What is the very worst thing a politician might have to deal with in an election year? Tax reform. It's baaack!
Most Minnesotans are just now experiencing the results of federal tax reform in the form of lower withholding from our paychecks that will lead to fewer taxes paid to the U.S. government when we settle up in April 2019.
But what the Congress and president did does not automatically translate to our Minnesota taxes. That will be up to the Legislature and governor in the session that starts Feb. 20. What they could or should do is neither obvious nor automatic — and the choices are frightening.
Let's start with the basics. Every tax change requires that elected officials make two decisions. First, they decide what to tax (that's called the base) and then how much to tax (by setting the rate). So, for the income tax, some things are included in the base, like what you earn, while other things are excluded or deducted, like what's called the "standard deduction" or your contributions to charity.
Adding up the "includeds" and subtracting the "excludeds" determines your "taxable income."
The "tax rate" is the percentage of your taxable income you pay to the government in taxes. The rate you pay typically depends on the size of your taxable income. The larger your income, the higher your rate. Such an income tax is called "progressive."
Minnesota's state income tax is one of the most progressive in the country.
Compared to the federal system, the Minnesota income tax is pretty simple to figure. That's because, over the years, Minnesota has conformed its definition of taxable income to the federal definition. As a result, we first fill out our federal tax return and then use our federal taxable income as the starting point to calculate our Minnesota income taxes.
Easy-peasy. When the feds have changed their definition, Minnesota pretty much has conformed and kept our taxes relatively simple. That's worked because the federal changes have been pretty small. Until now.
The federal tax reform that just passed made huge changes in the definitions of taxable income. Overall, they include more of our income in what's taxable (while generally lowering rates).
Now the choices that the Legislature and governor face are not so easy.
Choice 1: Conform as we usually do. If we just adopt the federal changes to taxable income and do nothing else, our state taxes will remain simple. But they will increase, a lot!
For families of four earning between $50,000 and $100,000, the Minnesota Center for Fiscal Excellence estimates that state taxes will increase by between 9 percent and 25 percent. How's that? Wasn't tax reform about cutting taxes for everyone? Yes, and those same families will experience federal tax cuts of at least 40 percent. Their state taxes (and yours) go up because if Minnesota merely conforms to changes in the federal definition of taxable income, more of their income will be taxable at the current state rate.
The state Department of Revenue estimates that if Minnesota simply conforms, federal tax reform will add $700 million to $800 million to state revenue in each of the next three years. That's probably an attractive prospect to cash-starved governments and some Democrats. For most Republicans and most taxpayers, it's a tax increase, pure and simple.
Choice 2: Conform — and cut tax rates. The feds, remember, didn't just expand the base, they also cut federal tax rates. That's how tax reform became a tax cut. The state could do the same thing. But how? Should it cut state rates so that each of us pays about the same as we do now? Maybe less? Possibly more?
Should the state cut rates to make the overall system more progressive, less progressive, about the same? (Because of how they redefined taxable income and changed the rates, the Congress and the president made the federal system less progressive while also shifting more of its burden to larger families.)
Wading into the debate over rates means opening up this legislative session to bitter, divisive, partisan fighting. After all, it's an election year.
Choice 3: Do nothing! Election years cause politicians to do weird things. Doing nothing is nobody's first choice but could be everybody's second choice, and therefore the only thing they can agree on.
Doing nothing would mean that our state taxes would not change. That sounds easy enough, but filing state taxes would become a nightmare.
Essentially, we would have to (1) fill out the new federal tax form with its new definition of taxable income, then (2) convert to the old federal tax form with the current definition of taxable income that we want to keep using in order to "do nothing," and finally (3) fill out our Minnesota taxes as we do today.
Doing nothing is easy for the politicians, but it would turn our simple tax system into one of the most complex in the country. Worse, those politicians who might let this happen wouldn't be around when it all hits the fan. That's because most of us won't be subjected to this insanity until we file our 2018 taxes in April 2019, long after this fall's elections. The governor will be gone along with a bunch of legislators who leave or are thrown out. Woe be to the winners.
So, what to do? We would argue for the following:
First, conform as much as possible to the federal definitions of income and keep Minnesota's tax filing as simple as possible.
Second, do everything possible to hold Minnesota taxpayers unharmed. Make only those changes to the tax rates and other provisions needed to keep people's taxes at their current level. To facilitate this, it makes sense to move the starting point from the "taxable income" line on our federal form to the "adjusted gross income" line.
Don't change how much is raised, and don't make the system either more or less progressive. Don't make it more complicated.
And, for crying out loud, don't get into a partisan brawl that ends up with the state shut down or the courts acting as referee.
Peter Hutchinson was formerly Minnesota's commissioner of finance, superintendent of the Minneapolis Public Schools and the Independence Party candidate for governor in 2006. John P. James was formerly Minnesota's commissioner of revenue.
