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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.
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