On November 18th, the Michigan Supreme Court ruled on the constitutionality of Public Act 38 of 2011, finding that part of the law violated the prohibition on a graduated income tax.  The ruling effectively creates a $60 million hole in the state budget.  Addressing such a shortfall requires either reducing enacted appropriations or providing replacement resources from some other source(s).  The latter option may be viewed as more tenable to policymakers in light of recent state revenue performance and the likelihood of improved projections for the current year.

Public Act 38 is a key component of the state’s new fiscal plan.  It contains a complex and varied mix of changes to the state’s personal income tax, primarily modifying, limiting, and eliminating certain tax exemptions and credits.  The changes increased income tax collections on net ($1.4 billion on full-year basis), offsetting some of the revenue loss from the direct business tax cuts associated with the elimination of the Michigan Business Tax and creation of a new corporate income tax ($1.6 billion on full-year basis). 

While the FY2012 budget took effect at the start of the fiscal year (October 1), the income tax changes included in PA 38 are scheduled to go into effect on January 1, 2012.  The partial year revenue effects were factored into the FY2012 budget.  Perhaps the most significant aspect (in terms of both public attention and dollars) is the elimination of the public pension income exemption, which is expected to generate $225 million in FY2012 and rise to $343 million in the first full year (FY2013). 

In light of the budget implications, Governor Snyder asked the Supreme Court whether the elimination of the exemption violated either Article IX, Section 24 (public pension diminishment provision) or Article I, Section10 (contract provision).  The Court answered “no” in each case.  (Governor Snyder exercised a little-used constitutional provision to request the Supreme Court’s opinion on these matters.  Article III, Section 8 allows the governor or either house of the legislature to request a Supreme Court advisory opinion on the constitutionality of legislation after it has been enacted but prior to becoming effective; a situation that applies to PA 38.)

The governor also asked whether the provisions of PA 38 that use age and/or income criteria to phase-out income tax exemptions violate the constitutional prohibition against graduated income taxes (Article IX, Section 7).  The Court found that provisions related to a phase-out based on income create a graduated income tax and they were severed from PA 38.  This creates an immediate $60 million hole in the FY2012 budget, and the revenue loss will rise to $91 million in FY2013.  The General Fund portion of the budget assumes 75 percent of loss and the School Aid Fund the remainder.

Now that the Supreme Court has ruled, the General Fund and School Aid Fund portions of the budget must be brought back into balance.  Enacted appropriations could be reduced by $60 million or a like amount of resources could be identified to fill the budget hole created by the Court’s decision.  Although $60 million in spending cuts may be relatively minor to a General Fund budget totaling $8.3 billion, policymakers might find the latter budget balancing option more palatable given the extent of cuts already included in the FY2012 budget and recent news about state revenue growth. 

While the state has not completed its final FY2011 book closing, estimates suggest that revenues will exceed target by $500 million between the two major funds.  The strength of revenue growth in FY2011 will generate an additional $423 million in FY2102 and an additional $370 million in FY2013 over the May 2011 projections made for each year, according to the recent forecast from the University of Michigan.  Solving the budget problem created by the Supreme Court’s recent decision is made much easier by the news of stronger than expected revenue growth.  Directing some of these new revenues to fill the budget hole will leave a substantial amount of resources for other priorities that the legislature might later identify.

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