Connecticut Democrats are hell-bent to notch another progressive milestone. They want to impose the nation’s first state-level surcharge tax on investment income, 2 percent on the capital gains and dividend income of high earners.
The surcharge would be unlikely to raise the roughly $262 million annually that Democrats say it would, but it would be virtually certain to drive more high income individuals out of a state already suffering an exodus. For the state, it would be a millstone, not a milestone.
Capital gains are unlike all other forms of income. They are only taxable when assets are sold. Investors can and do defer sales to avoid paying taxes — until a looming tax increase triggers a stampede of gains-taking at the expiring lower rate.
History provides proof. Federal tax rates on net long-term capital gains have increased significantly twice in the last half century.
In 1985, with a 20 percent capital gains tax in place and little talk of tax changes, individuals reported $166 billion in net long-term capital gains. In 1986, after enactment of the Tax Reform Act but before it took effect, reported gains doubled to $319 billion in an obvious effort by investors to take advantage of the expiring 20 percent tax rate before the new 28 percent rate took effect the following year. In 1987, only $140 billion was reported. Naturally, capital gains tax revenue followed the same pattern, doubling to $50 billion in 1986 before plummeting in 1987.
The same dynamic was repeated over the 2012-2013 period. Reduced first under President Clinton and then further under George W. Bush, the capital gains rate was 15 percent in 2011, when investors reported $376 billion in net long-term gains. In late 2012, they took $610 billion in gains as they anticipated the year-end passage of the Obama tax hike, which took the rate for high earners to 23.8 percent in 2013. In 2013, investors reported only $462 billion, despite a whopping 30 percent gain in the stock market.
Naturally, stock market and economic performance influence gains-taking, not just tax rates. In 1987, there was the famous stock market crash. Subsequently, a relatively weak market and economy produced only modest gains. In contrast, the market has been on a joy ride since 2013, producing robust gains and gains tax revenue.
With both the market and the economy about to set records for their longest periods of uninterrupted advances, continued extraordinary capital gains are unlikely. At best, Democrats’ proposed gains tax would trigger a surge in gain tax revenue before the tax hike took effect and depress it thereafter. It would merely accelerate future revenue into the present, narrowing the budget deficit this biennium and widening it in the next. That’s called kicking the can down the road.
That’s bad enough, but the real problem is that a state-level capital gains tax surcharge is completely uncharted territory. In a December 2018 study, the Center on Budget and Policy Priorities, a progressive think tank, reported that not a single state imposes an investment income surcharge on top of an income tax. Actually, nine states tax capital gains at discounted rates.
Individual high-earners could move anywhere else to avoid a surcharge. If it were just the surcharge, perhaps high-earners might hesitate, but Connecticut also has the 11th-highest individual income tax rate and is one of only six states with an inheritance tax. So high-earners are taxed heavily on their regular salary earnings, prospectively even more heavily on investments made with their earnings, and, finally, on their estates if they die in Connecticut. Why stay?
Employees of the state’s huge investment industry pay an enormous share of state income taxes. Several hedge fund founder-managers, including Steven Cohen, Ole Halvorsen and Clifford Asness, own large personal stakes in their gigantic funds. Each pays huge taxes, mostly on investment-classified income. They could move their individual tax residences and still manage their investment firms — arguably, for 183 days by computer, telephone and teleconference from another state, and for 182 in person. Why stay and pay the surcharge?
Recently, Asness retweeted a news story about the proposed surcharge and asked the Twitterverse: “Do people generally prefer living in Texas or Florida?” Those fast-growing states don’t have income, capital gains or inheritance taxes.
Red Jahncke is president of The Townsend Group International, a business consulting firm in Greenwich.
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Red Jahncke is a nationally recognized columnist, who writes about politics and policy. His columns appear in numerous national publications, such as The Wall Street Journal, Bloomberg, USA Today, The Hill, Issues & Insights and National Review as well as many Connecticut newspapers.