open and easy access to the road network and private roads are not practicable. Putting aside that the government is delivering the service, charging for highways isn’t really all that different than individuals buying food, housing or other essential items in the private market, all of which have a regressive distribution (lower income folks spend higher percentages of their incomes on consumption). Second, the distributional effects are not that different than a general consumption tax, like the sales tax which is typically presented as the prime alternative funding mechanism. (The Minnesota Tax Incidence Study reports a Suits Index for the gas tax that is about one-third lower or more regressive than for the general sales tax.) And if regressivity is a killing concern, it can be addressed through supplemental mechanisms (see below), rather than forgoing a good funding source altogether.
Second, political economy considerations – relying on user charges could help make decisions that get beyond the pro- and anti-government budget debate we now seem to be mired in. Much of the discussion under the previous bullet represents conventional wisdom in the policy community. The views I’m expressing here are not but reflect my experience working in the legislature over the last 15+ years and how I think the budget and tax policy debate in the Minnesota legislature has been hijacked by the polarization and rote repetition of little more than partisan talking points. During that period, I found that the budget debate has devolved into largely meaningless sloganeering on the size of government and whether (GOP mantra) taxes are driving businesses, investment, and people out of Minnesota or whether (DFL mantra) the tax structure is allowing the affluent to avoid paying their fair share.
The Republicans have largely become a party whose primary (almost exclusive) budget policy is to propose tax cuts. There are a few areas in which they want to spend more money (i.e., beyond current services levels), but they can always propose reallocating money away from other programs with heavy DFL or urban constituencies to do so. That’s fine, but it also creates a “free lunch” element to their arguments: they’re for more limited government and tax cuts, except when the spending is popular with their constituencies, in which case they say the spending increases can easily be accommodated by reducing spending on DFL/urban type programs (center city LGA being the obvious target). What’s been unclear to me, because the GOP has never controlled the governorship, House, and Senate when I was around, is whether that is just a negotiating ploy or whether they really would do it.
In any case, transportation is one of the areas – I assume because it is a core government function and because it has a heavy rural focus (the GOP is fundamentally a rural and exurban party in Minnesota) – in which the Republicans do advocate for spending more (at least relative to what the inelastic dedicated funding sources produce). Their natural response is to make a sort of free lunch argument – sure the dedicated funding sources are not generating enough, but we can easily reallocate general fund sources to make up the difference. And to be consistent with Minnesota’s earmarking practices, we’ll do that permanently and submit it to the voters to enshrine in the constitution.3
To me these arguments undercut the debate over how much more to spend on highways, given our history of using dedicated funding, a substantial portion of which comes from de facto user charges and benefit taxes. A primary benefit of relying on user charges and benefit taxes is that increased spending comes at the price of paying more in user charges and benefit taxes (i.e., increasing the gas tax or tab fees). That is a more honest frame of reference for the public to consider how much they want more spending on highways and roads. Permanently reallocating general fund revenues (especially by constitutional amendment) reflects a judgment that the general fund does not need all its current revenues over the long run (not just when we have a surplus, like we do now). I don’t think there is a good case to be made for that – the median Minnesota voter has too much of a taste for government for that to be true.
My bottom line: Linking spending and taxing directly, as Minnesota traditionally has done for highway spending, is good political economy. I would limit this practice to areas where the linkage is relatively easy to implement and clear, such as highways. (I’m hard put to think of many other big areas.) The long history of that linkage working (until the 1990s) is a compelling reason for sticking with it. Maintaining the linkage tells voters that if they advocate for or expect more highway spending, the consequences will be paying more gas tax or higher tab fees. That is likely to lead, in my view, to better decisions about how much to spend.
