President Biden has proposed raising the top federal tax rate on long-term capital gains from its current level of 20 percent to 39.6 percent. The rate would apply to people with income of $1 million a year or more. There are many good reasons to oppose an increase in the federal tax rate on capital gains. The capital gains tax taxes you on income you’ve already paid tax on, discourages capital formation, taxes capital gains that are due to inflation, and doesn’t raise as much revenue as a static analysis would predict.
But California Democrats have an especially good reason, whatever their personal feelings and circumstances, to oppose an increase in the capital gains tax: it will generate less tax revenue for California’s state government and, therefore, less money for them to spend.
Double, Triple, and Quadruple Taxation
First, let’s consider why capital gains taxes, and especially high capital gains taxes, are a bad idea. Let’s say you make $100,000 in a year and pay federal income tax on it. You have been taxed once. If you spend all your after-tax money on consumables—rent, food, entertainment, etc.—then end of story. You have been taxed once. I’m ignoring the sales taxes you pay because many items you buy are not taxed and sales tax rates in the United States are typically less than 10 percent.
But what if you save, say, $10,000 and use it to buy shares in a company? The company makes money and pays you dividends. In a sense, then, you have been taxed a second and third time. The second time is the 21 percent tax on the company’s profits, which means the company has less to pay you. The third time is the federal income tax you pay on the company’s dividends.
Then the company does really well and you decide to sell your shares at a price substantially above what you paid per share. You then pay a capital gains tax. That makes quadruple taxation. President Biden says he believes in tax fairness. Quadruple taxation seems incredibly unfair.
Capital Gains Taxes Hurt Even Those Who Never Pay Them
Perhaps you’re someone who pays little or no capital gains tax. Does that mean the tax doesn’t hurt you? Not at all. The capital gains tax, like the corporate income tax and the tax on dividends, discourages saving. As noted above, someone who spends his after-tax income doesn’t pay those taxes. But if he saves some after-tax income, and uses it to buy shares in companies, and if those shares gain value, he does.
So what? Here’s what. Two things that economists are most sure of are that savings are absolutely necessary for capital investment and that investment is absolutely necessary for the growth of income per capita. The more capital there is, the greater is the amount of capital per worker; the greater the amount of capital per worker, the greater is productivity; the greater is productivity, the higher are real wages and salaries. So the non-saving wage earner and salaried worker both gain from saving and capital investment. Both of them lose, therefore, when government discourages investment with high taxes on saving.
Some Capital Gains Taxes are Taxes on Inflation
Imagine you paid $100 twenty years ago for a share in a company. Today, the share is worth $180. You sell. You then pay capital gains tax on the $80. But did you really gain $80? No. In the last twenty years, the consumer price index has risen by 50 percent. So $50 of your $80 gain is just an adjustment for inflation. Your real gain is only $30. You’re paying the capital gains tax on the real gain and on the “phantom gain” due to inflation. Again, that seems unfair. Even cutting the capital gains tax rate to zero, which many economists advocate because it would increase investment and, therefore, real wages, would still leave triple taxation in place. But that’s better than quadruple taxation.
Higher Capital Gains Taxes Don’t Lead to Large Increases in Tax Revenues
If you think people don’t respond to incentives, then you will likely think that approximately doubling the tax rates on capital gains would double the amount of revenue the federal government collects from the capital gains tax. It won’t. The amount of revenue collected would likely increase but it wouldn’t come close to doubling.
The reason is that capital gains taxes are paid only when an asset—a house, shares in a company, a business, or a farm—is sold. People have a lot of discretion about when to sell a capital asset. The very fact that capital gains tax rates are increased causes people to hold off on selling their assets. So in the short run—and the short run can last a few years—many people do hold off. Some have argued that another provision of the Biden plan, taxing the capital gains in an estate after the person has died, will cause at least some people to sell assets rather than wait until they die. True, but if people expect that an increase in the capital gains tax will be repealed when a new president and Congress are elected, they will be even more likely to hold off on selling.
Sure enough, in the years after capital gains tax rates fell, capital gains realizations increased and in the years after capital gains tax rates increased, capital gains realizations fell. Here’s how Joseph J. Cordes, an economics professor at George Washington University, who was previously deputy director for tax analysis in the Congressional Budget Office, put it:
Thus, cutting the tax rate on capital gains has two opposite effects on tax collections. On the one hand, taxing each dollar of realized capital gain at a lower rate reduces revenue. On the other hand, a lower rate means there are more dollars of realized gains to tax because people have less reason to stay locked in.
Similarly, increasing the tax rate has two opposite effects on tax revenues: the higher rate on a given capital gain yields more revenue but the higher rate means fewer realized gains and, therefore, less revenue. What’s certain is that revenue would increase by a lower percent than the percentage increase in the capital gains tax rate.
For California, All Pain and No Gain
That brings us to why California Democrats should strongly oppose the capital gains increase. Even if we ignore fairness and the harmful effects on the economy, we can see that the higher federal capital gains tax rate will make the California state government’s revenues lower than otherwise.
Why? Because, as noted above, the effect of a higher tax rate will be fewer capital gains realizations. Whereas the feds could tell themselves that they’re trading off higher rates with lower realizations, that doesn’t apply at the state level where the California capital gains tax rate remains unchanged at its current high level. The California government, more than most state governments, relies on high-income taxpayers for much of its revenue. It also taxes capital gains at the same rate as normal income. In California, therefore, the tax rate on capital gains for married people filing jointly is 9.3 percent for income between $117,269 and $599,016 and reaches a whopping 13.3 percent for income over $1,198,024.
In recent years, the state government’s income from high-income Californians paying capital gains taxes has been huge. In 2018, for example, the latest year for which there are good data, Californians paid $15.17 billion in capital gains taxes. Total revenue collected that year was $133.33 billion. This means that 11.4 percent of total revenue was from capital gains taxes alone. Moreover, $13.02 billion of this was collected from taxpayers with an adjusted gross income of $1 million or more. That’s 85.8 percent of the total capital gains taxes paid and 9.8 percent of overall tax revenues. It’s too soon to tell what the data are for 2020 but the odds are that even more was collected in capital gains tax revenue.
The fact that high-income Californians, the Californians who are targeted by President Biden’s tax proposal, pay so much has huge implications. It’s quite plausible, given past experience, that the higher capital gains tax rate would cause high-income people to cut their capital gains realizations by 40 percent or more. If that happened, and if high-income Californians acted like other high-income Americans, then the state government’s revenue from capital gains taxes would fall by 40 percent. If 2022, when the tax increase would presumably take place, were like 2018 in terms of percent of state revenue accounted for by capital gains taxes, then California’s state government revenue would be 3.9 percent lower than otherwise.
Why do I focus on California Democrats? Because, in case you haven’t noticed, California is a one-party state. The Democrats have supermajorities in both houses of the legislature and have the governorship as well. Also, in case you haven’t noticed, they love spending our tax money. If the Biden capital gains tax increase were to pass, they would have less money to spend. Even if they don’t care much about tax fairness or about the economy generally, I’m quite confident that they care about having more money to spend rather than less. That’s enough of a reason for them to oppose the Biden capital gains tax increase with all their might.
