Michigan Governor Gretchen Whitmer (D) this week released her fiscal year (FY) 2020 budget bill, central to which is a 45-cent gas tax increase and a new entity-level tax on unincorporated businesses.
Currently, Michigan’s fuel excise tax is 26.3 cents per gallon (cpg). Under the governor’s proposal, a 45-cent increase would occur in three 15-cent increments over a one-year period: the excise tax would reach 41.3 cpg in October 2019, 56.3 cpg in April 2020, and 71.3 cpg in October 2020.
While the proposed excise tax increase alone would make Michigan’s gas tax the highest in the nation, it’s important to keep in mind that per-gallon excise taxes are not the only taxes states collect on gasoline. In fact, Michigan is among the few states that applies its sales tax to purchases of fuel, bringing the total state tax on a gallon of gas to an average of 44.13 cpg, the sixth-highest in the nation. As such, a 45-cent increase would bring Michigan’s total average gas tax to 89.13 cpg, by far the highest in the nation, and over 30 cents higher than in Pennsylvania, which currently has the highest gas tax (58.7 cpg). The result: Michiganders would be paying double the state taxes they currently pay at the pump.
To offset the gas tax increase for lower-income residents, this proposal would incrementally double the Earned Income Tax Credit (EITC) from 6 percent to 12 percent of the federal credit amount, starting with a 4 percent increase in FY 2020 and an additional 2 percent increase in FY 2021.
In addition, the governor’s budget would create a new entity-level tax on pass-through businesses, including sole proprietorships, partnerships, limited liability companies (LLCs), and S corporations. Currently, the income of unincorporated businesses is taxed at Michigan’s flat 4.25 percent individual income tax rate. That’s because, with limited exceptions, pass-through businesses are taxed under federal and state individual income tax codes. It’s in their very name: business income passes through to owners’ individual income tax returns.
However, under the governor’s proposal, pass-throughs would be subject to an entity-level tax at a higher rate of 6 percent. Business income would still technically flow through to owners’ individual income tax returns, but owners would receive an offsetting credit so only non-business income would be taxed at the lower 4.25 percent rate.
The governor’s proposal cites “tax parity” as the justification for the tax increase on pass-through businesses, since traditional C corporations are subject to a 6 percent income tax. It’s important to keep in mind, though, that parity of rate does not equate to parity of tax burden. Strict comparisons cannot be made between corporate income tax rates and individual income tax rates, in part because corporations are taxed at the entity level and again when profits are distributed, and because differences exist between individual and corporate income tax bases. If parity truly becomes an issue that prevents businesses from incorporating when they otherwise would, there are better solutions than raising tax rates on small businesses and forcing them to pay taxes at the entity level.
Another reason for the tax increase on pass-throughs is as an offset to “pay for” the creation of a new income tax exemption for pension income. Currently, Michigan properly treats most retirement income, including pension income, like other forms of income for tax purposes, but the governor’s proposal would carve pension income out of the income tax base. The governor’s proposal characterizes this move as a repeal of the “pension tax,” but that term is misleading because pension income is not subject to a special tax; it is treated like other forms of income and taxed at the state’s 4.25 percent rate. Exempting pension income would in fact create a disparity in the tax treatment of retirement income. A more neutral approach is simply to tax all income, whether personal income, pass-through business income, or retirement income, at the state’s competitive, flat rate.
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