Connecticut Lawmakers Mull Capital Gains Surtax

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 tax, yielding a capital gains tax 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.

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.

Capital gains taxes represent an additional layer of tax on capital income after the corporate and individual income tax; any tax on them is double taxation. Moreover, gains are not adjusted for inflation, 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 base 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 Recession, overall adjusted gross income 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 surtax 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.