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    March 31, 2021

    With COVID’s Fiscal Impact Clearer, Lawmakers Should Re-examine Michigan’s Automatic Income Tax Rate Trigger

    In A Nutshell

    • A rate trigger added to Michigan’s personal income tax law in 2015 will likely reduce the state’s income tax rate and associated income tax revenues in 2023.
    • The rate trigger is pegged to Fiscal Year (FY)2021 General Fund revenue collections, which will fall well below recent trend levels because of the COVID-19 economic slowdown.
    • Revisions to the trigger’s base year would allow General Fund revenue to eventually return to its pre-pandemic trend.

    As we examined previously, official state revenue projections from January’s revenue estimating conference suggest that Michigan’s income rate will need to be lowered from the current 4.25 percent rate to 4.15 percent beginning in January 2023. The automatic rate reduction trigger was included in a 2015 road funding plan.  

    And now, the exemption of certain federal unemployment benefits from state taxation will create an even steeper rate reduction. The exemptions, part of President Biden’s recently-signed $1.9 trillion American Rescue Plan Act, will reduce state revenues beyond what was projected at January’s revenue estimating conference.

    As a refresher, the 2015 road funding package, in addition to raising state transportation taxes, also established an effective ceiling on the growth of state General Fund revenues.  Starting in 2023, the income tax rate would be subject to an automatic reduction following any year where state General Fund revenue grew faster than the U.S. Consumer Price Index (CPI) inflation rate.  The amount of any reduction would be based on the amount by which actual General Fund collections exceeded a revenue ceiling established through a statutory formula. 

    The new revenue ceiling is equal to FY2021 actual General Fund revenue adjusted over time by the inflation rate multiplied by a fixed factor (1.425) set in statute. To illustrate how it will work, consider current revenue projections:  Inflation is projected at 2.23 percent. If these projections hold, the trigger cap allows for revenue growth of 3.18 percent (2.23 percent inflation times 1.425).  FY2022 General Fund revenue is expected to grow by 6.09 percent from FY2021 levels.

    Based on these assumptions, the CY2023 income tax rate would have to be reduced by a percentage tied to the amount by which actual General Fund revenue exceeds the statutory CPI-adjusted revenue ceiling.

    The COVID Pandemic Impact on FY2021 Revenue

    Let’s be clear. The architects of the 2015 income tax rate trigger could not have envisioned the disruptions caused by the COVID worldwide pandemic, especially the virus’ impact on the state’s economy and its fiscal effects. Given this, examining the intent of the tax rate trigger, at least in the current context, is a bit of a moot point. All the more reason for the current cohort of policymakers (new legislative leaders in each chamber and a new governor) to reexamine certain provisions of the automatic rate trigger with a focus on the longer-term, lasting effects of this fiscal mechanism.

    Of particular note for state policymakers is the fact that the revenue cap under current law is permanently tied to FY2021 General Fund revenue.  

    Why does this matter? Because FY2021 will be a uniquely bad year for state tax collections. This is the first full year in which state revenue will be impacted by the COVID recession.  Current projections, even before the expected negative revenue impact of the unemployment benefit exemption, call for FY2021 General Fund revenue to be down by more than 3.6 percent from FY2020.  Further, FY2020 revenue was already down 1.2 percent from FY2019.  

    In short, the trigger’s permanent base year will most likely be the low point for revenue collections affected by the COVID-19 pandemic slowdown.  On the flip side, the depressed FY2021 revenue base is a key reason strong revenue growth is projected in FY2022. Underlying this revenue rebound is a gradual return to a more fully open economy.

    With the automatic rate trigger provision is on a path to collide with a COVID-induced revenue dip, discussions have surfaced regarding how to soften the expected fiscal impact by modifying the base year of the rate trigger mechanism.  One suggestion already made would change the base year from FY2021 to a multi-year average revenue figure.  Other proposals would establish a corresponding revenue “floor” to keep General Fund revenue from falling below a certain amount. 

    Illustrating the Impact of Base Year Adjustments

    As policy discussions move forward on this topic and specific alternatives offered, we set out to model some possible proposals and what they would mean for the state’s finances.

    The chart below examines the potential impact of the trigger on state General Fund revenue under two base-year revenue scenarios.  The blue line shows actual and projected General Fund revenue through FY2025.  The orange line shows the long-term projection for capped General Fund revenue under the trigger assuming an inflation trend of 2 percent.  Because the trigger is tied to the COVID-depressed base year, the orange trend line reflects inflationary growth from the FY2021 low point. Most striking is the fact that current revenue projections (blue line) are ABOVE the rate-triggered revenue limit; an average of $238 million per year between FY2022 and FY2025.

