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THE ECONOMICS OF TAX REDUCTION:
Clean Cut or Compromise
April 5,2002

The Massachusetts state tax on personal income is 5.85% and, under current law, will fall to 5.75% by 2002. The Fiscal Year 2001 budget proposed by Governor Cellucci and a measure to be placed on the November ballot would further cut the tax rate, in stages, to 5% in 2003.

Debate over this proposal has so far focused on its "affordability": whether the state can, in good conscience, forgo some $1 billion annually in tax revenue (roughly the estimated eventual “cost” of the tax cut) in order to provide what, for the average household, amounts to a few hundred dollars a year in new disposable income. Thus put, the question seems to pit public spiritedness against self-interest – paying for the Big Dig, protecting the state's bond rating, and financing innumerable capital projects and government programs, rather than extending the family vacation for another day or two.

Absent so far from this debate has been a consideration of the benefits that the proposed tax cut would confer on the state economy. Insofar as Massachusetts is a high-cost-of-living state, made all the more so because of its high personal income tax, this is an important matter. The state income tax poses an obstacle to economic growth. It makes it more difficult for Massachusetts employers to attract workers. It widens the gap between job opportunities – particularly high-tech, high-paying job opportunities – and the availability of workers qualified to fill them. In a new economy dominated by footloose dot-com companies able to operate as easily in no-tax New Hampshire as in high-tax Massachusetts, this is no small consideration.

This reasoning reminds us that there are economic benefits from the proposed tax cut to weigh against the spending priorities that it is deemed to threaten. Failure to consider these benefits biases the debate against more rapid economic growth and in favor of continued growth in state government spending.

Tax Policy Options

It appears now that there are three options before the legislature. The first is to preserve the status quo, in which case the personal income tax rate will fall to 5.80% in 2001 and then go down to 5.75% in 2002, where it will remain. The second is, as the Governor proposes, to cut the tax rate to 5.60% in 2001, to 5.30% in 2002 and finally, to 5% in 2003. The third, proposed by the Massachusetts Taxpayers Foundation as a kind of compromise between these options, would cut the tax to 5.75% in 2001 and thereafter by .1-percentage-point increments for every 2.5% increase in real personal income, until the rate reaches 5%.

The MTF proposal would make the .1-percent-point cuts after 2001 contingent on expansion of the state economy. Beginning in 2002, the tax rate would go down .1 percent point for each 2.5% increase in “real” inflation-adjusted personal income, as recorded over the one-year period that ended one and a half years before the tax cut goes into effect. From 1994 to 1999, the average annual rate of growth of real state personal income has been 3.4%. Barring a substantial softening in the economy, the MTF proposal would bring the rate down to 5% by 2007.

Table 1
Personal Income Tax Rates: Three Options (%)

Year

(1) Current Law

(2) Governor's/Ballot Proposal

3) MTF Proposal

2000
5.85
5.85
5.85
2001
5.80
5.60
5.75
2002
5.75
5.30
5.65
2003
5.75
5.00
5.55
2004
5.75
5.00
5.35
2005
5.75
5.00
5.25
2006
5.75
5.00
5.05
2007
5.75
5.00
5.00
2008
5.75
5.00
5.00
2009
5.75
5.00
5.00

Table 1 compares these three options for the years 2000-2009.

This assumes that real personal income grows by 3.2% annually, which is in line with recent experience.

STAMP Estimates

The Beacon Hill Institute has developed its State Tax Analysis Modeling Program (STAMP) for the purpose of determining the economic effects of state tax-law changes. It has applied STAMP to five states, including Massachusetts, and will have applied it to six additional states by June 2000. We used the Massachusetts STAMP to evaluate Option 2 (cutting the tax to 5% in three years, as under the Governor's proposal) and Option 3 (cutting the tax to 5% in seven years, as under the MTF proposal).

