BILL ANALYSIS
AB 876
Page 1
Date of Hearing: May 18, 2009
ASSEMBLY COMMITTEE ON REVENUE AND TAXATION
Charles M. Calderon, Chair
AB 876 (Harkey) - As Amended: May 5, 2009
Majority vote. Tax levy. Fiscal committee.
SUBJECT : Income tax: capital gains: exclusion.
SUMMARY : Exempts from taxation any gain from the sale or
exchange of capital assets purchased during the 2009 or 2010
calendar year. Specifically, this bill :
1)Excludes from gross income, under both the Personal Income Tax
(PIT) Law and the Corporation Tax (CT) Law, any gain
recognized from the sale or exchange of certain capital
assets.
2)Applies to capital assets that are purchased by a taxpayer
during the 2009 or 2010 calendar year and held by the taxpayer
for more than one year.
3)Defines the term "capital asset" by reference to Internal
Revenue Code (IRC) Section 1221.
4)Disallows net capital losses with respect to any capital asset
that is purchased during the 2009 or 2010 calendar year.
5)Takes effect immediately as a tax levy
EXISTING FEDERAL LAW :
1)Provides a preferential tax treatment for certain capital
gains and losses recognized from the sale or exchange of a
capital asset (i.e., assets held for at least one year from
the date the taxpayer acquired the assets). Property held for
personal use or investment purposes, generally, is a capital
asset.
2)Applies maximum tax rates from 0% to 28% to the taxation of a
capital gain realized by individual taxpayers.
3)Excludes up to $250,000 ($500,000 in the case of a married
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couple filing a joint return) from gross income.
4)Allows an exclusion to a holder of small business stock of up
to 75% of gains realized from the sale or exchange of that
stock, provided that the stock was held more than five years
and was acquired after February 17, 2009, and before January
1, 2011. For taxable years beginning before 2011, 7% of the
amount of capital gains excluded from gross income on the
disposition of small business stock is considered an
alternative minimum tax (AMT) preference item.
5)Provides that stock of a "C" corporation, generally, qualifies
as a small business stock if the corporation's gross assets do
not exceed $50 million on the date of the stock's issuance,
unless the "C" corporation is in certain types of businesses.
6)Specifies that property used in a taxpayer's trade or business
is not a capital asset.
7)Treats capital gains realized by corporate taxpayers as
ordinary income and taxes those gains at ordinary income tax
rates.
8)Defines "net capital gain" as the excess of the net long-term
capital gain for the taxable year over the net short-term
capital loss for such year.
9)Allows a corporation to deduct capital losses only to the
extent of its capital gains. Allows excess capital losses to
be carried back three years and forward five years.
10)Allows a noncorporate taxpayer to deduct capital losses only
to the extent of capital gains, plus the lower of $3,000 or
the excess of the capital losses over the capital gains.
Allows a carryforward of capital losses indefinitely, but
carrybacks are disallowed.
EXISTING STATE LAW:
1)Treats all capital gains as ordinary income (e.g., wages and
interest) for the year in which the gain is recognized.
2)Exempts from tax 50% of the gain from the sale of certain
small businesses, but this exclusion requires certain
California activity and provides that 50% of the excluded
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small business stock gain is an AMT preference item.
Corporations do not qualify for the "small business stock"
exception.
3)Exempts from tax capital gain from the sale of a personal
residence, up to $250,000, or $500,000 in the case of married
taxpayers filing jointly.
4)Allows a deduction of up to $3,000 of capital losses against
ordinary income.
5)Does not allow taxpayers to carry back capital losses.
6)Follows the federal income tax rules relating to the
definition of capital assets and determination of holding
periods.
FISCAL EFFECT : The Franchise Tax Board (FTB) staff estimates
that this bill will result in a revenue loss of $130 million in
fiscal year (FY) 2009-10, $590 million in FY 2010-11, $1.15
billion in FY 2011-12, and $1.375 billion in FY 2012-13.
COMMENTS :
1)The author states that, "Encouraging capital investment in our
state at this time, when we are facing increasing
unemployment, would create an incentive for companies to
remain in state, expand or start new business enterprises.
