BILL ANALYSIS
SENATE REVENUE & TAXATION COMMITTEE
Senator Lois Wolk, Chair
SBx6 10 - Dutton
Amended: May 5, 2010
Hearing: May 12, 2010 Tax Levy Fiscal: Yes
SUMMARY: Excludes from Income the Sale or Exchange of a
Capital Asset Held for More than Three Years.
EXISTING LAW
Capital Assets:
In general, property held for personal use or
investment purposes is a capital asset.<1> Examples of
capital assets include held-for-investment stocks and
securities as well as an owner-occupied personal residence.
Property used in a taxpayer's trade or business is not a
capital asset.
When a capital asset is sold or exchanged, the
difference between the selling price and the asset's
adjusted basis, which is usually what was paid for the
asset, is a capital gain or loss.
Federal Law:
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<1> Internal Revenue Code (IRC) section 1221(a).
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Under existing federal law, there are circumstances
when a percentage of a capital gain may be excluded from a
taxpayer's gross income. For example, an individual may
exclude a gain from the sale of a personal residence as
follows: the individual may exclude up to $250,000 of gain,
while a married couple filing a joint return may exclude up
to $500,000. A second example is a holder of small
business stock<2> who may exclude 75 percent<3> of the gain
on the sale or exchange of the stock. For tax years
beginning before 2011, 7 percent of the amount of capital
gain excluded from gross income on the disposition of small
business stock is an alternative minimum tax (AMT)
preference item.
Complex rules allow personal income taxpayers to apply
maximum tax rates from 0 percent to 28 percent to the
taxation of a net capital gain, whereas under the corporate
tax, capital gains are taxed at ordinary income tax rates.
" Net capital gain " means the excess of the net
long-term capital gain for the taxable year over the net
short-term capital loss for such year. When calculating
the net capital gain also called "netting," the following
definitions apply:
The term "net long-term capital gain" means the
excess of long-term capital gains for the taxable year
over the long-term capital losses for such year.
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<2> A special security subject to rules designed to
encourage investment in small business.
<3> The American Recovery and Reinvestment Act of 2009
(P.L.111-5) changed the exclusion percentage to 75 percent
(rather than 50 percent or 60 percent) for exchanges of
small business stock held more than 5 years and acquired
after February 17, 2009, and before January 1, 2011.
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The term "net long-term capital loss" means the
excess of long-term capital losses for the taxable
year over the long-term capital gains for such year.
The term "net short-term capital loss" means the
excess of short-term capital losses for the taxable
year over the short-term capital gains for such year.
The term "net short-term capital gain" means the
excess of short-term capital gains for the taxable
year over the short-term capital losses for such year.
State Law
California generally follows the federal rules for
defining capital assets, identifying holding periods, and
determining the gain or loss from the sale or exchange of a
capital asset with the following exceptions:
Capital gains are taxed at ordinary income tax
rates under the personal income tax and are generally
taxed at 9.3%,
Small business stock exclusion equals 50 percent,
Small business stock exclusion rules require
certain California activity, and
50 percent of the excluded small business stock
gain is an (AMT) preference item.
THIS BILL provides that for taxable years beginning on or
after January 1, 2013, and before January 1, 2016, this
bill would amend both the personal income tax and the
corporate tax laws by allowing a 50 percent exclusion from
gross income for any gain from the sale or exchange of a
capital asset held for more than three years.
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FISCAL EFFECT:
According to the FTB, the February 24, 2010 version of
SBx6 10 resulted in revenue losses of $0 in 2010-11, $6
million in 2011-12, $82 million in 2012-13, $530 million in
2013-14, and $360 million in 2014-15. The May 5, 2010
amendments delay implementation for one year, so a
reasonable inference can be drawn that the same revenue
estimates from the introduced bill would occur one fiscal
year later than the estimate for the measure as introduced.
COMMENTS:
A. Purpose of the Bill
The author provides the following statement:
"California, like the rest of the nation, is in the
midst of a severe economic downturn. The latest
unemployment rate is 12.4%, the highest it has been in over
a decade, and 5th worst in the nation. Something needs to
be done to stimulate economic growth and get California out
of this viscous economic cycle.
