Reports tackle Social Security state taxation issue – Twin Cities

As COVID cases lessoned, Minnesota found itself an enormous state budget surplus. That was an enable position but raised perennial questions about what to do. Taxes could be reduced or spending increased. Paying down debt was another option, though more complicated than people understand.

Edward Lotterman
Edward Lotterman

After a long, contentious session, the Legislature hit a tentative deal combining some tax cuts with some spending increases.

On taxes, there are many choices on what should be cut and how. Ending application of Minnesota’s personal income tax to some Social Security benefits is a perennial proposal. It strikes most citizens as a good idea. But what exactly are the economics of doing this? Is it really as good a step as off-the-cuff reactions of the public might indicate?

We are fortunate to have public policy research institutions to explain such issues. Two — one deemed “conservative” politically and another deemed “progressive,” did such analysis and issued excellent reports. Both methodically explore issues that many people never thought about.

In evaluating any policy issue, economists start with two criteria. One is “efficiency.” How will changing how benefits are taxed change incentives for saving and investing, or any other factor that determines how many needs and wants of people we can satisfy with a given set of resources?

Then there is the incentive of “equity,” or fairness. Who benefits and who loses? How are higher-income people affected versus lower-income ones? Will our society become more just — or less?

The excellent report of the Minnesota Center for Fiscal Excellence gets to the point in its lead paragraph, describing full exclusion of Social Security from taxation as “a lot more surprising and justifiably curious.” It then notes one measure is by far the largest tax-reduction in the package, accounting for more than $500 million a year, and that it “is a tax break mainly benefiting upper-middle and high-income retirees.” Hurray for insight and common sense!

The Center is not alone. The Minnesota Budget Project, an initiative of the Minnesota Council of Nonprofits, also issued an excellent, but somewhat briefer, report. It is headlined: “Tax cuts from full Social Security exemption skewed to higher-income Minnesotans.”

The Center, originally organized as the Minnesota Taxpayers Association, generally favors low taxation and is seen as “conservative” in orientation. The “progressive” Budget Project focuses more on effective spending to reduce poverty and improve social justice. Yet the two agree on the efficiency and equity of this major tax change.

So, what’s going on?

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

For the Center, it means giving up other possible tax reductions that it sees as causing greater efficiency and greater fairness. For the Project, it means giving up additional spending on social needs that it sees as pressing. Yet both agree that excluding all Social Security benefits from taxation is a bad idea. why?

Start with some history, which gets more attention in the longer Center report.

Why are Social Security benefits taxed at all? Because in the tax-cutting Reagan years of the 1980s, the federal government began running large budget deficits. Taxing Social Security benefits was one way to reduce the gap without an increase in tax rates. It was “broadening the base.”

But fairness and political considerations resulted in a partial measure. Only a portion of benefits would be taxed and then only for people with overall incomes above a certain threshold. The typical retiree with little income beyond their monthly Social Security check would pay nothing.

Minnesota had long been criticized for the complexity of its state income tax. In the days before Turbo Tax, filling out one’s state return required hours of effort. So the Legislature moved to make our state’s tax “conform” to federal provisions as much as possible. Agree or not with some specific detail of federal tax, we would keep things simple by just going along.

Why discard it now? Because many other states have done so. And states compete for revenue. Keeping it here, the argument goes, provides an incentive for high income people to move to those other states. Their moving would take their overall spending with them, harming the general level of economic activity here, leaving the rest of us worse off.

Why would “full exclusion” primarily benefit the wealthy? Because Social Security benefits themselves are skewed. For 2022, the highest monthly amount one could get is $3,345. The average is about $1,600 for retirement benefits. But the median, the amount that is the exact middle point, is even lower. Most recipients don’t pay taxes on their benefits under current law. In Minnesota, most of the taxes actually paid come from high income people who already are in the highest tax rate brackets and also get the very highest Social Security benefits. So a full exclusion would primarily benefit them.

Isn’t current taxation driving such people away? No, that’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. Benefits are a small fraction of their total income. If high taxes are going to drive them away, full exemption of benefits won’t make an appreciable difference.

There are more details. Both reports are well-written and concise, just a few pages, including graphs, tables and citations. And be glad we have both institutions.

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