California State Government Will Lose Big from Capital Gains Tax Increase

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.

These are the opening two paragraphs of David R. Henderson, “Capital Gains Tax Hike: No Gains, No Fairness,” Defining Ideas, May 6, 2021.

Why should California Democrats be especially upset about an increase in the federal capital gains tax rate? Here’s why:

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 billionin 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.

Thanks to economist Justin Garosi of the California Legislative Analyst’s Office for steering me quickly to the revenue data.

By the way, I also argue that the capital gains tax amounts to a fourth level of taxation on earned income. Read the whole thing.

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