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BHI FaxSheet: Information and Updates on Current Issues

Massachusetts Tax Cut Would Generate $21 Billion in New Capital, Create 105,000 New Jobs

According to econometric analysis performed by the Beacon Hill Institute, a ballot initiative for cutting the marginal tax rate on earned income in Massachusetts to 5% would increase the state capital stock by $21 billion. It would create more than 105,000 new jobs, raising employment by 3% above the level it would otherwise have achieved. Payroll would rise by $4.93 billion. The tax rate cut would be phased in over a three-year period, falling from the current rate of 5.95% to 5.6% in 1999, 5.3% in 2000 and 5.0% in 2001.

Economic Effects of Tax Cut Initiative

Year

Change in Payroll

Change in Jobs
Change
in Capital Stock
“Static”
Tax Revenue Effect
“Dynamic”
Tax Revenue Effect
Net Tax Revenue Effect
1999 $1.543 billion 36,689 $6.5 billion -$479 million $86 million -$393 million
2000 $1.566 billion 33,369 $6.7 billion -$482 million $78 million -$404 million
2001 $1.821 billion 35,223 $7.8 billion -$556 million $82 million -$474 million
Total $4.930 billion 105,281 $21.0 billion -$1.517 billion $246 million -$1.271 billion

The tax cut would produce a net revenue loss of about $1.271 billion. This is the net result of two effects: (1) the “static” revenue loss of $1.517 billion (the loss computed on the assumption that the tax cut would have no effect on the Massachusetts economy) and (2) the “dynamic” revenue gain of $246 million (the revenue gained as a result of the increased production and personal income that the tax cut would bring about).

Proponents of the ballot initiative, which was certified by Massachusetts Attorney General Scott Harshbarger on September 3, 1997, must gather the signatures of 64,928 registered voters by December 3, 1997 in order for the proposal to be sent to the Legislature.

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Methodology

Two steps are needed in order to measure the effect of the proposed tax cut on the variables of interest – the number of jobs (L), the wage rate (w), the capital stock (K) and state tax revenue (TR). First we must establish baseline values for the variables, projecting them out through the year 2001 on the assumption that the tax rate does not change. Then we use the Beacon Hill Institute's State Tax Analysis Modeling Program (STAMP) to estimate and project employment, wages and the capital stock in the presence of the tax cut. These projections may then be compared with the baseline values in order to isolate the effects of the tax cut.

A. Baseline Projections of Wages, Jobs and Capital

The baseline projections are shown in the table below, and were constructed as follows. Information on employment is available for 1996, and we suppose that the growth rate in jobs observed for the first half of 1997 persists for the rest of the year. We assume that employment continues to grow thereafter at 2.33% annually through 2001; this is the growth rate which was observed from 1995-1997.

The value of the total payroll is known for 1996, and we assume that it will continue to grow (in nominal dollars) at the same speed as it did during 1995-1997, which is by 7.97% per year. We also assume that the capital stock grows at the same speed as total payroll, which amounts to assuming that the capital/labor ratio does not change over time. Information on the capital stock in Massachusetts is available for 1994, and so we use the historical growth rates of total payroll to arrive at a value for 1997, and project continued growth thereafter (in nominal dollars) of 7.97% annually. The average wage is simply the total value of payroll divided by the number of jobs.

B. Applying the Tax Analysis Model

A fuller description of the tax analysis model is given in An Application of the BHI Tax Analysis Model to the Massachusetts Mutual Fund Industry (Beacon Hill Institute, October 1996). The model is designed to allow the analyst to trace the effects of changes in state tax rates on employment, wages and the stock of capital. It begins with a series of structural equations which aim to capture the behavior of firms and households, and then re-arranges these equations to arrive at a set of reduced form equations which are both theoretically consistent and may be estimated econometrically. The equations are estimated using data from 1970-1993. In simplified form, the two which are relevant here are the labor equation and the capital equation.

The labor equation shows how changes in state tax rates (and other variables) affect the number of jobs in Massachusetts. The estimated equation is of the form

(1) ln(L) = -0.032 t + other variables

where ln(L) is the natural log of the number of jobs, and t is the state tax rate on earned income. The coefficient

0.032 is statistically significant, and measures the effect of a change in the tax rate (t) on ln(L); in other words ln(L)/t = -0.032.

The capital equation is similar, except that the dependent variable is capital rather than labor. Specifically the estimated equation is of the form

(2) ln(K) = -0.053 t + other variables

where ln(K) is the change in the natural log of the value of the capital stock from one year to the next. The coefficient -0.053 is statistically significant.

C1. Projecting the Effects of the Tax Cut: Employment

In 1999 the tax cut would reduce t from 5.95% to 5.60%, or by 0.35%, so t = -0.35. Thus from equation (1) we have

(DELTA)ln(L) = (-0.032)(DELTA)t = (-0.032)(-0.35) = 0.0112.

The baseline value of ln(L) [=14.9965 = ln(3,257,459)] now rises by 0.0112 to 15.0077; taking the antilog gives the number of jobs with the tax cut, which is 3,294,148, or an increase of 36,689 over the baseline case.

