The grad tax will hit and hurt the middle class

As the economy grows, downward bracket creep will envelop more middle income earners.

David G. Tuerck

August 1994

The graduated income tax referendum that goes before Massachusetts voters in November promises middle-class tax relief. However, should it pass, it almost certainly guarantees a tax increase for many middle-income taxpayers.

The measure would amend the state constitution to require the imposition of a graduated in come tax. One proposed statute that would implement the grad tax replaces the existing flat tax with a system of new tax brackets, rising, for married couples, from 5.5 percent on income less than $81,000 to 9.8 percent on income greater than $150,000.

The debate over this proposal centers on its effects on middle-income taxpayers. One side touts the grad tax as unambiguously beneficial to these taxpayers as an antidote to the tax system "stacked against the middle class and the poor." Meanwhile the other side condemns the grad tax as "a tax on the American dream."

This emphasis on the middle class and on middle class values is a predictable feature of ballot politics. Low income taxpayers are generally expected to vote yes and high income taxpayers to vote no on the grad tax. But, middle-income voters either way. How they vote will depend upon which of two very different views of tax policy they decide to endorse.

One option is to take a "static" view of the economy. This means believing that changes in tax rates have no effect on people's economic behavior. Thus, for example, the tax rate on your income could be increased from 10 percent to 90 percent and you would go on working just as hard as before. You would make no changes in your work efforts even if your $9 per hour is after-tax wages were reduced to $1 per hour in after -tax wages.

The same view also means believing that your standard of living will remain fixed for the rest of your working life. In a static world, there is no such thing as economic progress.

Viewed in this way, the grad tax looks like a good deal to middle-income taxpayers. It reduces state tax liabilities for married filers making less than about $100,000. So it's a good deal as long as your income never exceeds this amount. It's a good deal, too, as long as the increased tax rates imposed on high-income filers do not discourage them from working, saving or creating jobs in Massachusetts.

The world, however, is not static. Changes in tax law do effect peopleÍs economic behavior. People work and save less when they have less incentive to work and save. Furthermore, taxpayers, do not expect their living standards to remain fixed for the rest of their working lives. They want and expect their living standards to improve. The American dream lives.

A "dynamic" view of the economy incorporates these realities. It recognizes that changes in tax law affect taxpayers' economic decisions and that the economy itself tend to improve over time.

It is odd that anyone would expect middle-income voters to adopt a static view of the economy. Yet, the grad tax campaign is largely predicated on their willingness to do so.

These realities are particularly important to the middle class. Lacking the social or financial safety nets available to low and high-income taxpayers, middle-income taxpayers care most about how higher taxes might weaken the economy. Likewise, it is the middle-income taxpayers whose work and saving in the years to come will lift them from the lower to higher brackets instituted by the grad tax, should it become law.

It is odd in this light that anyone would expect middle-income voters to adopt a static view of the economy. Yet, the grad tax campaign is largely predicated on just that. A report repeatedly cited in support of the campaign concludes that the grad tax lowers taxes for 92 percent of filers affected by it. The report, which was prepared by the Massachusetts Department of Revenue, also concludes that the grad tax is "revenue neutral," which is to say that neither increases nor decreases the amount of revenue collected under the income tax.

The authors of the report admit that their analysis was static in nature. For some reason, the dynamic economic model to which they ordinarily turn in analyzing tax law changes was not used in examining the grad tax.

What this means is that the findings of this report are of almost no value in assessing the effects of the grad tax on taxpayer welfare or on tax revenues. It is simply impossible to analyze a tax law change as sweeping as the grad tax without taking into account how the change would effect taxpayer behavior. Until someone develops a dynamic model equal to the task, our only recourse in analyzing the grad tax is to make whatever educated guesses we can about its dynamic effects.

For the short run, one fairly safe guess is that the grad tax would be revenue negative, not neutral: The higher brackets imposed on high-income filers would lead them to reduce their taxable income, through tax shelters, reduced work or other legitimate means. Massachusetts would thus take in less revenue than predicted by grad tax proponents. Since high-income filers pay a large percentage of state income taxes (the richest 20 percent pay about 60 percent), the revenue shortfall from this quarter would probably more than offset any unanticipated revenue gains from other quarters.

If this turns out to be the case, the grad tax would cause the state to lose revenues in the short run. The state would have to cut services or raise taxes. Between the two, it is easy to guess what would happen. We would get what businessman Richard Valentine of the Massachusetts Business Association calls "downward bracket creep" - a rise in taxes brought about by a reduction of the income threshold above which the higher tax rates apply.

As for the long-run, no guesswork is needed. Even indexed against inflation, the grad tax amounts to a built-in tax increase on the middle class.

This is because middle-income taxpayers enter the higher tax brackets imposed by the grad tax as their "real," inflation-adjusted taxable income rises. Real taxable income rises as taxpayers get raises, enter the labor force or expand their work hours.

The real per capita personal income of the average American rose by 86 percent over the past 30 years, for an average annual growth rate of 2.1 percent. The real taxable income per Massachusetts taxpayer rose at an average annual rate of about 2.5 percent from 1981 to 1991. The Conference Board predicts that, as a share of all US households, those making more than $100,000 will rise by 80 percent over the current decade.

This means that, under the grad tax, many thousands of middle-income households can expect to pay higher taxes over their working lives. Consider for example, two married taxpayers, age 35, with two children and with a combined income of $70,000. Suppose their standard of living, measured by their inflation adjusted income, grows annually by 3 percent until they retire at the age of 65. They would over this period, end up paying about $7,000 more in combined federal and state taxes under the grad tax than under the present law. Similar results can be obtained for other middle-income taxpayers.

Opponents emphasize that the grad tax would make it easier for the Massachusetts legislature to raise taxes in the future. True, but the grad tax will cause future taxes to rise even if the legislature does nothing more to raise them. All that is needed is normal economic growth of the kind that the static view ignores.

A recent Boston Herald poll shows an erosion of political support for the grad tax proposal. Perhaps middle-income voters are beginning to see the proposal for the snake oil it really is. For them the grad tax is indeed a bad tax.

David G. Tuerck is executive director of the Beacon Hill Institute and chairman and professor of economics at Suffolk University.

This article first appeared in the Boston Sunday Herald on June 5, 1994.

Of interest: BHI's Grad Tax Archives
Texts of Ballot Questions 6 & 7
Questions 6 & 7 Final Election Results
Selected Bibliography

Format revised on August 18, 2004