BILL ANALYSIS
SENATE REVENUE & TAXATION COMMITTEE
Senator Lois Wolk, Chair
SB 472 - Dutton
As Introduced
Hearing: May 13, 2009 Tax Levy Fiscal: Yes
SUMMARY: Allows taxpayers to exclude from gross income 50
percent of a capital gain
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.
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.
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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 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
For taxable years beginning on or after January 1,
2009, and before January 1, 2012, 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.
FISCAL EFFECT:
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FTB estimates the following revenue associated with
this bill; as proposed to be amended, the revenue effect
would likely begin in 2012-13:
-------------------------------------------------
| Effective for Taxable years BOA 1/1/2009 and |
| before 1/1/2012 Assumed Enacted after 6/1/2009 |
| |
-------------------------------------------------
|------------+-----------+-----------+------------|
| 2009-10 | 2010-11 | 2011-12 | 2012-13 |
| | | | |
| | | | |
| | | | |
|------------+-----------+-----------+------------|
| -$2.5 | -$2.35 | -$1.5 | -$.25 |
| Billion | Billion | Billion |Billion |
| | | | |
-------------------------------------------------
COMMENTS:
A. Purpose of the Bill
According the author: California, like the rest of
the nation, is in the midst of a severe economic downturn.
The latest unemployment rate is 9.3%, the highest it has
been in over a decade, and economists estimate that in
2009, economic output will fall for the first time since
1991. 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
rate of any state and one of the highest 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.
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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. Author's Amendments
The author will take amendments in committee to make
this bill effective after the enactment date of the bill;
assuming the bill becomes operative in 2009, taxpayers
would not be able to take the income exclusion until 2012.
The intent of the bill is to encourage the investment
today; taxpayers must hold the investment for three years
before taking the 50 percent exclusion.
The author will also take amendments to require that
all assets purchased must be in the state. This may raise
Commerce Clause issues as it relates to fair taxation
across state lines.
Finally, the author will correct a technical issue
relating to netting capital gains and losses.
C. To Make Lemonade or Sell the Lemonade Stand?
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
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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.
D. All Income is Not Created Equal, or is it?
The policy questions are: 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 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 as the lemonade stand or other
factory.
E. 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
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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
output and higher incomes throughout much of the economy."
F. 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
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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
investment, (basically the rich choosing where their money
goes, and then getting dividends in return) which in turn
promotes growth.
G. 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
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does not lay the golden egg, we speak about killing him.
Does it make more sense to kill the goose or simply to save
his eggs? Proposition 1A, on the ballot on May 19th,
arguably saves the 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.
H. Similar But Different
SB 568 (Hollingsworth) and SB 473 (Dutton), both in
this committee on May 13, 2009 relate to the capital gains
and the associated tax. SB 568 (Hollingsworth) relates 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) relates to
gross income and allows half of a capital gain to be
excluded from income before calculating the tax owed.
Support and Opposition
Support: Metal Finishing Association of Southern
& Northern California
California Small Business Association
Oppose:California School Employees Association,
AFL-CIO
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Consultant: Gayle Miller
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