The complex set of tax changes in the recent federal tax bill creates a set of challenging decisions for states like Minnesota. Because Minnesota’s state income and corporate taxes use federal tax law as their starting points, when federal laws change, Minnesota policymakers need to decide whether to incorporate those changes into our tax system.
As they decide how to respond to the federal tax law, Minnesota policymakers should be guided by principles including fairness and sustainability of the tax system. One element of fairness that is particularly at play this year is how much the tax code takes family size into account. Our current tax system recognizes that a household’s basic expenses grow with each additional family member, and takes that into account when determining how much of a household’s income is taxable. But conforming to the federal tax law could change that.
If Minnesota adopted all of the federal changes that effect our state income taxes, that would raise an estimated $121 million in FY 2019 and more than $200 million per year after that. Tax increases on some Minnesotans would pay for tax cuts for others. Among those likely to face tax increases under conformity are families with children or other dependents.
The Institute on Taxation and Economic Policy modeled the effect in Minnesota of conforming to the federal tax bill’s increased standard deduction, the elimination of personal and dependent exemptions, and changes to itemized deductions. They estimate that 70 percent of families with dependents would see a tax increase as a result of conforming to these provisions, including 53 percent of families with one dependent and 84 percent of families with two dependents.
A primary cause is the federal tax law’s elimination of personal and dependent exemptions. For many families with dependents, the new larger standard deduction is not enough to make up for the lost dependent exemptions. These families will have higher taxable incomes, and likely a state tax increase under conformity. (Some households taking itemized deductions could also see tax increases from the elimination of exemptions, but more factors come into play in determining how they fare under conformity.)
Fortunately, there are policy choices to prevent families with dependents paying more to fund tax cuts for others. One approach is to not conform to the federal changes in deductions and exemptions that causes it. This is what Governor Mark Dayton proposes in his tax plan. The plan would keep the value of exemptions, the standard deduction, and itemized deductions the same as before the federal tax law passed. In addition, his plan would cut taxes on most Minnesotans through a new per-person tax credit and expansion of the Working Family Credit.
A second approach is to largely conform to those federal changes, but also enact targeted policies to offset the impact. This could be creating a state Child Tax Credit, a state dependent exemption, or a combination of both. Legislation taking this approach includes Senate File 2982 and House File 2942.
However, these policies need to be big enough to fully offset the lost exemptions in order for low- and middle-income families with dependents to avoid tax increases. And it is hard to do that if policymakers also try to enact broad income tax rate reductions, as Idaho recently found out.
As the Tax Policy Center’s Richard Auxier writes, Idaho provides a cautionary tale. Idaho is in a somewhat similar situation to Minnesota in that it also has a tax system that incorporates the value of federal deductions and exemptions. Idaho policymakers were told that conforming to the federal tax law would raise an estimated $100 million. They responded earlier this month by passing a $130 Child Tax Credit, but also cutting income and corporate tax rates.
But the Child Tax Credit was too small and left some Idaho families with children with tax increases, even when combined with the income tax rate reductions. For example, a married couple with three children earning $50,000 would pay nearly $200 more under this legislation. Those tax increases paid for tax cuts for others. Idaho policymakers went back to the drawing board, and passed additional legislation to expand the Child Tax Credit to $205. But that’s still short of the $287 that would be needed to fully offset the loss of personal exemptions for all Idaho families.
As Minnesota policymakers respond to the federal tax bill, they would be wise to remember Auxier’s caution: “The new money is a windfall only if you ignore that someone is paying for it with higher taxes. And that someone mostly will be low- and middle-income families.”