BOSTON — MassINC today released a policy brief exposing the fiscal risks of Massachusetts’ overreliance on the capital gains tax, an unpredictable and volatile revenue stream subject to swings in the economy such as the current downturn. In “Capital Gains: Avoiding Harm to the State Budget,” author Cameron Huff states that Massachusetts is now third in the nation in its dependence on capital gains, making the state’s reliance on capital gains 47% greater than the national average.

The brief also notes that as the state’s dependence on capital gains has grown, the state’s rainy day fund has declined – down almost $400 million since 2002 after accounting for inflation.

“We’re looking at a budgetary “perfect storm” but one that could have been avoided,” said Greg Torres, president of MassINC, who pointed to the report’s recommendations on how the state can manage the volatility of capital gains such as changing the way capital gains are paid and broadening the sales tax to cushion a decline.

“Every 8 to ten years, we see how a decline in capital gains affects our budget in a poor economy, but we tend to focus our reform efforts on spending and not on revenue. With the right information, we can address the revenue issues – such as the capital gains dilemma – before we get hit with the next economic downturn.”

As the policy brief describes in detail, capital gains taxes are levied on investment transactions, such as stocks, bonds and real estate, and are therefore difficult to predict given their relationship to the economy.

Further increasing our vulnerability is the fact the vast majority of capital gains taxes are paid by a very small percentage of taxpayers. “The Commonwealth’s state budget depends on the choices of a handful of taxpayers,” said Cameron Huff. The new report cites that in 2006, 9,521 Massachusetts taxpayers – less than 0.4 percent of the state’s 2.7 million filers – paid nearly two-thirds of all capital gains taxes.

“Capital Gains: Avoiding Harm to the State Budget,” stems from previous MassINC research released last winter that analyzed trends in the Massachusetts state budget over the last two decades. With that policy brief’s revelation that capital gains accounted for the majority of all tax revenue growth over the past 4 years, (54 percent of the state’s growth in tax revenues from 2002 to 2006), MassINC chose to further examine this phenomenon.

The new policy brief provides additional information on capital gains, such as risk factors should capital gains revenue drop, such as the sharp decline this year, which could become even worse over the next several months. It also provides a tutorial of sorts on the mechanics of capital gains.

Finally, a series of recommendations direct policymakers to ways of reducing the unique risks of the tax.

Recommendations include: establishing a new capital gains reserve account to even out the flow of capital gains revenues to the budget; using any excess revenues above the account’s ceiling to help build up the existing stabilization reserve; dedicate any additional excess capital gains receipts to one-time purposes directed to the state’s long-term priorities; broadening the state’s tax base, with particular focus on the sales tax.

Key findings of “Capital Gains: Avoiding Harm to the State Budget”:

• In recent years, Massachusetts has become increasingly reliant on capital gains. In 2006, Massachusetts ranked 3rd in the nation in the relative importance of capital gains, up from 7th place in 1999. The overall importance of capital gains in Massachusetts is 47 percent greater than the national average.
• From 2002 to 2006, capital gains tax revenues accounted for 54 percent of the state’s growth in tax revenues (which was partially offset by declines in other tax collections). The state relies on capital gains receipts to fund ongoing programs. This year, capital gains receipts were originally expected to fund approximately $1.5 billion of state programs.
• At the same time the state has become more dependent on capital gains tax revenues, the state’s rainy day fund is almost $400 million lower today than it was in 2002, after adjusting for inflation. The fund’s share of the budget has declined from about 10 percent to 6 percent.
• Capital gains – and capital gains taxes – are volatile and tied to a large degree to the boom and bust cycles of the stock market. In addition, unlike other major sources of income, capital gains are by their nature a series of one-time events.
• The vast majority of capital gains taxes are paid by a very small percentage of taxpayers. In 2006, 9,521 Massachusetts taxpayers – less than 0.4 percent of the state’s 2.7 million filers – paid nearly two-thirds of all capital gains taxes. These taxpayers all had incomes of $1 million or more. Thus, the Commonwealth’s state budget depends on the choices of a handful of taxpayers about when and how they will realize their gains.
• Capital gains have a ripple effect on a state’s economy, especially in Massachusetts because of the high concentration of financial services. The success of these companies is linked to the same activities that generate capital gains. For instance, in 2002, the decline in bonuses led to an estimated drop of $300 million in income taxes, which came on top of the $1 billion plunge in capital gains revenues.

About MassINC:
The Massachusetts Institute for a New Commonwealth (MassINC) MassINC (The Massachusetts Institute for a New Commonwealth) is a nonpartisan, evidence-based organization. Its mission is to develop a public agenda for Massachusetts that promotes the growth and vitality of the middle class. Its governing philosophy is rooted in the ideals embodied in the American Dream: equality of opportunity, personal responsibility, and a strong commonwealth.