    Adjusting the trigger’s base year shifts that capped revenue trend line upward more or less in parallel with the current FY2021 base revenue projection. The chart shows the impact of two alternative base year adjustments. The yellow line displays future capped revenue under the trigger when the base year is revised to a three-year average (FY2019-FY2021) of General Fund revenue.  This increases the capped revenue in FY2022 by around $324 million, enough to negate the rate reduction that would otherwise be implemented when the FY2021 low-revenue mark is used as the base. It is more forgiving than a trigger based solely on FY2021, but still incorporates two years of revenue below trend in the calculation.

    Another approach would be to push back the base year to a pre-pandemic year and build the trigger mechanism from there. The gray line shows the impact of using FY2019 as the base year.  Using the FY2019 General Fund revenue with three years of realized CPI inflation through FY2022 increases capped revenue for FY2022 to $12.3 billion, about $1.1 billion above the expected revenue generated under the current law trigger.  The revenue gap between this scenario and the current-law projection gradually increases over time as the dollar change in revenue tied the 2 percent inflation adjustment is larger with the higher revenue base.  

    Most significantly, adjusting the base year to FY2019 essentially would allow General Fund revenue to return to its long-run trend before the pandemic without setting off the rate trigger.  When lawmakers added the trigger to the Income Tax Act in 2015, this gray line looked a lot more like the capped revenue path that would have been anticipated at that time.  Notably, if the inflation-adjusted revenue ceiling calculation relied upon FY2016 as the base year, rather than delaying until FY2021, capped General Fund revenue in FY2022 would be $622 million higher than under the current law.  Next January, state economists are required under current law to crunch the numbers and make a final determination as to whether the income tax rate should be reduced under the trigger based on revenue and inflation data.  Before that happens, state policymakers would be well advised to reexamine the trigger’s base year and assess reasonable alternatives that would avoid permanently locking some of COVID’s negative fiscal impacts into Michigan’s future revenue picture.   Fortunately, time remains to do that.

    About The Author

    Bob Schneider

    With COVID’s Fiscal Impact Clearer, Lawmakers Should Re-examine Michigan’s Automatic Income Tax Rate Trigger

    In A Nutshell

    • A rate trigger added to Michigan’s personal income tax law in 2015 will likely reduce the state’s income tax rate and associated income tax revenues in 2023.
    • The rate trigger is pegged to Fiscal Year (FY)2021 General Fund revenue collections, which will fall well below recent trend levels because of the COVID-19 economic slowdown.
    • Revisions to the trigger’s base year would allow General Fund revenue to eventually return to its pre-pandemic trend.

    As we examined previously, official state revenue projections from January’s revenue estimating conference suggest that Michigan’s income rate will need to be lowered from the current 4.25 percent rate to 4.15 percent beginning in January 2023. The automatic rate reduction trigger was included in a 2015 road funding plan.  

    And now, the exemption of certain federal unemployment benefits from state taxation will create an even steeper rate reduction. The exemptions, part of President Biden’s recently-signed $1.9 trillion American Rescue Plan Act, will reduce state revenues beyond what was projected at January’s revenue estimating conference.

    As a refresher, the 2015 road funding package, in addition to raising state transportation taxes, also established an effective ceiling on the growth of state General Fund revenues.  Starting in 2023, the income tax rate would be subject to an automatic reduction following any year where state General Fund revenue grew faster than the U.S. Consumer Price Index (CPI) inflation rate.  The amount of any reduction would be based on the amount by which actual General Fund collections exceeded a revenue ceiling established through a statutory formula. 

    The new revenue ceiling is equal to FY2021 actual General Fund revenue adjusted over time by the inflation rate multiplied by a fixed factor (1.425) set in statute. To illustrate how it will work, consider current revenue projections:  Inflation is projected at 2.23 percent. If these projections hold, the trigger cap allows for revenue growth of 3.18 percent (2.23 percent inflation times 1.425).  FY2022 General Fund revenue is expected to grow by 6.09 percent from FY2021 levels.

    Based on these assumptions, the CY2023 income tax rate would have to be reduced by a percentage tied to the amount by which actual General Fund revenue exceeds the statutory CPI-adjusted revenue ceiling.

