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Tying down the grabbing hand of state government
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from NewsLink, Vol. 6, No. 4, Summer 2002
In November 1986, Massachusetts voters approved a ballot measure that was intended to limit the growth of the state's tax revenues. This “Tax Cap” was based on the principle that state taxes should grow no faster than state taxpayer earnings. The law limits the growth of state tax revenues to the three-year average growth in Massachusetts wages and salaries. If revenue growth exceeds that average growth, then excess revenues are to be returned to the taxpayers in the form of a rebate.
The formula that determines whether, and the amount by which, taxpayers receive a refund is based on a distinction between “allowable” and “actual” revenues. Allowable revenues for the current year equal net tax revenues for the previous year, adjusted for the growth in wages and salaries. If actual net tax revenues for the current year exceed allowable net tax revenues, so defined, taxpayers receive a refund equal to the difference.(1)
The Tax Cap has not, however, worked as intended. After 15 years, it has limited the growth in tax revenues only once: In 1987, the first year that the Tax Cap was in place, actual revenues exceeded allowable revenues, necessitating a tax refund. Since then, actual revenues have stayed well below allowable revenues.
The ineffectiveness of the existing Tax Cap results from a peculiarity in the calculation of allowable revenues. Under current law, allowable revenues for the current year are calculated by increasing allowable revenues for the previous year by the growth of wages and salaries.(2) This method has been ineffective for limiting tax revenue growth because allowable revenues have grown faster than actual revenues.
The Massachusetts High Technology Council has proposed an alternative method that would compute allowable revenues for the current year by applying the growth of wages and salaries to actual, not allowable, revenues for the previous year. Table 1, columns (B), (D) and (F) show how this method would have affected tax revenue collections, had it been in place over the period 1990 to 2001. In the recession years, 1990 and 1991, allowable revenues would have exceeded actual revenues, so that the Tax Cap would (as under current law) have been ineffective (the amounts in column D are negative), and taxpayers would have received no refunds. Beginning in 1992, however, actual revenues exceeded what would have been allowable revenues, necessitating tax refunds equal to the difference.
The refund for 1992 would have been $49,124,000. By 2001 the refund would have grown to $1,190,095,000. If the Mass High Tech Method had been in place, taxpayers would have been owed refunds in 11 of the years since 1986. The cumulative result of these refunds would have been the return of about $10 billion to taxpayers over the period, nearly 6% of actual net revenues collected. Cumulative average refunds would have been about $1,700 per capita and about $3,600 per tax filer.
The New State Method
In its FY 2003 budget, the Massachusetts legislature provides a method of its own for capping taxes. This “New State Method” caps the growth of state tax revenue at two percentage points above the growth of the state and local government price deflator (the inflation rate that applies to state and local government purchases).
Table 1.
Comparison of Mass High Tech Method and New State Method
As Table 1 shows, the New State Method would have been more effective than the Mass High Tech Method in limiting revenue growth in some years but less effective in others. The most important difference lies in tax refunds, for which the two methodologies give very different results, especially for the early years.
The difference lies in how the New State Method disburses actual revenues received by the state in excess of allowable revenues. In any year that the actual tax revenues exceed allowable revenues under the New State Method, the state will be required to apportion this excess in the following manner: 40% to the Stabilization Fund; 35% to the One-Time Capital Projects Improvement Fund; 15% to the Open Space Acquisition Fund; and 10% to the Tax Reduction Fund. Thus taxpayers get only a small portion of the excess, at least so long as the Stabilization Fund remains below capacity.
Because, unlike the Mass High Tech Method, the New State Method does not return all excess revenues to the taxpayers in the form of refunds, taxpayers would have received cumulatively $6.6 billion less in refunds under the New State Method than under the Mass High Tech Method.
The reason that 2001 taxpayer refunds would have been similar under either method has to do with a feature of current law that puts a limit on the size of the Stabilization Fund. Under the New State Method, the Stabilization Fund would have reached this limit in 1998. As a result, a portion of the 40% that would have otherwise gone into the Stabilization Fund would, under that method, have gone to the Tax Reduction Fund.
Comparing Methods
The intent of the New State Method is clearly to put taxpayers at the bottom of the pecking order in the distribution of excess revenues. It seems likely that the designers of this method did not anticipate an eventuality in which far more than 10% of these excess revenues would be returned to taxpayers. Should the Stabilization Fund reach capacity, it seems likely, furthermore, that the legislature would simply raise the limit on the Stabilization Fund, rather than let the Tax Reduction Fund balloon to the level shown for 2001.
The Mass High Tech Method is therefore superior to the New State Method for guaranteeing that all revenues collected in excess of allowable revenues are returned to the taxpayer, rather than absorbed into government funds from which they can be easily diverted into new state expenditures. For a revenue limitation to be effective, it must translate as well into a spending limitation.
There is one more consideration: The most effective way to limit the growth of tax revenues is to reduce tax rates. Tax refunds are temporary and do nothing to reduce marginal tax rates or therefore to increase incentives to work, save, locate and invest in Massachusetts. This argues for a permanent reduction in tax rates of the kind mandated by the voters in 2000 and negated by the legislature in 2002. A permanent reduction in tax rates, combined with the Mass High Tech Method outlined above, would combine an economic stimulus with an effective curb on the size of government.
ENDNOTES
1 Net tax revenues equal actual tax revenues minus the excise derived and retained by local government units.
2 The formula, under current law, is: Allowable net tax revenues for the current year equal allowable net tax revenues for the previous year multiplied by (1 + the three-year average growth of wages and salaries).
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