Understanding Tax Policy

1

Understanding Tax Policy
MN Department of Revenue, Leadership Academy
Updated, July, 2008 Dan
Salomone, Deputy Commissioner
2
Outline

• Big Tax System Questions
• Tax Principles and Tradeoffs
• Major Trends Affecting Taxation
• Review of Major Taxes
• Special Attention to Property Tax

3
The Big Questions of Public Finance

• Why should government do it?
• Should we use fees or taxes?
• How should the tax system be designed? (what
  principles?)

4
Why should government do it?Three classical
functions of government
Principles

• Allocation providing things markets cant
  provide
• Distribution changing the distribution of
  income in society
• Stabilization stabilizing the economy,
• minimizing
  unemployment,
• stabilizing prices, interest rates

5
Should we use fees or taxes?
Principles

• Use fees if
• The benefits of public expenditures go to
  specific persons or entities, not the general
  public
• The benefits can be measured with reasonable
  accuracy
• Fee payers are free to adjust their consumption

Otherwise, use general taxes.
6
The Fairness Continuum
Principles

• Benefits received
• (Fees)

Ability to pay (Taxes)
Public Benefits
Private Benefits
7
Why Tax Principles?
Principles

• To help identify and recommend changes to
  align the
• revenue system with economic activity
• (DOR Strategic Plan, June 2004)
• To constrain the tax debatea framework for
  discussion
• To set standards for measuring progress
• To improve our ability to influence tax
  proposals and law
• changes

8
Why Tax Principles?
Principles

• To minimize unguided, conflict-creating,
  incremental
• law changes
• To provide an agenda for periodic review and
  evaluation
• To assist the Departments internal planning for
  tax
• administration
• To evaluate each tax in the context of the whole
  tax system

9
Tax Principles
Principles
Taxes should be

• Simple and understandable
• Stable, predictable, adequate
• Efficient
• Fair
• Competitive
• Visible

10
Simple and understandable
Principles

• Critical for voluntary compliance
• Simplicity breeds a sense of fairness
• Minimizes administrative costs
• Strategies
• Broad bases, low ratesminimize tax
  expenditures
• Maximize federal income tax conformity
• Clear statutory language (minimize rule-making)
• Uniform, convenient administrative procedures
• Balance costs of enforcement with desired level
  of compliance

11
Stable, Predictable, Adequate
Principles

• Taxes raise sufficient revenue to cover spending
  commitments
• Facilitates tax planning, aids in forecasting
• Avoids disruption of unexpected, non-optimal
  changes in tax laws
• Strategies
• Broad bases, low rates, minimize tax expenditures
• Law changes with long-term focus vs. quick fixes
  (steady, purposeful, aimed at the ideal end-state
• Approximate 3-legged stool balance (personal
  Income, sales, and property taxes)
• Budget reserves, rainy day funds

12
The Fiscal Balancing Act
The Three-legged Stool
Three-legged Stool (FY2007)
Ideal MN Actual

• Income tax 33.3 38.7
• Sales tax/MVST 33.3 27.8
• Property tax 33.3 33.5
• 100.0 100.0

before PTR Source
DOR Tax Research Division
13
Efficient Two Definitions
Principles

• Administrative Efficiency
• Low admin cost (ease of understanding, low
  compliance costs, etc)
• Allocative Efficiency
• Tax policy does not distort private economic
  decisionswhat to produce, how to produce it, to
  save or invest, types of investments (unless
  distortion is a goal)
• Strategies
• Broad bases, low rates
• Minimize use of the revenue system as a tool of
  social policy
• Taxes should not impede productivity
• Tax policy should preserve relative prices

14
Fairness (equity)
Principles

• Use benefits-received theory/fees if
  appropriate
• Otherwiseuse ability-to-pay theory
• a. Horizontal equity Treat equals equally (see
  allocative
• efficiency)
• b. Vertical equity meet some politically
  acceptable standard
• of tax incidence
• Strategies
• Tax those who benefit from specific, identifiable
  expenditures in proportion to benefit received,
• Broad bases, low rates, minimize tax
  expenditures, avoid boutique rates
• Clear statutory language
• Minimize tax shelters

