Massachusetts Budget Tax Plan: Gov. Healey Budget

The tax relief package in Massachusetts Governor Maura Healey (D)’s fiscal year 2024 budget proposal includes several positive developments for the Bay State. It acknowledges that Massachusetts is an outlier with respect to the estate tax and its bifurcated capital gains tax. It also subtly concedes the poor condition of the Commonwealth’s tax competitiveness while noting that reforms to the estate and capital gains taxes are important for making Massachusetts “a more attractive place to live, work, and do business.” The proposed reforms would be welcome changes to the Commonwealth’s tax code, but the economic principles behind the reforms also have important implications for the Bay State’s income tax system writ large.

To drive economic competitiveness, the governor has proposed a $742 million tax relief package that includes a reduction of the short-term capital gains rate from 12 percent to 5 percent, an increase in the estate tax exemption, and a new estate tax credit. According to the governor’s office, the elimination or reduction of estate tax liability would affect approximately 70 percent of estate tax returns. A tripling of the exclusion amount from $1 million to $3 million would shield smaller estates from the tax, while larger estates could see their tax reduced by as much as $182,000 if they qualify for the full value of the proposed tax credit.

Capital Gains and Estate Tax Reforms Are Good Policy

The capital gains reform is good policy because it would result in the neutral treatment of short- and long-term capital gains income. Under the current system, income earned from selling an asset held for a year or less is taxed at 12 percent while income earned from selling an asset held for more than a year is taxed at only 5 percent. There is no meaningful difference between capital assets owned for 365 days and capital assets owned for 366 days. Yet, under the current structure, selling an asset after holding it for just over a year would decrease the seller’s tax liability on the capital gain by 58 percent.

Consider a Massachusetts resident who bought a capital asset for $10,000 on January 1 and sold it for $12,000 later that year. If she sold the asset on New Year’s Eve, she would pay a $240 tax on the $2,000 gain. But if she waited to sell the asset until New Year’s Day, she would only pay $100 on the same gain. The seemingly arbitrary distinction in rates effectively encourages holding assets longer than economically practicable just to avoid taxation. And whereas the federal code also treats short- and long-term capital gains differently, it does so by providing a preferential rate to long-term gains, in part as a recognition that the taxable nominal gain has been eroded by inflation. Massachusetts instead imposes a punitive rate on short-term gains, more than twice the ordinary income tax rate.

The proposed estate tax reform is also a positive incremental change for the Commonwealth. While a tax credit is not the ideal design for estate tax relief (it would be simpler to lower the tax rate and even better to phase out the estate tax entirely) the reform is likely to keep more capital in the Commonwealth. On the margin, this is good economic news.

Policymakers Should Follow Reforms to Their Logical Conclusions

The governor is right to call for the neutral tax treatment of capital gains income, but the logical conclusion of her argument supports the return to a flat rate individual income tax. Just as it is sound policy to tax capital gains income in a neutral manner, so it is sound policy to tax wage, salary, and other kinds of income in a neutral manner. Massachusetts undermined its competitiveness by adopting a high top marginal income tax rate. Eliminating a punitive tax on short-term gains is a step in the right direction, but the new 9 percent top marginal rate will continue to impair economic growth.

Taxing short-term gains at a punitive rate slows the turnover of capital and influences people to make investment decisions based on tax preferences rather than market forces. Similar barriers are raised by progressively higher marginal income tax rates, which disincentivize production past certain income levels. Just as it is arbitrary to lower the capital gains tax rate by 7 percentage points on day 366, it is also arbitrary to increase marginal taxes on wage and salary income by 4 percentage points simply because the taxpayer earned one dollar more than a legislated threshold. These policies hobble economic growth by distorting people’s decision-making and impeding economic resources from flowing where and when they are most valued.

Expectations for a Post-Flat Tax Massachusetts

We wrote last fall about what to expect in a post-flat tax Massachusetts. In that analysis, we noted the surtax amendment would likely result in individuals and companies limiting their productivity or relocating outside of Massachusetts to minimize exposure to the surtax. An income tax change of the type approved last November would be challenging for a competitive tax system to absorb. But even more important for Massachusetts is how the surtax interacts with the uncompetitive corporate income, property, and unemployment tax policies already in existence.

People respond to taxes by altering their behavior—like spending, working, and making residency decisions. If taxes go up people tend to buy less, work less, and move out. If taxes go down, people tend to buy more, work more, and move in. Not everyone makes these decisions at the same point or all at once, but they do make them. Consequently, some behavioral change from those affected by the income surtax is inevitable. One study suggests nearly 1,800 millionaires could leave the Commonwealth due to last year’s 80 percent income tax rate increase.

Additional Reforms to Consider

To mitigate capital flight, we suggested Massachusetts legislators make structural changes to the systems not enshrined in the constitution, including the estate tax and other taxes that sideline capital or drive it out of the state. The two headline tax reforms in Governor Healey’s budget are consistent with our analysis of policies that could have a positive marginal impact on those most beset by the Commonwealth’s uncompetitive tax climate. Other tax issues ripe for reform include repealing the capital stock tax (which disincentivizes investment in equipment and other physical components a firm uses for production), adopting full expensing of short-lived capital investment (which promotes modernization and productivity), and eliminating the throwback rule (which taxes income from sales in states lacking jurisdiction to tax the income).

These policy reforms won’t fully offset the economic effects of the surtax, but that does not mean policymakers should ignore them. Though the full repeal of the estate tax is preferred, the estate tax provisions discussed here would likely keep more capital inside the Commonwealth than the status quo.

Only 12 states including Massachusetts still levy an estate tax. Notably, New Hampshire and Florida, the top destinations for net outmigration of Bay State residents, are among the 34 states that do not levy an estate or inheritance tax. That the estate tax would remain in the tax code explains why the recent proposal fails to move the needle of the State Business Tax Climate Index, which ranks Massachusetts’ property tax system 46th most competitive in the country before and after the reform.

As lawmakers consider the governor’s budget, they should keep the broader implications of these reforms in mind. On the whole, the capital gains and estate tax reforms are good policy and welcome incremental changes to the Commonwealth’s tax code, but they beg for consistency.

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