One of the biggest thorns in the state budget has been overreliance on revenue from the tax levied on capital gains. In good times, the capital gains tax funds programs and services and supports an operating reserve. But in bad times, this revenue evaporates. Long overdue reform to smooth spending to accommodate these fluctuations was passed with the FY2011 budget, but more must be done to better insulate the state budget from future volatility.

In a 2008 policy brief, we analyzed the problem with capital gains revenue and recommended several strategies about how to deal with the significant variability in collections from year to year. While exposure to capital gains volatility is something all states face, the challenge has been even more difficult to hedge against for Massachusetts, which ranks third in the nation for reliance on capital gains.

At the most recent peak, the capital gains tax brought in $2 billion, over 10 percent of state tax revenues. When capital gains collections fell by 62 percent in 2008, the state budget suddenly had a $1 billion hole. These swings were not unpredictable. Between 2000 and 2001, capital gains revenues dropped 75 percent, an even steeper dive (Figure 1).

MassINC’s 2008 policy brief recommended depositing all capital gains collections above a seven-year average in a reserve fund. The fix passed in this year’s budget – spending up to $1 billion in capital gains revenue and diverting anything above this threshold to the state’s reserve fund – was originally proposed by Gov. Deval Patrick during debate over the FY2010 budget. This approach differed from the Legislature’s, which would have sent 50 percent of all capital gains revenues above the previous year’s level to the stabilization fund. No agreement was reached on language and the proposal died. In this year’s budget, the governor achieved the solution he had been seeking.

How different are these three proposals? One way to compare is looking at where we would be had they been in place over the last business cycle (Figure 2). Between 2000 and 2007, Gov. Patrick’s $1 billion threshold would have transferred $2.6 billion in capital gains revenue to the rainy day fund. The 50 percent rule would have sent just $1.1 billion to reserves. MassINC’s 7-year-average approach would have sent $2.4 billion to the reserve fund.

The $1 billion threshold seems like the most fiscally conservative. But it remains to be seen how sustainable this approach will be. Without a rule-of-thumb for smoothing out spending, budget makers will be left to their own devices in determining how and when withdrawals should be made from the rainy day fund to compensate for the inevitable fluctuations in capital gains collections.

Providing more structure and certainty around capital gains spending is critical because the state’s other revenue sources have been overcome by a perfect storm. Aside from capital gains, business taxes – another highly cyclical revenue source – were the only other revenue source that increased during the last expansion (Figure 3). Online shopping has eroded the sales tax, fuel efficiency has taken a heavy toll on the gas tax, and lawmakers have, understandably, wanted to keep income taxes low given increasing strain on family budgets.

Given that capital gains will most likely continue to be the engine of state revenue growth in the years ahead, additional action is needed to avoid more instability. Once capital gains taxes replenish the rainy day fund, legislation is needed to direct the state to use excess revenue to address one-time, long-term projects, such as paying down unfunded pension liability and reducing the state’s high debt burden. With this second piece of reform in place, we’ll be left with two options to fund ongoing activities: Raising additional revenues using other taxes or holding the line on spending as tax revenues rebound. Only by adopting one of these two approaches can the state truly address its unhealthy exposure to capital gains volatility.

While these last reforms remain, we must acknowledge the hardworking fiscal stewards at A&F and the Ways & Means committees. They managed to keep this important issue on the agenda during a very challenging year for the Legislature.

(Greg Torres is the president of MassINC and Sam Greeley is a public policy intern at MassINC.)