Eliminating the capital gains tax for any new investment in
calendar year 2009 and 2010 would encourage new venture
capital and investment in start up industries, such as green
technologies, manufacturing and other much needed areas of
growth, as well as provide an incentive to alleviate excess
real property inventories.
"Presently, capital gains are taxes at the personal income tax
rate (PIT) or a maximum of 10.3%. California has one of the
highest PIT rates in the nation and is approaching the highest
unemployment rate at 10.5%. We compete for business with
other nearby states with no capital gains tax, or a lower tax
rate (Nevada, Arizona, Texas). As a comparison, the after tax
interest and capital gains income for a $1,000 investment in
Texas is 11.5% lower than in California, with Nevada making a
similar claim. To compete and create employment, we must
provide an incentive to invest in our state."
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2)The opponents believe that AB 876 would not lead to increased
capital investment in California because this bill covers all
capital gains invested anywhere in the world. The opponents
maintain that the state's capital gains tax is a small
fraction of the overall costs of investing in capital assets
and, thus, this bill is unlikely to have any significant
impact on investment. Finally, the opponents argue that there
is no evidence that the federal capital gain tax cuts have
lead to increased capital investment and that these tax cuts
only served to reward wealthy investors for something that
they were going to do anyway.
3)Background . Prior to 1987, capital gains were allowed
preferential tax treatment. Under federal law, individuals
were allowed to exclude 60% of gains from the sale of capital
assets held one year or more. Under state law, for assets
held between one and five year, 35% of gains were excluded,
while 50% of gains from assets held more than five years were
excluded from income. California followed the federal lead in
repealing these preferences as part of our conformity with the
federal Tax Reform Act of 1986.
Under federal law, capital gains are generally taxed at a
preferential rate in comparison to ordinary income.
Short-term capital gains are taxed at the investor's ordinary
income tax rate, and are defined as investments held for a
year or less before being sold. Long-term capital gains,
which apply to assets held for more than one year, are taxed
at a lower rate than short-term gains. In 2003, the long-term
rate was reduced to 15%, and to 5% for individuals in the
lowest two income tax brackets. These reduced tax rates are
effective through 2010; if they are not extended before that
time, they will expire and revert to the rates in effect
before 2003, which were generally 20%.
Currently, California partially conforms with the current
federal provision excluding 50% of capital gains on the sale
of small business stock (75% is allowed under federal law for
certain types of small business stock). California also
conforms with the federal exclusion of certain amounts of gain
from the sale of a principal residence. However, no
distinction is made under California law between ordinary
income and capital gain.
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4)What are "capital gains"? Capital gains are profits from the
sale or exchange of a capital asset. Almost everything that a
taxpayer owns and uses for personal purposes, pleasure or
investment is a capital asset. For example, shares of
corporate stock, a business, a parcel of land, a piece of art
could qualify as capital assets. Almost consistently, capital
gains have been taxed at lower rates than ordinary income. It
has been asserted that the lower tax rate offsets taxes paid
at the corporate level, encourages risk taking and
entrepreneurship, offsets the effects of inflation, and
provides an incentive not to hold assets for too long.
5)Does the preferential tax treatment of capital gains promote
economic growth ? According to the author, AB 876 is intended
to promote new venture capital investment, encourage the
creation of new jobs, and provide an incentive to alleviate
excess real property inventories. Critics, however, argue
that there is little connection between lower capital gains
taxes and higher economic growth, in either the short-run or
the long-run. (Jeff McLynch, "Repeal State Tax Breaks for
Capital Gains," A Special Report by the Institute on Taxation
and Economic Policy, Tax Analysts, April 29, 2009, p. 152).
