(Archived document, may contain errors)
December 29,1995
BALANCED BUDGET TALKING POINTS #8: HOW A CAPITAL GAINS TAX CUT WOULD BOOST STATE REVENUES
William W. Beach Visiting Fellow in Tax Analysis The vetoed congressional budget plan would significantly cut effective taxes on capital gains, both for individuals and for businesses. The Heritage Foundation estimates that this important tax cut could cause millions of taxpayers to declare billions of dollars in capital gains during the first year of the lower effective rates. Because 40 states require taxpayers to report all capital gains de- clared on their federal tax forms, this sudden growth in capital gains may create a one-year state income tax windfall of $9.5 billion. If taxpayers were to "unlock" appreciated assets during the first year of lower capital gains taxes under the congressional budget plan, states that tax capital gains would Rely see their income tax revenues increase by an average of 11.6 percent. Some states might experience an especially high one-time percentage increase in their income tax receipts. For example: State Percent Increase in Income Dx Revenugs California 16.01%
Connecticut 21.28%
Iowa 18.92%
New Mexico 27.28%
Ohio 12.24%
The reason for this state tax "windfall" actually is quite simple. Reducing the tax rate for capital gains actually increases tax revenues from taxpayers who own appreciated assets. Experience over the last 25 years with changes in capital gains tax rates strongly indicates that rate decreases pro- duce more declarations of capital gains and more capital gains taxes. Owners of appreciated assets who face high tax rates generally hold on to or "lock up" their assets in anticipation of lower future rates. When the raies come down, the amount of capital gains declarations goes up. YY1 MW5
Economists estimate that trillions of dollars in unrealized or "locked up" capital gains (perhaps has high as $7.5 trillion) exists in the portfolios of American taxpayers. I Some economists have esti- mated that significant capital gains rate changes could produce substantial economic benefits and create revenue windfalls for federal and state governments. 2 In an article last year for the American Economic Review, Leonard Burman and William Randolph, two leading tax economists on the staff of the Congressional Budget Office, estimated the response of taxpayers to rate reductions as being in the order of 6 to 1. That is, for every one percent drop in the rate, capital gains realizations rose by 6 percent. 3 The accompanying table shows three different state "windfall" scenarios, representing the range of expert opinion on how declarations are affected by a change in the rate. Each scenario uses the ac- tual capital gains declarations by individuals as reported in the IRS's Public Use File for 1991. 4 The first set of columns shows the low estimate, which is calculated by multiplying the drop, in the effective tax rate by 0. 17. This means a 50 percent decrease in the effective capital gains tax rate re- sults in a 51 percent increase in capital gains declarations. The third set of columns shows the high estimate, which multiplies the 50 percent decrease by the "transitory tax elasticity" estimated by Burman and Randolph: 6.42. While Burman and Randolph offer solid evidence for this strong level of taxpayer response to a change in the capital gains tax rate (which in the table leads to a 321 per- cent increase in declarations), it is probably imprudent for states to budget on this optimistic out- come. Thus, the second set of columns shows the midpoint between the low and high responses. The midpoint estimates reflect an increase in declarations of 156 percent for a 50 percent drop in the tax rate.
As always, the difficult part of estimating tax revenues from capital gains is forecasting the value of the appreciated assets taxpayers will liquidate and the time of their liquidation. No particularly good and reliable revenue model exists for this purpose. Thus tax analysts are left with calculating historical responses to tax changes and assuming that the future will be very much like the past. Thus, these Heritage "mid-poinf' estimates, based as they are on data from a slow economic year and a mid-range level of taxpayer response, should give state revenue officers a reasonable number for incorporating into their state income tax forecasts. These middle estimates also illustrate conser- vatively that what happens to capital gains at the federal level has important implications for the revenues of 40 states. Besides the good economic effects on state economies resulting from a bal- anced budget with tax cuts, the congressional budget plan actually supplies the states with addi- tional revenue that they can use to meet their additional responsibilities. If, on the other hand, the capital gains cut were to be pared back or eliminated in the negotiations over a budget, that would reduce or eliminate the revenue benefit to states with a capital gains tax.