Third, climate change considerations supportincreasing the gas tax; it is a mini-carbon tax or, at least, does not encourage more carbon emissions, as financing more highway expenditures with general revenue sources would. The gas tax is a carbon tax, since it is imposed on the use of fossil fuels. Of course, its low level and application only to highway fuels makes it a relatively minor tax. The fact that its revenues are used for highway construction and maintenance (spending which stimulates carbon emissions by encouraging more road use) makes its effects ambiguous. But compared to using general revenue taxes for roads, such as dedicating more general sales taxes, a gas tax is preferable if a secondary policy goal is to discourage carbon emissions.4
My responses to the common objections that are made to gas tax increases. Many arguments against increasing the gas tax are typically made during legislative debates. In my judgment, none of them, singly or together, are sufficient to overcome the case for the gas tax. The main arguments that I have heard and how I would respond are:
It’s regressive, unfair to the poor (the prime Democratic objection). The gas tax is more regressive than the sales tax. But contrary to the apparent DFL mode for evaluating taxes, that should not be the only criteria to use in deciding among taxes. Its other advantages, in my opinion, outweigh that disadvantage. User charges meet a very basic element of fairness – expecting people to pay for costs they impose or what they use. Moreover, other more progressive taxes in the general fund portfolio (i.e., the individual income tax) help to offset that disadvantage. Not every tax needs to be progressive if it has other attractive attributes.
A low-income credit, either tied specifically to the gas tax or as part of a more comprehensive credit to offset other regressive taxes, could be adopted to address this concern. The 2008 increase in the tax bill did precisely this to gain a handful of votes (primarily Tom Rukavina’s but others as well) necessary for the required supermajority to override the governor’s veto. The provision lasted only one tax year, however, as Governor Pawlenty and some DFL legislators united to repeal it and use the revenues for other purposes.5 The 2008 credit was poorly designed, and its effects were very modest at best. A better approach probably would be to convert the property tax refund into a comprehensive low-income tax credit/refund to offset a portion of the average property, sales, and excise taxes borne by low-income households. That has been discussed with some regularity and elected officials have shown little interest.
We have plenty of general fund revenues, so we can simply use more of them for a core government function like highways and roads (the prime Republican objection). I outlined my main reasons for rejecting this above. I would add that given the GOP’s persistent advocacy for tax cuts in all circumstances (even in 2011 with a $6 billion difference between projected revenues and expenditures!), they should recognize that reallocating general fund money to highway really reduces their ability to cut general fund taxes. At least that would seem to be the logic to me, and it undercuts their implicit “it won’t cost you anything” argument for using general fund revenues.
Trucks damage the roads more, but don’t use enough more fuel to offset that damage. This statement is (I assume) true and is a mild objection to the present excise tax; a more accurate user charge on heavy trucks and similar vehicles would be scaled to recover more fully the costs they impose on the road system. Because heavy vehicles are not very fuel efficient, they do pay more per mile in gas tax, but likely not enough to pay for the damage. (I have not attempted to research the magnitude of the difference, and I know a large share of the cost of Minnesota road maintenance is driven by our harsh climate, which subjects concrete and asphalt to breakup from frequent freezing and thawing.)
A simple fix would be to impose a higher rate of tax on diesel fuel, since almost all heavy vehicles run on diesel and very few cars do.6 Some states already do that. I’m not sure why Minnesota does not or if it has ever considered it. I’m sure the trucking and business lobbies would oppose it and that alone may make it politically infeasible. In any case, the objection of too favorable treatment of heavy vehicles is not a good argument for not continuing to use the gas tax as a cornerstone of our highway finance system and to raise any needed new revenues from it, rather than using general revenues. It’s a minor objection that could be easily fixed, if policy makers think it is a serious flaw and have the will to do so.
Electric vehicles (EVs) don’t pay tax and they comprise a growing share of the fleet of highway users. This statement is also true, but I don’t think it is a good reason for not using the gas tax as the prime source of added highway revenue. First, EVs comprise a trivial portion of the fleet using Minnesota highways and roads. I do not know what percentage EVs are of the fleet, but they are less than 1% of new vehicle purchases in Minnesota. That a very small share of the fleet uses electricity as power does not undercut that the gas tax still functions very well as an easy-to-administer, user charge on 99%+ of Minnesota vehicles.
Second, the government is trying to encourage purchase of EVs for environmental reasons by offering tax credits against their purchase price and by imposing fleet mileage requirements on automakers. A better way to encourage EV adoption and use is simply to push the price of petroleum-based fuels higher by raising the gas tax, rather than to push down the price of EVs with tax credits or by regulating what automakers can seller. Doing that targets the incentive to those we would most want to incent, i.e., heavy users of petroleum fuels, not those who have the income/wealth and the predilection to buy a Tesla (for status, feel-good green vibes, or whatever reason).
