High-stakes debate coming to Minnesota Legislature after federal tax changes

Lost in the debate over the vast overhaul of the federal tax code, some Minnesotans' state taxes could rise sharply while others would fall depending how the Legislature responds this year.

Minnesota is one of a few states that base state taxes on an income figure plucked from the federal filing called "federal taxable income." If Minnesota adapts its own tax code to the new federal law, some families — like those with lots of children — could see higher state tax bills, while others with certain business income could get a break.

But if lawmakers do nothing, the state Department of Revenue would have to administer the state's tax system based on the old federal law, leaving a complex maze for both tax collectors and taxpayers.

"It would be very complicated and challenging," said Joel Michael, a nonpartisan research analyst for the House Taxes Committee.

Revenue Commissioner Cynthia Bauerly said the Legislature could address these issues by bringing the state tax code into what's called "conformity" with the federal code. They have done so in recent years relatively painlessly, although not in the face of such a massive federal tax overhaul. Bauerly said she looks forward to working with lawmakers to find the best solution.

And the problem is more than just technical: Amid the arcane language of tax administration lies a debate about the size of Minnesota's government and the equity of its tax code. In other words, who gets what, and who pays what?

"There are a lot of philosophical questions that policymakers need to ask," said Minnesota Management and Budget Commissioner Myron Frans, who was previously the revenue commissioner and a tax lawyer in the private sector.

The debate comes at a time of political polarization: A debate over tax policy between DFL Gov. Mark Dayton and the Republican-controlled Legislature grew so contentious last year that they wound up at the Supreme Court, fighting over constitutional prerogatives.

The tax dilemma also arrives in an election year, in which Republicans have a shot at controlling both the Legislature and the governor's office for the first time in more than half a century. A number of sitting lawmakers are candidates for governor and will want to influence the tax debate — via grandstanding if necessary.

The new federal law reduces or eliminates a number of significant deductions, like on state and local taxes and mortgage interest, while increasing the standard deduction. That's the amount not subject to tax for filers who take the simplest route, forgoing any itemized deductions. The rationale is to make it simpler for many people to pay their taxes while eliminating some deductions that economists say distort economic activity, like borrowing more money for a bigger house because the interest is tax deductible.

Once Minnesotans move into this simpler "standard deduction" category, however, they have to forgo all those deductions on their state return, too. Taxpayers who take the federal standard deduction must do so on the state side as well, Bauerly said.

In just one example of the complex policy questions, lawmakers will have to consider family size. In the old system, parents with five children got to claim the children as "dependent exemptions" and themselves under "personal exemptions," reducing their taxable income and thus their taxes significantly. The new federal law eliminates the dependent and personal exemptions, which means if Minnesota wants to adapt its tax code to the federal law, the Legislature would also need to create a new system if it wants to protect large families from a tax hike.

The federal law also creates preferential tax treatment for certain kinds of business income, reducing federal taxable income for these taxpayers. That means their Minnesota taxes would go down if the Legislature were to adopt the same provision.

House Taxes Committee Chairman Greg Davids, R-Preston, said Minnesota should do it.

"That would really get business going. I think a lot of jobs would get created if companies could do that," he said.

Opponents of the law say it will just lead to creative tax avoidance strategies.

On the other side of the ledger, the amount of state and local taxes that Minnesotans can deduct to reduce their federal tax bill was sharply reduced.

Bauerly, Frans and other commissioners under Dayton wrote a letter to the Minnesota congressional delegation in November calling reduction of the state and local deduction "egregious." More than one-third of all Minnesotans claim the deduction for income taxes, averaging more than $9,000 per year, for a total of $8.9 billion in annual tax benefits, they wrote.

Davids and Senate Majority Leader Paul Gazelka, R-Nisswa, both said they want to give these taxpayers state tax relief to make up for the loss of the federal deductions.

Mark Haveman, executive director of the Minnesota Center for Fiscal Excellence, said his group's analysis finds that cases of Minnesotans with a higher federal tax bill under the new law will be rare. That's because even though Minnesotans will lose some of their state and local tax deduction, they'll benefit from new lower tax rates and the higher standard deduction.

Still, Gazelka said of the state and local tax deduction, "It's a huge number for a lot of people, and I want to explore what we can do about it."

Those Minnesotans, however, tend to be high on the income ladder, which is where the debate about equity comes in. The federal bill already gives relief to the top income tax bracket, as well as wealthy estates and corporations.

"It would be a big mistake to replicate the overall outcome of the federal bill, the benefits of which go to those who are already doing well," said Nan Madden, director of the liberal-leaning Minnesota Budget Project.

Frans said the Legislature would have to consider the overall budget picture. The tax bill is expected to add $1.45 trillion to the federal debt during the next decade, which has some in Congress musing about cutting spending on programs like Medicaid, which could blow a hole in the state's budget.

The state already faces a small budget shortfall, which Frans attributed to Congress not fully funding the state children's health insurance program, known as CHIP.

Members of the state's budget team don't know yet how changes to the tax code will affect the revenue outlook, especially since they can't know for sure how certain provisions will change taxpayer behavior.

Taken together, Frans said, "It's an extremely complicated set of issues that we'll have to work through with the Legislature. I hope they're up to the task."