The Governor's Proposal

Table 2 shows how the Governor's proposal (Option 2) would affect employment, the capital stock (factories, trucks, office computers, etc.), payrolls and tax revenue over the period 2001 to 2009. This proposal would create 74,505 new jobs, $956 million in new capital and $3.733 billion in new payrolls by 2003.

Ignoring these effects (taking the "static" estimate that omits "dynamic" effects), Option 2 would "cost" the state $1.244 billion in annual tax revenue by 2003. Because, however, the new jobs and payrolls would create new tax revenues, ignoring these dynamic effects means exaggerating the revenue loss – a common error. Subtracting the $179 million in new revenues created by the expansion in payrolls, we find that the actual revenue loss (the “dynamic” estimate) in 2003 would be $1.065 billion.

Table 2
Economic Effects of Governor's Tax Proposal

      Change in Tax Revenue
  Employment Capital Stock Payroll Dynamic Estimate Static

Estimate

Dynamic Effect
    $ millions $ millions $ millions $ millions $ millions
2000
0
0
0
0
0
0
2001
19,391
251
873
-246
-294
48
2002
44,124
568
2,102
-596
-704
107
2003
74,505
956
3,733
-1,065
-1,244
179
2004
75,038
962
3,957
-1,129
-1,319
190
2005
75,574
969
4,194
-1,196
-1,398
201
2006
76,113
976
4,446
-1,268
-1,482
214
2007
76,657
983
4,712
-1,344
-1,571
226
2008
77,205
990
4,995
-1,425
-1,665
240
2009
77,756
997
5,295
-1,510
-1,765
254

It is important to understand that these figures represent changes from the “baseline” defined by Option 1 or current law. That is, there would be 74,505 more jobs in 2003 under Option 2 than under Option 1, $956 million more capital and about $1 billion less tax revenue.

The MTF Proposal

Table 3 provides comparable data for the MTF proposal (Option 3). Under this proposal, and given annual economic growth of 3.2%, the tax rate would be 5.55% under the MTF proposal, as opposed

Table 3
Economic Effects of MTF Proposal

      Change in Tax Revenue
  Employment Capital Stock Payroll Dynamic Estimate Static

Estimate

Dynamic Effect
    $ millions $ millions $ millions $ millions $ millions
2000
0
0
0
0
0
0
2001
4,837
63
218
-61
-73
12
2002
9,755
126
465
-131
-156
25
2003
19,707
254
987
-279
-332
53
2004
39,813
513
2,099
-595
-703
108
2005
50,196
646
2,786
-791
-932
141
2006
70,987
911
4,146
-1,182
-1,383
201
2007
76,657
983
4,712
-1,344
-1,571
226
2008
77,205
990
4,995
-1,425
-1,665
240
2009
77,756
997
5,295
-1,510
-1,765
254

to 5% under the Governor's proposal in 2003. The economic effects of the MTF proposal are correspondingly smaller. By 2003, the MTF proposal would generate 19,717 new jobs, $254 million in new capital and $987 million in new payrolls. It would impose a cost of $279 million in lost tax revenues (taking dynamic effects into account).

Because the MTF proposal phases in the tax cut more slowly than the Governor's, the state would reap the benefits of cutting the tax to 5% more slowly. The benefits generated by the MTF proposal are smaller than those generated by the Governor's proposal until 2007.

The MTF and Governor's Proposals Compared

Table 4 shows the differences in the two proposals' economic effects. We see, for example, that, in 2003, there would be 54,798 more jobs under the Governor's proposal than under the MTF proposal.

Table 4
Differences in Economic Effects: Governor's Proposal v. the MTF Proposal

      Change in Tax Revenue
  Employment Capital Stock Payroll Dynamic Estimate Static

Estimate

Dynamic Effect
    $ millions $ millions $ millions $ millions $ millions
2000
0
0
0
0
0
0
2001
14,554
188
655
-185
-220
35
2002
34,370
442
1,637
-465
-547
82
2003
54,798
701
2,745
-786
-912
126
2004
35,224
450
1,857
-533
-615
82
2005
25,377
324
1,408
-405
-466
61
2006
5,127
65
299
-86
-99
12
2007
0
0
0
0
0
0
2008
0
0
0
0
0
0
2009
0
0
0
0
0
0
Sum
169,450

NA

8,603
-2,461
-2,860
399

Similarly, there would be $701 million more in capital, $2.745 billion in payrolls and $786 million less in tax revenue. The differences get smaller as we approach 2007, when the tax rate would go to 5%.