Ultimately, a system for imposing a user charge on EVs will need to be designed and implemented, because they will become a large part of the fleet. But that likely will take some time to occur and the surcharge on the tab fee that applies now helps somewhat make EVs pay their fair share. When the EV fleet becomes large enough, I assume it will be feasible to impose some sort of mileage charge on EVs, administered using a technological solution (GPS transponder attached to every EV?). Because EVs are all relatively new and expensive vehicles, it seems easier to implement a mileage charge for them, as compared with implementing such a user charge for all vehicles. The latter (ditching the gas tax in favor of a mileage fee for all vehicles) has always struck me as pie-in-sky and/or a clever way to thwart the sensible policy of just raising the gas tax.
The gas tax is unfair to owners of gas guzzlers, particularly those who are poor and/or don’t drive much (e.g., compared with high income owners of hybrids who drive a lot). This is essentially an argument that the gas tax is a flawed user charge or another version of the regressivity argument. My general response is that the tax is a pretty good user charge and falling for arguments like this allows the perfect to be the enemy of the good.
The gas tax is unfair to Greater Minnesota. This objection is based on the reality that a resident outside of the 7-county metro area typically drives more miles than a metro area resident – both because of geography and because the lack of density limits transit options outside the Twin Cities. I have two responses to this – one is politically unpalatable but reflects reality. Geography makes it more expensive to construct and maintain a road system in Greater Minnesota, not just for residents to drive and pay for gas. That reality must be reflected somewhat in how much residents of the region pay in tax; they can’t expect their metro aunts and uncles to neutralize this reality can they?
The second response is that a look at the numbers reveals that the situation is not that bleak. Yes, more gas tax is collected in the 80 non-metro counties (about 52.5%) than in the 7 metro counties. (For context, the 7 metro counties pay about 54% of the other state sources of highway finance revenues – tab fees and motor vehicle sales tax – counterbalancing that somewhat.) That is a relatively small difference. But the more important fact is that even more of the spending goes to the nonmetro area. About 40% of the state highway revenues are paid as state aid to local government. This aid goes heavily (about 65%) to the nonmetro counties (see the graph below). These numbers are from the House Research publication, Major State Aids and Taxes and are for 2015.
I could not find easy access to data on the geographic distribution of direct state highway spending; I’m sure that the metro/nonmetro breakdown varies from year to year. There are many more miles of state highway in the nonmetro counties, but maintenance and construction cost/mile is undoubtedly higher in the metro. Over the long run, I’d guess that number of miles outweighs the higher metro costs. (Maybe MNDOT puts out this type of breakdown, but I couldn’t quickly find it.)
The bottom line is that residents of Greater Minnesota enjoy a balance of payments that provides them comfortably more in spending than they pay in gas taxes. The balance payments is even more favorable when tab fees and motor vehicle sales taxes are taken into account. It’s unclear to me how this is an unfair situation. Of course, politicians representing rural areas can easily conjure up arguments with superficial appeal – typically focusing on what a rural voter would consider to be frivolous or wasteful general fund spending that occurs in the metro area. This “what-aboutism” muddles the issue in my view and is a prime reason why I favor a user charge that as much as possible links beneficiaries and payers, as I suggest above.
A per mile user fee (administered with transponders on every vehicle) would allow imposing a better more accurate user charge to replace or supplement the gas tax. I discussed this above under EVs. It just doesn’t seem very practical at this point to use as a replacement for the gas tax; I could see it as a supplement for EVs and hybrids along with a gas tax increase. It is just the latest shiny new object distracting from tried-and-true financing policies. In the long run (10 to 20 years), some sort of solution like this will need to be implemented and I think it will be driven by how fast we convert to EVs and driverless vehicles. Of course, there is a very good chance I’m wrong about all of this. A 2016 article, Jerome Dumortier, Fengxiu Zhang, and John Marron, State and federal fuel taxes: The road ahead for U.S. infrastructure funding, makes the case that the need for some sort of funding source beside the gas tax is coming much sooner than I think. It also provides evidence as to the effects of the lack of indexing of the gas tax that I like harp on.
