Albert Einstein once said, “in the middle of difficulty lies opportunity.” That sums up the situation Minnesota lawmakers now face figuring out how to respond to federal tax reform.
The difficulty is created by the need to act this year in a short Minnesota legislative session on something that is justifiably controversial and extremely complicated. The opportunity arises in the circumstances this unique moment offers to improve the operation of our own state tax system.
With the release of his supplemental budget, Gov. Mark Dayton is first out of the blocks in offering his federal tax response plan. The proposal smartly disconnects the starting point for calculating state income taxes from the federal government, which would allow us to design our own system of deductions and credits that makes sense for the state.
However, instead of creating something new, the governor’s plan basically recreates most of the lost federal deductions and exemptions at the state level.
This approach offers two advantages. First, it minimizes the time and effort needed to craft a state response — we would just continue more or less with how things used to be. Second, it’s also the most reliable way to avoid creating “losers” — households whose state income taxes would increase because of the state’s response to the federal reform. Tacking on the governor’s proposed new personal and dependent credit goes even further and turns many break-even households into “winners.”
It’s a smart political approach.
But Minnesota’s long term interests would be better served by taking full advantage of disconnecting from the federal government’s income tax starting point and thinking more strategically about our own package of deductions, exemptions and credits.
There are three reasons why lawmakers should pursue this kind of state tax policy response — one driven by good tax policy.
First, moving away from old federal rules on how income is taxed allows Minnesota to pursue one of the fundamental principles of good tax policy: pairing a broader tax base with lower tax rates. Conforming to federal actions would expand Minnesota’s corporate tax base and allow us to lower one of the nation’s highest corporate tax rates. Lawmakers could apply the same principle to Minnesota’s individual income tax rates, which could be reduced with thoughtful review of not just the tax preferences the federal government has eliminated, but also the ones we have built up in the state tax code over time.
These preferences are often inefficient, unfair, complex and hard to administer. And rate reductions matter, even if the same amount of revenue is collected in the end. Not only are Minnesota’s high “advertised” income tax rates a competitive concern, but research has shown that high rates encourage tax avoidance behaviors and make them more socially acceptable — creating permanent damage to a tax system.
Second, we have the opportunity to greatly simplify our tax system. Under the governor’s proposal, many taxpayers would continue to itemize deductions just for state tax purposes. The record keeping and hassle of itemizing are time consuming — and the value of that effort would be a fraction of what it used to be. That’s because the state-only benefit of itemizing is much smaller than a combined state-federal benefit used to be.
Simplification also prevents questionable policy outcomes. For example, why allow deduction of property taxes greater than $10,000 when the state already allocates hundreds of millions per year through the property tax refund program for homeowners with high taxes relative to their incomes? Several states with similar “fiscal DNA” to Minnesota do not allow itemized deductions and instead combine a state standard deduction with a package of personal exemptions to create a simpler and more efficient tax system.
Finally, a status quo strategy entails new risks because state tax policy now matters more than it did prior to federal reform. With business and individual tax relief coming on a national level, state tax policies are now more competitively relevant.
The disadvantage of this good-policy approach is that, as in any true reform, some “losers” might emerge along with “winners.” That prospect can stop tax system improvement in its tracks, especially in an election year, when showing interest in anything that could increase taxes on some subgroup of taxpayers is guaranteed to show up in someone else’s campaign literature.
We need a bipartisan approach and bipartisan cover to take full advantage of the opportunity federal reform presents us. A bipartisan agreement will materialize eventually — the only question is whether it will be driven by politics or good tax policy.
Mark Haveman is executive director of the Minnesota Center for Fiscal Excellence.