In a Nutshell

• After the legislature rejected her proposed motor fuel tax increase, Governor Whitmer turned to bonding to provide a short-term revenue injection for road projects, but new ongoing revenues are still critical.
• Large state revenue surpluses would allow the state to eliminate the sales tax on motor fuel and replace it will a revenue-neutral increase in the motor fuel tax rate while drawing on the surpluses to mitigate budget holes inherent in the tax shift.
• We estimate such a shift could generate $1.15 billion in ongoing road revenue while still leaving room for other one-time and ongoing budget needs.

With a large COVID-induced revenue windfall at its disposal, now is the perfect time for state policymakers to implement a often-discussed tax reform to generate more revenue for Michigan’s road infrastructure. Michigan’s road funding efforts are hampered in part by a tax policy that includes motor fuel purchases in the base of the state’s sales tax. As a result, a significant amount of tax revenue from fuel sales goes not to road maintenance but to other areas of the state budget. Past proposals to untangle the separate sales and motor fuel taxes imposed on fuel purchases faced challenges based on the budget holes the tax reform created, but the state’s revenue surplus now provides a safety value to policymakers to backfill these shortfalls.

A focal point of Governor Whitmer’s 2018 gubernatorial campaign was her promise to “fix the damn roads”. As a newly-elected governor, she proposed an historic 45-cent increase in the motor fuel tax rate as part of her first Executive Budget recommendation. Phased in over three years, the rate hike was expected to eventually generate $2.5 billion in new dedicated transportation revenue.

However, the Republican-led legislature rejected her proposed tax increase. As a fallback, the Governor tapped her executive power to issue bonds. At the Governor’s request, the State Transportation Commission approved a plan to issue $3.5 billion in “Rebuilding Michigan” bonds over five years to jumpstart major reconstruction projects on state roads across Michigan. Thus, many of the orange barrels you see along state highways and freeways are financed not by ongoing transportation revenues but by one-time bond proceeds.

As we’ve noted previously, bonding can provide a short-term boost in revenue as the state plays catch up on deferred road maintenance, but it is not a long-term solution. The Governor’s bonding plan focuses solely on “state trunkline” roads (e.g., M-route highways and expressways); it provides no new support to local road agencies responsible for maintaining local roadways. Further, bond funding eventually runs out and creates debt service costs that cut into available future transportation revenue. At some point, the state will need to generate new ongoing revenue to reverse the degradation in road conditions.

Fixing the Damn Roads: What’s Next?

With Democrats having secured control of both the Michigan House and Senate in the November election, any partisan barrier to generating additional road revenue is now gone.  However, the Governor has signaled she does not intend to resurrect her motor fuel tax proposal in the upcoming session. Instead, she wants to pursue broader change to the state’s transportation financing system that recognizes long-term challenges related to the transition from gas-powered to electric vehicles. A per-gallon motor fuel tax does not work in a world of electric vehicles; instead, charging motorist based on travel miles makes better sense.

Forward-looking consideration of funding changes is wise, especially if it is combined with reforms to the state’s road funding distribution formula to ensure that scarce state resources are deployed most efficiently to the highest-need roads.

However, the state is well positioned financially to immediately boost dedicated road funding, and the Governor and legislature should not pass on the opportunity to do so. Our 2019 report on options for increasing revenue for road infrastructure suggested one specific mechanism for boosting road funding: exempting motor fuel from the state’s sales tax and then increasing the motor fuel tax rate to generate an equivalent amount of revenue.  This approach keeps gas prices at the pump unchanged; motorists simply pay less sales tax and more motor fuel tax when purchasing gasoline.

The concept of such a tax shift has received support from both political parties in the past, and the public has generally expressed support for ensuring that all taxes paid at the pump go to road maintenance. However, a perennial challenge to implementing such a shift has been the budget tradeoffs that come with it. About 73 percent of sales tax revenue is distributed to the state’s School Aid Fund which primarily supports K-12 schools. Another 10 percent is distributed to cities, villages, and townships as part of dedicated state revenue sharing. Most of the remainder falls to the state’s General Fund to support other state programs.  The creation of “budget holes” in other areas of the state budget makes this approach more difficult unless state revenue is available to backfill those holes.