Excessive capital gains taxes are a disincentive for
both individuals and corporations to invest in California.
Yet, California has the highest personal capital gains tax
rates. This bill would place California in the top quarter
of states for personal capital gains tax and the top 10 for
corporate capital gains tax rates.
By adjusting California's capital gains tax rate,
business and individuals will be more likely to invest and
do business in California. This temporary reduction would
not result in any costs to the state for at least three
years, and arguably would result in increased state
revenues."
B. To Make Lemonade or Sell the Lemonade Stand?
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The difference between capital gains and other forms
of income is like the difference between Joey's lemonade
stand and the lemonade he sells. Suppose government imposes
a 15-percent tax on each glass of lemonade sold. Such a
tax would be an income tax. Now, suppose he wanted to sell
his lemonade stand. The profits from this sale would
represent his capital gains; the value of the lemonade
stand may be hundreds, even thousands of times greater,
because of its ability to keep generating profits.
Is there a value difference between the two items?
Opponents of this measure argue that the tax on capital
gains (the lemonade stand) should be no different from that
on normal income. In fact, they argue that it makes sense
to tax investment income as the state shifts from wage
earners (selling lemonade) to investments (lemonade
stands). This argument states that there is no value
difference between the lemonade stand and the lemonade but
that they are both sales, like any other sale. Even if the
lemonade stand is 1,000 times more valuable than the
lemonade it sells, the market forces should ostensibly
engineer the correct sales price for the stand.
Proponents of this measure argue that the lemonade
stand should be taxed at preferential, lower rates because
by making lemonade stands more profitable than lemonade,
investors will want to invest in more lemonade stands thus
increasing the means of production and spurring economic
growth.
C. All Income is Not Created Equal, or is it?
The policy question is: should we distinguish between
various types of income? The idea of a capital gains
reduction is to charge a 15-percent tax on a worker but a
10-percent income tax on an owner, for example. Economists
would call this a regressive tax which creates inequalities
in the system. The fact that the lemonade stand is more
valuable due to its ability to keep generating profits
should be factored into the sales price instead of the tax
rate being factored into how much the investor makes. The
second question is: why should human capital be taxed at a
higher rate than investment capital? Workers can improve
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their worth through better education just as an owner can
improve his business through modernization. Both will
result in higher productivity and income; only one is taxed
at a higher rate (the worker). Finally, not all capital
assets are as productive as lemonade stands: from a
production and job-creation point of view, some assets such
as art, wine, classic cars and antiques do not produce the
same number of jobs or increase productivity in the same
way that the lemonade stand or other factory does.
D. How Low Can You Go: President Bush's Tax Cuts
In 2003, President Bush lowered the tax rates on
capital gains and dividends; these rates expire on December
31, 2010, and will go back up to the previous levels.
According to the Heritage Foundation, many economists agree
that the expiration of these tax cuts will discourage
investment and slow economic growth. High capital gains
taxes do create what is called a "lock-in effect," where
investors avoid onerous taxation by not selling assets.
Econometric analysis shows a strong link between higher
capital gains tax rates and the lock-in effect. Investors
are willing to hold onto investments for a longer period of
time in order to pay the lower taxes on long-term capital
gains.
If high taxes make investors unwilling to sell taxable
assets, the lock-in effect can reduce economic growth by
preventing the reallocation of capital in low-performing
investments to more profitable ventures. Economic growth
slows as new businesses find it difficult to acquire
start-up or expansion capital.
The Heritage Foundation further states, however, that
reducing the tax on capital gains is beneficial to the
economy, a better tax policy would reduce the tax rate on
all capital investment. A broad reduction in the taxation
of capital will lead to more investment and more capital
stock. As the Congressional Budget Office notes,
"Reductions in capital taxation increase the return on
investment and therefore the formation of capital. The
resulting increase in the capital stock yields greater
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output and higher incomes throughout much of the economy."
