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Gov. Mark Dayton is embarking on what could be the most dramatic overhaul of the state tax system in a generation.
After years of careening from one budget crisis to the next, the alarm bells are sounding everywhere: Minnesota's corporate income tax rate is among the highest in the nation, yet many businesses don't pay it. The sales tax rate is the highest in the region, but includes the least amount of goods and services. Legal fees, food, clothing, architectural plans, baby bottles and feminine hygiene products all are exempt. And over time, the state has carved out obscure tax breaks for an array of powerful industries, including mining companies, hospitals and even ski hills.
Minnesota collects $16 billion in taxes every two years. But in that same period, another $11 billion goes out the door in tax breaks. Legislators even exempted their own stipends from taxation.
If Dayton is to succeed, he must overhaul the tax system without causing a wobble in an already fragile economic recovery and do it in a way that appeals to Minnesotans' sense of fairness. He also must contend with a chorus of Republicans ousted from power who remain fiercely committed to blocking tax hikes.
"Everything is a minefield," said Minnesota Revenue Commissioner Myron Frans. "The last thing we want to do is do something that would somehow be viewed as a roadblock or hindrance to any kind of economic growth."
Emboldened by a new, DFL-controlled Legislature, the Democratic governor stands to eliminate certain corporate tax breaks, expand the sales tax and finally make good on a campaign pledge of raising state income taxes for the highest earners.
The goal, Dayton has said, is to create a more stable revenue stream, more predictability in state budgeting and a more modern tax system that can match the shifting dynamics of the economy.
The last time the state embarked on such an endeavor was in the late 1980s, years before the first Internet purchase and long before income tax rate reductions siphoned $11 billion from state coffers. Now the tax system is out of whack, in Dayton's view, relying too little on sales and income tax and far too heavily on property taxes.
The payoff for this complex and risky renovation could be enormous: Direct and immediate property tax relief for homeowners, lower corporate income tax rates and a new tax system designed to finally break a cycle of paralyzing budget deficits.
The first big hurdle comes Wednesday when state budget officials release the November economic forecast, a twice-annual economic snapshot that many expect to project another sizable deficit. The forecast will serve as the foundation for Dayton's budget and tax proposal, which is due in January. Always a moving target, this forecast carries greater uncertainty, as Washington leaders struggle to avoid the so-called fiscal cliff. The White House recently released state-by-state projections that show a 1.3 percent drop in Minnesota's gross domestic product should the nation go over the cliff.
Weeks of planning
"If they fail to reach an agreement and get mired in political bickering, we could be heading for another recession," State Economist Tom Stinson said.
For weeks, Dayton has been huddling behind closed doors with commissioners and budget officials to arrive at a budget and tax plan.
The governor has demanded his new budget not add red ink to future budget cycles and end the practice of borrowing from public schools or taking on other debt to fill budget gaps.
"We will pay for everything," said Frans, who has spent months meeting with thousands of Minnesotans to hear their concerns and ideas about the tax system. "The governor is so serious about that. We want to restore the predictability and adequacy so that we don't have to do the one-time gimmicks."
Dayton has declined to share details of his proposal, but recent statements show he has drawn a bead on providing property tax relief. Years of deficits and reductions in aid to cities and counties has socked taxpayers in the form of double-digit property tax hikes and reductions in services.
"We are looking for ways we can broaden the base of other taxes and emphasize property tax relief, but we haven't come to any conclusions," Dayton said recently.
Dayton's team is looking at lowering the state's corporate income tax rate. That could appease business leaders who complain the state's current rate is choking growth and turning off businesses looking to relocate.
To pay for that lower rate, Dayton could eliminate a menu of corporate tax breaks. That way, more businesses pay the lower rate and the state potentially collects more revenue.
"One of the things we think is fair is that if you are lowering any rate, like the corporate income tax, and say OK, what kind of deductions can be eliminated that can level the playing field so that everyone is paying the same lower rate?" Frans said.
Frans acknowledges this could chafe some businesses that have fought hard to keep their tax breaks.
"You are going to find people who won't like the tradeoff," he said. "But you have to ask the question: Mr. Corporation, why don't you like this lower tax rate? It's probably because they get a lot of benefit under the system."
Dayton's staff also is looking at reviving an old idea: Lowering the state's overall sales tax rate but broadening it to include more goods and services. That may provide a significant stream of new revenue that could be directed toward property tax relief or to help repay the $2.4 billion the state borrowed from K-12 schools.
"There has got to be some kind of payment or mechanism that convinces the public it is under control," Frans said.
Previous efforts to tinker with the sales tax system have died a quick death at the Capitol, as powerful industries like retails stores and lawyers rose up against them. Many Democrats and Republicans have been harshly critical of sales tax hikes, which can disproportionately affect low to moderate income earners.
But there may be no popular solutions.
"The easy stuff is done," said Rep. Ann Lenczewski, DFL-Bloomington, a former House Taxes Committee chair who will resume that post in January. "The hard stuff is left over."
That's precisely what worries Republicans. They spent years refusing to raise income or sales tax rates, backed by eight years of a Republican governor. Now they are squarely in the minority.
Preston GOP Rep. Greg Davids, the outgoing House Taxes chair, offered a gloomy prediction: "This next session has disaster written all over it. You get what you voted for. I guess Minnesotans want two years of higher taxes and misery."
But there's no guarantee that legislative Democrats will eagerly line up to raise taxes. Incoming DFLers run the gamut from fiscal conservatives to far-left liberals. DFL caucus leaders don't want to push so far on tax hikes that they sink their fortunes in two years.
"The governor is one person and he gets to put together his budget the way he wants," said Sen. Rod Skoe, a Clearbrook DFLer who is incoming chairman of the Senate Taxes Committee. "The Legislature is a different beast."
Baird Helgeson • 651-925-5044