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BHI FaxSheet: Information and Updates on Current Issues
House Leadership's tax cut proposal offers relatively small benefits for the Massachusetts economy
The Legislature is debating a tax proposal introduced by the House leadership, comprised of Thomas M. Finneran, Speaker, Peter J. Larkin, Chairman of the Taxation Committee, and Paul Haley, Chairman of the Ways & Means Committee. The proposal would change Massachusetts tax policy in three ways: (1) It would cut the marginal tax rate on earned income in Massachusetts from 5.95% to 5.7%. (2) It would adjust the tax on investment or unearned income, cutting the tax rate on certain investor income and raising it on others. (3) It would increase the exemption for dependents from $1,000 to $1,500, would expand the definition of dependents to include elderly or disabled relatives living at the taxpayer's home and would double the deduction for children.
Tax reduction of some kind appears certain to take place in Massachusetts in 1998. Other proposals are contending for serious consideration. In order to evaluate the implications of the leadership's proposal for the Massachusetts economy, it is useful to consider it in the context of other proposals before the legislature and the voters.
As it applies to earned income, the leadership's proposal would exert a positive but relatively weak effect on the economy. As it applies to investor income, it would have a mixed effect. As it applies to exemptions and deductions, it would have almost no effect except to cost the state tax revenue.
Changes in the Tax on Earned Income
The principal alternative to the leadership's proposal as it affects earned income is a proposal introduced by acting Governor Cellucci that would cut the tax rate to 5%. According to comparative analysis done by the Beacon Hill Institute, the leadership's proposal represents a far smaller stimulus to the economy. The leadership's proposal would increase the state capital stock by $5.1 billion and would create only about 28,615 new jobs by 2001. The governor's proposal would roughly quadruple these results: $19.6 billion in new capital stock and 109,965 new jobs by 2001. See Table 1.
Table 1–Effects of House Leadership's and Governor's Tax Cuts on Earned Income in 2001
Leadership $1.2 billion 28,615 $5.1 billion -$372 million $68 million -$304 million Governor* $4.6 billion 109,965 $19.6 billion -$1.413 billion $230 million -$1.184 billion (*Updated from BHI FaxSheet, September 24, 1997. Analysis of both proposals was conducted using BHI's econometric State Tax Analysis Modeling Program.)
The leadership's proposal would be effective January 1, 1998, whereas the governor's proposal would be phased in over three years and fully implemented in 2001. Table 1 assumes full implementation of both proposals in 2001.
Both proposals would cause revenue losses. The revenue losses associated with the cut in tax rates on earned income are presented in Table 1. The net revenue loss of the leadership's proposal is $304 million (about 1.6% of the FY 99 budget) while the net revenue loss of the governor's proposal is $1.184 billion (about 6% of the FY 99 budget).
The relatively small revenue losses associated with the leadership's tax cut on earned income are offset, however, by its correspondingly weak contribution to job creation and capital spending. The larger losses associated with the governor's proposal are mitigated by the greater economic gains.
Both tax cuts would affect the economy through the way they affect the cost to Massachusetts employers of hiring workers. The lower the tax on earned income, the lower this cost and the greater the number of workers that employers are able to hire. As employers hire more workers, they also create more capital (production facilities, warehouses, office buildings, computers, and so forth).
Changes in the Tax on Investment Income
The leadership's proposal also makes changes in Massachusetts taxes on investment income. [1] Under current law, dividends, certain kinds of interest and short-term capital gains are taxed at 12%. Under a 1994 law, which was passed in conjunction with a substantial pay hike for state legislators, the legislature substantially reduced the tax on long-term capital gains. Presently, under the 1994 law, long term capital gains (capital gains on assets held more than one year) are taxed on a declining scale, from 5% to 0%, depending on the length of time the asset is held. See Table 2.
Table 2–Current Long-Term Capital Gains Schedule
Tax Rate* Up to a year More than one, but less than two years More than two, but less than three years More than three, but less than four years More than four, but less than five years More than five, but less than six years More than six years *Applicable to assets acquired January 1, 1996 or later. [2]
The leadership's proposal has a mixed effect on investment incentives, raising the tax on long-term capital gains and lowering the tax rate on other kinds of unearned income. It raises the tax on long-term capital gains in two ways. First, it eliminates the sliding scale enacted in 1994 (and detailed in Table 2) and raises the tax rate on all long-term capital gains to 5.7%. Second, it redefines long-term capital gains as assets being held longer than 18 months. This represents a tax hike for assets held from 12 to 18 months since the tax on these assets would rise from 5% to 10%.
The leadership's proposal reduces the tax on dividends and certain interest income from 12% to 5.7% and reduces the tax on short-term capital gains (as now redefined) from 12% to 10%. However, there is the possibility that the voters or the legislature would, absent this proposal, enact much steeper cuts in these rates. A measure headed for the fall 1998 ballot would cut the tax rate on dividends, certain interest and short-term capital gains from 12% to the level applicable to earned income. Under the governor's proposal, this would mean cutting the tax from 12% to 5%, rather than to 5.7%.
The economic effects of the leadership's proposal, as it changes tax rates on unearned income, derive from its consequences for saving and for business expectations. Any tax on investor income violates the principle that all income should be taxed only once, that is, when it is consumed. Taxes on investor income are taxes on saving and therefore amount to penalties on saving.
The leadership's proposal violates this principle by changing the direction of Massachusetts policy away from lower taxes and toward higher taxes on long-term capital gains. It forestalls the possibility of much lower tax rates on other investor income. It undermines the confidence of investors in the legislature's ability to develop a consistent policy toward the taxation of investor income.
According to the Department of Revenue, Massachusetts taxes on unearned income yielded only about $603 million in 1994, which was about 5.64% of all state tax revenue. [3] The House leadership's proposal preserves a relatively small revenue flow while at the same time violating widely recognized principles of good tax policy.
Changes in Exemptions and Deductions
There are other proposals to expand or liberalize deductions and exemptions. Attorney General and gubernatorial candidate Scott Harshbarger would double the personal exemption. Acting governor Cellucci would give an additional exemption of $5,000 for providing half the support for elderly relatives.
Because all such changes have almost no effect on marginal tax rates, they have almost no effect on jobs, capital spending, saving or business expectations. They amount mainly to a “tax expenditures” that respond more to political than to economic imperatives. Expanding the exemptions and deductions in the leadership proposal would cost $122 million in revenue, with almost no attendant benefits to the economy.
Footnotes
[1] Although the leadership proposal distinguishes between investment income and capital gains, this distinction is misleading and is not made here. Capital gains are correctly understood as part of investment income.
[2] As established in House 1, The Governor's Budget Recommendation, Fiscal Year 1996, January 24, 1995, p. I-122.
[3] Massachusetts Statistics of Income: 1994 Individual Income Tax Returns, Commonwealth of Massachusetts Department of Revenue, Office of Tax Policy Analysis, Table II, p. 30.
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