For example, in 2002, the Congressional Budget Office (CBO)
evaluated the stimulative effect of different federal tax
incentives. It found that, in general, "there is significant
consensus that broad-based reductions in taxes on capital have
the potential to boost economic growth over the long run," but
"the potential for big growth effects from a capital gains tax
cut is much smaller than it is for a more general cut in the
tax on capital." The CBO concluded that "capital gains tax
cuts would provide little fiscal stimulus," since most of the
benefits of such cuts would accrue to high-income households,
households that are more likely to save than spend, when the
very aim of such stimulus is to boost consumption. (CBO,
"Economic Stimulus: Evaluating Proposed Changes in Tax
Policy," Washington, DC, January 2002). The CBO determined
that, among various approaches that it examined, capital gains
tax cuts were among the least effective. Similarly, research
by the Brookings Institution-Urban Institute Tax Policy Center
indicates that, over the last 50 years, real GDP growth has
not varied in response to changes in federal capital gains tax
rates; even when one accounts for the possible lag between a
capital gains rate cut and subsequent economic activity, the
relationship between rates and growth is not statistically
significant. (Burman and Kravitz, "Capital Gains Tax Rates,
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Stock Markets, and Growth," Tax Notes, Nov. 7, 2005). In
fact, some researchers have found that economic growth after
the 2003 federal tax cuts actually proved weaker than economic
growth during the 1990s, when tax rates on capital gains and
dividends ran higher. (Aviva Aron-Dine, "The Effects of the
Capital Gains and Dividend Tax Cuts on the Economy and
Revenue: Four Years Later, a Look at the Evidence," Center on
Budget and Policy Priorities, revised July 12, 2007).
6)The effect of the capital gains exclusion on economic growth
in California . It appears that using a capital gains tax
exclusion, as proposed by AB 876, to promote economic growth
on a state level may be even less beneficial to California's
economy. First, the term "capital asset," as defined by IRC
Section 1221, excludes property used in trade or business,
inventory items, business supplies, etc., and therefore, any
gain from the sale of that business property would still be
taxed. It is unclear how this bill would have any significant
impact on the sale of excess real property inventories or
other business property.
Furthermore, AB 876 does not require that capital assets be
located in California, and therefore, a gain generated from
the sale of capital assets anywhere in the United States
(U.S.), or even abroad, would be non-taxable under this bill.
Since AB 876 allows California investors to receive a tax-free
return on their investment anywhere in the world, it is
uncertain whether AB 876 would lead to the creation of new
jobs in this state (as opposed to China, for example) or would
greatly benefit California's economy. Committee staff
suggests that this bill be amended to limit its application
only to qualified investment in California and to provide a
specific period of time within which qualified capital assets
must be maintained in this state prior to a qualifying sale.
Finally, due to the interaction between the federal and state
tax laws, a state capital gains tax exclusion will result in a
subsidy to the federal government. Most taxpayers who realize
capital gains itemize their deductions on their federal income
tax returns, and one of the largest of those deductions is the
deduction for state and local income taxes. Any reduction or
exclusion in state capital gains taxes will lead to an
increase in federal income tax liability. The exclusion may
even act as "an economic depressant" because "a portion of any
capital gains tax break will never find its way into the
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pockets of state residents nor, by extension, into the cash
registers of local merchants or onto the balance sheets of
local employers." (See, e.g., "Repeal State Tax Breaks for
Capital Gains," A Special Report by the Institute on Taxation
and Economic Policy, supra, p. 151).
7)But what if this bill is limited only to California-based
assets? Committee staff suggested that this bill be amended
to limit its application only to capital assets located in
California. However, limiting a tax exemption to gains
derived from a sale or exchange of a California- based capital
asset may also be problematic. A state law that extends a
preferential tax treatment to California capital assets in
comparison to non-California capital assets may be
unconstitutional as violating the Commerce Clause of the U.S.
Constitution (Article I, Section 8, Clause 3). For example,
in Boston Stock Exchange v. State Tax Commission (1977) 429
U.S. 318, the U.S. Supreme Court held that the Commerce Clause
prohibits the State of New York to impose a stock transfer tax
on in-New York stock sales at a rate lower than the rate of
tax imposed on sales made outside of New York.
