The taxA tax is a mandatory payment or charge collected by local, state, and national governments from individuals or businesses to cover the costs of general government services, goods, and activities. 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 taxAn estate tax is imposed on the net value of an individual’s taxable estate, after any exclusions or credits, at the time of death. The tax is paid by the estate itself before assets are distributed to heirs. and its bifurcated capital gains taxA capital gains tax is levied on the profit made from selling an asset and is often in addition to corporate income taxes, frequently resulting in double taxation. Capital gains taxes create a bias against saving, leading to a lower level of national income by encouraging present consumption over investment. . 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 exemptionA tax exemption excludes certain income, revenue, or even taxpayers from tax altogether. For example, nonprofits that fulfill certain requirements are granted tax-exempt status by the IRS, preventing them from having to pay income tax. , and a new estate tax creditA tax credit is a provision that reduces a taxpayer’s final tax bill, dollar-for-dollar. A tax credit differs from deductions and exemptions, which reduce taxable income, rather than the taxpayer’s tax bill directly. . 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 inflationInflation is when the general price of goods and services increases across the economy, reducing the purchasing power of a currency and the value of certain assets. The same paycheck covers less goods, services, and bills. It is sometimes referred to as a “hidden tax,” as it leaves taxpayers less well-off due to higher costs and “bracket creep,” while increasing the government’s spending power. . 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 taxAn individual income tax (or personal income tax) is levied on the wages, salaries, investments, or other forms of income an individual or household earns. The U.S. imposes a progressive income tax where rates increase with income. The Federal Income Tax was established in 1913 with the ratification of the 16th Amendment. Though barely 100 years old, individual income taxes are the largest source of tax revenue in the U.S. . 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 TaxAn income tax is referred to as a “flat tax” when all taxable income is subject to the same tax rate, regardless of income level or assets. Massachusetts
We wrote last fall about what to expect in a post-flat tax Massachusetts. In that analysis, we noted the surtaxA surtax is an additional tax levied on top of an already existing business or individual tax and can have a flat or progressive rate structure. Surtaxes are typically enacted to fund a specific program or initiative, whereas revenue from broader-based taxes, like the individual income tax, typically cover a multitude of programs and services. 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 expensingFull expensing allows businesses to immediately deduct the full cost of certain investments in new or improved technology, equipment, or buildings. It alleviates a bias in the tax code and incentivizes companies to invest more, which, in the long run, raises worker productivity, boosts wages, and creates more jobs. 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 taxAn inheritance tax is levied upon an individual’s estate at death or upon the assets transferred from the decedent’s estate to their heirs. Unlike estate taxes, inheritance tax exemptions apply to the size of the gift rather than the size of the estate. . 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 taxA property tax is primarily levied on immovable property like land and buildings, as well as on tangible personal property that is movable, like vehicles and equipment. Property taxes are the single largest source of state and local revenue in the U.S. and help fund schools, roads, police, and other services. 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.Share