Tax rate cut would be best

David G. Tuerck and Kathleen M. Lang

July 1996

Because of a surplus of state budget, Massachusetts taxpayers stand to pay $146 million to $206 million less in 1996 taxes than expected (provided the legislature doesn't spend it first). Good news? Sort of. Under the method prescribed by law, the money will be returned through a one time reduction in taxpayers' personal income exemption.

This, however, will do little to stimulate the economy. A different method would, on the other hand, do much to stimulate the economy. This method, readily available to the legislature and employed before, would spur the creation of 19,900 to 27,800 new jobs, bring about $1.4 billion to $2.1 billion in new capital spending, and increase annual wages of Massachusetts workers by $667 million to $932 million per year.

By way of background, Gov. William F. Weld recently announced a "fiscal dividend" for Massachusetts taxpayers. Because FY 1996 collections will exceed projections by $240 million to $300 million, taxpayers can look forward to a break on their 1996 taxes. The first $94 million of this surplus will go into the state's stabilization fund, leaving $146 million to $206 million to be returned to taxpayers.

According to law, a one-time surplus of this kind must be returned through a temporary increase in personal exemption. In this instance, the personal exemption would increase from $4,400 to $5,720 for joint filers. The governor has urged the legislature to return the money in this fashion "to its rightful owners" and, in so doing, to resist the temptation to increase spending.

But there are two ways to cut taxes and refund the surplus. One is by changing the tax base (taxable income). The other is by changing the tax rate. Suppose that the tax base is $100 billion and the tax rate is 5 percent, so that the government collects $5 billion in taxes. Then the government can "refund" by either (a) shrinking the tax base by $2 billion, or (b) cutting the tax rate to 4.90 percent. While the two methods may look identical, they are widely different with respect to their economic effects.

Temporarily raising the personal exemption reduces the tax base, but leaves largely unchanged the cost of getting workers to expand their hours. A permanent reduction in the tax rate, on the other hand, reduces the cost of labor and thus significantly expands employer demand for labor.

A one-time refund to Massachusetts taxpayers. however well-intended, will therefore do little to encourage job creation and stimulate state economic activity. In place of a one-time personal exemption increase, the Beacon Hill Institute suggest returning the money through a permanent reduction in the income tax rate. Such a reduction would create and increase wages and capital spending in Massachusetts.

Current taxable personal income in Massachusetts is $100.148 billion. Taxed at the current rate of 5.95 percent, personal income tax revenue would be $5.959 billion in 1996. Lowering the personal income tax rate between 5.74 and 5.80 percent would enable the state to return $146 million to $206 million in surplus revenues to taxpayers.

Returning this revenue by reducing the personal income tax rate would generate the increased jobs, wages and capital spending summarized below.

Number of new jobs 19,900 to 27,800
Rise in annual wages $667 to $932 million
New capital spending $1.4 to $2.1 billion
Tax refund(“Static”revenue loss) $146 to $206 million
“Dynamic”tax-revenue gain $39 to $54 million
Net tax-revenue loss $107 to $152 million

It would even produce A fiscal dividend for the state, insofar as the expansion in jobs and wages would increase the tax base, bringing in new revenues to offset partially the initial "refund." This "dynamic" tax-revenue gain, ranging from $39 million to $54 million, would cause the net revenue loss to be between $107 million and $152 million.

Some Massachusetts legislatures are arguing that the state could not "afford" to give back any of the surplus revenue, that it should instead "invest" the money in new government projects. But these legislators have things backwards. That the state has surplus revenue shows that the tax rate has been too high, destroying jobs that would have been created if the tax rate had been lower in the first place.

In practical terms, the state government would never miss the $152 million that, at most, it would lose by instituting a permanent rate reduction. Tax revenues have grown at an average annual rate of almost 5 percent over the last four years. A net revenue loss of $152 million would be less than 1 percent of state spending.

George Will has said, "The only news is economic news, and the economic news is bad." And so it is with this supposed windfall to Massachusetts taxpayers. The budget surplus and the tax cut it makes possible are signs that the tax rate has been too high. Good economic news will come when the legislature lowers the tax rate permanently and by enough to prevent future surpluses.

David G. Tuerck is executive director of the Beacon Hill Institute and chairman and professor of economics at Suffolk University. Kathleen M. Lang is a BHI Research Associate. This article first appeared in the July 27, 1996 issue of Mass High Tech.

Format revised on 18 August, 2004