BHI FaxSheet: Information and Updates on Current Issues

Economic Analysis Shows Impact of Cellucci, House Leadership and Birmingham Proposals

March 1998

There are currently three major tax cut proposals before the Massachusetts Legislature: a proposal introduced by acting Governor A. Paul Cellucci in 1997 and revised this week; a proposal introduced by the House Leadership and passed by the House of Representatives on March 11; and a proposal introduced by Senate President Thomas Birmingham in February. Evaluation of these proposals requires consideration of their effects on the state economy and on state tax revenues. A tax-law change is generally more attractive (1) the more it contributes to economic expansion, (2) the less revenue it causes the state to lose, and (3) the more it contributes to economic “equity.”

A comparative analysis prepared by the Beacon Hill Institute shows that, on the basis of the first two criteria, the Cellucci proposal would confer substantial economic benefits at correspondingly high costs in terms of lost revenue, while the Leadership proposal would confer smaller economic benefits and imposes a smaller revenue loss. The Birmingham proposal is by far the least satisfactory of the three. It would contribute less to economic expansion and cost more in tax revenues than the Leadership proposal.

In terms of “equity,” the Leadership proposal would offer more generous deductions for dependents, while the Birmingham proposal would double the personal exemption. Both thereby favor low-income taxpayers, making the tax code effectively more progressive and thus more “equitable” from certain points of view.

Changes in the Tax on Earned Income

The Cellucci proposal would cut the tax rate on earned income from 5.95% to 5% over four years beginning in 1998. As a result, it would create $17.3 billion in new capital stock and 96,585 new jobs by 2001. See Table 1.

Table 1 – Cut in State Tax in Earned Income: Economic Effects in 2001

Proposal
Change in Payroll
Change in Jobs
Change in Capital Stock
“Static” Tax Revenue Effect
“Dynamic” Tax Revenue Effect
Net Tax Revenue Effect
Cellucci*
$4.1 billion
 96,585
$17.3 billion
-$1.209 billion
 $198 million
-$1.011 billion
House Leadership*
$1.0 billion
 24,500
$4.4 billion
-$376 million
 $56 million
-$320 million
Birmingham
$634 million
 15,066
$2.7 billion
-$588 million
 $34 million
-$554 million

*Updated from BHI FaxSheet, March 11, 1998. Analysis of all proposals was conducted using BHI's econometric State Tax Analysis Modeling Program. All proposals would be partially effective January 1, 1998, with the Cellucci proposal phased in over four years and fully implemented in 2001. Table 1 assumes full implementation of all proposals in 2001.

The House Leadership proposal, introduced by Speaker Thomas M. Finneran, Taxation Committee Chairman Peter J. Larkin, and Ways & Means Committee Chairman Paul Haley, will be considered by the Senate. It would cut the marginal tax rate on earned income in Massachusetts from 5.95% to 5.7% immediately. It would also increase the exemption for dependents from $1,000 to $1,500, expand the definition of dependents to include elderly or disabled relatives living at the taxpayer's home and double the deduction for children under 12 from $1,200 to $2,400 extending it to families with children under 18.

The Leadership's proposal would exert a positive but relatively weak effect on the economy. It would increase the state capital stock by $4.4 billion and would create only about 24,500 new jobs by 2001. This represents a far smaller stimulus to the economy than the Cellucci proposal.

Senate President Birmingham's proposal would permanently increase the personal exemption from $2,200 to $4,400 for single filers, and from $4,400 to $8,800 for joint filers. [1] Because it affects the marginal income tax rate minimally, the Birmingham proposal would have very limited impact on the economy. While Birmingham's proposal would cost a little more than half of what Cellucci's plan would cost, it would create less than 16% of the new jobs (15,066) and capital stock ($2.7 billion) created by the Cellucci proposal.

Because changes in deductions and exemptions have a small effect on marginal tax rates, they have a small effect on jobs, capital spending, saving or business expectations. They amount mainly to “tax expenditures” - revenue givebacks motivated more by equity (which is to say, political) considerations than by economic considerations.

