The problem with Minnesota’s tax system is that it generates more than two-thirds of the state’s revenue from tax bases (income and sales) that fluctuate with the state’s economy. The result is a boom and bust budget cycle in which the state runs budget surpluses when the economy is growing and budget deficits when the economy is in decline. Theoretically, cyclical fluctuations in revenue can be mitigated through the use of budget reserves, but as we know, political realities usually prevent this from occurring in practice. Over the past decade, Minnesota has consistently responded to projected surpluses (FY00-01, FY02-03, FY08-09) with increased spending, tax cuts, and other measures designed to return revenue back to the public. These measures are generally popular and may be justifiable on ideological and/or policy grounds, but they leave the state ill equipped to deal with inevitable budget deficits. In the face of immediate revenue shortfalls, governors and legislatures have little choice but to pursue solutions that prioritize short-term cost controls over long-term objectives.
In the absence of a robust budget reserve, a revenue system tied to volatile tax bases will tend to prohibit a prudent level of investment in long-term priorities like education and infrastructure. Recognizing this, Budget Trends Study Commission drew considerable attention to revenue volatility in its 2009 report the Legislature. Although the report stopped short of recommending major revisions to the state’s tax system, many of its findings addressed the relative volatility of different forms of taxation. A recreated table summarizing some of the Commission’s findings on tax volatility is included below.
General Fund Revenue Volatility Study; 2005-2007
|Trend Growth Rate||Tax Base |
|Individual Income Tax Base||5.40%||3.10%|
|Corporate Income Tax Base||14.90%||12.10%|
|MN Sales Tax||5.20%||2.10%|
|Other Revenue (fees)||11.00%||10.90%|
|Total (excluding local taxes)||6.50%||2.60%|
Source: Minnesota Management and Budget
It should be noted that volatility is not the only, or even the most important, criterion to consider when evaluating a tax system. Property taxes (not included in the table) are far away the least volatile source of revenue (since state or local government officials readjust rates annually to generate the desired level of revenue), but they are generally among the most regressive. For this reason, few lawmakers would propose reducing Minnesota’s budget volatility through increased reliance on property taxes (although it may be some politicians default position). A more promising discussion about revenue volatility is likely to center on the state’s current balance between income taxes and consumption taxes.
As you can see from the table above, the sales tax is the state’s least volatile revenue source (excluding the property tax.) This suggests that one way for Minnesota to decrease the volatility of its tax system would be to increase its reliance on the sales tax. The idea is particularly attractive when you consider that the Budget Trends Study Commission looked only at the volatility of the state’s current sales tax. Under current law, Minnesota exempts necessities (such as food and clothing) and services from its sales tax base. As a result, in 2006 only 28.5% of personal expenditures in Minnesota were assessed a state sales tax. One could reasonably assume that if the state were to expand the sales tax base to include food, clothing, and other necessities, its volatility as a revenue source would decline even further. This assumption is supported by a 2008 study done by the Federal Reserve Bank of Kansas City, which estimated that consumer spending on durable goods was roughly 5 times more volatile than spending on clothing and 15 times more volatile than spending on food.
Admittedly, sales taxes are a regressive form of taxation and increasing the state’s reliance on them could introduce additional regressivity into the tax system. It is possible, however, that this negative consequence would be offset by additional revenue stability. When deficits occur, it is usually low-income populations that suffer the most in the form of budget cuts to state services. A more reliable revenue system may enable legislatures to preserve programs and maintain safety nets in times of recession. Additional revenue stability at the state level could also preserve local government aid funding and thus reduce the need for property tax increases. If so, then an expansion of the sales tax base might end up being neutral in its equity effect. In any case, expanding the sales tax base holds great potential to reduce volatility in the overall tax system, suggesting the days of the three-legged stool may soon be over.