Massachusetts’s proposed ‘Millionaires’ Tax’ will push up the federal deficit

While many readers are focused on Tax Day, there is a proposed tax change in Massachusetts that should have all who are interested in fiscal policy concerned. In November, Bay State voters will decide whether to adopt an amendment to the state constitution imposing a 4 percent surtax on annual taxable income above $1 million starting in 2023. If successful, Massachusetts will join California, New Jersey and Washington, D.C., as a member of the Millionaires’ Tax Club. 

While a 4 percent surtax may seem small, it would be added on top of a 5 percent flat state individual income tax rate and a top federal individual income tax rate of 37 percent. If the amendment is adopted, the combined federal-state marginal tax rate on ordinary income for high-income earners in Massachusetts will be 46 percent in 2023 (lower rates will apply to dividends and capital gains). Progressives may be drawn to the social justice and “fair share” arguments for this tax hike, but the fiscal consequences — including the effects on federal revenue — may be quite disappointing.

To begin, the revenue raised by the surtax at the state level will be smaller than many people think. Raise Up Massachusetts, the advocacy group supporting the tax, has offered a wildly optimistic forecast that the tax hike would raise $2 billion in additional revenue each year. Unfortunately, this forecast ignores the well-known reality that taxpayers try hard to reduce their tax liability, a behavioral response that economists refer to as the elasticity of taxable income. High-income taxpayers are known to be the most adept at these strategies.

Modifying the revenue forecast to incorporate evidence from the academic literature about likely behavioral changes yields a significantly lower estimated revenue pickup. I estimate that about 400 of the 22,000 taxpayers affected by the surtax would exit the state and many others would reduce work or shift and relabel their income to avoid the tax. By my estimate, the surtax would generate approximately $1.5 billion in 2023, since these behavioral responses would offset 32 percent of the revenue gain that would occur if taxpayers kept their behavior unchanged. Using a similar approach, Tufts University’s Center for State Policy Analysis recently estimated that the proposed surtax would generate only $1.3 billion in 2023.

The surtax’s impact on federal tax revenue raises bigger concerns. Every $100 decline in taxable income among millionaires in Massachusetts would reduce federal revenues by as much as $37, depending on the type of income and the adopted tax avoidance strategy. Strikingly, the federal revenue loss, which I estimate to be $1.9 billion, would exceed the revenue gain for Massachusetts. And who would save on their federal tax bill? Millionaires in Massachusetts. Advocates of the surtax may not realize that it would result in some wealthy Massachusetts residents actually paying less total tax than they would have.

Finally, the expected revenue from Massachusetts’s surtax depends on future federal tax changes. For example, President Biden has proposed increasing the top marginal federal income tax rate to 39.6 percent. With a 4 percent surtax in effect, that change would bring the top combined marginal tax rate to 48.6 percent in Massachusetts, and high-income taxpayers in that state would respond by further reducing their taxable income. I estimate this increase in the top federal rate would cause Massachusetts’s tax revenues to fall by an additional $180 million, pulling the annual revenue forecast of the proposed millionaire’s tax down to $1.3 billion.

As the proposed surtax illustrates, the use of high marginal income tax rates to achieve income redistribution and finance expanding government services faces significant practical limitations. The interplay between state and federal tax policy changes further complicates matters. When Democrats at the state and federal level raise tax rates in pursuit of populist and progressive goals, they are effectively stealing from each other’s coffers.

Alex Brill is a senior fellow at the American Enterprise Institute in Washington. He previously was the policy director and chief economist at the House Committee on Ways and Means.