My wife and I are retired and our only income is from Social Security, pensions and interest. These are our figures for the 2010 tax year: 

Our federal tax for 2010 was $4604. Our state tax was zero. Actually, we got a $691 “refund”, which was our homestead property tax credit. Although our gross income was $70,083, the state paid us. Had our pensions and Social Security been taxable to the extent they are for the federal tax, our state tax would have been $1,336:

$56,097	adjusted gross income from federal return
-9,500	two regular exemptions @ $3,600 plus $2,300 for one senior (me)
46,597
x .0435	the tax rate for 2010
2,027
-691	property tax credit
$1,336

The reason we pay no state taxes is that Michigan doesn't tax pensions or social security. Michigan's personal income tax starts with the adjusted gross income (AGI) from your federal tax return, but then there are "additions" and "subtractions" that are reported on MI-1040 Schedule 1. There are 13 subtractions (the numbers are the line numbers from Schedule 1):

  8.  Income from U.S. government bonds and other U.S. obligations
  9.  Military pay from U.S. Armed Forces
10.  Gains from federal column of Michigan MI-1040D and MI-4797
11.  Income attributable to another state
12.  Retirement or pension benefits
13.  Dividend/interest/capital gains deduction for senior citizens
14.  Social Security benefits
15.  Income earned while a resident of a renaissance zone
16.  Michigan state and local income tax refunds received in 2006
17.  Michigan Education Savings Program
18.  Michigan Education Trust
19.  Venture Capital Deduction
20.  Miscellaneous 

Detailed explanations of each of the subtractions are in the instructions for Schedule 1.

There is no reason for pensions to be exempt. They are a form of wages - a delayed payment of wages. Part of the pension comes from contributions made to the pension fund by the employee, and if those contributions were made from after-tax wages, that part should not be taxed again. The “taxable amount” is the part that has never been taxed.

Governor Rick Snyder has proposed ending the exemption of pensions along with the exemption of dividends, interest and capital gains for senior citizens. He would also do away with the special personal exemption for seniors, which in 2010 was $2300 (on top of the standard $3600). Finally, he would reduce the property tax credit for seniors. This is from the House Fiscal Agency analysis of House Bill 4361:

Under current law, the credit is equal to 60% of the amount by which property taxes (or 20% of rent for renters) exceed 3.5% of household income, up to a maximum of $1,200. For seniors and disabled filers, the credit is equal to 100% of the difference. The proposed changes would adjust the percentage by which property taxes exceed 3.5% of household income to 80% for all filers except disabled taxpayers, who remain at 100%. In addition, the credit will begin to phase-out at an income level of $60,000.

The cost. I have been arguing against the special tax treatment of seniors since 2007. In November of that year, I sent a Freedom of Information Act request to the Department of Treasury asking for a breakdown by item of total "subtractions from income" and they said they didn't have it. The net amount of additions and subtractions are expected to reduce income tax revenues by over $4.6 billion in 2010 (Executive Budget Appendix on Tax Credits, Deductions, and Exemptions, page 63), and although we report them item by item on our Schedule 1, Treasury didn't have totals by item. I followed up with a letter to State Treasurer Robert Kleine saying that the information would be very helpful to policy makers. I urged him to make the system changes necessary to collect the information. Jeff Guilfoyle of Treasury's Office of Revenue and Tax Analysis responded on behalf of Mr. Kleine saying that Treasury had decided to capture the data on 2007 returns, and the data should be available in about a year. So now we have some data. The following figures are from pages 20-21 of Treasury's analysis of the income tax for 2008:

Retirement/Pension Incl. in MI-1040	$20,934,400,000
Dividend/Interest/Capital Gain Exemption	1,088,400,000
Social Security	5,880,300,000
Total:	$27,903,100,000

The AGI for all Michigan taxpayers in 2008 was $257,476,500,000, so the total for the above "subtractions" is 9.2% of AGI. Had that amount been taxed at 4.35%, the rate for 2008, it would have generated over $1.2 billion in revenue.

In 2008, homestead property tax credits received by seniors totaled $349,200,000. (Source: Michigan's Individual Income Tax 2008, page 24)  Had that group not been over 65, the credit would have been 60% of that amount, or $209,520,000. The difference - the senior bonus - is $139,680,000.  

Here are the known revenue losses from special tax treatment of seniors:

Exclusion of pensions, dividends, interest, capital gains and social security (2008)	$1,200,000,000
Homestead property tax credit bonus (2008)	139,680,000
Special exemption for senior citizens (2005; from Jeff Guilfoyle's letter)	29,900,000
Total:	$1,369,580,000

No justification. There is no reason for seniors to get a break on their state income tax. They are no worse off financially than other age groups. Of all the 2008 federal income tax returns from Michigan residents that reported Social Security benefits, 50.2% had AGI over $50,000 (source: IRS report), and when income includes Social Security and/or pensions, the gross is likely to be more than AGI. Seniors are also more likely to have medical insurance, either with their pensions or with Medicare. Anyway, an income tax by definition considers ability to pay: seniors with low incomes would pay little or no tax, just like anyone else with low incomes.

