In A Nutshell

• The State of Michigan and Michigan local units of government will receive $10.3 billion from the federal government through the American Rescue Plan Act.
• A rate trigger added to Michigan’s personal income tax law in 2015 will likely reduce the state’s income tax rate in 2023; that could threaten the state’s ability to tap into all of the federal COVID relief funding.
• The rate trigger is pegged to Fiscal Year (FY) 2021 revenue, which is likely to be unusually below trend because of the pandemic.  This could affect Michigan’s state revenue picture far into the future.

Last Thursday, President Biden signed the American Rescue Plan Act, a $1.9 trillion economic relief plan to provide direct stimulus payments to Americans and extend current federal enhancements to unemployment benefits through early September.  Notably, the Act also provides $350 billion in assistance to state and local governments to help address COVID-19 response efforts and to mitigate the negative impacts of the pandemic on state and local economies and revenues. But one notable provision added to the Act by the Senate would prohibit states from using these funds to cut taxes.  The provision has shined another light on Michigan’s built-in personal income tax trigger and what it means for state finances.

A Haul of Federal Cash with Few Restrictions

While Michigan state and local governments have received billions in restricted federal dollars through previous relief bills, the American Rescue Plan provides greater flexibility in how funding is used, including allowing these dollars to cover pandemic-induced revenue shortfalls. The federal allocation among states and their local governments will bring $10.3 billion in new revenue to Michigan. Funding is split between the State of Michigan ($5.3 billion), counties and municipalities ($4.4 billion), and an additional $250 million allocation for infrastructure projects.

The law requires state and local governments to spend the money by the end of calendar year 2024 to: (a) respond to COVID-19 and its negative economic impacts; (b) provide premium pay for frontline workers performing essential public health and safety functions; (c) offset any revenue losses from FY2019 levels caused by the pandemic; or (d) finance water, sewer, and broadband infrastructure projects.  These broad parameters provide states and local governments with considerable discretion with the federal dollars.

Flies in the Ointment?

As legislative deliberations were wrapping up, the U.S. Senate added a notable restriction: States cannot use this funding to cut taxes.  So, for instance, a state cannot reduce its income tax rate and tap into the new stimulus funds to offset the resultant lost tax revenue.

Important guidance on interpreting this prohibition will likely be coming from the U.S. Department of Treasury, but speculation has already begun as to what this means for state and local tax policy. And in Michigan, a unique provision in the state’s income tax law may provide an interesting test case regarding how this section of law is interpreted and implemented.

Back in 2015, as part of the road funding package that increased motor fuel taxes and vehicle fees, policymakers added a new provision to the Income Tax Act that would automatically reduce the tax rate when certain “triggers” are met.

The trigger calculation to determine any automatic rate reduction is set to start in tax year 2023 looking back on previous years’ data. In short, if General Fund revenue between FY2021 and FY2022 grows in percentage terms by more than Consumer Price Index inflation rate times a statutorily-established multiplier (1.425), then the 2023 personal income tax rate would be reduced.  And the rate would drop by the amount necessary to reduce General Fund revenue by what would be considered the “excess growth” in that calculation.  The same process would be followed in subsequent tax years where General Fund revenue growth exceeds CPI inflation.

Significantly, the 2015 law change sets FY2021 as the permanent base year for the revenue growth and inflationary calculations, and those General Fund revenues are currently forecast to be $10.2 billion, a decline of 4.9 percent from $10.8 billion in FY2020 (The state fiscal year runs from October to September).  Note that last year, General Fund revenue dropped 3.1 percent from the year before with the onset of the pandemic.  

As the national and state economy begin recovery next year, FY2022 General Fund revenue is expected to jump to $10.9 billion, an increase of 6.4 percent. This means that the base year for the tax rate trigger calculations is set at a COVID-19-influenced low point for General Fund revenue after two years of decline.

Further, a separate provision of the American Rescue Plan is likely to make the revenue picture a little gloomier for FY2021 by exempting the first $10,200 in unemployment benefit payments from the federal income tax for filers with adjusted gross income (AGI) below $150,000.  This new exemption will flow through to Michigan’s income tax collections as well – making the FY2021 low-point for General Fund revenue even lower.   For quick reference, Michigan residents received over $5.6 billion in UI benefits during 2020 – seven and half times more than in a normal year. Michigan collected $557 million in withholding revenue alone from these benefits during FY2020; much of which would need to be refunded in FY2021.  Annual payments in April from those without withholding would also not be realized.

Going forward, the FY2021 low-year base means that the trigger calculations are more likely to set off the rate reduction both now and in the future. State economists estimated in January (before the new unemployment insurance impact was recognized) that the new trigger provision would result in a 2023 income tax rate reduction from 4.25 percent to 4.15 percent, resulting in a loss of $193 million in income tax revenue based on their revenue and inflation forecast at that time.

So,  it seems very likely that the trigger will be activated and the income tax rate will be reduced, perhaps by even more than was initially estimated in January.   

Impact on Michigan’s Finances

If the income tax rate trigger is implemented in 2023 as expected, will Michigan need to give up  a portion of its stimulus funds? 

Interpretation of the American Rescue Plan’s prohibition on state tax cuts will be fundamental to answering this question. The federal stimulus act requires states to pay back any stimulus dollars used to offset revenue losses from tax cuts.   But the specific language from the act may provide Michigan a loophole.   The federal act specifically prohibits using the new funding:

“to either directly or indirectly offset a reduction in the net tax revenue… from a change in law, regulation, or administrative interpretation during the covered period…” (Emphasis added)

For Michigan,  the “covered period” in the law starts on March 3, 2021, and ends once the federal dollars are fully spent. As noted, the Michigan income tax trigger provisions were enacted in 2015.   No change in law, regulation, or interpretation will have occurred to change the revenue implications of these provisions.  So, does this mean Michigan can use its new stimulus dollars to back fill for any trigger-related revenue loss?  On the other side of the argument, the federal law also restricts the use of federal stimulus funds to revenue losses “due to the COVID-19 public health emergency”.  Any revenue reduction from the trigger would clearly not be COVID-induced.

No doubt, the answer to that question will loom large in legislative debates on what, if anything, should be done to eliminate or revise the trigger provisions.  To be sure, policymakers would be wise to step back and consider that the permanent base year for the trigger calculations will likely be a fiscal year outlier due to pandemic impacts.

But as states await U.S. Treasury guidance on what handcuffs this new prohibition will and won’t place on tax policy reforms in the coming few years, Michigan’s income tax trigger provision will provide a unique test case. One that will have a major influence on tax policy in the years ahead.