An essentially similar procedure is applied for 2000. We take the new employment number for 1999 and raise it by 2.33% to project employment in 2000 for the situation in which there is no further tax cut. Then we apply the further tax cut, which is from 5.60% to 5.30%, using the coefficient from equation (1) to determine how many additional jobs are created in this next round. The approach is repeated for the third phase of the tax cut which is scheduled for 2001, from 5.3% to 5.0%. The results are shown in the table below, and indicate that by the year 2001 an estimated 105,281 jobs will have been created which would not have existed in the absence of the cuts in the state tax on earned income.

C2. Projecting the Effects of the Tax Cut: Capital

The effects of the tax cut on the stock of capital are estimated in the same manner as for employment. Thus from equation (2) we have for 1999

(DELTA)ln(K) = (-0.053)(DELTA)t = (-0.053)(-0.35) = 0.0186.

The baseline value of ln(K) [=26.5782 = ln($348.95 billion)] now rises by 0.0186 to 26.5968; taking the antilog gives a new capital stock, after the tax cut, of $355.49 billion, or an increase of $6.53 billion over the baseline case. For the subsequent two years the capital stock is first adjusted upwards to reflect the assumed annual nominal growth rate of 7.97% and then adjusted for the tax cuts in the same manner as was done for employment.

C3. Projecting the Effects of the Tax Cut: Wages

The estimated reduced form equations of the tax analysis model show that the state tax rate on unearned income does not have a statistically significant effect on the wage rate in Massachusetts. Wages are thus assumed to follow the baseline projections both with, and without, the tax cut. The total value of the payroll, in the presence of the tax cuts, is calculated by multiplying these average wage rates by the number of people employed.

C4. Projecting the Effects of the Tax Cut: Tax Revenue

What effect will the cut in the tax rate have on state tax revenue? First there is a “static” revenue loss, which is measured as the reduction in the tax rate (i.e. 0.35% in 1999, 0.3% in 2000 and 2001) times the tax base, which we take to be the baseline payroll. For instance, the static revenue loss in 1999 would be $479 million

(= 0.35% of the payroll of $136.98 billion). But this overstates the true revenue loss, because there is also a “dynamic” revenue effect: the tax cut leads to an increase in the number of jobs and hence the total payroll, and therefore to some offsetting increase in revenue. For instance in 1999 the dynamic revenue gain would be $86 million (= 5.6% of the $1.543 billion increase in payroll induced by the tax cut).

 

Appendix Table: Effect of Massachusetts Tax Cut on Employment, Capital Stock and Tax Revenue

 

1997

1998

1999

2000

2001

 

Baselines

A

Employment

3,111,007

3,183,391

3,257,459

3,333,251

3,410,807

B

Payroll ($ billion)

117.50

126.87

136.98

147.91

159.70

C

Average wage ($ p.a.) (=B/A)

37,770

39,854

42,053

44,373

46,821

D

Capital Stock ($ billion)

299.32

323.19

348.95

376.77

406.81

 

Effects with Tax Cut

E

Proposed earned income tax rate

5.95%

5.95%

5.60%

5.30%

5.00%

F

New Employment

3,111,007

3,111,007

3,294,148

3,403,309

3,516,087

G

Cumulative job increase due to tax cut (=F-A)

36,689

70,058

105,281

H

Annual job increase due to tax cut

36,689

33,369

35,223

I

New Capital Stock ($ billion)

299.32

299.32

355.49

389.98

427.82

J

Cumulative extra capital due to tax cut ($ billion) (=I-D)

6.53

13.21

21.01

K

Annual capital increment due to tax cut ($ billion)

6.53

6.67

7.80

L

New Payroll ($ billion) (=C*F)

117.50

126.87

138.53

151.01

164.63

M

Cumulative extra payroll due to tax cut ($ billion) (=L-B)

1.543

3.109

4.929

N

Annual payroll increment due to tax cut ($ billion)

1.543

1.566

1.821

O

"Static" tax revenue effect: cumulative ($ billion)

-0.479

-0.961

-1.517

P

"Static" tax revenue effect: annual ($ billion)

-0.479

-0.482

-0.556

Q

"Dynamic" tax revenue effect: cumulative ($ billion)

086

0.165

0.246

R

"Dynamic" tax revenue effect: annual ($ billion)

0.086

0.078

0.082

S

Net tax revenue effect: cumulative ($ billion) (=O+Q)

-0.393

-0.797

-1.271

T

Net tax revenue effect: annual ($ billion) (=P+R)

-0.393

-0.404

-0.474

D. The Total Effect

According to BHI estimations, by the time the tax cut is fully implemented in the year 2001, the number of new jobs created will be 105,281, raising employment by 3% above the level it would otherwise have achieved. The capital stock will be $21 billion (almost 5%) higher than it would otherwise have been. Annual state tax revenue will be $1.27 billion lower than it would otherwise have been; this total consists of a static revenue loss of $1.52 billion, offset by higher revenue of $0.25 billion generated by taxes on the additional payroll resulting from the tax cut.

 

Format Revised on 12-Jul-2007 10:48 AM

 

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