State governments and budgets are always subject to the ups and downs of the economic cycle. Massachusetts is no exception. The current economic crisis demonstrates that the volatility of the Commonwealth’s budget is exacerbated by its reliance on capital gains tax revenue to support spending. The fiscal year 2011 budget includes a proposal to reform the way the Commonwealth budgets for capital gains tax revenues to promote fiscally sound budgeting practices and curb the problem of recurring structural deficits.
Tax receipts from capital gain income are the state’s most volatile source of revenue. These tax revenues nearly doubled from fiscal year (“FY”) 2004 to 2008, from $869 million to $2.2 billion. But in fiscal year 2009 fell by over $1.6 billion to $554 million. While some of the revenue during the 2004-2008 period was used to replenish the state’s Stabilization Fund, there was no formal policy guiding the use of these revenues. Without such a policy, fluctuations in tax revenue can contribute to structural budget deficits when the state makes spending commitments during strong years that cannot be fully sustained when the economy declines.
To address this problem, the fiscal year 2011 budget establishes a new mechanism for budgeting for capital gains revenues. As one element of the yearly consensus revenue process, the Governor and Legislature would agree on a maximum amount of capital gains tax revenues that would be included in the overall consensus revenue estimate. This amount would be based on projections for the fiscal year, as well as principles of prudent budgeting necessary to modulate the impact of this fluctuating revenue source, and subject to a $1 billion annual maximum.
Any capital gains tax revenues in excess of $1 billion would be transferred to the Stabilization Fund, except for 5% of such excess which will be transferred to the State Retiree Benefits Trust fund to pay for unfunded retiree health insurance liability.
How was the $1B threshold established?
Long-term historical averages were mostly in the $.9-$1.2 billion range depending on the time period and inflation assumptions. We selected a figure at the low end of the range to ensure discipline and in light of the recent steep decline in the stock market. This decline has resulted in a significant amount of unrealized losses and capital loss carryovers that will likely dampen growth in revenue from capital gains income over the next several years.
The deposit of excess capital gains tax revenues to the state’s Stabilization Fund during periods of economic prosperity would serve as a “cushion” in years when markets decline and capital gains revenues fall. This will help ensure that the state does not build recurring spending on a foundation of unsustainable levels of revenue and help mitigate the fiscal impact of economic downturns.