Gov. Mark Dayton took a historic step toward the return of fiscal sanity in Minnesota by proposing reforms that will increase tax fairness, adequately fund critical public investments, and solve the state’s budget deficit without shifts or accounting gimmicks. The following analysis will focus on the governor’s recommendations pertaining to income taxes, property taxes, and sales taxes. Many of these changes were previewed during a series of Minnesota 2020 articles posted last week.
True to recent public pronouncements, the governor proposed a “fourth tier” income tax increase for the wealthiest 2 percent of all Minnesotans — focusing on income in excess of $250,000 for married joint filers, $200,000 for heads of households, and $150,000 for single filers. The tax rate on this income will increase from 7.85 percent to 9.85 percent, and the average tax increase on households in the top 2 percent will be $7,240. Ninety-eight percent of filers will be unaffected by these rate changes.
This is the single most powerful element in the Dayton tax proposal in terms of reducing the regressivity of Minnesota’s tax system. Currently, the wealthiest 2 percent of Minnesota households pay 20 percent less in state and local taxes per dollar of income than do middle-income households. After the governor’s proposed income tax increase (in isolation from all other proposed changes), the wealthiest 2 percent will be paying about 8 percent less — definitely a major leap in the direction of tax fairness. At the same time, the fourth-tier income tax increase will generate $1.1 billion in badly needed revenue.
The governor’s proposal both expands the corporate income tax base while reducing the corporate income tax rate. The base broadening is accomplished by eliminating several inefficient tax preferences that were doing little to create new jobs and new economic activity, including foreign operating corporation (FOC) provisions, the foreign royalty subtraction, the double deduction for dividends received through a real estate investment trust, and other provisions.
'Economic substance test'
Dayton is also recommending adoption of an “economic substance test,” which would require that corporate transactions have a legitimate business purpose other than tax avoidance. Most other states have already adopted an economic substance test.
The expansion of the corporate income tax base will be offset by a significant reduction in the corporate income tax rate from 9.8 percent to 8.4 percent. This will reduce the state corporate income tax rate rank from the 4th highest in the nation to 12th highest. The corporate income tax broadening combined with the rate reduction should result in no net change in total corporate income tax revenue.
In aggregate, Dayton’s corporate income tax reforms will level the playing field among businesses by providing a tax rate reduction that will benefit all corporations and paying for this tax relief by closing tax loopholes that benefit primarily large corporations with the legal acumen to exploit these elaborate tax dodges.
Sales tax exemptions
The most significant change in the governor’s budget in terms of generating new revenue is in the area of sales taxes. The governor broadens the sales tax base by eliminating many current exemptions, including the following.
Selected consumer goods and services, including clothing items over $100, over-the-counter drugs, digital goods, repair services (including auto repair), personal care and instruction services, and legal and accounting services.
Selected business services, including legal, accounting, computer, advertising, architecture, employment, specialized design, management consulting, and business support services.
Goods sold over the Internet through Minnesota-based affiliates. (This change, referred to as “affiliate nexus,” eliminates a competitive disadvantage between main-street businesses — which must charge a tax on their sales — and on-line retailers with a Minnesota presence — which frequently do not collect taxes on similar sales.)
Certain types of digital video recorder and programming services sold by a direct satellite service provider and charges for the use of pre-written software if the customer does not have title to or control of the software.*
Selected other items, including telecommunications equipment, advertising materials and publications, and court reporter documents.
While taxpayers will start paying a tax on a variety of goods and services that were previously exempt, the sales tax rate itself will fall from 6.875 percent to 5.5 percent,† thereby reducing Minnesota’s sales tax rank from 7th highest in the nation to 27th. As a result of this rate reduction, the tax on goods that are already taxable under current law — items ranging from school supplies and shampoo to hockey sticks and hula hoops — will fall by 20 percent.
The combination's effects
According to Dayton, the combination of the expanded sales tax base and reduced sales tax rate will result in no net tax increase for the typical Minnesota family. However, largely as a result of extending the sales tax to include a variety of previously exempt business services, the Dayton sales tax proposal will generate a net revenue increase of $2.1 billion in the FY 2014-15 biennium.
Property tax relief has been a priority for Dayton since day one of his administration. Dayton’s budget follows through on this commitment by providing a rebate of the first $500 of each homeowner’s property tax. Homeowners would apply for the rebate on their income tax return. (Homeowners who do not file a return would have to do so in order to receive the rebate.) The first rebate would appear on the 2013 income tax form that would be filed in 2014 and would be based on property taxes paid in 2013. The total amount of the rebate for the FY 2014-15 biennium is projected to be $1.45 billion.
In addition, the Dayton budget provides for an $80 million (19 percent) increase in city Local Government Aid and a $40 million (24 percent) increase County Program Aid that partially replaces cuts to these two programs over the previous decade. While the increases in funding for these aids will provide badly needed property tax relief and funding for local services, the fact that neither appropriation is adjusted for inflation will mean that the tax relief provided will diminish over time as the value of the dollar erodes.
According to information from the Minnesota Department of Revenue, the property tax relief initiatives in Dayton’s budget will result in an aggregate statewide property tax reduction of 9.7 percent.
Net change in tax revenue
The table below shows the net change in tax revenue for FY 2014-15 under Governor Dayton’s proposal, including increases in cigarette and tobacco products taxes and other changes not described above.
Tax / Tax Relief Components | FY 2014-15 Amount |
Individual IncomeTax | $1.13 billion |
Corporate Income Tax | $0.00 billion |
Sales and Use Tax | $2.08 billion |
Property Tax Relief | -$1.58 billion |
Cigarette and Tobacco Tax | $0.37 billion |
Other | $0.02 billion |
TOTAL | $2.02 billion |
The $2 billion generated by Governor Dayton’s tax plan will be sufficient to close the FY 2014-15 structural deficit of $1.1 billion while also providing revenue to fund investments in K-12 and higher education and other areas that have been allowed to languish over the last decade.
The Dayton tax proposal is not perfect. However, all things considered, the Dayton tax plan is the most comprehensive and thoughtful reform initiative since the turn of the century and represents a major move forward in terms of promoting tax fairness, revenue adequacy, and budget stability.
* Other functionally equivalent sales of similar products are already taxable. For example, pay-per-view programming services are taxable if sold by a cable company, but not if sold by a direct satellite service provider. The governor’s proposal makes the sales tax more fair by treating sales of similar items similarly.
†The current 6.875 percent state sales tax rate includes the general 6.5% rate which goes to the state general fund and the 0.375 percent “legacy” rate, which is dedicated to natural resource and art funds. The language of the 2008 “legacy amendment” which authorized the 0.375 percent rate allows the rate to be reduced in the case of sales tax base expansion, provided that the reduced rate generates the same amount of revenue. Under the governor’s proposal, the legacy sales tax rate is reduced from 0.375 percent to 0.234 percent with no loss of legacy fund revenue, while the state general tax rate is reduced from 6.5 percent to 5.266 percent.
‡Includes the new homestead rebate and increases in Local Government Aid and County Program Aid, as well as the two-year freeze in the state business property tax, not described above.
Jeff Van Wychen is a Fellow and Director of Tax Policy & Analysis at Minnesota 2020. He served as a senior research analyst for Gov. Mark Dayton from January 2011 - December 2012. Minnesota 2020 is a nonpartisan, progressive think tank based in St. Paul. This article first appeared on the organization's website.
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