When one group does not pay its share, the burden is greater for other taxpayers. As the Department of Treasury puts it in their analysis of 2008 income taxes (page 19):

The favorable treatment of pension income and interest, dividend and capital gains results in filers with similar income facing significantly different tax burden, with younger filers shouldering a heavier tax burden than older filers.

The Michigan Income Tax was enacted in 1967. Here is a history of changes to the tax that affected seniors.

Income tax breaks for seniors are not unique to Michigan. This report on the website of the National Conference of State Legislators talks about how all 50 states tax pensions and social security. Most states to some extent exempt pensions and social security from their income taxes, but some don't. California taxes pensions, but doesn't tax social security. Minnesota, Nebraska, Rhode Island and Vermont tax pensions and tax social security to the same extent the federal government does.

The following is from a story that appeared in USA Today on 9/17/2010:

Senior citizens are enjoying some of the biggest income gains in decades at a time when every other age group is losing ground in the recession, the Census Bureau reported Thursday. The 31 million households headed by people 65 and older saw their median income rise by a healthy 5.8% in 2009 after inflation and 7.1% since the recession began in December 2007. Every other age group has suffered income losses of at least 4% during the recession, the data show. Seniors got a lift last year from a $250-per-person Social Security bonus included in the federal stimulus program. That helped boost income more than any year since 1973 and led to seniors out-earning 15-to-24-year-olds for the first time.

"Retired folks are sheltered from big swings in the labor market," says Heidi Shierholz, economist at the liberal Economic Policy Institute. Deflation also helped because Social Security checks didn't decline even though prices did, she says. By contrast, the median income of working-age households has tumbled 4.6% in the recession.

Public outcry. There has been a huge outcry from the public about Governor Snyder's proposal to tax pensions. A lot of it has been from Democrats who, while they secretly agree that seniors should receive no special treatment, are nevertheless using the issue to beat up on the Governor. They like to claim that those poor seniors are being taxed to pay for a business tax cut. But not taxing the income of seniors is unfair regardless of what happens to business taxes; the connection is artificial.

And many pension recipients are not actually seniors. UAW members working for GM, Ford or Chrysler can retire with full pensions after 30 years on the job, as young as 50. Same goes for public school employees. State police can retire at any age after 25 years of service. Other state employees can retire at 55 with 30 years of service.

Finally, don't feel sorry for us seniors because we are on a "fixed income". First of all, being able to count on that check coming every month for the rest of your life without having to anything (further) to earn it is really delightful. Secondly, our income is not "fixed". Social security benefits increase annually to keep up with the cost of living. State and public school employee pensions increase by 3% each year regardless of the cost of living. The increase is not compounded, but does accumulate. For state retirees, the increase is limited to $300 a year.

Protecting the lowest incomes. There is one big flaw in the Governor's personal income tax plan, but it is flaw that has always been there. The personal exemptions are not nearly enough to protect really low incomes from the tax. I offered a solution in a letter emailed to Representative Jud Gilbert, the sponsor of H.B. 4361, on April 4, 2011:

Dear Representative Gilbert,

I have a suggestion that will make House Bill 4361 more acceptable to people concerned about taxing seniors. It is a simple change that will make sure no household with income below the poverty level is taxed. 

The poverty guidelines calculated by the U.S. Department of Health and Human Service are at this site: http://aspe.hhs.gov/poverty/10poverty.shtml. Here they are, compared with the $3700 per person personal exemption totals in House Bill 4361:
 

Family Size	Poverty Guidelines	$3700 per Person
1	$10,830	3,700
2	14,570	7,400
3	18,310	11,100
4	22,050	14,800
5	25,790	18,500
6	29,530	22,200
7	33,270	25,900
8	37,010	29,600
+1	+3740	+3,700

As you can see, the income protected by the $3700 per person exemption is way below the poverty level. No one with income below the poverty level should be expected to pay income taxes. 

This could be fixed by allowing each household a $7500 exemption in addition to the $3700 per person:
 

Family Size	Poverty Guidelines	$3700 pp +$7500
1	$10,830	11,200
2	14,570	14,900
3	18,310	18,600
4	22,050	22,300
5	25,790	26,000
6	29,530	29,700
7	33,270	33,400
8	37,010	37,100
+1	+3740	+3,700

Consideration should also be given to a deduction for out-of-pocket medical expenses.

These measures would, of course, reduce revenue from the tax. That could be made up by increasing the rate.