15
Fairness (equity)
Principles

• Strategies
• Publish and publicize tax expenditures--monitor
  trends, review and sunset
• Assess system-wide tax incidence
• Shield subsistence income from taxation
• Avoid regressivity
• Use income tax rates, , low income credits, PTR
  to achieve desired level of system progressivity

16
More on Fairness
Principles

• Its not who writes the checks that matter
• Its who bears the burden of taxes
• Fact only people bear the burden of taxes
• Businesses pass taxes on to people (workers,
  customers, investors)
• Analysis of the tax incidence of taxation must
  recognize this
• DORs biennial Tax Incidence Study does this

17
Taxes Progressive, Proportional, Regressive
Principles
Tax Rate
5 4 3 2 1
progressive
proportional
Regressive
Income
18
DOR Tax Incidence Study, March 2007 (TY2004 data)
19
Competitive
Principles

• Maintain a competitive business climate
• Tax system should recognize the necessity of
  competing in the global economy
• Strategies
• Recognize the growing insignificance of place
  and invisibility of tax transactions in tax
  administration
• Recognize changes in competitive regimes (eg.
  Electric utility deregulation)
• Tax burdens should not get too far ahead of other
  states
• Make tax structure more competitive for all,
  avoid picking winners or losers
• Focus on long-run competitiveness
• Use direct appropriations for incentive, rather
  than tax expenditures

20
Principles

• Price of Government (FY2000-2011)
• Price Total State and Local Revenue
• Personal Income

Source Minnesota Department of Finance, May
2008, End of Legislative Session
21
Minnesota State and Local Tax Ranking, FY 2006

Per 1,000 PI Per Capita
Rank of US
Rank of US
Ind. Income Tax
8th 114.3
8th 122.2
Corp. Franchise Tax
10th 116.3
13th 108.6
Sales and Use Tax
23th 90.4
35th 84.3
Property Tax
35th 80.3
28th 86.2
Total State and Local Taxes
20th 101.6
14th 109.1
Source Minnesota Taxpayers Association, June,
2008
22
Visible
Principles

• Often overlooked principle
• Encourage transparency critical to healthy
  democracy
• Avoid hidden taxes (eg. Pyramiding sales taxes)
• Avoid creating a fiscal illusion (prices less
  than cost)
• Strategies
• Make taxpayers aware of linkage of taxes to
  spending
• Report on tax incidence
• Small tax payments are less visible than large
  ones
• Avoid automatic tax increases (triggers, indexed
  rates)
• Keep Truth-in-Taxation meetings
• Codify differential property assessments in
  statute

23
If broad bases and low rates are so good, why
do we have so many exemptions, and such high
rates?
Principles
24
ExampleSimplicity-Fairness Tradeoff
Principles
Tax all income, Flat Rate
Simple
Exemptions, Progressive Rates
Fairness
25
Individual Income Tax

• No. 1 Tax Source (42 of GF rev., 47 of GF
  taxes)
• Used in 43 states
• Federal History
• Federal tax Birthed in the Civil War
• Very unpopular, Administrative nightmare
• 1872Repealed
• 1894 -- Unsuccessful attempt to revive
  (protectionists v. anti-protectionists),
  resentment of wealth accumulation
• Reenacted in 1893 to lift depression-era revenues
• Declared unconstitutional not apportioned based
  on population
• 1913 U.S. Constitution Amended to allow income
  taxation (16th Amendment) Income tax enacted

26
Individual Income Tax

• State History
• Predates federal history
• 1911Wisconsin enacts first real state income tax
• Earlier unsuccessful experiments in other states
• Administrative problems
• Wisconsin introduced source documentation,
  central state-level administration
• Adoption in other states quickly followed
• By 1919 9 additional states
• By 1940, 33 state personal income taxes
• (Alaska repealed their income tax in 1979)
• MN enacted tax in 1933, rates from 1 to 5
• Philadelphia enacted first local income tax in
  1939 to combat real estate property devaluation

27
Individual Income Tax

• Other Attributes
• Broad base means High-powered money small
  rate increases yield significant revenue gains
• Base corresponds to Ability to Pay, though not
  perfectly
• Source documents mean cost-effective
  administration
• Progressive base and rates result in high revenue
  elasticity (though diminished by bracket
  indexing)
• MN does not allow local governments to have a
  personal Income tax
• Like most states, MNs tax base is linked to the
  federal base
• (Federal Taxable Income, in our case)
• Linkage to the federal system promotes simplicity
  and ease of administration, but can create state
  revenue losses when the feds restrict their tax
  base (requires MN to monitor federal legislation,
  identify state fiscal impacts of federal changes,
  promote conformity)