I’m skeptical of how practical (including politically) a mileage charge is, based on the little I know about it. Minnesota would be the first state to adopt one (other than as a pilot project), which says a lot. This piece (Information Technology & Innovation Foundation, A Policymaker’s Guide to Road User Charges), makes the case for Congress enacting a national user charge now. Besides my skepticism about the practicalities and politics, I strongly prefer the gas tax because of my perception that it will better help address climate change. Of course, a mileage charge system would be better than dedicating part of the general sales tax on that score.
Notes
I had thought no one read my earmarking publication, based on the very few hits it got on the House Research website, so I was surprised in 2018 when the North Carolina governor’s office scheduled a conference call with me to discuss earmarking. Apparently NASBO referred them to me based on the publication, suggesting someone must have read it. ↩︎
I think it is fine for locals to use and increase property taxes for streets and roads, since there is clear benefit linkage between property ownership and construction and maintenance of roads. That seems better than the apparent growing urge, led by Duluth, to use local sales taxes. St Paul apparently wants to follow Duluth’s lead. Here, I’m confining my discussion to state funding issues, although increasing state funding through the highway user trust fund materially would reduce some of the pressures on local financing because it automatically yields more city and county aid. ↩︎
I’m sure the voters would approve, just as they did in 2006 with the motor vehicle sales tax, because there is a strong political constituency for highway spending. They would probably approve a tax increase if submitted – given how voters responded in 2008 to the Legacy Amendment, easily approving a tax increase for what I perceive to be less popular spending. ↩︎
I don’t want to underestimate the effects of maintaining a robust gas tax on carbon emissions. Based on my calculations if the gas tax had been indexed for inflation when it was increased in 1988 to 20 cents/gallon, the state would have collected about $6.5 billion more revenue (assuming little or no behavioral response to the higher tax rates). Had it done so, it is reasonable to conclude that it would have caused some behavioral response (less driving or a more efficient fleet) that would have lowered carbon emissions somewhat. ↩︎
To me that suggests that the concerns about its regressivity are not really strongly held. ↩︎
Diesel vehicles typically generate more pollution, so a differential rate might be justified on that basis as well. ↩︎
I regularly read John Rekenthaler’s Morningstar column, largely because he is very good writer and often has interesting insights into investing and the financial industry (mainly mutual funds). He and other Morningstar commentators occasionally lapse into writing about public policy – mainly retirement, financial regulation, and taxation of mutual funds. I find that their policy prescriptions miss the mark (in my view) as often as they hit, mainly I think because they come at it from a different frame of reference than I do.
Rekenthaler’s last two columns address a public policy issue he has been visiting over the years – problems with America’s retirement system reliance on 401(k) and similar plans (e.g., 403(b)s) as its core source of retirement income (beyond Social Security, of course) – but now he actually is proposing a number of fixes or solutions, rather than just pointing out problems and flaws. I have generally agreed with his criticisms and now find his proposed solutions to be sensible, as far as they go (not very). Unfortunately, the hyper-partisan gridlock that defines Congress is likely to prevent any measured consideration and discussion of his or similar improvements. So, we are likely to continue to muddle along with accidental policy (401(k)’s, as Rek points out were a policy accident that employers hopped onto) that is a mess, at best.
In my view, using voluntary defined contribution plans, like 401(k)s and 403(b)s, as a basic building block of a national retirement system has two huge flaws:
They depend upon voluntary, regular saving for the distant future – consistently setting aside a portion of earnings to be used often decades later. Many/most humans are not psychologically set up to do that; deferred gratification is not easy evenif the payoff is in the near term.
They require individuals themselves to do the investing in a way that realizes a reasonable rate of return. That is an immensely complex task that the vast majority of people do not want to undertake, even if they were intellectually capable of doing so (and many/most are not). Of course, a vast pool of people/entities is out there and more than happy to do that for a fee. Unfortunately many of them are either incompetent or charge high fees or both, making it much more difficult to earn the necessary reasonable rate of return on those savings.
Thus, in my view, a voluntary, defined contribution system faces the basic problem that it must swim against strong currents of human psychology and behavior that make it difficult to save consistently and invest intelligently. The expected result is what we have for the generation that is dependent on these plans – many people have saved little or nothing and those that have saved often realize below market returns, either because they were lured into high-fee plans or bought high and sold low.
