Washington State Capital Gains Tax Proposal Raises Volatility Concerns

May 14, 2015

The ability to foresee that some things cannot be foreseen is, as Rousseau once observed, a very necessary capacity. Several states learned that lesson with regard to capital gains revenue during the last recession—but can Washington State benefit by their example?

I’ve written previously about Washington State’s budget debate, as Governor Jay Inslee (D) and his legislative allies seek to raise taxes to fund a multibillion dollar increase in state expenditures. Among the most controversial elements of the proposal is a proposal that would make Washington the only state to tax capital gains but not impose a general income tax.

Critics of the plan have already documented how capital gains taxes substantially increase tax volatility, but to many, it may not be obvious just how volatile capital gains can be. The following chart, which shows realized capital gains as a percentage of GDP, provides an idea:[[{“type”:”media”,”view_mode”:”media_large”,”fid”:”14990″,”attributes”:{“alt”:””,”class”:”media-image”,”height”:”373″,”style”:”font-size: 13.0080003738403px; line-height: 1.538em; width: 450px; height: 271px;”,”typeof”:”foaf:Image”,”width”:”620″}}]]
Sources: U.S. Department of the Treasury; Bureau of Economic Analysis

The realization of capital gains slid 71 percent between 2007 and 2009. The data from previous recessions are little better: capital gains slipped 55 percent in a single year in 1987 and 46 percent in 2001. Large swings in capital gains are not uncommon, making capital gains income a particularly risky tax base—so much so that they’ve been identified by some as the lead culprit behind state revenue forecasting errors. According to the Rockefeller Institute:

Increases in forecasting errors have been driven by increases in revenue volatility, which in turn have been driven in large part by volatile capital gains, which have grown as a share of adjusted gross income over the last several decades.

Researchers at the Chicago Federal Reserve Bank reached a similar conclusion, writing that “increasing income cyclicality, in particular of capital gains, have made state revenues more responsive to the business cycle since the mid-1990s.” The researchers further noted that “The cyclicality of capital gains tends to have a disproportionate effect on state income tax revenues compared to other sources of taxable income because capital gains are more concentrated in the top tax brackets.”

How volatile are capital gains compared to other economic measures? Consider this bracing statistic from the final report of the State Budget Crisis Task Force (co-chaired by Richard Ravitch and Paul Volker): “In New York, overall adjusted gross income fell by 18 percent between 2007 and 2009, and capital gains subject to income tax fell by 75 percent” (emphasis mine). As the report noted, “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.”

That is to say, heavy reliance on capital gains as a revenue source magnifies existing volatility in the system, and capital gains can even see large swings when other revenue streams are stable, depending on taxpayer decisions on when to realize their capital gains or losses.

Effective budgeting requires revenues to be predictable and relatively stable. All projections err to some degree, and no revenue sources are immune to economic conditions, but what Washington State is considering—ultimately relying on capital gains taxes for $1.3 billion in tax revenue per biennium—could leave the state in a serious bind.

The reliability problem is so acute that Massachusetts recently undertook measures to insulate itself, prohibiting any budget from relying on more than $1 billion in capital gains revenue. Any amount received in excess of that sum is to be deposited into the state’s Rainy Day Fund to help bridge the gap when revenues inevitably come up short, and to keep the state from relying too heavily on such a volatile revenue source.

The Massachusetts policy was praised by Fitch Ratings. Meanwhile, in response to Governor Inslee’s budget, S&P noted, “We have observed that capital gains-related tax revenues are among the most cyclical and difficult to forecast revenues in numerous other states,” though in doing so, they only echoed the state’s own fiscal analysts, who previously concluded that “Capital gains are extremely volatile from year to year” and warned that “[f]orecasted amounts in this fiscal note could be greatly over or understated.”

That’s certainly something for Washington State lawmakers to bear in mind.

More on Washingon State here.

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