California Falls the Hardest if Feds Go Over the Cliff

Published in Investor's Business Daily

‘Fiscal cliff” is the most popular buzz term these days in Washington D.C., and with good reason. A wrong turn in policy might mean another economic recession next year.

As the two parties posture and negotiate, states are also keeping a watchful eye, particularly those with high stakes budgets on the table. The latest example of that is California.

In its latest fiscal outlook, California’s nonpartisan Legislative Analyst’s Office predicts that if lawmakers fail to strike a deal, California’s projected budget deficit of $1.9 billion in 2013-14 period might become an even bigger headache and future predicted surpluses after 2014 might turn into deficits.

In this alternative scenario, the analyst assumes a 0.6% contraction of real U.S. GDP in 2013, rather than 1.8% growth in their original baseline. This switch from economic growth to a recession at national level means $11 billion lower state revenues for the 2012-13 and 2013-14 combined budget period for California.

As wisely noted in the report “uncertainty about federal tax and spending policy inhibits risk-taking and causes businesses and consumers to be more cautious in their spending and investment decisions.”

One of these uncertainties sure to have an impact on investment decisions of consumers and businesses is capital gains tax rates.

Investors already face high combined federal and state tax rates on capital gains. A recent analysis released by the American Council for Capital Formation based on survey conducted by Ernst & Young shows that currently, investors face state-level capital gains taxes in 41 states with an average top individual capital gains tax rate on corporate equities of 5.7% in 2012.

Combined with the federal rate, these taxes substantially increase the separation between what an investment yields and what an individual actually receives (known as the “tax wedge”).

The higher the tax wedge, the fewer investments that will be worth an investor’s time and risk, resulting ultimately in fewer investments being undertaken and longer holding periods as investors delay selling assets. Both of those outcomes will ultimately further pressure tax receipts.

California is among a handful of states with extraordinarily high state taxes on capital gains.  Recent approval of retroactive tax changes in California already increased the top capital gains tax rate to 13.3% from 10.3%.

Currently, a California resident pays a top combined effective federal and state rate of 23.6%.  That’s under the current tax scenario where the Bush-era tax cuts, including those on capital gains, were extended until the end of this year.

Investors will be subject to a mandatory 3.8% Medicare surcharge on savings and investment as part of the new health care law so the effective combined rate increases to 27.4% in 2013 if federal rates extended one more year.

Then there’s the most sobering scenario — if Congress doesn’t act — and allows rates on federal capital gains taxes to return to 20% plus the Medicare surcharge.  Under that scheme, Californians would see a dramatic jump to 33% combined rates.

What does this mean for California’s capital gains tax revenues? Californians have been already suffering due to harsh economic conditions and the state’s overall tax revenues reflect this trend.

Capital gains revenues are only one part of this trend and you don’t need to look very far back in history to see that collections from capital gains taxes dropped substantially in 2009-10 to $2.6 billion from almost $12 billion during more prosperous times, according to revenue estimates of the governor’s 2012-13 January budget.

Imagine what a top 13.3% state tax rate combined with a jump in the federal capital gains tax will do to the state if the extension on Bush-era tax cuts are allowed to expire at the end of this year.

Then there’s the impact on employment. In recent years each $1 billion increase in investment in the U.S. is associated with an additional 23,200 jobs. Conversely, decreasing the amount individuals and firms will invest due to federal and state capital gains taxes form a direct impediment to entrepreneurship and economic growth.

Recent research by economist Allen Sinai has already predicted a decrease in jobs simply from moving from the current 15% tax rate on long-term capital gains to 20%. Real economic growth falls by an average of 0.05 percentage point and jobs will decline by an average of 231,000 per year.

The political poker over the fiscal cliff will continue until time runs out. Unfortunately, Californians have the highest number of chips on the table and they can’t afford to lose this hand.

Wilber is senior economist for the American Council for Capital Formation, a nonprofit, organization promoting pro-capital formation policies and cost-effective regulatory policies.