Certain terms drip cynicism. “Surgical airstrike” and “usual, customary and reasonable” fees for medical services are now joined by “tax reform.” Nevertheless, an ill-considered, undebated and error-filled tax bill cutting corporate and personal tax rates did pass Congress and was signed by the president. Now the states have to deal with this and it is a knotty puzzle, especially here in Minnesota.
In a federal system like ours, where three different levels of government — federal, state and local — all have autonomous taxing and spending powers, there inevitably are interactions between tax systems at different levels. That is particularly true for income taxes. The federal personal and corporate income taxes hit all households and businesses. In addition, 41 states have broad personal income taxes and two more tax “non-earned” income such as dividends. Forty-four states have corporate income taxes and four more have “gross receipts” taxes on businesses.
So virtually all 50 states must rework their own tax codes to best mesh with federal changes. This isn’t easy.
Any tax system has goals that conflict at some point. People want them to be “fair.” But they should also be “simple.” Taxes that are extremely simple sometimes have outcomes, often unintended, that are unfair. Attempts to make tax systems more fair, inevitably seem to introduce complexity.
This is true even when viewed only through the lens of raising needed revenue to operate government. When taxes are used as vehicles to motivate certain activities, such as investment, education, charitable giving and child-rearing, or to discourage other activities, the tax code gets longer.
Reducing the “excess burden” of a tax, the amount by which the total cost to society exceeds revenue raised, is seen as good by economists, though not necessarily by politicians. This burden includes the administrative costs to people or businesses of keeping records and preparing tax returns. When you have state income tax systems paralleling a federal one, you can minimize the additional admin cost by keeping all the provisions of the state system as close to the federal one as possible
One might wish for the mythical postcard tax return with one line: “What is the ‘total tax’ on Line 63 of your Federal 1040 form? Send in X percent of that.” But if you actually look at the lines just above 63, you see why that would not be feasible. These list FICA taxes on self-employment that would be paid again to the state for such workers but not by those employed by others. Also included are withholding taxes on household employees and so on. So a simple percentage of the federal total won’t work. All states adopt some adjustments to or deviations from the basic federal approach.
In some cases, states adopt methods that most economists would agree on as true “reform,” but that the Congress repeatedly refuses to adopt nationwide. One example of this is replacing “deductions” with “credits.” If one wants to give special treatment to some expense like mortgage interest or union dues or medical or day care expenses, one can allow these to be subtracted or deducted from taxable income. This means that if someone has $2,000 in such expenses and is in a 35 percent marginal tax bracket, her tax owed will be reduced by $700. For someone in a 10 percent bracket, the tax reduction will only be $200.
The credit approach is to apply some stipulated percentage to the expense and reduce the tax owed by that amount for all filers, regardless of what marginal bracket they are in. For the case above, if a 20 percent credit were allowed, the tax reduction would be $400 whether taxable income was $5,000 or $500,000. Most economists think the credit approach fairer and less economically distortive that deductions and many states, including politically conservative ones, have adopted this. But that is not yet true at the federal level for most commonly claimed categories.
The 2017 changes in the corporate income tax raise two questions for Minnesota and other states. First, there was a major cut in the federal marginal rate. So should Minnesota also cut its rates? That will have effects out into the future.
Second, the federal act gives one-time special treatment to corporate profits realized in overseas operations that were not “repatriated” to the United States, because doing so would subject such earnings to the marginal rates that were higher than in most other countries. So if the feds are giving corporations this one time opportunity to bring back profits at a fire-sale tax rate, should Minnesota do the same?
Corporations feel that it would be curmudgeonly of Minnesota or any other state to not give a similar one-time deal to these repatriations. If Minnesota chooses to not do so, there will be much political harrumphing about “bad business climate,” and “anti-business attitudes.” There may be threats to move corporate headquarters. I think this unlikely, but, as always, the Legislature must weigh the odds.
At the personal level, the changes are more complex and more idiosyncratic if only because the federal personal income tax has so many complex provisions.
One change is to nearly double the standard deduction to $24,000 for those filing jointly. Yet the per person “personal exemption” for each family member, adult or dependent child, goes away. That might leave some households worse off. But the “child tax credit” doubles to $2,000 for kids under 17. And $1,400 of that is refundable, meaning you can get a check back even if you owe no tax. Exactly how each household will come out on this is complicated. And exactly how to tweak Minnesota’s code to minimize adverse effects here is a challenge to legislators and tax officials alike.
Similarly, while the doubling of the standard deduction simplifies things for many filers, it also reduces the incentive for some to give to charity, for example. If a couple’s itemized deductions totaled, say, $15,000 under the old parameters, they had an incentive to give yet more to charity because the federal and state governments would, in effect, pick up part of that increase. Now, with the same deductions, they would have to increase their giving by at least $9,000 before there was any decrease in taxes owed.
This, combined with the $10,000 cap on deductible state and local taxes, opens the door to game playing. One could load up on tax payments and charitable contributions, and itemize, one year and then take the new, larger standard deduction the next, alternating perpetually. It is clear that the federal government had not fully assessed this possibility and it is hard for any state to establish a policy when it is all up in the air.
Ditto for the farcical 20 percent exclusion of income from grain sold to a cooperative rather than a private LLC or corporation. This is going to go into public finance history as one of the stupidest measures ever passed through Congress, and that says a lot. Should Minnesota enact a similar exclusion and further tilt the playing field against lots of family-owned small-town grain businesses, all under the guise of sticking it to Cargill? I hope not. But if it doesn’t get rescinded at the federal level, eschewing it for Minnesota returns means yet another complication in Minnesota forms.
One could go on and on. True reform at the federal level rather than cuts in top rates combined with ad hoc measures to punish the majority’s enemies and reward their friends, could open the way for simplification and optimization at the state level. But legislatures and revenue officials have to deal have to deal with the stinky mess that national politics produced for us. It isn’t going to be easy or pretty.