The Reckoning

A taxing solution?

  • Article by: DAVID PHELPS , a nd JENNIFER BJORHUS
  • Updated: March 22, 2011 - 2:40 PM

Expanding state sales tax could fill hole, but industries are ready to fight.

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Mall of America officials are warning that its $2 billion economic impact on the state is at risk if legislators move to close sales-tax exemptions, especially the one on clothing.

Photo: Jim Gehrz, Star Tribune

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Lawyers across Minnesota -- 16,000 of them -- have been urged to join a "call to action" and vehemently oppose what the state's bar association is blasting as "a very bad idea."

The Mall of America is warning that its $2 billion economic impact on the state is at risk.

The state's grocers, too, have marked it as top legislative priority.

All of that ire is aimed at the prospect of raising taxes to help cover the state's gaping $6.2 billion deficit. The long list of exemptions to the state's sales tax is expected to be a target. Only Minnesota's personal income tax produces more money for state coffers.

While expanding the sales tax hasn't been proposed, it looms in the background when deficit talk turns from cutting costs to increasing revenue.

Already, businesses are bracing for battle.

"Every Minnesotan must understand that a sales tax on legal services is not a tax on lawyers -- it's a tax on every citizen!" Terry Votel, president of the Minnesota Bar Association, said in a recent newsletter to members.

The state doesn't tax a long list of professional services such as legal work or consulting. Sales on food and clothes also are exempt. And yet, enough cash would be generated to cover the entire deficit if the sales tax was applied to those categories. Such a scenario is highly unlikely, but even the influential new chair of the House Taxes Committee acknowledges that the state's tax exemptions could be reviewed.

"Some services we'll probably look at," said Rep. Greg Davids, R-Preston. "We're going to need to raise some revenue." But, he added, applying the sales tax to food, like more than a dozen other states have done, is "for sure a no."

'There is no free lunch here'

Minnesota is facing such difficult choices because state leaders have been avoiding higher taxes for too long, said Art Rolnick, former chief economist at the Federal Reserve Bank in Minneapolis. He advocates applying the state's 6.9 percent sales tax more broadly but at a lower rate.

"They've been putting it off with smoke and mirrors," Rolnick said. "You can't have exemptions. There is no free lunch here."

More than 30 states face some type of budget shortfall, though Minnesota's gap, at close to 20 percent of the state budget, is one of the worst in the country.

In California, Gov. Jerry Brown proposed extending a temporary income and sales tax hike that already exists to combat its $25 billion, two-year budget hole. Illinois is hiking the state personal income tax from 3 percent to 5 percent and boosting its corporate income tax rate from 4.8 percent to 7 percent to address a deficit that could hit $15 billion in fiscal year 2012.

Meanwhile, tax lines are being drawn at the Capitol in St. Paul. Arguing that easing tax burdens on business will spur new economic growth, Republicans, who now control the Legislature, have already submitted bills to reduce and to eliminate the state's 9.8 percent corporate income tax rate.

Other Republican proposals floated so far include $1 billion in state program cuts and $400 million in state employee cuts.

Gov. Mark Dayton's staff won't discuss his budget plan. On the campaign trail, Dayton opposed another candidate's suggestion to tax clothing. Instead, he proposed raising taxes on high-income earners, which businesses fear will make it hard to recruit talent.

Tina Smith, Dayton's chief of staff, would say only that in terms of taxes, the governor's prime focus remains changing the state's personal income tax. Sales taxes are considered more regressive, she said, meaning they cause lower- and middle-income taxpayers to pay a greater share of their income in taxes.

But Dayton will vet any good ideas, Smith said. "It would be wrong to say anything is off the table, but the core value of fairness is there."

A shifting economy

A lot has changed since 1967, when Minnesota's sales tax was enacted. Then services were less than half of consumer purchases. Now they're about two-thirds of consumer transactions.

Groceries and clothing, considered necessities, were left out, a philosophy that has remained intact even as other states tax one or both items.

"It's more a case of the power of the status quo than any clear policy -- or even lobbying power," explained Paul Wilson, director of tax research at the state Department of Revenue.

The Legislature hasn't seriously broadened the sales tax to new items since the late 1980s, though there have been tweaks, according to House legislative analyst Joel Michael.