28
Minnesotas Individual Income Tax
Individual Income Tax

• Federal taxable income
• MN additions
• MN subtractions
• Minnesota taxable income
• X tax rates (5.35, 7.05, 7.85)
• Minnesota gross tax
• tax credits (refundable, nonrefundable)
• Net Minnesota individual income tax

29
Federal Tax Expenditures Cost MN 4.39 billion
Individual Income Tax
Minnesota Tax Expenditure Report, Feb. 2008
30
Minnesota Tax Expenditures Cost MN 294 million
Individual Income Tax
Minnesota Tax Expenditure Report, Feb. 2008
31
Taxable Share of Gross Income
Individual Income Tax
32
Sales Tax

• No. 2 Tax Source (29 of GF rev., 31 of GF
  taxes)
• Used in 45 states
• Federal History (theres not much)
• Most other industrialized countries adopted sales
  taxes after WWI to prop-up revenues
• Facing strong resistance from labor and farm
  groups, Congress rejected the national sales tax
  in the early 1930s, and has never adopted one
• Hence, state governments laid claim to the sales
  tax
• By WWII, half the states had sales taxes (on
  goods, not services)now a major revenue source
  for most states

33
Sales Tax

• State History
• MN was one of the last three states to adopt a
  sales tax in 1967 _at_ 3
• MN rate increased to 4 in 1971, 5 in 1981, 6
  in 1983, and 6.5 in 1991
• In theoryits a consumption tax
• In practicemany exemptions (services), taxation
  of business inputs

34
Sales and Use Tax (State)
Selected Sales Tax Expenditures Cost MN 5.1
billion
Minnesota Tax Expenditure Report, Feb. 2008
35
Sales Tax

• State History
• Mn is average in its dependence on state sales
  taxes
• but uses local sales taxes only 10 as much as
  the average state
• Partly explains why we rank higher in dependence
  on local property taxes
• Current issues
• Remote sellers (Streamlined Sales Tax Governing
  Board)
• Business Inputs
• Services
• Local sales taxes

36
Minnesota General Sales TaxSimple in Concept,
Complex in Practice
Sales Tax

• Tax base x 6.5 tax collections
• MN Base includes tangible personal property,
  
• and some
  services
• MN Base excludes food, clothing, prescriptions,
  
• heating fuel,
  capital
• equipment, farm
  machinery
• Local sales taxes (about 15 cities, six counties)

37
The Growing Service Economy
Sales Tax
38
Most Service Consumption is Not Taxed140
Billion Total Consumption Base
Sales Tax
Taxed 10
Untaxed45
Taxed 55
Goods 57 billion tax base 41 of total
Untaxed90

• Services 83 billion 59 of total

Personal consumption sales tax base CY 2007
39
The Ideal Sales Tax?
Sales Tax

• Taxes personal consumption of goods and services
• Exempts business inputs
• Avoids fine distinctions based on use or status
  of purchaser
• Applies to electronic commerce and catalog sales
  as well as main street businesses
• No state has an ideal sales tax!

40
Property tax simple mechanics
Property tax

• Unlike income and sales taxes,
• Property tax collections are set in advance, and
• the tax rate is determined by dividing
  collections by total taxable value of property in
  the taxing jurisdiction

Therefore exemptions for some properties means
other properties pay more, unless levies are
reduced to offset the shift. This is a unique
aspect of the American property taxes
41
Property Tax
Two Basic Moving Parts

• In a given jurisdictionTwo moving parts
• A. The Levy
• Local budget (spending)
• less Non-property tax revenue (incl. state
  aids)
• equals Total property tax levy (collections)
• B. The Distribution of the Levy across
  properties
• Estimated market value
• times Applicable Class Rate(s)
• equals Taxable value

42
Property Tax

• Two Moving Parts Levy vs. Distribution

Classified system
Business tax
A
Unclassified system
Home tax
The local levy

• The levy determines the overall community tax
  burden
• Point A depicts the average property tax burden
  (effective tax rate)
• Lack of classification creates a uniform
  effective tax rate (level A)
• Classification raises the effective rate for some
  properties, reduces it for others