8)Who benefits from the preferential capital gain tax rates
under federal law? It is worth noting that the two most
common assets held by working Americans - their investment for
retirement and their homes - generally, are not treated as
capital gains when they are sold. Most middle-income
taxpayers own much or all of their stock through 401(k)s,
Individual Retirement Accounts (IRAs), or other tax-preferred
saving accounts. Assets held in 401(k)s or IRAs are
considered ordinary income and the preferential tax treatment
of capital gains does not affect owners of those accounts.
The gain on the sale of one's principal residence is exempt
from tax, up to $250,000 ($500,000 in the case of married
taxpayers filing jointly). Principal residences and
retirement accounts constitute 74% of the net worth of the
bottom 50% of all families in the U.S. and 61% for all
families in the 50% through 90% of the wealth distribution.
(A. Kennickell, Currents and Undercurrents: Changes in the
Distribution of Wealth, 1989-2004, U.S. Federal Reserve Board,
Washington, DC, Jan. 30, 20060). So, who currently pays the
capital gains tax? Very few low- and moderate- income
taxpayers report income from capital gains. Data from the
Internal Revenue Service's (IRS) 2006 Statistics of Income
demonstrate that taxpayers with an adjusted gross income (AGI)
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of less than $50,000 comprised 67% of all federal tax returns
filed, but constituted just 3% of all returns with income from
capital gains. In contrast, 2% to 3% of U.S. taxpayers -
those with federal AGIs in excess of $200,000 - make up a
disproportionate share of filers with capital gains income.
(IRS, 2006 Statistics of Income). The Tax Policy Center
estimates that the highest-income 5% of U.S. households
receive 83% of total capital gains. The average household in
the middle of the income spectrum received $20 from the 2003
capital gains and dividend cuts. But the average household
earning over $1 million received $32,000, or 1,600 times as
much. (Center on Budget and Policy Priorities, Experts Agree
That Capital Gains Tax Cuts Lose Revenue, Policy Points,
Revised May 7, 2008). 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.
9)AMT . Existing law - an AMT - ensures that taxpayers with
substantial economic income and credit, deductions, and other
preference items do not completely escape taxation. The
Committee may wish to consider whether, similarly to the
exclusion of gains from the sale of small business stock, all
or a portion of the amount of income excluded under this bill
should be treated as a tax preference item for purposes of the
AMT.
10)Implementation concerns . The FTB staff identified several
implementation concerns, including the internal inconsistency
of disallowing "net capital losses" with respect to "any
capital asset." "Net capital losses" refer to the excess
capital losses over capital gains for multiple capital assets,
whereas "any capital asset" refers to a single capital asset.
Amendments are necessary to remove this inconsistency.
11) Related Legislation.
SB 472 (Dutton), introduced in the current Legislative Session,
would amend existing law to allow a 50% exclusion from gross
income for any gain from the sale or exchange of a capital
asset held for more than three years. SB 472 was placed on
the Senate Revenue and Taxation Committee suspense file.
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SB 568 (Hollingsworth), introduced in the current Legislative
Session, would allow a taxpayer to elect to pay a 2% tax on
any "net capital gain," as defined. SB 568 is pending in the
Senate Revenue and Taxation Committee.
AB 1897 (Zettel), introduced in the 2001-02 Legislative Session,
was similar to SB 472. AB 1897 was held under submission in
this Committee.
AB 7 (Campbell), introduced in the 1999-2000 Legislative
Session, would have excluded from gross income any gain from
the sale or exchange of a capital asset held for five years or
more. AB7 was held under submission in this Committee.
SB 37 (Baca), introduced in the 1999-2000 Legislative Session,
was identical to AB 7, and failed passage in the Senate
Revenue and Taxation Committee.
SB 34 (Brulte), introduced in the 1999-2000 Legislative Session,
was identical to AB 7, and died in the Senate.
AB 9 (Campbell), introduced in the 1997-98 Legislative Session,
would have excluded 29% of any gain if the capital asset was
held for less than five years and 36% of the gain if the
capital asset was held for five years or more. AB 9 was held
under submission in this Committee.
REGISTERED SUPPORT / OPPOSITION :
Support
None on file
Opposition
California Tax Reform Association
Analysis Prepared by : Oksana Jaffe / REV. & TAX. / (916)
319-2098