State’s Current Revenue Surplus Fills the Void

Fortunately, the state is in an unprecedentedly good position to facilitate that backfill.  A Senate Fiscal Agency (SFA) analysis conducted after the enactment of the FY2023 budget in July showed the state was still sitting on revenue reserves of around $7 billion. Since then, another $1 billion in General Fund/General Purpose (GF/GP) was tapped in an October supplemental appropriation act – the largest component being a $846 million deposit to replenish the state’s Strategic Outreach and Attraction Reserve Fund used to provide business attraction incentives.

Still, that leaves the state with $6.0 billion in reserve: $2.8 billion in discretionary GF/GP revenue and another $3.2 billion in School Aid Fund (SAF) revenue used primarily for K-12 education. Notably, a significant portion of those reserves represent available “ongoing” revenue. In other words, looking ahead to FY2024, estimates of anticipated GF/GP revenue exceed “baseline” spending – what is already appropriated for FY2023 plus known spending pressures from things like Medicaid and public assistance caseloads – by about $1.4 billion.  For the School Aid Fund, revenue projections come in about $1.1 billion above baseline spending.

In short, that means that when the Governor releases her Executive Budget recommendation next February, there’s room for a combined $2.5 billion in some combination of new ongoing spending or permanent tax relief.

Implementing the Tax Shift: Running the Numbers

This ongoing revenue surplus can aid the state in addressing the budget holes that would otherwise be generated by a revenue-neutral shift of the sales tax on motor fuel to an offsetting increase in the motor fuel tax rate. This summer, the Michigan Senate passed legislation that would have suspended the sales tax on motor fuel for three months. We extrapolate from the SFA analysis of that bill to estimate the annual impact of implementing a full tax shift.

Importantly, the impact of the shift depends on the underlying retail price of motor fuel. Eliminating the state’s 6 percent sales tax on motor fuel costs the state more revenue – and generates bigger budget holes – when fuel prices are higher. The SFA analysis assumed an average retail price of gasoline of $4.50 per gallon (reflective of the prevailing prices at the time of the analysis). For our analysis, we assume $3.50 per gallon.

Our analysis suggests that eliminating the sales tax on motor fuel at this price point would reduce sales tax revenue by around $1.15 billion. In terms of budget holes, around $840 million of the revenue loss would hit the School Aid Fund, while $142 million would come out of GF/GP revenue and $115 million would reflect reduced revenue sharing payments.

The state’s ongoing revenue surplus is more than sufficient to provide a permanent backfill for this revenue loss.  Drawing an additional $840 million from the School Aid Fund and $257 million from GF/GP (to cover the general GF/GP loss and revenue sharing) each year still leaves a GF/GP ongoing surplus of $1.1 billion and a SAF surplus of $290 million.

Ongoing Revenue Surplus After Tax Shift (in millions)

Source: Backfill estimate based on Research Council calculations based on Senate Fiscal Agency analysis of Senate Bill 972; current annual surplus from Senate Fiscal Agency.

With each penny of motor fuel taxes raising about $53 million in tax revenue, the state could then raise the motor fuel tax rate by about 21-22 cents per gallon without impacting pump prices. The $1.15 billion foregone from the sales tax would be replaced by an additional $1.15 billion in motor fuel tax revenue to the Michigan Transportation Fund.

Now is the right time to implement this tax policy change.  Doing so would:

• Generate over a billion dollars in new dedicated transportation funding while backfilling budget holes with the existing revenue surplus
• Boost funding to local agencies that were left out of the Rebuilding Michigan bonding plan
• Leave a sufficient GF/GP revenue balance to cover the Governor’s tax relief proposals related to retirement income and the Earned Income Tax Credit
• Leave another $3.5 billion in one-time revenue in reserve for potential one-time priorities like economic development incentives or retaining a recession buffer

If fixing the damn roads is still priority one for Michigan, the Governor and legislature should move to implement this tax policy change without delay.