Capital Gains Taxes and the State

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Meg Whitman and Jerry Brown don't often talk specifics, but they do talk about one particular policy very often. The state's capital gains tax. Whitman wants to eliminate state taxes on capital gains; she says such a change will boost jobs. Brown says that would blow a hole in the budget and opposes that change.

How does this tax fit with the rest of the tax system? In fact, there is no separate "capital gains tax" per se. In California, capital gains are treated like income and taxed under the rules of the state's personal income tax. The irony: while Whitman is a Republican, California's existing policy sounds exactly like the model many fiscal conservatives nationally say they want: treating capital gains and income the same. (Federal law taxes capital gains at a different -- and mostly lower rate). Whitman wants to treat them differently in the name of producing more jobs.

Research suggests that a lower tax might produce a few more jobs--but at a high cost. Eliminating the tax would cost the state several billion dollars annually. In fact, the percentage of personal income taxes attributable to capital gains and stock options has been growing. This is a problem for the state budget, since such revenues tend to be more volatile than ordinary income. In good years, a surge in captal gains-related tax income can prompt legislators and governors to enact unsustainable spending increases. (This is what happened in California during the dot-com boom of the late 1990s).

So the best case for reducing capital gains taxes might not be Whitman's unsupported claims about the tax' effect on jobs. The best case would be that California's dependence on capital gains is one reason why the budget is a mess. So restructuring the tax or creating a separate tax bracket for capital gains income might make sense -- if the changes were made with corresponding tax increases in other areas.

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