Opinion: New policymakers may revisit pension tax

James M. Hohman

The so-called “pension tax” affects a lot of people in Michigan. It’s why there’s been so much interest in it since it was passed in 2011 as part of a larger tax reform to reduce business taxes. With a new governor in office, there is interest in revisiting it. Especially so when you consider that 8 percent of taxpayers are subject to it.

"One reason why the pension tax rankles residents is that they don’t like sticking people that were already retired with a larger tax bill."

When it was put in place, the pension tax wasn’t a special new tax on pensions, but a change to the tax preferences for retirement income. Michigan had fully exempted the defined benefit pensions of public workers from taxes and provided generous exemptions to private sector pensions. People retiring on income from savings, on the other hand, did not get either preference.

The various treatments for different income sources were replaced by a blanket deduction on most kinds of retirement income, starting at age 67. But the tax didn’t grandfather everyone in. People that had retired earlier than age 59 at the time would be paying a tax on all income, and those between 60 and 67 would pay taxes on income above $20,000 for single filers and $40,000 for joint filers.

Taxing more people was part of the point. There were a lot of moving parts to the tax reform that year, and lawmakers didn’t want to further reduce government expenditures. They used the pension tax, eliminated income tax rate reductions and a bunch of tax credits, to raise revenue the state lost from reducing business taxes. State officials expected to collect $340 million from the pension tax in its first year.

One reason why the pension tax rankles residents is that they don’t like sticking people that were already retired with a larger tax bill. I assume fewer people would have been upset if it only had been changed for people who were still working and could thus plan their retirement around different tax rules.

As time goes by, people will adjust to the newer preferences in place, which makes the outcome fairer than imposing taxes on those already retired. And generally, fewer people are earning pensions, making a larger exemption for pensions less expensive to the state budget. The more modest impact on the state budget, consequently, would make reinstalling a pension exemption more politically feasible.

Still, a large number of people are affected by the pension tax. According to data from the Senate Fiscal Agency, 376,000 taxpayer returns listed retirement income above the new blanket deduction in 2016 ($20,000 for single returns and $40,000 for joint ones), or around eight percent of all tax returns. The figure could be higher or lower depending on how many people were 70 or older, how many people retired before age 67, and how many people were retiring on savings instead of pensions.

So the interest in repealing the pension tax is understandable.

But if there is enough slack in the budget to afford a tax cut — and there is — there are better tax reforms than to tinker again with pension rules. Michigan still offers preferences for retirement income and there is nothing special about pensions that ought not apply to other sources of retirement income.

The rate of taxation matters more. Lightening the portion of income that the state claims from retirees and workers alike encourages economic growth in ways that retirement exemptions do not.

But there are spending desires that conflict with tax cuts. The state has a balanced budget requirement, so replacing money lost from scrapping the pension tax would have to come from growth in the state budget or budget cuts elsewhere. The governor called for more tax money for roads, schools, environmental cleanup and college scholarships in her State of the State address.

Something has to give. Eliminating the pension tax is going to be weighed against those priorities. But at least 8 percent of taxpayers will be paying close attention.

James M. Hohman is director of fiscal policy at the Mackinac Center for Public Policy.