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Connecticut Lawmakers Mull Capital Gains Surtax

3 min readBy: Jared Walczak

Governor Ned Lamont (D) is sounding a skeptical note, but in Connecticut’s legislature, a capital gains surtax proposal may be gaining steam. Under the proposal, capital gains—both short- and long-term—for filers subject to the state’s current top rate (6.99 percent) would be subject to an additional 2 percent on the income taxA tax is a mandatory payment or charge collected by local, state, and national governments from individuals or businesses to cover the costs of general government services, goods, and activities. , yielding a capital gains taxA capital gains tax is levied on the profit made from selling an asset and is often in addition to corporate income taxes, frequently resulting in double taxation. These taxes create a bias against saving, leading to a lower level of national income by encouraging present consumption over investment. rate of 8.99 percent. If adopted, it would make Connecticut only the second state to adopt a higher rate on short-term capital gains than on ordinary income, and the only state to impose a higher rate on long-term capital gains (though under a recent proposal, Minnesota would do likewise).

At 8.99 percent, Connecticut would have the sixth-highest top rate on long-term capital gains and the fifth-highest rate on short-term capital gains in the country, which could pose problems for a state already struggling with an outmigration of high earners.

Highest Top Marginal Rates on Capital Gains
State Short-Term Gains Long-Term Gains Ordinary Income
California 13.3% 13.3% 13.3%
Massachusetts 12.0% 5.05% 5.05%
New Jersey 10.75% 10.75% 10.75%
Oregon 9.9% 9.9% 9.9%
Minnesota 9.85% 9.85% 9.85%
Connecticut (proposed) 8.99% 8.99% 6.99%

Concerns grow when you consider that Connecticut has the third-most hedge fund managers in the country, after New York and California, and the second largest pool of assets under management ($390 billion). Thirteen percent of all hedge fund assets are in Connecticut, even though the state only accounts for 1 percent of the nation’s population. The state is home to many wealthy individuals with significant capital gains income—and they’re highly mobile, already paying a lot.

Connecticut’s proposed higher tax on capital gains income would be the opposite of federal treatment, where capital gains receive a preferential rate. This is even more significant a difference when it is recognized that, even with a lower federal rate on long-term capital gains, the tax code is biased against saving and investment. The federal government is attempting to mitigate that bias with preferential rates; Connecticut would exacerbate it.

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Capital gains taxes represent an additional layer of tax on capital income after the corporate and individual income taxAn individual income tax (or personal income tax) is levied on the wages, salaries, investments, or other forms of income an individual or household earns. The U.S. imposes a progressive income tax where rates increase with income. The Federal Income Tax was established in 1913 with the ratification of the 16th Amendment. Though barely 100 years old, individual income taxes are the largest source of tax revenue in the U.S. ; any tax on them is double taxationDouble taxation is when taxes are paid twice on the same dollar of income, regardless of whether that’s corporate or individual income. . Moreover, gains are not adjusted for inflationInflation is when the general price of goods and services increases across the economy, reducing the purchasing power of a currency and the value of certain assets. The same paycheck covers less goods, services, and bills. It is sometimes referred to as a “hidden tax,” as it leaves taxpayers less well-off due to higher costs and “bracket creep,” while increasing the government’s spending power. , so investors are often taxed on phantom gains. This is bad for investors—a group that includes worker pension and retirement fund holders—and for entrepreneurs alike, the former because it cuts into gains, the latter because it reduces return on investment and skews what sort of investments are made.

Singling out capital gains for an additional tax also doubles down on an extremely volatile source of revenue. Capital gains are already responsible for a significant share of forecasting error in individual income taxes. A task force co-chaired by former Federal Reserve Board Chairman Paul Volker and former New York Lt. Governor Richard Ravitch (D) found that “capital gains are the most erratic [tax baseThe tax base is the total amount of income, property, assets, consumption, transactions, or other economic activity subject to taxation by a tax authority. A narrow tax base is non-neutral and inefficient. A broad tax base reduces tax administration costs and allows more revenue to be raised at lower rates. component] as they depend not only on stock market performance but also on taxpayers’ choices about whether and when to sell assets,” noting that during the Great RecessionA recession is a significant and sustained decline in the economy. Typically, a recession lasts longer than six months, but recovery from a recession can take a few years. , overall adjusted gross incomeFor individuals, gross income is the total pre-tax earnings from wages, tips, investments, interest, and other forms of income and is also referred to as “gross pay.” For businesses, gross income is total revenue minus cost of goods sold and is also known as “gross profit” or “gross margin.” in New York (including income from capital assets) fell 18 percent, but capital gains subject to income fell a full 75 percent.

Nationally, the realization of capital gains slid 71 percent between 2007 and 2009; 55 percent just in 1987; and 46 percent in 2001. Massachusetts, the only state with a surtaxA surtax is an additional tax levied on top of an already existing business or individual tax and can have a flat or progressive rate structure. Surtaxes are typically enacted to fund a specific program or initiative, whereas revenue from broader-based taxes, like the individual income tax, typically cover a multitude of programs and services. on capital gains income (and then only on short-term gains), has sought to insulate itself from some of the volatility by prohibiting any budget from relying on more than $1 billion in capital gains revenue, dedicating anything in excess of that amount to the state’s Rainy Day Fund.

Gov. Lamont, responding to the proposal, said, “I’ve been pretty strict on not raising tax rates. Everybody comes in and goes, ‘C’mon, Gov, it’s just a half a point. It’s just another point. It’s not that big a deal.’ But it’s the fourth time in 12 years or something like that.” He’s right—and lawmakers would do well to keep any such proposal out of the state budget.