On the other hand, cuts in the marginal tax rate affect the economy because they affect the cost to Massachusetts employers of hiring workers. The lower the tax on earned income, 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).

All three proposals would cause revenue losses. The net revenue loss of Cellucci's proposal is $1.011 billion (about 5.3% of the FY 99 budget). The net revenue loss of the Leadership's proposal is $320 million (about 1.68% of the FY 99 budget) and the net revenue loss of Birmingham's proposal is $554 million (about 2.91% of the FY 99 budget). See Table 1.

The relatively small revenue losses associated with the Leadership and Birmingham tax cuts on earned income are offset, however, by their 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. Compared to the Leadership's proposal, the Cellucci proposal gives almost four times the economic gain at a little more than three times the cost in tax revenue. Compared to the Birmingham proposal, the Cellucci proposal gives more than six times the economic gain at less than twice the cost in tax revenue.

In summary:

Because the Birmingham proposal provides for almost no change in marginal tax rates while offering a substantial revenue giveback, it involves the worst of all worlds: not very much economic gain and a substantial loss in state revenue.

Because the Cellucci proposal provides for deeper cuts in marginal tax rates, it generates a more powerful stimulus to the economy, albeit larger revenue losses.

Changes in the Tax on Investment Income

Two of these proposals also make changes in Massachusetts taxes on investment income. Under current law, dividends, certain kinds of interest and short-term capital gains are taxed at 12%. Under a 1994 law, 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 – Long-Term Capital Gains Schedule

Holding Period*
Current Tax Rate
Leadership Tax Rate
Up to a 12 months 12% 10%
More than 12 months, but less than 18 months 5% 10%
More than 18 months, but less than two years 5% 5.7%
More than two, but less than three years 4% 5.7%
More than three, but less than four years 3% 5.7%
More than four, but less than five years 2% 5.7%
More than five, but less than six years 1% 5.7%
More than six years 0% 5.7%

*Applicable to assets acquired January 1, 1996 or later.

The Cellucci proposal would reduce the tax on dividends and certain interest income from 12% to 5%, phased in over time. The Leadership's proposal would reduce the tax on dividends and certain interest income from 12% to 5.7% and reduce the tax on short-term capital gains from 12% to 10% immediately. But it would also raise the tax on long-term capital gains in two ways. First, it would eliminate the sliding scale enacted in 1994 (and detailed in Table 2) and raise the tax rate on all long-term capital gains to 5.7%. Second, it would redefine long-term capital gains as assets being held longer than 18 months. This would represent a tax hike for assets held from 12 to 18 months since the tax on these assets would rise from 5% to 10%. [2] The Birmingham proposal would have only a minimal effect on the marginal tax rate for interest income and capital gains.

The Birmingham proposal would preserve the tax on investor income. 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.

Although the Leadership proposal reduces some taxes on investment income, it raises the tax on long-term capital gains. This is a change in the direction of Massachusetts tax 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 also undermines the confidence of investors in the Legislature's ability to develop a consistent policy toward the taxation of investor income.

The Cellucci proposal, on the other hand, only lowers taxes on investment income and cuts them by a greater amount. It therefore sends a far more positive message to businesses and investors about the direction of Massachusetts tax policy.

Footnotes

[1] In fact, the actual change in personal exemptions would be smaller than this. The actual change is the difference between the new levels proposed by Senator Birmingham and the levels currently in effect. In 1997 these levels were $2,360 for single taxpayers, $5,260 for married taxpayers filing jointly, and $4,065 for heads of household. Because the Birmingham proposal would largely deplete the tax reduction fund, the exemption for heads of household would actually fall from its 1997 level of $4,065 to its permanent level of $3,400, which remains unchanged under the Birmingham proposal.

[2] 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.

Posted 3/31/98 Revised on 11-Jul-2007 1:46 PM