43
Property Tax
Simple Example of Property Tax Mechanicsfour
jurisdictions
School district
Your home
County
City
Mosquito control District
44
Property Tax
Mechanics, contd

• Levy Taxable Value
  Tax Rate
• (aka, Tax Capacity) (levy/taxable value)
• 
  (millions)
• School 16.0 27.0 16/27
  59.3
• County 20.0 50.0
  20/50 40.0
• City 2.3 19.0 2.3/19
  12.1
• Mosq. 0.6 12.3
  0.6/12.3 4.9
• Total Tax Rate (on your home) 116.3
• (Tax Capacity Est. Market Value x Statutory
  Class Rate)

45
Property Tax
Mechanics, contd

• Tax on Your Home
• Your Est. Market Value 240,000
• X Residential Class Rate 0.01
• Your Tax Capacity 2,400
• X Your local tax rate 116.3
• Your property tax (before credits)
  2,791
• (Tax Capacity Est. Market Value x Class Rate)

46
Property Tax
MN History (One interpretation)

• 1967 1979 - The Golden-Age of the State and
  Local Relationship
• (the buy-down years)
• Reducing local levies by increasing state
  aidfunded with higher state taxes
• 1967 Sales Tax at 3, 4 in 1971 (temporary
  increase), new funds used for aid programs
• Top income tax rate increased
• New homestead credit
• Renters/Seniors credit
• Pension aid for large cities
• Property tax relief fund
• New school, city, county, town aids
• Metro fiscal disparities program
• Levy limits.
• Goal use state revenues to soak-up property
  tax levies
• During much of this period, state revenue growth
  was very strong
• Strong ag sector, mining sector, strong inflation
  (pre-indexing)

47
Property Tax
MN History (One interpretation)

• 1980 1988 The Desperate Years (learning to
  live with less)
• Gov. Quie indexed the income tax brackets
• Legislature forced big, costly increases in the
  homestead credit
• Economy tankedinterest rate recession (20
  interest rates, weak Ag, Mining)
• State revenues dropped (starting Aug. 1, 1980)
• Numerous special sessions to patch the budget
• Temporary sales tax rate increases--to 5 (81),
  then 6 (83)
• Temporary income tax surcharges (which really
  were temporary)
• Sales tax base expansions
• Accounting shifts
• Unable to increase state aids (to soak up
  levies), the state protected homeowners (voters)
  with excessive classification
• Business to homestead ratio rose to a high of
  5.25 to 1 in 1987

48
Property Tax
MN History (One interpretation)

• 1989 2000 Transition Years (Sorting out state
  and local responsibilities)
• Last-gasp increase in the homestead credit
• Some aids capped, reduced
• Severed the direct tie between local spending
  levels and levels of state aid (via more
  thoughtful, objective state aid formulas)
• State takeovers of local costsdistrict courts,
  income maintenance
• Conversion of general aid to categorical
  aid(i.e. know what youre supporting)
• Growing aversion to classification rate changes
  (gradual reductions in disparities between
  properties
• Use of new Education Homestead Credit to provide
  homestead relief, instead of classification

49
Property Tax
MN History (One interpretation)

• 2001 ReformsMaking local levies more local
• Full takeover of general education costsstate
  share now 80
• Additional 415 per pupil takeover of existing
  school referenda levies
• New Market Value Homestead Credit ( of res. and
  farm market value)
• Elimination of Homestead and Agricultural Credit
  Aid (HACA)
• Increase in LGA (14 million for reform account)
• Increase in PTR program
• 6-yr phase out of limited market value
• Takeover of transit levies (metro and non-metro)
• Dedicated a portion of sales tax revenue for
  transit fund
• Compressed class rate disparities to a ratio of 2
  to 1 for local levies
• Introduced state-level property tax for education
• Significant property tax cuts for all classes of
  property
• Homes, 22, farm homes, 27, cabins, 11, Apts,
  24, Businesses, 10

50
Property Tax
Property Tax Issues

• Whos responsible for increases?
• State pays local property tax aid to local
  governments
• State is often blamed for not keeping up
• Most unpopular tax!
• Not based on ability-to-pay, seniors uneasy
• Cabin/lakeshore property values soaring
• How to distribute the burden
• Purely value-driven, or
• State policy intervention?