    The COVID Pandemic Impact on FY2021 Revenue

    Let’s be clear. The architects of the 2015 income tax rate trigger could not have envisioned the disruptions caused by the COVID worldwide pandemic, especially the virus’ impact on the state’s economy and its fiscal effects. Given this, examining the intent of the tax rate trigger, at least in the current context, is a bit of a moot point. All the more reason for the current cohort of policymakers (new legislative leaders in each chamber and a new governor) to reexamine certain provisions of the automatic rate trigger with a focus on the longer-term, lasting effects of this fiscal mechanism.

    Of particular note for state policymakers is the fact that the revenue cap under current law is permanently tied to FY2021 General Fund revenue.  

    Why does this matter? Because FY2021 will be a uniquely bad year for state tax collections. This is the first full year in which state revenue will be impacted by the COVID recession.  Current projections, even before the expected negative revenue impact of the unemployment benefit exemption, call for FY2021 General Fund revenue to be down by more than 3.6 percent from FY2020.  Further, FY2020 revenue was already down 1.2 percent from FY2019.  

    In short, the trigger’s permanent base year will most likely be the low point for revenue collections affected by the COVID-19 pandemic slowdown.  On the flip side, the depressed FY2021 revenue base is a key reason strong revenue growth is projected in FY2022. Underlying this revenue rebound is a gradual return to a more fully open economy.

    With the automatic rate trigger provision is on a path to collide with a COVID-induced revenue dip, discussions have surfaced regarding how to soften the expected fiscal impact by modifying the base year of the rate trigger mechanism.  One suggestion already made would change the base year from FY2021 to a multi-year average revenue figure.  Other proposals would establish a corresponding revenue “floor” to keep General Fund revenue from falling below a certain amount. 

    Illustrating the Impact of Base Year Adjustments

    As policy discussions move forward on this topic and specific alternatives offered, we set out to model some possible proposals and what they would mean for the state’s finances.

    The chart below examines the potential impact of the trigger on state General Fund revenue under two base-year revenue scenarios.  The blue line shows actual and projected General Fund revenue through FY2025.  The orange line shows the long-term projection for capped General Fund revenue under the trigger assuming an inflation trend of 2 percent.  Because the trigger is tied to the COVID-depressed base year, the orange trend line reflects inflationary growth from the FY2021 low point. Most striking is the fact that current revenue projections (blue line) are ABOVE the rate-triggered revenue limit; an average of $238 million per year between FY2022 and FY2025.

    Adjusting the trigger’s base year shifts that capped revenue trend line upward more or less in parallel with the current FY2021 base revenue projection. The chart shows the impact of two alternative base year adjustments. The yellow line displays future capped revenue under the trigger when the base year is revised to a three-year average (FY2019-FY2021) of General Fund revenue.  This increases the capped revenue in FY2022 by around $324 million, enough to negate the rate reduction that would otherwise be implemented when the FY2021 low-revenue mark is used as the base. It is more forgiving than a trigger based solely on FY2021, but still incorporates two years of revenue below trend in the calculation.

    Another approach would be to push back the base year to a pre-pandemic year and build the trigger mechanism from there. The gray line shows the impact of using FY2019 as the base year.  Using the FY2019 General Fund revenue with three years of realized CPI inflation through FY2022 increases capped revenue for FY2022 to $12.3 billion, about $1.1 billion above the expected revenue generated under the current law trigger.  The revenue gap between this scenario and the current-law projection gradually increases over time as the dollar change in revenue tied the 2 percent inflation adjustment is larger with the higher revenue base.  

    Most significantly, adjusting the base year to FY2019 essentially would allow General Fund revenue to return to its long-run trend before the pandemic without setting off the rate trigger.  When lawmakers added the trigger to the Income Tax Act in 2015, this gray line looked a lot more like the capped revenue path that would have been anticipated at that time.  Notably, if the inflation-adjusted revenue ceiling calculation relied upon FY2016 as the base year, rather than delaying until FY2021, capped General Fund revenue in FY2022 would be $622 million higher than under the current law.  Next January, state economists are required under current law to crunch the numbers and make a final determination as to whether the income tax rate should be reduced under the trigger based on revenue and inflation data.  Before that happens, state policymakers would be well advised to reexamine the trigger’s base year and assess reasonable alternatives that would avoid permanently locking some of COVID’s negative fiscal impacts into Michigan’s future revenue picture.   Fortunately, time remains to do that.

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    About The Author

    Bob Schneider

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