Capital Gains tax hike will hurt state coffers

Published in The Hill

The Buffett Rule, a measure to raise income tax rates on individuals and capital gains of top-earning Americans, recently received its first close up in the U.S. Senate and failed. Nevertheless, President Obama, Senate leaders and others have pledged to continue to raise the Buffett Rule again and again this campaign season in the name of tax “fairness.”
Many arguments against the Buffett Rule have been made, but perhaps a very compelling is the unintended consequences this war on savings and investment could have on our economic recovery, particularly in states whose budget receipts are dependent on collection of capital gains taxes.

Investors already face high federal and state tax rates on capital gains. A new 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 5.2 percent 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.

Consider the perspective of a potential investor, who sees the tax wedge growing larger and larger on the horizon. The ACCF paper examined three scenarios: first, the current 2012 rates; second, the current federal capital gains rate of 15 percent along with the 3.8 percent Medicare surcharge on filers making $200,000 and above individually or 250,000 and above as a couple; and third, the increased capital gains rate of 20 percent along with the Medicare surcharge. Ask yourself: How excited am I to take a risk in this environment?

Under the third and entirely plausible scenario, Californians and Hawaiians will pay more than 31 percent of their long term capital gains directly to various governments, with 39 other states feeling various forms of pain, including Vermont, Maine, and D.C. residents, who will pay 30 percent. If the Buffett Rule means a 30 percent tax rate on all income over $1 million is enacted, the combined federal and state tax capital gains tax rate will rise even further.

These consequences should not be taken lightly. Investment is a key factor in creating and growing jobs. To wit, in recent years each $1 billion increase in investment is associated with an additional 15,000 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 Dr. Allen Sinai, an internationally highly regarded economist, has already predicted a decrease in jobs simply from moving from the current 15 percent tax rate on long-term capital gains to 20 percent. Real economic growth falls by an average of 0.05 percentage points and jobs will decline by an average of 231,000 per year.

A hike in the federal rate will be bad for states and those trying to govern them, as well—especially in those areas that rely on individual capital gains taxes to pay for services. The ACCF report shows that in 2009 New York was the most dependent state on capital gains taxes taxes with 7 percent of its individual taxable income. Four states (Georgia, Virginia, Pennsylvania, New Jersey) counted on such taxes for 3 percent of their taxable income, three states (California, Massachusetts, Illinois) tallied 4 percent, and one each at 5 percent (Connecticut), and 6 percent (Colorado).

Perhaps vocal proponents of the Buffett Rule may be unaware of the importance of  capital gains taxes for state fiscal integrity but this is cold comfort to states feeling the pinch today and tomorrow. Raising taxes on capital gains will surely hurt these states’ budget receipts, especially when one considers that between 2007 and 2010 individual income tax receipts went down by 14 percent in California, 15 percent in Colorado and Virginia, and 20 percent in Georgia.

Taken at their word, politicians and pundits looking to the Buffett Rule for its economic benefits (rather than political attractiveness) would do well to keep looking for solutions that boost investment. That is the steadfast and reliable “rule” that will lead to more jobs and fuller state and federal coffers.

Thoming is senior vice president and chief economist of the American Council for Capital Formation, a nonprofit, nonpartisan organization promoting pro-capital formation policies and cost-effective regulatory policies.