These are only the big problems; there are plethora of smaller ones with the current system. However, the mobility of employees more or less dictates a defined contribution structure. Even if employers wanted to provide defined benefit plans and they obviously don’t, that model only works for long-term employees. The practice of working for one employer for your whole career is now the exception, not the rule. And as a society, we should encourage or make it easy for people to change employers and careers. Multi-employer plans have been an abject failure – witness the problems with the plans covering miners and truckers. (Watching The Irishman gives you one idea of the problem, but not the real one.) So, we should to fix the 401(k) system.
Rek’s proposed improvements all make sense to me. They are largely based on systems in other countries, so he concludes (correctly, I think) that they are workable. His proposed changes include (read the column for the full view):
Delinking access from your employer’s choice to offer a plan – currently many employers (mostly smaller ones) do not offer 401(k) plans forcing their employees to use IRAs. Rek would take employers out of the picture altogether and create one national plan that everyone would have access to. That makes sense to me for many of the reasons he outlines.
Basic participation would be involuntary – you would be auto enrolled but could opt out of increases in contributions. He allows as how he’s not stuck on the involuntary element. Making participation mandatory would ensure that all workers accrue some retirement savings beyond social security; makes sense to me but I don’t see any Congress I can imagine going for it.
Stop leakage – do not allow assets to be withdrawn for anything other than retirement or disability. There is evidence of a lot of leakage – when people change jobs, to finance home purchases, etc. It is worth noting that preventing leakage seems to run counter to the thinking of some Republicans in Congress who are proposing to allow people to tap their social security benefits to pay for child care! I really don’t get that.
Mandating some sort of default, diversified investment options (undefined) that would insure a basic market return at low fee levels. Other countries apparently manage to do this.
You can debate whether America has a retirement crisis or not. I think it does, but it’s a slow decay, not a rapid burn. As a result, Congress is unlikely to address it. Congress should at least have the discussion Rek’s columns suggest but it likely won’t because it will inflame opposition from many quarters, I’m sure. It always does and that apparently freezes any meaningful congressional action. I expect that members of Congress will content themselves with doing more meaningless stuff like the SECURE Act. They won’t even discuss small bore issues like:
Why do we have both Roth and traditional IRAs, 401(k)s, etc.? The amount of needless time and energy spent by savers trying to divine which flavor IRA to use is staggering. Just Google “Should I contribute to a traditional or Roth IRA?” I may write a separate post that explains why I think Roths are the version that should go.
Along similar lines, why don’t we have one plan for the self-employed? Why should they need to figure out whether a SEP IRA, Simple IRA, a Keogh, etc. is better for them?
Are the tax benefits more generous than necessary to encourage funding a basic retirement? Does Mitt Romney really need to be allowed to have a $50+ million IRA? (How did he ever accumulate that much? He never released the relevant tax returns to allow determining that; a fact that now pales in the light of the current occupant of the office refusal to release any returns at all.) Or should there be a cap on contributions or IRA assets, just as there are limits on the benefits that can be paid under defined benefit plans? Obama proposed a $3.5 million cap, I think. That might be too low, but the concept sure seems reasonable.
There is a long litany of similar and even smaller-bore issue that should be addressed or at least debated.
After I initially posted this, Rekenthaler followed up with a third column/post that responds to criticisms or other feedback that he received about his proposal. This followup contains a useful summary of what he is proposing and made me think about another implication of his proposal, because he obliquely addresses it:
By going to one national plan (i.e., employers no longer would voluntarily decide whether or not offer 401(k)s to their employees), that opens up the possibility – indeed, it seems like a certain implication – that employers would no longer be constrained by nondiscrimination rules. Nondiscrimination rules likely drive many employers who do participate (particularly smaller one) to provide employee matches, because doing so is necessary to satisfy the nondiscrimination rules that allow participation and contributions by highly compensated employees and owners.
If that occurs and I’m sure it would, the system could tilt a little bit even more to favoring high income individuals. At least, I’m guessing that employer matches drive a lot of contributions. This offsets a bit the benefits of making access easier for employees of firms that don’t offer 401(k)s.
It’s unclear to me how to fix that in a sensible way, unless you mandate matches if owners and highly compensated employees participated at some level in the previous tax year. This could be done similar to the current nondiscrimination rules, I would suppose. The linkage would be less clear and harder for elected officials to justify I would think.
SALT Speak - Joel Michael's Blog 