Mind the Gap
This is a warning that a conductor on a train tells passengers who are departing to watch for the gap between the train and the platform. In the case of municipal finance, the gap refers to when revenues do not match the expenditure requirements in a proposed budget.
Budget gaps are becoming more frequent this year and have become larger in scope. Some of this growth is due to the lapsing of federal aid that was passed during the Covid years. Traditional sources of revenue do not appear to be sufficient to the task of fully funding all the expenditure needs and requirements.
Due to this recent trend, many governments are interested in adopting measures to assist in closing the gap. Among these measures are millionaire’s taxes, billionaire’s taxes, asset taxes, and other variations. If one examines these proposals through the political prism, much smaller groups are affected by the proposals than the general electorate.
In 2023, Massachusetts imposed a 4% surtax on incomes over $1 million. Since the level is indexed the threshold is $1.083 million for FY 2026 and $1.107 million for FY2027. There is also a capital gains tax of 8.5% for holdings less than a year and 5% for holdings more than one year. Capital gains are figured into the basis for the income tax surcharge.
There is not much evidence that there has been a flight of millionaires from the Commonwealth. More important is the revenue gains have been quite significant. Surcharge revenues for FY2026 are estimated at $2.4 billion and for FY2027 are estimated at $2.2 billion. Clearly, these amounts are bolstering the budget.
Earlier this year California distinguished itself by disclosing the initiative push to put a billionaire’s tax into effect if approved by the voters in November. This would be a 5% tax on assets held for those residing in the state on January 1, 2026. Estimates vary on the estimated receipts that would assist with the gap and presumably for MediCal (Medicaid in California). The estimated range of receipts is $100 billion over the five-year period.
Some members of the billionaire’s class became aware of the 01/01/26 deadline and moved prior to the proposed deadline and vote. Others remain but are spending heavily to thwart the initiative. Even if enacted, some believe the measure may be disputed on legal grounds.
The state of Washington just enacted an income tax for the first time to be applied to incomes of $1 million and more. The tax does not go into effect until 2029. Some believe that legal challenges may have some traction since the state has never had an income tax and there was a belief that the state’s constitution prohibits such a tax. Nevertheless, the legislature approved the tax.
Other states are also engaged in an array of proposals. It appears that New York State has approved of a pied a terre tax for second homes with valuations over $5 million. This new tax is designed to raise $500 million to be applied to a budget gap of some $5 billion for the NYC. According to the most recent iteration of the proposed formula, second single family residences will be taxed on a graduated scale from an 0.8% additional tax at the $5million level to an additional 1.3% at the $25+ million level. For COOPs and Condos for the next two years the additional tax will start at 4% at the million level to 6.5% at the $5 million plus level.
Another feature of the proposed law is a tacit admission that the valuation system for COOPs and Condos does not reflect the real valuations for these units. There is an explicit proscription to create a new valuation system over the next two years that will be a more reality-based system based on actual market values. The implication is that the new valuation will establish a much higher basis of valuation for the new pied a terre taxes.
The key to all these proposals and new tax laws is whether the revenues will be forthcoming. The eventual yield from the proposed tax is critical.
In the past, one of the practices in municipal finance has been to put temporary surcharges into place. New York state has done so in the 1990’s. The problem is the eventual lowering of the rate does not always take place due to tighter financial times.
These actions are being taken to reduce the need for expenditure cuts among other reasons. One of the most important reasons is to preserve the entities’ bond ratings. Rating agencies generally view tax increases as reliable revenue sources that ramp up quickly.
It remains to be seen how many more of these actions will be taken. Blue states are clearly more predisposed to taking such actions than Red states.
Market Matters
As for market matters, the crossing of the 4.5% level for the ten-year treasury is instructive. Rates are going higher in part due to the higher inflation readings. Hopes are dimming that there will be at least one ease this year. The new Fed Chair will be navigating many crosscurrents including implications from the wars, inflation, slowing hiring and employment, and other factors. The mandate is focused on inflation and employment as the most critical items for Fed consideration. The context includes a relatively strong equity market despite a heightened level of volatility.
As for the municipal market, we are closing in on the deadlines for budget enactment. In New York State we are well beyond the deadline. Final features and details of the budgets will affect credit and spreads. Spreads are more likely to be affected than credit ratings.
John Hallacy
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