What’s up with the sales tax?

A few lawmakers, including the chair of the House Ways and Means Committee, were taken aback earlier this month while listening to Minnesota Management and Budget officials lay out the November budget forecast.

Specifically, the eyebrows of committee Chair Jim Knoblach, R-St. Cloud, and Vice Chair Tony Albright, R-Prior Lake, were raised by a large discrepancy in projected revenues from income taxes and sales taxes.

Both were being adjusted downward: Income tax revenues were lowered $16 million for fiscal year 2016-17 compared with the February 2016 forecast’s projections. At the same time, sales tax revenues were downgraded a lot. The November budget forecast released on Dec. 2 knocked $107 million off projections for fiscal year 2016-17 compared with the earlier forecast.

Sales taxes are expected to perform even worse in fiscal year 2017-18, according to MMB figures. They were downgraded $428 million below February’s forecast. Income tax projections for that period were reduced much more modestly — just $36 million less for 2107-18 than the February forecast.

Knoblach said the anemic sales tax projection was surprising, given that the November forecast also calls for modest growth in Minnesota wages of between 3.6 percent and 4.7 percent per year over the 2016-2018 period.

“That sales tax number — why was it so much larger than the income tax number?” Knoblach said. “I find that a little bit strange.”

Albright also expressed concern that the numbers appeared to be “outliers.” He asked State Economist Laura Kalambokidis how much confidence lawmakers could reliably put in them while making budgeting decisions in the coming session and beyond.

Kalambokidis, who is MMB’s lead economic analyst, replied that the forecast represents the office’s best interpretation of current economic evidence. Lawmakers should always approach forecasts with caution, she said.

“Whenever there is taxpayer behavior change that we have to guess about and forecast on,” Kalambokidis replied, “we can be surprised.”

That didn’t exactly soothe Albright’s nerves. “It’s a bit of a precarious position to balance the state’s budget when the expectation is that we don’t really know if these numbers are going to hold true or not,” he said in an interview Thursday. 

Economist explains

In the Ways and Means meeting, Kalambokidis offered several reasons for MMB’s sales tax projections. First, she said, lower-than-anticipated actual sales tax receipts collected over the last fiscal year were factored in for the November forecast.

Second, she said, the forecast incorporated early November data from IHS Markit — Minnesota’s macroeconomic consulting firm — which projects a drop in national consumer spending. (Consumer spending for Minnesota alone is not readily available, Kalambokidis said.) Slowed consumer spending will generate less sales tax revenue, she said.

Finally, Kalambokidis said, the latest forecast was affected by a change in state law on capital equipment purchases. Formerly, she said, businesses buying capital equipment paid sales taxes and then could file with the Revenue Department for a full rebate.

Recently those collections were halted altogether so the money never enters state coffers, where some of it would have stayed if rebates went unclaimed­. Meanwhile, rebate requests for older capital equipment purchases continue to trickle in. Those two factors tended to “obfuscate” the previous projection, Kalambokidis said.

Right after the meeting, Knoblach said he “didn’t completely buy” her explanation.

“Consumer spending is 70 percent of the economy, and so if consumer spending is down that much, it seems to me like the income tax number would be affected more,” he said then.

On Thursday he backed off his initial comments, saying he did not intend to question the economist’s work or conclusions. “I just thought it seemed a little unusual that there was that much of a difference between the two numbers,” he said.

 Long-term trend?

Albright, on the other hand, is not backing down. “If incomes are not going down precipitously but consumer spending is, we have got a dichotomy here,” he said. “It’s a foggy bottom, really.”

What he worries about most is that the projected drop in sales tax receipts might become a long-term reality.

Along with the nation, he noted, Minnesota rapidly is transforming into a service economy. That could spell bad news for long-term sales tax receipts — and government budgets — because it is harder to assess sales taxes on services.

In fact, total combined state and local sales tax revenue in Minnesota has been dropping for years. They peaked at 26 percent of state and local tax revenues in 2005, but accounted for just 21 percent in 2015, according to the Minnesota Department of Revenue.

State sales taxes — excluding locally assessed sales taxes — accounted for 25 percent of Minnesota’s tax receipts in 2015, according to Minnesota Management and Budget. In 2009, a Budget Trends Study Commission report pegged that number at 31 percent.

That’s a far cry from the situation 40 years ago. According to a 2015 tax study by the Washington, D.C.-based Urban Institute, sales taxes were the top revenue-generator for state governments nationwide in 1977. Receipts kept growing until the mid-1990s, when sales tax receipts started to decline, the Urban Institute study shows.

To offset the losses, many states including Minnesota raised sales tax rates. Minnesota’s most recently rose from 6.5 percent to 6.875 percent in 2009. (Minnesota is one of just three states to raise both income and sales taxes since 2008.)­ Still, according to the Urban Institute, sales tax rate increases generally have failed to keep pace with changing consumption patterns.

“The sales tax has become less efficient,” the study said.

That is why the discrepancy between projected income and sales tax numbers bothers Albright so much, he said.

“We are moving more toward a service economy of a digital nature. How do you capture that in the numbers?” he said. “I strongly believe that we are not seeing the full force of that in the state’s economic database.”

MMB Commissioner Myron Frans defends his department’s work on the forecast, adding the state’s move to a service economy is hardly news to him or his colleagues. In fact, when he was revenue commissioner a few years ago, he proposed expanding the sales taxes into services to offset the service-economy trend, he said. The Legislature shot that idea down, and Frans said he would not propose it again.

Frans agrees that sales taxes are a sluggish component of the state’s revenue stream and might not keep up with revenue demands as well as they might were “a service-economy sales tax component” added to the state’s income stream.

He also said he is glad that lawmakers are weighing all that out. “It is a risk factor and it is something that has changed on us,” Frans said. “I think it is good for us to stop and talk about it and to think about what does it mean long-term for us.”

Rep. Greg Davids, the House Tax Committee chair and a Ways and Means Committee member, was also present at the Dec. 5 Ways and Means meeting. He takes seriously the concerns raised by Knoblach and Albright, but he is not quite as worried.

Davids said he has seen forecast numbers swing wildly in the past. The November 2010 forecast, for example, projected a $6.2 billion deficit. By the following February’s forecast, he said, it was reduced to $5.2 billion.

While that was an unusual case, numbers often fluctuate between the November and February forecasts, Davids said. And since the February forecast is the one legislators use for budgeting decisions, any worries now might be premature.

“We need to let this play out for a couple of months until we get the February forecast,” Davids said, “and then get to work with that.”