It’s budget surplus time again in Minnesota. Once more the pressing political question of the day is how best to get rid of excess money. All three parties, Reform, Democratic and Republican, favor some sort of rebate program to return the current surplus to taxpayers. Most likely we will have a repeat of last year’s rebate in which checks, styled as a refund of sales taxes but computed primarily on the basis of reported income, will be mailed to everyone who filed an income tax return or a request for a state property tax rebate.
Both parties in the Legislature have also fielded plans for some sort of permanent tax reduction. Here the key candidates for change seem to be the state income tax and local taxation of real estate. The differences here center on the relative degree of relief given to higher-income and lower-income households.
I want to suggest another alternative. Skip the rebate checks and cut back the state sales tax by a percentage point or two. This would be simple. It would be fair, benefiting virtually all households. It would give greater tax relief to households for a given cut in state tax revenue. Moreover it could be done in a way that would minimize the danger of the state falling back into deficit when the economy slows down.
Let’s start with simplicity. Skipping the refund avoids the administrative costs of computing refunds and mailing checks, which runs into the millions of dollars. It avoids the administrative hassle of devising increasingly convoluted ways to reach those low-income households that do not need to file state tax returns or rebate requests.
A change in the sales tax rate is a familiar procedure that retailers usually can implement by changing one variable in an electronic cash register.
What about fairness? The sales tax is the least fair of the state’s taxes. When economists analyze the effects of taxes, one thing they look at is whether the tax bite increases or decreases as incomes go up. When the proportion of income that a person pays in tax goes up as income goes up, the tax is said to be progressive. But when the percentage paid in tax goes down as income goes up, the tax is regressive.
Two examples from federal taxes illustrate this.
The federal income tax, with a zero-bracket amount and roughly five tax brackets, is somewhat progressive. A household earning $100,000 not only pays more tax in dollars than one earning $10,000, but the tax it pays is a larger percentage of income than it is for the low-income household.
FICA, the federal taxes to support Social Security, is regressive. It is levied on the first dollar that anyone earns, but income above a certain level, $72,600 in 1999, is exempt from most of it. For a person earning minimum wage, Social Security and Medicare, taxes amount to 7.65 percent of earnings.
The same is true for someone earning $50,000. But the bite drops to just under 6 percent for someone earning $100,000 and to under 2 percent for a person who gets $1 million.
Like Social Security, sales taxes generally are regressive. This results from low-income households generally spending a higher proportion of their income on taxable items than do higher income ones.
Minnesota’s sales tax is less regressive than those of some other states due to its exclusions of food, clothing and some other necessities, but it still bites the poor more than the rich. Retirees living on Social Security or the disabled on Supplemental Security Income don’t pay any income tax, but they do pay sales tax.
What do I mean by giving “give greater tax relief to households for a given cut in state tax revenue?” This is an issue that proponents of permanent state income tax reductions ignore. IRS rules allow state income taxes, which can be accurately tabulated for specific households, to be deducted from taxable federal income.
But sales taxes, which can only be estimated for most families, no longer are deductible. That is why last year’s rebate was styled as a sales tax refund rather than a refund of income taxes.
For many households, a cut in Minnesota income tax rates would mean decreased remittances to the state of Minnesota, but increased federal payments. Each $1 decrease in Minnesota revenues would only put 60 to 80 cents in the pockets of Minnesotans. But a $1 dollar decrease in sales tax revenues would all go into consumers’ pockets.
The sales tax brings in a bit more than $3 billion per year compared to nearly $6 billion for the personal income tax. Each percentage point in the sales tax thus raises some $500 million in revenue, about the sum that may be rebated this year.
Any sales tax reduction need not be permanent. The law could be amended to drop the rate by one percentage point whenever the Department of Finance projects a budget surplus above some ceiling amount. The state could automatically revert to the higher rate when the projection falls below some floor. Changes could take place 60 or 90 days after regular revenue forecast is issued.
True, John Maynard Keynes would not approve of cutting taxes during prosperity and raising them when the economy sours. But the stimulative effect of a one-point change in a state’s sales taxes is minor. And the current surplus could be maintained as a permanent cushion to tide the state through most garden-variety recessions without a return to the higher rate.
© 2000 Edward Lotterman
Chanarambie Consulting, Inc.