Tax cuts likely in Minnesota session but who benefits still unknown

Minnesota lawmakers are immersed in another robust debate over taxes – who should pay more or less given a giant budget surplus and what constitutes fair treatment. 

It’s the backdrop for the Legislature’s consideration of Social Security tax cuts, new dependent care credits, potential tax rebates and proposed increases to taxes on investment earnings. The state’s $17.5 billion projected budget surplus, although not all of it permanent, has intensified the discussion.

Aside from the back-and-forth over granular details, the broader philosophical divide is on full display.

House Tax Committee Chair Aisha Gomez, DFL-Minneapolis, has signaled hesitance about slicing taxes rather than directing more money to schools, housing and infrastructure needs.

“This is a fairness and equity issue,” Gomez said in the days after an updated economic forecast was released. “We have to be very careful in this moment even with this sort of eye-popping number in front of us.” 

At a hearing across the Capitol at almost the same time, Sen. Carla Nelson, R-Rochester, said Minnesota can’t miss its moment to create a more-favorable tax climate for people and businesses that can easily go elsewhere.

“I'll be careful as I say my words here. We have to make sure that fairness is not envy,” she said. “So, yes, we expect fair tax policy, but I also think we have to do the math here.”

The legislative session will almost certainly produce tax reductions of some kind. DFL Gov. Tim Walz and party leaders in the Legislature all say they’ll include tax relief in the final agreement on a two-year budget.

“There will be tax cuts,” said Senate Majority Leader Kari Dziedzic, DFL-Minneapolis.

“That money does need to start making its way back to Minnesotans,” House Minority Leader Lisa Demuth, R-Cold Spring, said of the surplus.

The debate comes down to who will get the tax breaks and how much.

A few proposals appear to have the most traction.

There is considerable interest among top legislative DFLers to offer extra dependent credits for low-to-middle income families, particularly those with young children. The argument is it would help offset child care expenses. Credits might be higher for children younger than five but there would be some allowance for those up to age 17.

Walz is back with another rebate proposal to provide tax givebacks of up to $2,600 per family making $150,000 or less in taxable income, with lesser amounts for single filers making $75,000 and below. His administration estimates that nearly 2.6 million households would share in about $3.9 billion in rebates.

He’s had trouble getting DFL lawmakers to bite, but he’s found allies in Republican lawmakers who favor a rebate-style proposal.

Also high on the list are broader exemptions around income from Social Security benefits. All of the major Capitol players are pushing some version of that.

The way it works now that people receiving Social Security can subtract a portion of that money from their Minnesota taxable income. 

The subtraction currently caps out at $5,840 for married joint filers and $4,560 for single filers. That exemption is reduced if other kinds of income — wages, other retirement earnings, investment proceeds — exceed a certain amount.

According to statistics from Minnesota House Research, more than half of Minnesota households receiving Social Security pay no taxes on that. But that leaves about 446,000 who could benefit if the law changes. 

The debate centers on where to draw the line or whether to wipe that line out all together and just declare the payments off limits to state tax collectors. The federal government still imposes its own tax on many Social Security earnings.

Supporters of expanding the exemption or eliminating the tax entirely say Social Security was created largely to support the elderly in retirement, and it’s money that they helped pay in during their working years. 

Several DFL lawmakers, including a group of first-term members in the 34-33 Senate, ran on pledges to get rid of the tax.

“The time to stop taxing the hard-earned Social Security benefits is now,” said Rep. Dave Lislegard, DFL-Aurora, as he presented his full elimination bill. “With the unprecedented budget surplus in Minnesota, we have an historic opportunity to eliminate this tax and start protecting older Minnesotans.”

Minnesota is a bit of an outlier, with about a dozen states taxing Social Security to some degree. Backers contend the current structure encourages retirees to move out of state to avoid a tax hit, although it’s hard to tell how often that happens. 

The House Tax Committee got a flavor of that last week from Mark Felsheim, a retiree who said he and his wife are contemplating moving from Eagan to western Wisconsin.

“You will definitely not get tax money on every other income I make,” Felsheim said. “And I think we need to think about that: How many people, how much money are you losing for retirees who decide to go to another state where they don't have to pay that tax?”

A full elimination of the tax would be pricey. Estimates are that it would be a $1.3 billion hit in tax collections the first two years and rise into the future as the state’s retiree population grows.

Analysis of the full phaseout shows that while the average annual decrease in state taxes would be around $1,300, it would be double that for taxpayers with incomes above $250,000.

Retired nurse Naomi English spoke against the tax cut.

 “I don’t wake up every morning eager to pay more taxes, but I have lived here 33 years and I am proud of our commitment to one another,” English told lawmakers. “And I am certainly not going to leave Minnesota over a couple of bucks a month.”

Tax policy expert Mark Haveman, executive director of the Minnesota Center for Fiscal Excellence, wrote in a briefing paper that politics appears to be the strongest driver of the Social Security tax-cut push, given that older voters tend to be among the most politically engaged.

He told lawmakers last week that confusion around tax treatment of the retirement benefits is also at play.

“It's reasonable to conclude current state tax treatment, based on the federal system, is likely causing a lot of constituents that lawmakers are hearing from to believe their income is being taxed when it isn't or will be taxed, as they approach retirement, when it wouldn't be,” he said. 

Haveman recommended the Legislature up the threshold for a tax exclusion but not fully phase out the tax. He said lawmakers could also raise the senior standard deduction to ease pressure on fixed-income households.

Tax increases are also possible in some areas this session.

Lawmakers are weighing proposals for a higher regional sales tax in the seven-county metro area to help pay for transit. 

There is potential for a new employer and employee payroll tax to eventually pay for a proposed paid family and medical leave insurance fund. And Walz recommended new taxes on capital gains and dividends earnings above $500,000.

Revenue Commissioner Paul Marquart defended the capital gains proposal at a recent Senate hearing.

“When we come back to tax fairness, I think the rationale is really weak for why you would treat income differently between kind of a paper income versus wages,” Marquart said, adding that people with investments fared better during COVID-19 than those without.

Nelson, the Republican senator, said it punishes some taxpayers and could drive them away. 

“I do not believe this is a fair policy whatsoever,” she said. “And I do not believe that people who have capital gains taxes have not worked hard for their income.”

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