E. Only the Rich Benefit Directly But do Others Benefit
Indirectly?
In practice, very few low- and moderate-income
taxpayers report income from capital gains. Federal data
from 2006 indicate that, for the country as a whole,
taxpayers with adjusted gross income (AGI) of less than
$50,000 comprised 67 percent of all federal tax returns
filed, but constituted just 3 percent of all returns with
income from capital gains. Similarly, taxpayers in this
income group held 23 percent of nationwide AGI in 2006, but
received just 4 percent of reported capital gains income.
As a result, the impact of repealing capital gains tax
breaks would fall almost exclusively on the most affluent
state residents. Some estimates state that 94 to 97 percent
of the additional tax revenue generated by repeal or
reduction in capital gains would be paid by the richest 20
percent of taxpayers in those states.
Proponents of this measure are generally considered
"supply side economists" and claim that if the top income
earners invest more into the business infrastructure and
equity markets , it will in turn lead to more goods at lower
prices, and create more jobs for middle and lower income
individuals. Proponents argue economic growth flows down
from the top to the bottom, indirectly benefiting those who
do not directly benefit from the policy changes. However,
others have argued that "trickle-down" policies generally
do not work, and that the trickle-down effect might be very
slim.
Opponents of this meausre are more closely related to
Keynesian economics which often criticize tax cuts for the
wealthy as being "trickle down," arguing that tax cuts
directly targeting those with less income would be more
economicly stimulative. Keynesians generally argue for
broad fiscal policies that are direct across the entire
economy, not toward one specific group. Supply-siders, on
the other hand, argue that tax cuts for the rich promote
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investment, (basically the rich choosing where their money
goes, and then getting dividends in return) which in turn
promotes growth.
F. The Goose that Laid the Golden Egg & Volatility
Proponents of this measure argue that the state has
been entirely too dependent on high income individuals to
fund the state's personal income tax revenue. In 2006, the
top 10-percent of income earners paid more than 78.5
percent of the personal income tax revenue. This "boom and
bust" cycle along with the budget requirements for spending
has created volatility in the state's general fund. The
question of volatility, however, is not black and white. A
long-time Revenue & Taxation committee consultant, Martin
Helmke compared the state's volatility to the goose that
laid the golden egg. Every few years California's goose
would lay a golden egg and we all enjoy it; when the goose
does not lay the golden egg, we speak about killing her.
Does it make more sense to kill the goose or simply to save
her eggs? Proposition 1A (2009) arguably would have saved
future eggs by requiring any annual state revenue increase
that is above "historic trends," plus an increase for the
rate of inflation and population growth, up to a maximum of
three percent of annual revenues, to be deposited into the
state budget stabilization fund (BSF or " rainy day fund ")
each year until the fund reaches an increased target
balance equal to 12.5 percent of the state general fund.
Voters rejected the measure.
G. Urge Overkill
Even if lower tax rates and tax incentives do enhance
employment, California has enacted seven new tax incentive
programs in the last two years to assist business and grow
the economy in California:
Net Operating Loss Carrybacks for $250
million, effective in the 2010 tax year (AB 1452,
Committee on Budget, 2008).
Allowing firms to share tax credits
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within the unitary group for $265 million,
effective in the 2009 taxable year (AB 1452,
Committee on Budget, 2008).
Elective sales-factory only apportionment
of corporate income for $750 million, effective
in the 2010 taxable year (ABx3 15, Krekorian,
2009, SBx3 15, Calderon, 2009)
Small business hiring credit capped at
$400 million over the 2010 and 2011 taxable
years. (ABx3 15, Krekorian, 2009, SBx3 15,
Calderon, 2009)
Movie Production tax credit, which can be
applied to the sales and use tax, shared within
the unitary group, or sold under specified
circumstances for $500 million over the next five
taxable years, commencing in the 2010 tax year
(ABx3 15, Krekorian, 2009, SBx3 15, Calderon,
2009).
Tax Credits to purchase new homes for
$100 million last year (SBx2 15, Ashburn, 2009)
and new and existing homes for $200 million (AB
183, Caballero, 2010), currently in place.