I See, for example, Jude Wanniski's testimony before the Senate Finance Committee on March 15, 1995, as cited in Stephen Moore and John Silvia, "The ABCs of the Capital Gain Tax," Cato institute Policy Analysis No. 242, October 4, 1995. 2 For an overview of how the economy likely will react to the tax and spending policy changes contained in the congressional budget plan, see William W. Beach and John S. Barry, "What a Balanced Federal Budget with Tax Cuts Would Mean to the Economy," Heritage Foundation F. Y.L No. 69, November 14, 1995. 3 Leonard E. Burman and William C. Randolph, "Measuring Permanent Responses to. Capital-Gains Tax Changes in Panel Data," American Economic Review, Vol. 84, No. 4 (September 1994), p. 803. 4 Because the economy performed poorly in 1991 and the year saw weakgrowth in the value of stocks and other capital assets, the Heritage estimates of state revenue increases probably are understated. The Public Use File for 1991 is the only publicly available source of detailed taxpayer information extracted from actual tax returns. The Public Use File. for 1992 was not available at the time Heritage performed this analysis. Thus, Heritage is using the most recent, detailed tax data supplied to the general public by the IRS. Chart 1 Estimated One-Time State Revenue Windfall from Capital Gains Tax Cuts in the Congressional Plan (Estimates Reflect the Possible Capital Gains Declarations from a 50% Reduction in U.S. Effective Tax Rate) Low Estimate Mid-Point Estimate High Estimate Dollar Increase in Percentincrease Dollar Increase in Percentincrease Dollar Increase in PercentIncrease States Individual Income in Revenues Individual Income in Revenues Individual Income in Revenues Tax Revenues Tax Revenues Tax Revenues
Alabama 7,533,095 0.64% 13Q78Z903 11.14% 268.68Q396 22.88% Alaska 0 0.00% 0 0.00% 0 0.00% Arizona 10.786,428 0.87% 1 B7,264,375 15.03% 384.715,931 30.88% Arkansas 4.548.869 0.57% 78.973.413 9.95% 162.242.979 20.44% California 155,097,431 0.92% 2,692.663,733 16.01% 5,531,808,373 32.89% Colorado 7,962.217 0.54% 13813Z927 9.43% 283.985,725 19.37% Connecticut 5.816.343 1.23% 100,978,177 21.28% 207,449.566 43.71% Delaware 1,457.085 0.32% 25,296,609 5.48% '51,969,353 11.26% DC 3,189.210 0.52% 55,368.225 8.99% 113,748,482 18.47% Florida 0 0.00% 0 0.00% 0 0.00% Georgia 14,751,984 0.50% 256.1 IQ828 8.69% 526.154.085 17.85% Hawaii 5,610,924 0.64% 97,411,867 11.16% 200,122.940 2193% Idaho 3,858,120 0.86% 66.981,242 15DI% 137,606.264 30.84% Illinois 14.033.483 0.31% 243.636,851 5.37% 500.527.546 11.03% Indiana 7,094,706 0.32% 123,171,972 5.64% 253,044.499 11.59% Iowa 14.640.163 1.09% 254,169,504 18.92% 522.165.829 38.86% Kansas 6,980.442 0.79% 121.188,222 13.76% 248,969.083 28.27% Kentucky 8,135,410 0.48% 141,239.755 8.34% 290.16Z953 17.14% Louisiana 6,867,028 0115% 119,219,229 14.84% 244.923,984 30.48% Maine 4.237.460 0.73% 73.567,010 12.67% 151,136,065 202% Maryland 9,021.993 0.31% 156.631,816 5.34% 321.784.402 10.98% Massachusetts 0 0.00% 0 0.00% 0 0.00% Michigan 16,197.016 a43% 281.198,203 7.42% 577.693.588 15-25% Minnesota 17,092.545 0.57% 29045573 9.98% 609.634,105 20.49% Mississippi 0 0.00% 0 0.00% 0 0.00% Missouri 11,468.196 0.63% 199,100,618 10.88% 409.032,311 2136% Montana 3,850,865 1.36% 66.855.294 23.63% 137,347,516 48-54% Nebraska 4,639,335 0.77% 80,544,017 13.35% 165.469.629 27.44% Nevada 0 0.00% 0 0.00% 0 0.00% New Hampshire 0 0.00% 0 0.00% 0 0.00% New Jersey 17,476,986 0.52% 303,419,893 8.95% 623345,829 1 B.38% New Meyjco 5,805,653 1.57% 100,79Z579 27.28% 207.06B.275 505% New York 49,180,189 0.34% 853,822,727 5.88% 1.754.093.411 12.07% North Carolina 21.422,754 0.61% 371,922.819 10.52% 764.078.240 21.62% North Dakota 1.748.615 1.53% 3Q357.896 26.57% 6Z367,261 54.58% Ohio 29,729,688 0.70% 516,140,423 12.24% 1,060,358,885 25.14% Oldahoma 6.763.424 0.56% 117.420563 9.64% 241,228,805 19.80% Oregon 14,016,131 0.71% 243,335,610 12.27% 499.908.678 25.20% Penns*,ania 12,168,256 0.37% 211,254,438 6.45% 434.001,117 13-25% Rhode Island 4514.543 1.05% 78377,487 18.26% 161,018.710 37.51% South Carolina 6,405,125 0.46% 111,200,079 8.02% 228,449A42 1 &47% South Dakota 0 0.00% 0 0.00% 0 0.00% Tennessee 0 0.00% 0 0.00% 0 0.00% Texas 0 0.00% 0 0.00% 0 ODO% Utah 4.325.586 0.61% 75.096,978 10.50% 154.279,232 21.58% Vermont 2.785,669 1.08% 48362.313 18.78% 99.355,536 38.58% Virginia 13.940,717 0.43% 242,026,340 7.48% 497,218.913 15.37% Washington 0 0.00% 0 0.00% 0 GO= West Virginia 3,060,439 0.53% 53.132.613 9.22% 109,155,640 18.94% Wisconsin 5,992.429 0.20% 104,035,217 3.46% 213,729,951 7.12% Wyoming 0 a00% 0 0.00% 0 0.00%
Total & % Change 544,206,548 0.67% 9,448,030,339 11.61% 19.410,033.528 23-86% Note: States with zero effect do not tax gains on capital assets. Source: IRS Public Use File for 199 1. These estimates assume capital gains tax reductions as described inthe Balanced l3udget Act Of 1995.
