A proposal that would have imposed more than $2 billion in new taxes on Minnesota businesses is no longer part of Gov. Mark Dayton's budget proposal.

After weeks of criticism from business leaders, Dayton announced Friday he would not seek to tax business services, like legal and accounting fees.

"I thought it was going to be very divisive and ... probably extremely difficult to get through the Legislature," Dayton said Friday. Even if he could muscle it through, "the consequences would be a real rupture of the relationship with the business community, and they are very important to Minnesota."

Dayton is also ditching his proposal to tax clothing valued at more than $100 and consumer services like haircuts and auto repair. But with that retreat, his plan to lower the overall sales tax rate is also abandoned. The consumer and business taxes became fused in Dayton's plan as he argued it is not fair to raise taxes for consumers and not businesses.

The changes blow a $2 billion hole in Dayton's budget plan, which means he will not have the money for his proposed property tax rebate of $500 for every homeowner. Sales tax and corporate income tax rate reductions are likely off the table as well.

Dayton endured battering criticism as business leaders weighed his proposal to tax business services. Several of the state's largest companies said they were exploring options to relocate their headquarters to low-tax states. The deluge of criticism came as DFL legislative allies provided scant support, even publicly questioning the plan's viability at the Capitol. Dayton immediately found himself in a one-man battle against some of the state's most powerful business interests, trying to explain why they should cough up billions of dollars in new revenue to boost state spending.

Dayton

Dayton said his administration was not able to effectively sell the benefits of the entire package. Many Minnesotans would have paid less in taxes, based on the proposal to lower sales tax rates. Those in the struggling construction industry would have experienced a massive savings on the lowered sales tax rate.

"I sensed we hadn't communicated effectively the fact that most Minnesotans' taxes were going to go down because all of the attention was focused on the increases," Dayton said. "It's my fault."

Plan B

Dayton is convening his top budget and finance officials over the weekend to patch together a stripped-down proposal. A new economic forecast that slashed the projected deficit to $627 million from $1.1 billion gives Dayton the opportunity to retool his budget outline into something that could pass the Legislature.

House Speaker Paul Thissen, DFL-Minneapolis, said members have heard overwhelming criticism about the business taxes.

"The proposal was never going to be part of Plan C in the House," Thissen said.

Dayton made the surprise announcement at a TwinWest Chamber of Commerce breakfast meeting. Dayton overheard freshman Sen. Melisa Franzen, DFL-Edina, talking to the group about her reservations about the businesses tax.

Dayton, who was up next to speak, said later that for the sake of his reception and "perhaps even survival it would be a good thing if I let them know what my thinking is."

"I think today was good news," said Franzen, who is from a swing district Democrats fought hard to win.

Republicans, who are in the minority in both chambers and have been largely cut out of budget talks, rejoiced in the governor's retreat from his tax plan and used it to underscore the message they've been delivering for years.

"The governor has finally conceded that taxes have consequences, that high taxes result in less jobs in Minnesota," said state Rep. Kelby Woodard, R-Belle Plaine.

Taxing the wealthiest

Dayton's new budget will include his signature proposal to raise income taxes on high earners, single residents with taxable income of more than $150,000. That money can be used to wipe out the deficit and potentially put some money toward education, an area where he and business leaders found some agreement.

"I've been strongly committed to it from the beginning of my quest for this office," Dayton said. "I continue to believe that the wealthiest Minnesotans can afford to pay more of their fair share and they aren't paying their fair share now."

State Sen. Julie Rosen, R-Fairmont, said Dayton's pivot on business taxes will allow them to refocus on beating back the governor's proposed income tax hike on high earners.

"The business to business was the big elephant in the room," Rosen said. But many smaller companies affected by the income tax hike on high earners "are working on their own exit strategies."

Business leaders plan to keep up the relentless pressure.

More than 800 business leaders are expected at the Capitol Wednesday to press legislators to reject tax increases.

David Olson, president of the Minnesota Chamber of Commerce, said tax hikes would force companies to scale back, not grow. "I want them to look [legislators] in the eye and say, these are the kind of decisions you are forcing me to make."

Dayton's decision to pull back on businesses taxes likely won't smooth out his sometimes-volatile relationship with business groups.

When business leaders met personally with Dayton, they heaped criticism on his tax plan, but also pledged to help the state make reductions or find efficiencies. They argued the savings could come in lieu of tax hikes and allow the state to invest in something they universally support — improved education from pre-kindergarten through college.

"I am hearing from some groups telling me where you save hundreds of millions of dollars through quote-unquote reform," Dayton said. "I haven't seen any of that detail."

Some business leaders, Dayton concluded, want increased funding for education, "but they don't want to pay anything for it. So it doesn't work in the real world."

baird.helgeson@startribune.com 651-925-5044 Rachel E. Stassen-Berger Twitter: @RachelSB