Minnesota Considers $1.35 Billion Biennial Tax Increase

April 23, 2019

Minnesota is running a surplus, but you wouldn’t know it given that House leaders are pushing a $1.35 billion tax increase, larger and more aggressive than the revenue-raising measures already proposed by Gov. Tim Walz (DFL). The proposal (H.F. 2125), which is advancing in the legislature, contains a laundry list of tax changes, including dramatically higher levels of business taxation, the second highest capital gains tax rate in the nation, resumption of inflation indexing for cigarette taxes, and higher state property tax rates.

Corporate Taxes

Minnesota has high corporate taxes, but due to the state’s single sales factor apportionment method, many large state-based corporations have minimal corporate income tax exposure. A multinational corporation based in Minnesota would only have its income taxed in proportion to the percentage of its sales made in the state—which, for a company with worldwide reach, can be very small. This is a significant factor in the state’s attractiveness to certain businesses despite high statutory tax rates, and H.F. 2125 has the potential to undermine it.

Under both Gov. Walz’s proposal and H.F. 2125, the accumulated post-1986 deferred foreign income of multinational corporations would be apportioned based on the sales of all related companies, with the apportioned share taxed in Minnesota. This “deemed repatriation” would be a $361 million hit on Minnesota companies in the coming biennium, and $219 million in the following biennium. And it’s almost impossible to apportion the income in an even remotely fair way, since it’s taking income from three decades and subjecting it all to the tax system that exists now—even though the state’s tax code has changed many times in the intervening years.

Both Gov. Walz and the sponsors of H.F. 2125 would also tax so-called GILTI income, though the House takes an uncommonly aggressive approach. GILTI stands for Global Intangible Low-Taxed Income, but the term is a bit of a misnomer; really, it’s a guardrail in the new “territorial” system of income taxation (which, as a general rule, only taxes income generated domestically), intended to tax high returns on foreign investment that were only subject to relatively low rates of foreign tax.

The design is more complex and doesn’t always work as intended. Minnesota, however, would make it even worse. At the federal level, there’s a deduction to apply a lower effective rate to GILTI income. Minnesota wouldn’t offer it. The federal government allows a credit for much of the foreign tax paid. Minnesota would not. And, under H.F. 2125, instead of treating GILTI as foreign dividend income like most states that have chosen to tax GILTI (which provides somewhat preferential treatment), Minnesota would simply consider the foreign subsidiaries part of the larger company and tax an apportioned share of foreign income just as if it were a domestic corporation, a proposal being called “worldwide combined reporting,” which intended to raise $384 million in the next biennium alone.

And whereas, at the federal level, there’s an offsetting deduction for foreign derived intangible income (FDII), Minnesota would forgo it under H.F. 2125—closing the door on an offset worth more than $100 million.

Meanwhile, the state would conform to the federal government’s new limitations on the net interest deduction, but require an 80 percent add-back of the accelerated expensing provisions in the federal law, which is supposed to serve as an offsetting provision. All told, taxes on corporations would be about $860 million higher over the next biennium.

Capital Gains Surtax

Currently, only Massachusetts taxes capital gains income at a higher rate than it taxes ordinary income. (Connecticut is considering doing likewise.) In Minnesota, where ordinary income is already taxed at a top marginal rate of 9.85 percent, capital gains and dividend income greater than $500,000 would be taxed at a rate of 12.85 percent, lower only than California’s top rate of 13.3 percent.

Curiously, the higher rate would only apply to long-term capital gains, not short-term gains, the inverse of the federal policy of taxing long-term gains at a preferential rate but short-term gains at the ordinary rate. This choice is largely one of convenience for the state—it can piggyback on the federal definition of net capital gains income, which is the net of long-term capital gains and losses less short-term capital losses—but makes very little sense from a policy standpoint.

Long-term capital gains are subject to preferential rates at the federal level in acknowledgment of the fact that they represent double taxation, as a tax on capital income after the corporate and individual income tax, and that gains are not adjusted for inflation, meaning that a significant portion of the taxable gain may not represent any gain at all. Minnesota would throw all this out the window, actually penalizing long-term investment by the state’s highest earners (and thus most mobile residents).

As we recently noted regarding the Connecticut proposal, singling out capital gains for an additional tax also doubles down on an extremely volatile source of revenue. Capital gains are already responsible for a significant share of forecasting error in individual income taxes. A task force co-chaired by former Federal Reserve Board Chairman Paul Volker and former New York Lt. Governor Richard Ravitch (D) found that “capital gains are the most erratic [tax base component] as they depend not only on stock market performance but also on taxpayers’ choices about whether and when to sell assets,” noting that during the Great Recession, overall adjusted gross income in New York (including income from capital assets) fell 18 percent, but capital gains subject to income fell a full 75 percent.

Nationally, the realization of capital gains slid 71 percent between 2007 and 2009; 55 percent just in 1987; and 46 percent in 2001. Massachusetts, the only state with a surtax on capital gains income (and then only on short-term gains), has sought to insulate itself from some of the volatility by prohibiting any budget from relying on more than $1 billion in capital gains revenue, dedicating anything in excess of that amount to the state’s Rainy Day Fund. The state projects about $381 million in revenue over the biennium from a capital gains tax hike, but that estimate comes with an enormous margin of error, with revenues swinging wildly over the years.

Other Provisions

In addition to the aforementioned changes, the bill would also freeze the estate tax threshold at $2.7 million, instead of allowing it to rise to $3 million; reinstate inflation indexing of the cigarette tax; and increase the (highly unusual) state property tax levy by $55 million in the coming biennium and $176 million in the one after that. Most states only have local property taxes, and only twelve states still impose an estate tax, particularly given the evidence that estate taxes encourage inefficient tax planning and the outmigration of high-net-worth elderly individuals, many of whom would have otherwise paid state taxes for several more years at least.

Conclusion

All told, H.F. 2125 represents a $1.35 billion tax increase over the biennium, including $860 million in new taxes on corporations and $249 million on pass-through businesses (rising to $506 million in the subsequent biennium). Minnesota’s businesses already experience fairly high levels of taxation, but single sales factor apportionment has shielded many of them from its worst effects to date. Under H.F. 2125, businesses and individuals alike would experience significant, economically harmful tax hikes—all at a time when the state is running a surplus.

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