Sales Tax Exemptions for Manufacturing
Equipment used for green technology applications.
Cost unknown, and effective immediately. (SB
71, Padilla, 2010)
While it is difficult to trace individual firm
decision making to any one factor, shouldn't the
Legislature take pause from its generosity to see the
economic effects of these decisions? While many of the
programs have not been in place for long, firms should be
making decisions today to respond to the benefits because
they commence in the current taxable year, hopefully
increasing employment. Enacting additional tax incentives
of dubious effectiveness may instead reward incumbents who
would make the same economic decisions regardless of the
associated tax benefits, resulting in a windfall. The
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Committee may wish to consider deferring action on
additional tax incentives until it can adequately evaluate
those that are just now becoming economically
consequential, then engage with the business community to
find out what changed decision-making, what did not, and
additionally consider changing the incentive mix based on
that feedback.
H. Why Be Static When You Can Be Dynamic?
Tax expenditures result in reduced revenues with the
implied argument that the foregone revenue from the tax
expenditure will result in net positive benefits to the
public that are superior to the same amount of revenue
spent on other public services. Significant disagreement
exists, however, regarding how to measure benefits and
costs, with advocates for business interests arguing for
dynamic revenue estimation, which attempts to model
enhanced economic activity and government revenues
resulting from tax expenditures, versus static revenue
estimation models, which measure foregone revenue by
directly looking at how tax due for firms and individuals
changes as a result of tax expenditures.
In California, both static and dynamic revenue models
exist. FTB estimates the foregone revenue amount of tax
expenditures by looking at returns filed by taxpayers, and
estimates the effect of proposed tax expenditures by
calculating an anticipated revenue loss by modeling
taxpayer behavior based on past returns. Because FTB may
uniquely use taxpayer records to determine foregone
revenues, their estimates are the most accurate given
available information. FTB also conducts "microdynamic"
estimation by attributing changes in individual taxpayer
behavior caused by changes in tax law.
Advocates for business interests argue that static
estimates do not calculate the positive economic benefits
resulting from tax expenditures, which can offset the
static costs measured by FTB's current estimation
methodology. Dynamic models are complex mathematical
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instruments that attempt to measure the effect of law
changes by estimating secondary changes to economic
behavior. For example, the dynamic model would estimate
the economic effect of gasoline refineries likely laying
off workers if the Legislature approved a higher gasoline
excise tax rate because purchasers would buy less gasoline
at the tax-induced higher price. The model could also
guess whether other firms paying more for gasoline would
pay less income tax or reduce payroll.
SB 1837 (Campbell, 1994) required the Department of
Finance (DOF) to use dynamic models to estimate the effect
of legislation with a fiscal impact exceeding $10 million.
DOF, together with the Legislative Analysts' Office,
contracted with the University of California at Berkeley to
develop California's dynamic revenue model. The model
attempted to estimate the secondary effects of tax law
changes; numerous equations sought to describe complex
interconnections in California's economy. However, the
model determined that the most optimistic gains from tax
expenditures:
Provide a 18% offset for corporation tax
reductions
Provide an 8% offset for sales tax
reductions.
Provide a 1% offset for personal income
tax reductions.
The Department of Finance ceased using the model;
however, the California Air Resources Board is using it to
calculate economic effects resulting from implementation of
AB 32 (Nunez), which enacted California Global Warming
Solutions Act. Advocates for business interests continue
to argue that tax expenditures do pay for themselves
without evidence to demonstrate this dynamic effect.
I. Same Song, Second Verse
SB 568 (Hollingsworth) and SB 473 (Dutton), were
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considered by the Committee at its May 13, 2009, and held
on it suspense file. SB 568 (Hollingsworth) related to the
tax rate on capital gains and would allow a taxpayer to
elect to pay a 2 percent tax on any "net capital gain" as
defined under federal law. SB 473 (Dutton) is
substantively identical to this bill.
Support and Opposition
Support: None received.
Oppose:None received.
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Consultant: Colin Grinnell