Group 6: Is the 4th Tier a Solution to Minnesota's Budget Woes?

Like nearly every state, Minnesota needs more revenue. The current recession has exacerbated systemic imbalances between ongoing revenue and long-term expenditures, resulting in a projected $4.4 billion deficit for the FY2012-13 biennium. One possible solution, popular among Democrats, is the creation of a 4th tier state personal income tax bracket (4th tier). Under current law, the Minnesota personal income tax is a graduated tax with three rates: 5.35%, 7.05%, and 7.85%. The rates are applied to income tiers that vary by filing status (married joint, single, or head of household). Click here for more information about Minnesota's personal income tax A 4th tier would cap the 3rd tier at a high level of personal income, allowing income above that level to be taxed at a rate greater than 7.85%.

Most of the political debate surrounding the 4th tier involves equity concerns. Between 2002 and 2006, Minnesota’s tax system became increasingly regressive largely due to rising inequality between high and middle income earners and the state’s growing reliance on local taxes, which are generally regressive. According to the Suits Index – a -1.0 to 1.0 scale that measures the degree to which a tax or tax system is regressive (-1.0), proportional (0), or progressive (1.0) – the regressivity of Minnesota's tax system increased from -.018 to -.053 over that four year time period (2009 Minnesota Tax Incidence Study). Since the income tax is the state’s only major progressive tax, its promotion is seen by many as the key to reversing this regressive trend. Click here to read a report on tax fairness put out by the Minnesota Budget Project (sponsored by the Minnesota Council of Non-Profits)

But is the 4th tier an adequate source of revenue for the state? The answer to this question hinges on the 4th tier’s composition, its tax rate, and efficiency effect. For the purposes of 4th tier revenue projection, a good source for 4th tier composition and tax rate is House File 885 (HF 885), which passed the Minnesota Legislature in 2009 but was vetoed by Governor Pawlenty. Under HF 885, a 9% tax rate would have been assessed to income above $250,000 for married joint filers and $141,250 for single filers. If HF 885’s tax rate and income brackets are used to define the 4th tier, then a preliminary estimate of the 4th tier’s revenue potential can be made using Minnesota Department of Revenue (DOR) wage data (available online). In 2007, roughly $33 billion in taxable income was generated above the proposed 4th tier floors. At the 3rd tier tax rate of 7.85%, this tax base produced slightly more than $2.59 billion in income tax revenue. Were HF 885’s 9% tax rate applied with an assumption of no effect on efficiency, then this same tax base would have generated nearly $2.97 billion, for an estimated revenue gain for the state of about $380 million.

Of course, the assumption that a 14.6% income tax increase (7.85 to 9) would have no efficiency effect is unrealistic. It is much more likely that the implementation of the 4th tier would have some negative effect on economic activity in the state. A literature review conducted by Marsha Blumenthal and Charles Quimby for the think tank Growth and Justice suggests that interregional tax elasticity estimates typically range between -.1 and -.6. In 2006, income taxes represented roughly 58% of the total tax burden for the state’s wealthiest 5% (about half of whom would be assessed a higher rate on some of their income under the proposed 4th tier.) For these high income earners, a 14.6% income tax increase would equate to an approximately 8% increase in total tax burden. Using this figure and the midpoint of the tax elasticity estimates (-.35), we can reasonably estimate that Minnesota would lose 2.8% of its 4th tier tax base given a 9% tax rate (.08 * -.35 = -.028). In absolute terms, a 2.8% decline in the 4th tier tax base would cost Minnesota slightly more than $83 million in tax revenue. However, this loss is more than made up for by the additional revenue generated by the higher tax rate. All told, we estimate that had HF 885’s version of the 4th tier been implemented in 2007, Minnesota’s income tax would have generated slightly less than $300 million in additional revenue in that year alone.

Income Tax Revenue Generation from High Levels of Income

3-Tier and 4-Tier Income Tax Systems

(High Levels of Personal Income > $250,000 married joint filers, $212,500 heads of household, $141,250 singles)

	3-Tier System (Observed Data)	4-Tier System (Hypothetical Estimates)
2007 High Income Tax Base	$33 billion*	$33 billion
2007 Tax Rate	7.85%	9.0 %
Efficiency Effect due to 4th tier	---	-2.8%**
Modified Tax Base	$33 billion	$32.08 billion
Tax Revenue Generated off of High Levels of Income	$2.59 billion	$2.89 billion

*Estimated from 2007 Individual Income Tax Statistics (Minnesota Department of Revenue). Tax base was calculated from aggregate wage data for singles making over $150,000 and married joint filers making over $250,000. The resulting sum was multiplied by .65 to provide an estimate of total taxable income after deductions.
**Estimated by Nick Petersen using a -.35 tax elasticity assumption.

Based on this analysis, the 4th tier’s efficiency effects do not appear to significantly impact its adequacy as a revenue source. This finding suggests that the 4th tier is a viable option in the state’s search for new revenue.