One way to compare the two proposals is to assess the cumulative differences in certain effects over the six years, 2001 through 2006, during which the tax rate under the MTF proposal would exceed that under the Governor's proposal. We see, for example, that the cumulative difference in jobs (we could interpret this as total “person-years” of work) would be 169,450. Similarly, the cumulative difference in payrolls would be $8.603 billion. The Governor's proposal would “cost” the state altogether $2.461 million more in tax revenue over the period 2001-2006.

How Much In Tax Cuts Can the Commonwealth “Afford”?

If we are to use the rhetoric now fashionable to discuss these matters, the MTF proposal reduces the revenue “cost” of cutting the tax by an average of $410 million per year for the period 2001 to 2006, while sacrificing benefits of $1.434 billion in average annual payrolls. That leaves us with the question whether the MTF proposal is, indeed, a sensible compromise or merely a stalling tactic.

Let's ask why any compromise is needed. The answer, we are told, lies in Big Dig cost overruns, unfunded capital projects and other spending priorities that would be threatened by the larger revenue losses the Governor's proposal would impose. In evaluating this argument, consider the following facts:

• Since 1994, state revenues have been growing by nearly $1 billion per year or at about twice the inflation rate. The state will bring in about $21.3 billion in FY 2000. This means that, without any tax cut and at current rates of growth, the state will bring in about $24.3 billion in FY 2003. Adopting the Governor's tax cut means that it will bring in about $23.3 billion or about 4% less, instead. After 2003 and assuming continued economic growth, the state could go right on adding a billion dollars a year - and more - to its budget, with the tax rate at 5%. The Governor's proposal amounts, therefore, to a mere temporary slowdown in the expansion of state government.

• Over the last eight years, the state has consistently underestimated tax revenues, running up huge surpluses, portions of which disappear into spending projects that are unfunded during the normal budget process. Over the period FY 1996 – FY 2000, these surpluses will have averaged about $770 million per year. The Governor's tax cut would have the principal effect of limiting the state to spending levels that are consistent with its own budget priorities.

• A frequent worry – a Big Dig cost overrun of $1.4 billion – turns out to have little importance in considering a tax cut. The debt service on additional borrowing in this amount would come to only about $130 million per year or about .6% of the current budget.

• With over $3.3 billion in reserves ($1.8 billion in the unemployment insurance fund; $131 million in the welfare caseload reserve and $1.4 billion in the stabilization fund), recurrent large budget surpluses and a strong economy, the state is in a position to absorb a slowdown in tax collections.

The idea of tying personal income tax cuts to some lagged measure of economic growth strikes us as contrived. We wonder why the state would wish to hold personal income tax cuts to a higher standard than it has imposed on business and capital-gains tax cuts. We wonder also why it would wish to permit tax cuts only during periods of economic expansion, when tax cuts are least needed to stimulate the economy, and then forgo tax cuts during periods of economic contraction, when they are most needed to stimulate the economy.

In any event, the MTF compromise appears to deny the state substantial economic benefits at a gain of very little in saved tax revenue. It makes tax policy a hostage of past economic growth rates that bear no relation to current economic conditions, and it complicates tax planning. It creates a double standard whereby the state can spend during bad times even while individual taxpayers and businesses have to tighten their belts. Perversely, it attempts to protect the state against revenue losses during periods of declining real personal income when, in fact, tax revenues vary with changes in nominal personal income (personal income not adjusted for inflation), rather than with changes in real personal income. Massachusetts taxpayers would be better served by a clean cut in tax rates.

 

HTML format revised on 12-May-2005 11:56 AM


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