Not that it hasn't been proposed. A report last year from the Minnesota Budget Project said the state could raise $868 million over two years by extending the sales tax to certain consumer services such as haircuts, car repairs, legal services, accounting and funerals.

"I think a lot of people keep waiting for states to get to it," said Nan Madden, the Budget Project's director.

Former Gov. Tim Pawlenty's business-led tax reform commission in 2009 recommended extending the sales tax to a range of products and services consumers use. It also called for axing the state corporate income tax. The group's findings produced little action.

Timothy Taylor, the Macalester College-based managing editor of the Journal of Economic Perspectives, said expansion of the sales tax base, coupled with a lower overall sales tax rate, would minimize the pain caused by a budget-deficit solution that simply cuts state services.

"You need to spread the burden of taxes evenly," Taylor said.

Former Senate Majority Leader Roger Moe called spreading the sales tax "good public policy" if you lower the rate as you expand the base. It's a more stable tax that can reduce the volatility of income tax revenue when economic times are tough, he said.

"It makes sense, but the devil is in the details. The reality of getting it done is very difficult."

The enticing chunk

Only a handful of states tax some professional services, such as lawyers. South Dakota is one, although it has no personal or corporate income tax.

Minnesota does tax some services already. The tax man comes when trousers get hemmed or taxidermists mount a prize walleye. Window cleaning is also taxed.

But the list of untaxed services is longer. It includes car repairs, taxis and hiring white-collar professionals such as real estate agents, doctors, lawyers, engineers and consultants. (Health care providers pay a 2 percent state tax on revenue, however.) Extending the sales tax across all services would generate about $5.4 billion over two years.

The bulk of that enticing chunk -- $4.5 billion -- comes from business-to-business spending on services. Some policy wonks say business shouldn't be taxed when they hire lawyers, engineers, or consultants because those services are "inputs" going into the final products sold by companies -- a printer from Target or Ecolab's soap, which are taxed. Sales taxes, in general, are aimed at finished products, not raw materials that go into them because taxes would pile up along the way and drive prices of final products higher, the argument goes.

And, businesses are quick to point out, their clients will use ad agencies and lawyers in a state that won't tax them.

"That would cost Minnesota jobs," said Charlie Weaver, executive director of the Minnesota Business Partnership.

Worsening 'a high-tax state'

Still this time around, all options to raise money are expected to be on the table.

Doug Spong, of the Minneapolis public relations agency Carmichael Lynch Spong, said he expects lawmakers and the governor "to look under every rock" for new revenue, including taxing professional services. That, Spong said, would be catastrophic for Minnesota's $17 billion creative economy. "It would be the single dumbest piece of legislation ever passed by the state," he said.

Craig Thorvig, chairman of the Minnesota Grocers Association and the owner of Chris' Food Center in Sandstone, is also concerned. "Any time you tax people, that means they have less money to buy product."

The Mall of America study found that 40 percent of Minnesotans and 30 percent of nonresidents said they'd buy less if apparel was taxed. The lack of a sales tax also was one of the top three reasons, behind safety and store selection, that shoppers chose the Mall of America specifically and Minnesota in general to shop.

"So you can imagine it would hurt more than just us if people stopped coming to Minnesota to shop -- whether for a hunting jacket or a Chanel coat," said Maureen Bausch, vice president for business development at the Bloomington mall.

Tom Hanson, a lobbyist for the law firm Winthrop & Weinstine, which represents the Minnesota Bar Association, is ready to oppose any proposals to tax legal fees.

"It's a big political risk, and it only gets you partway there to a balanced budget," said Hanson, the former commissioner of Minnesota Management and Budget. "It makes a high tax state even worse."

Staff writer Patrick Kennedy contributed to the report. jennifer.bjorhus@startribune.com • 612-673-4683 david.phelps@startribune.com • 612-673-7269

  • about this series

  • In this 2011 series, Star Tribune reporters showed how the budget debate will play out across the state, from small towns to big cities, in the courts, schools, businesses, social services and state government.
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  • Doug Spong

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  • SALES TAX OR

    NO SALES TAX

    Groceries: Minnesota is one of 34 states that don't tax groceries.

    Clothes: Minnesota is one of about five states that don't tax clothing; there are four states with no sales tax at all.

    Services: The state generally doesn't tax services.

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