Reports Address Social Security State Taxation Issue – Twin Cities

As COVID cases dwindled, Minnesota found itself with a huge state budget surplus. It was an enviable position but raised permanent questions about what to do. Taxes could be reduced or spending increased. Paying off the debt was another option, although more complicated than people think.

Edward Lotterman

After a contentious long session, the legislature reached a tentative deal combining tax cuts with spending increases.

When it comes to taxes, there are many choices about what should be reduced and how. Ending the application of Minnesota personal income tax to certain Social Security benefits is a long-lasting proposal. This strikes most citizens as a good idea. But what exactly is the economics of doing this? Is this really as good a step as the spontaneous reactions of the public might indicate?

We are fortunate to have public policy research institutions to explain these issues. Two – one deemed politically ‘conservative’ and another deemed ‘progressive’, have done such analysis and published excellent reports. Both methodically explore issues that many people have never thought of.

To evaluate any political question, economists start from two criteria. One is “efficiency”. How will changing the way benefits are taxed change the incentives to save and invest, or any other factor that determines how many people’s needs and wants we can satisfy with a given set of resources?

Then there is the incitement to “equity” or justice. Who benefits and who loses? How are high-income people affected compared to low-income people? Will our society become fairer — or less?

the excellent Minnesota Center for Fiscal Excellence report cuts to the chase in its first paragraph, describing the total exclusion of Social Security from taxation as “much more surprising and justifiably curious.” He goes on to note that this single measure is by far the biggest tax cut in the program, worth more than $500 million per year, and that it is “a tax relief that primarily benefits low-income retirees upper middle and high”. Hooray for insight and common sense!

The Center is not alone. The The Minnesota Budget Project, an initiative of the Minnesota Council of Nonprofits, also released an excellent report, but a little shorter.. It’s titled, “Social Security Complete Exemption Tax Cuts Are Biased for High-Income Minnesotans.”

The Center, originally organized as the Minnesota Taxpayers Association, generally favors low taxation and is considered “conservative” in its orientation. The “progressive” budget proposal focuses more on effective spending to reduce poverty and improve social justice. Yet both agree on the efficiency and fairness of this major tax change.

So what’s up?

The answer is that both are aware of the fundamental principle of economics: “opportunity cost”. If we adopt this measure, what do we have to give up?

For the Centre, it is a question of renouncing other possible tax reductions which it considers to be a source of greater efficiency and greater equity. For the Project, this means giving up additional spending on social needs it considers urgent. Still, both agree that excluding all Social Security benefits from taxation is a bad idea. Why?

Start with a bit of background, which gets more attention in the longer Center report.

Why are social security benefits taxed? Because during the years of Reagan tax cuts in the 1980s, the federal government began running large budget deficits. Taxing Social Security benefits was a way to narrow the gap without raising tax rates. It was “broadening the base”.

But fairness and political considerations resulted in a partial measure. Only part of the benefits would be taxed and only for people whose overall income exceeds a certain threshold. The typical retiree with little income beyond his monthly Social Security check would pay nothing.

Minnesota has long been criticized for the complexity of its income tax. In the days before the turbo tax, filling out your state declaration required hours of effort. Thus, the Legislature decided to make our state’s tax “conform” to federal provisions as much as possible. Whether or not you agree with some specific federal tax details, we’ll keep it simple as we continue.

Why throw it away now? Because many other states have. And the states compete for revenue. Keeping it here, the argument goes, incentivizes high-income people to move to those other states. Their move would take their overall spending with them, hurting the general level of economic activity here, leaving the rest of us worse off.

Why would “total exclusion” primarily benefit the wealthy? Because social security benefits themselves are distorted. For 2022, the highest monthly amount one can get is $3,345. The average is about $1,600 for retirement benefits. But the median, the amount that is the exact midpoint, is even lower. Most recipients do not pay tax on their benefits under current law. In Minnesota, most of the taxes actually paid come from high-income people who are already in the highest tax brackets and who also receive the highest Social Security benefits. A complete exclusion would therefore above all benefit them.

Isn’t the current tax system driving these people away? No, it’s a myth. A concise paragraph in the Center’s report explains it well. These people have many sources of income already exposed to Minnesota taxes. The benefits represent a small fraction of their total income. If high taxes are going to scare them away, the total exemption of benefits will not make an appreciable difference.

There are more details. Both reports are well written and concise, only a few pages long, including graphs, tables and quotes. And be happy that we have both institutions.

St. Paul economist and writer Edward Lotterman can be reached at [email protected]