Taxing pensions is an explosive move aimed at fairness

(Originally published February 24, 2011) There’s no doubt that the biggest and most controversial idea in Gov. Rick Snyder’s proposed state budget is the one calling for the state to tax income from both public and private pensions.

As thing now stand, pensions for retired Michigan public employees – teachers, police and other government employees and former elected officials – are totally exempt from the 4.35 percent state income tax. Private pensions and other retirement income are exempt up to $45,120 for individuals, $90,240 for joint filers.

Some of that would change under the governor’s proposed budget. Henceforth income from both public and private pensions, including IRA’s and 401(k)’s, would be subject to state income tax, though Social Security will remain untaxed.

Taxing pensions, by the way, is something most states already do. As it now stands, only a handful of the 41 states that levy an income tax don’t collect it on pensions; beside Michigan, the others are Alabama, Mississippi and Pennsylvania.

The financial stakes are enormous. Administration officials estimate the state take from taxing pensions at $900 million, which goes a long way to plug the hole left by $1.2 billion tax cut for businesses that’s also embedded in the Snyder budget.

Not surprisingly, lots of seniors are enraged at the idea. That‘s a non-trivial political consideration; older folks tend to vote at a far higher rate than younger ones do. Some retirees have told me they intend to leave the state — PDQ — if any tax on pensions is passed.

Michigan AARP President Eric Schneidewind said Snyder had “declared war on senior Michiganders.”

Getting it passed may not be easy, and there may be state constitutional problems with the proposal, as well. Article 9, Section 24 of the Michigan Constitution says:

“The accrued financial benefits of each pension plan and retirement system of the state and its political subdivisions shall be a contractual obligation thereof which shall not be diminished or impaired thereby.” Does that mean public pensions can’t be taxed?

I’m not a lawyer, but I’ve talked with several who have studied the matter — but who refused to be quoted by name.

They draw a distinction between the pension benefits themselves, which are contractual and cannot be reduced, and the taxes that could be levied on them.

“The Constitution doesn’t talk about the net after-tax benefits from pensions,” one told me. Attorneys do think, however, that this matter “almost certainly” will be challenged in court.

According to our new governor, all this has to do with fairness.

At present, according to an administration analysis, a retired senior couple with household income of $59,000 from pension income and social security, would owe no state income tax. In fact, they’d get a refund check for several hundred dollars from the state.

However, a non-senior working couple with children whose household income is $10,000 less than the seniors would have to pay more than $1,000 in Michigan income tax!

There are also inequalities between seniors. Older Michigan residents who are still working are taxed on income from their jobs, while those who have retired and get income from a pension are not.

The Snyder administration maintains that one’s tax liability ought not be determined by whether or not the decide to retire.

Nor do they think people should be penalized for working. There is also an argument of generational fairness: As things now stand, young people who are working and being taxed on their income are, in practice, subsidizing older people whose retirement income is not taxed. As one senior Snyder advisor told me, “As things stand, we’re asking young people who have to work to subsidize folks who have chosen to retire. Public employee retirees benefit from services provided by the state, just like anybody else.

“So why exempt them from helping to pay for them?”

Old hands around Lansing recall that the decision to exempt private pensions from state income tax was taken in the mid 1990’s, an era when the state seemed to be rolling in money. “We didn’t tax pensions for public employees, and it didn’t seem fair to be taxing private pension income,” a former legislative leader told me.

But that was then. And this is now, when the world economy has changed and the state desperately needs to get its financial house in order … once and for all.

So what’s my verdict? I’m left with two thoughts:

1) It’s only fair to treat pension incomes alike, whether they’re for public or private sector employees. Either tax both or tax neither. But don’t discriminate between them.

2) Sooner or later, Michigan has got to start looking ahead toward the future rather than staring in the rear view mirror. We simply cannot allow our state to become a tax-free haven for older people while driving the younger ones away. Whether you agree with him of not, our governor has attempted to make a start.

Editor’s Note: Former newspaper publisher and University of Michigan Regent Phil Power is a longtime observer of Michigan politics and economics. He is also the founder and president of The Center for Michigan, a nonprofit, bipartisan centrist think-and-do tank, designed to cure Michigan’s dysfunctional political culture. The opinions expressed here are Power’s own and do not represent the official views of The Center. He welcomes your comments at ppower@thecenterformichigan.net.