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The Path Forward: Reforming Tax Expenditures

[The Path Forward will be a periodic series of posts filled with policy ideas to help Minnesota move forward together -- specifically to make our budget process more stable, to make government work smarter, and to help the state encourage the growth of emerging industries.]

The recent Minnesota state government shutdown revealed yet again not only the dysfunction of our current set of elected representatives, but it also revealed the warped sense of fairness that pervades our current state conversation on the budget.

The budget that was passed by the Republican majority and signed by Governor Mark Dayton makes significant cuts to health and human services and higher education.  By borrowing again from our local school districts, it takes money out of the classrooms of our public schools.  Through the continued use of budget shifts and gimmicks, it does little to put the state on a more sustainable path and assures of us yet another nasty budget battle in two years.  And, it doesn’t ask for shared sacrifice.  The damage in this bill is felt most acutely by the middle class, the poor, and the sick.  This budget is a direct repudiation of the values that have propelled Minnesota to the top of so many national rankings.

While the discussion this year focused on the Governor’s proposal to increase tax rates on the wealthy or on where and by how much government was going to be cut, there’s one area of the budget that was hardly talked about at all — tax expenditures.

Broadly defined, a tax expenditure is an instance in the tax code that provides preferred treatment to certain taxpayers or certain activities.  For instance, the provision in the tax code that allows deduction of mortgage interest or the sales tax exemption for clothing would both be considered tax expenditures. Many of these tax expenditures are really just spending administered through the tax code instead of having the government pay directly.

The size of these tax expenditures is rather large — over $24 billion per biennium.  That’s two-thirds of the state’s General Fund and over 40% of all the government funds collected and spent over a two-year period.  A complete list of all the expenditures and their expense can be found here.

The catch with tax expenditures is that, unlike normal government spending that has to be reauthorized every budget cycle, these expenditures go on indefinitely unless the Legislature takes action to end them.

Earlier this year, a bipartisan group reviewed Minnesota’s tax expenditures and recommended solutions designed to improve the process and end the “autopilot” nature of tax expenditures.  This has been an issue that has received much lip service by those in the Legislature – including Chanhassen’s State Senator Julianne Ortman — but little in the way of real reform.

There’s real opportunity to reform tax expenditures in a way that people of all parties can find acceptable.  Eliminating wasteful tax expenditures simplifies the tax code and limits the use of the tax code to pick winners and losers.  Additionally, the  increased revenue from eliminating the expenditure can be applied to either lowering tax rates across the board or towards closing the inevitable budget deficit we’ll be facing in 2014-15.  These are goals that representatives from both parties should be able to support.

Various groups have proposed different notions of which tax expenditures should be phased out.  Let’s review a few of the most commonly cited examples:

  • Mortgage interest deduction for second homes:  Minnesota state statute follows federal tax law in allowing deduction of mortgage interest on all properties owned by an individual.  Some states have moved, though, to limit such deductions on residences that are not the owner’s primary residence.  Such a change in Minnesota could produce an additional $30 million in revenue every two years.
  • Job Opportunity Building Zones (JOBZ) Program:  Designed by Gov. Tim Pawlenty as a way to stimulate job growth in rural areas, the JOBZ program is largely deemed a failure by folks on both sides of the aisle.  There are at least five separate tax expenditures as a part of this program, totaling $60 million every to years.
  • Corporate Dividends, Foreign Source Royalties and Foreign Operating Corporations:  These tax expenditures allow corporations to deduct up to 80% of dividends received or profits from foreign operations.  Combined, these three tax expenditures cost $485 million every two years.
  • Sales Tax Exceptions:  The state sales tax is littered with exceptions.  Notably, all services ($4.4 billion) are excluded, as well as food ($1.49 billion), clothing ($638 million), publications and textbooks ($191 million) and many other categories.  While many of these categories make sense, it also makes sense to expand the base of the sales tax and lower the rate.  That will be collections more stable and predictable, and the regressive nature of the sales tax can be offset by giving taxpayers at the lower end of the wage scale a cut in their income tax rate.

Any real attempt to fix our structural budget issues is going to have to involve a hard look at tax expenditures.  Let’s hope our representation in St. Paul is up to the challenge.


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