In an innovative political and economic trade-off, Massachusetts today required home-based life insurance companies to provide loans to small- and medium-sized companies in return for a tax break for the life insurance industry here.

The legislation, signed into law by Gov. Michael S. Dukakis today, replaces the state's 1 per cent investment income tax on state-chartered life insurance companies with a graduated net income tax starting at 45 per cent this year and phasing down to 14 per cent at the end of five years.

The tax, the only one of its kind in the nation, has been attacked by the industry since it was levied in 1971 as inequitable, placing the companies at a competitive disadvantage.

The state's price for this tax relief worked out over more than six months of tough negotiations, requires the 17 domestic life insurance companies to invest $100 million over five years in $20 million annual installments into long term, unsecured loans for Massachusetts businesses previously unable to obtain them.

The industry must fruther maintain or create 2,000 jobs in the state over that five-year period. State officials estimate the jobs will spur the creation of an additional 2,000 jobs.

The law also provides a penalty clause that would withdraw the phased tax relief to the companies if they fail to make the investment or provide the jobs.

The legislation, has been touted by various state business and consumer groups, as well as labor and political leaders.

"We're creating an important dialogue here for the first time, a marriage between the two major advantages of this state: high income service industries with high idea technology based businesses," said Robert Paterson, deputy director of the office of state planning and a driving force in the negotiations on the legislation. "I think the insurance industry will work very hard to make sure it works."

Although the legislation will cost the state about $100 million in revenue growth it anticipated over the next five years from the insurance industry, officials stressed the trade-off will keep those funds within the state and could serve as an additional source of revenue in its boost to economic development.

State Planning Director Frank Keefe, who along with the governor, State Director of Economic Development Howard Smith and Insurance Commissioner James Stone developed the trade-off plan, said the new law will help attract as well as maintain relatively small and medium sized businesses in the state.

"It was a chance to rectify what we acknowledged as aburdensome, inequitable task, and at the same time capture private investment resources that otherwise would have flown to the sunbelt, Keefe said.

Barry Gottherer, executive director of the Life Insurance Association of Massachusetts, which represents the 17 companies chartered here, said he is satisfied with the new law, terming it a "hell of a compromise."

"If the investments are out there - and we feel they are - and can be made, that I think it's an intriguing way to solve a difficult problem. Its a very innovative process and a very interesting public policy trade-off."

Gottherer said the 1 per cent investiment income tax was viewed by the insurance companies as punitive and put a tax tollback that should have been implemented several years ago.

"But as wrong as it was, we still had to deal with the political reality, he said. "There had to be a compromise to receive the tax burden and meet the political and economic needs of the state in getting that revenue."

Domestic life insurance companies were expected to have provided about $27 million in tax revenue to Massachusetts this year, according to insurance industry figures. Implementation of the 1 per cent investment tax, the industry says, caused a jump in tax revenues from these companies from about $6 million in 1970 to about $17 million in 1971.

Dukakis called the new law, "a major plus for the kind of economic development effort that we and the legislature have been trying to put together to reverse the stagnation and decline of the past.