On Election Day, a slim majority of voters passed Massachusetts Question 1, also known as the Fair Share Amendment, which would transition the Commonwealth from a flat individual income tax to a tiered tax rate system. Effective January 1, 2023, the Bay State will begin taxing all individual income over $1 million at a rate of 9 percent. Although Massachusetts has historically had the unflattering nickname of “Taxachusetts” and has begun to lose that reputation, the 105-year hiatus of the flat-rate system marks a seismic shift back to uncompetitiveness.
As taxpayers and policymakers begin to navigate this new reality, they should pay attention to how high-income people are reacting. If they decide to defer or withhold investments to avoid the tax break, it could seriously hurt Massachusetts’ economy.
The impact of the new tax depends on how millionaires react
Conflicting views on the behavioral impact of the tax led to widely differing tax revenue estimates during the campaign. Initially, it was claimed that new revenue from tax surcharges would amount to $2 billion. In the end, that figure was $1.2 billion. That’s a 40 percent difference between the estimates.
The wide range between the two estimates highlights a tension between two schools of thought regarding the behavior of high-income people. On the one hand, the passing millionaire hypothesis suggests that high-income individuals are highly mobile and move to low-tax countries to minimize taxation and maximize income. The lower Surtax revenue estimates reflect this assumption.
On the other hand, the elite embeddedness hypothesis suggests that high-income earners are reluctant to leave a given area, despite tax increases, because doing so would mean giving up the social capital and connectedness that are responsible for generating their substantial wealth. Higher estimates of surtax revenue would follow this school of thought.
Cristobal Young and Charles Varner of Stanford University and Ithai Lurie and Richard Prisinzano of the US Treasury Department examined this paradox in a 2016 paper using official millionaire tax return data collected between 1999 and 2011. Their findings show somewhat mixed results, beginning with evidence that “millionaires are not very mobile and actually have lower migration rates than the general population.”
However, they go on to report that “there is an observable pattern of elite migration from high-tax to low-tax countries; When millionaires migrate, their relocation decisions are influenced by tax rates in a way we don’t see for the general population.” Young and his coauthors also estimated a population elasticity of 0.1, “meaning that a 10 percent increase in the top tax rate leads to a 1 percent loss of the millionaire population”. When Young et al. When they looked at the millionaire population along state lines, they found “marked differences consistent with millionaire tax evasion within these small geographic zones.”
Despite these results, the authors concluded that the embedded millionaire hypothesis is correct. As Young and his colleagues wrote, “Millionaires do not use their higher income to achieve greater mobility between states, but rather are anchored in their states…[T]Their elite income itself embeds them: millionaires are not looking for economic opportunities – they have found them.”
This article was cited during the campaign to cast doubt on the idea that millionaires might relocate in response to the Massachusetts Question 1 Surtax, but both the transitory millionaire hypothesis and the embedded millionaire hypothesis may be true at the same time. Like everyone else, high earners have preferences and tolerances that influence their decisions.
High earners are likely to leave the state
As we’ve written elsewhere, relocation decisions are motivated by a variety of factors. The importance of each factor, including the mix of taxes deemed appropriate, may change over a lifetime. The Boy et al. The research essentially examined the tax tolerance of high earners at a given snapshot. Since then, the tax burden for elite earners has increased in many states. In 2011, California taxed $1 million in income at 10.3 percent. Now it is 13.3 percent. In 2011, the top rate in New Jersey and New York was 8.97 percent. Today, New Jersey charges a rate of 10.75 percent and New York charges a rate of 10.90 percent. The fact that more than two dozen countries have also lowered their top tax rates since 2011 only reinforces the difference between high and low tax countries. As increases in top tax rates have moved further into the fringes of what taxpayers are willing to tolerate, it’s very likely that many who were happy in 2011 have become unhappy in the 11 years since.
Because the income tax differential will place a higher tax burden on a narrower segment of earners, a key question for Bay Staters is how large the marginal effect on behavior will be. Taking the Young et al. as a conservative estimate for resettlement and applying it to the latest Treasury Department report for $1 million taxpayers, at least 1,760 millionaires should be expected to exit the Commonwealth above the 80 percent income increase in the tax rate.
If high earners leave, Massachusetts’ economy will underperform
We’ve written extensively about Massachusetts’ ongoing net churn with Adjusted Gross Income (AGI). Since 1993, Massachusetts has ceded nearly $23 billion worth of AGI to other states. The main recipients are New Hampshire and Florida, two states with no income tax on wages and salaries. As Massachusetts’ tax competitiveness is expected to fall by 34th until 46th in 2023, there’s little reason to think the trend will slow — especially since New Hampshire is phasing out its interest and dividend tax through 2027.
Policymakers should expect that the remaining high earners will limit or even reduce their productivity to avoid the cliff of the surcharge. This is especially true for small business owners in low-margin industries. Additional investments in productivity under the 5 percent flat tax scheme may have generated enough returns to justify the expense. But when the meager margin on additional investments is further eroded by a 9 percent tax, a simple cost-benefit analysis would tell many companies it’s not worth the risk.
While the constrained productivity approach may be rational from the perspective of a business striving to maximize profits, it is far from optimal for those seeking economic mobility or from a government perspective. A company that is limiting its productivity is a company that is not hiring new workers or increasing wages (which are highly correlated with output). A company that limits productivity to avoid paying an additional 4 percent in taxes is a company that may still have paid the base rate of 5 percent for additional activities.
The likely downstream effect on workers is perhaps the most damaging effect of the surcharge. Studies suggest the surcharge could shrink Massachusetts’ economy by $6 billion by the end of 2025. About $3 billion of that fall in GDP would likely come from lower consumer spending as workers have fewer job opportunities and the resulting lower, flatter wages take advantage of the outflow of wealth needed to sustain and grow small businesses.
After the approval of Massachusetts Question 1, policymakers should expect those subject to the surcharge to adjust their behavior to minimize the tax burden. An income tax change such as that approved on Election Day would be challenging for an economically efficient tax system. But even more important for Massachusetts is how the surtax interacts with the already uncompetitive corporate, wealth and unemployment taxes.
Massachusetts can mitigate damage with other reforms
To stave off greater capital flight, Massachusetts lawmakers should make structural changes to tax systems that are not enshrined in the constitution. One adjustment that could partially offset the uncompetitiveness of the surcharge tax is the reform of the property tax system, which currently ranks 45thth in the nation. Eliminating or reducing the capital stock tax, which affects all physical components a company uses for production, would be a good place to start. Property taxes, such as the inventory tax, and taxes on property transfers, such as the inheritance tax, also withdraw capital or force it out of the state. These taxes and the split property tax, which discriminates against business ownership in favor of home ownership, should be added to the capital stock tax on the list of tax reforms in 2023. This would improve the Commonwealth’s base tax system to 32nd national.
Reforms to the corporate tax system would also improve the Bay State’s fiscal competitiveness. If policies allow companies to fully account for capital investments in the year they are made and remove the throwback rule, the corporate tax system would improve by six notches to 29th national.
Massachusetts is a small state, and tax competitiveness is more important now than ever. As long as there are opportunities to shift economic activity to more competitive states, the income tax change is likely to fall short of revenue projections and exceed in its adverse effect on the state’s economy.