“Economics is a subject that does not greatly respect one’s wishes,” former Soviet Premier Nikita Khrushchev grumbled. Many an attractive idea has clashed with economic reality — and the harsh realities of the dismal science tend to win out.
Funding public education through a tax on capital gains is superficially appealing. Rather than taxing all income (prohibited by Washington’s constitution), recent proposals would tax only a species of income commonly equated with wealth. The stereotype does not always hold true: senior citizens paying capital gains taxes on retirement income, for instance, do not conjure up images of idle wealth.
The most glaring flaw in such tax proposals, however, is this: Some years, capital gains are a pipe dream. Even in the depths of recession, most people are drawing paychecks, and thus paying individual income taxes. They are making purchases subject to the sales tax. Assessed property values may decline, but property taxes continue to flow.
Capital gains are different. In a poor year they all but vanish, making taxes on them remarkably unstable.
The realization of capital gains slid 71 percent between 2007 and 2009, and previous recessions were little better: capital gains slipped 55 percent in 1987 and 46 percent in 2001. Large swings in capital gains are not uncommon, making them a particularly risky tax base. Nationwide, they are the single largest culprit behind state revenue forecasting errors.
Relying on such a volatile revenue source to boost educational expenditures is risky. A revenue stream that can decline this rapidly is not one that can be relied upon to support meaningful long-term investments in public education.
The individual income tax systems adopted in many other states have significant volatility, but much of it is concentrated in capital gains. New York’s State Budget Crisis Task Force concluded that overall adjusted gross income declined by 18 percent during the Great Recession, substantially driven by capital gains income, which plummeted 75 percent. “Capital gains are the most erratic, as they depend not only on stock market performance but also on taxpayers’ choices about whether and when to sell assets,” the study concluded.
Researchers at the Chicago Federal Reserve Bank said much the same thing, writing (as only economists would) that “(t)he cyclicality of capital gains tends to have a disproportionate effect on state income tax revenues” and that capital gains “have made state revenues more responsive to the business cycle since the mid-1990s.” Economics does not respect one’s wishes.
Forty-one states tax capital gains income. In all cases, it is captured by the state’s individual income tax and not by a discrete tax on capital gains. Indeed, all states currently treat capital gains as income. Proposals to label a Washington tax as an excise on buying and selling stock, designed to elide constitutional restrictions, fall apart when one considers that the “excise” is imposed on realized gains less losses (that is, income), and not on total share value or financial transactions.
Effective budgeting requires revenues to be predictable and relatively stable, yet the capital gains tax reliability problem is so acute that Massachusetts now prohibits any budget from relying on more than $1 billion in capital gains revenue. When Washington Gov. Jay Inslee’s last budget included a capital gains tax, the S&P rating agency highlighted the difficulty of forecasting revenues from such a tax. In this, they echoed the state’s own fiscal analysts, who cautioned that “[c]apital gains are extremely volatile from year to year” and warned that revenue forecasts “could be greatly over- or understated.”
Foregoing an income tax is the Washington tax system’s competitive advantage, an inducement to individuals and entrepreneurs alike. And make no mistake, a capital gains tax is a form of income tax. Every tax system has its selling point, and this is Washington’s—one that could be seriously undermined by capital gains taxation. More importantly, such a tax could undermine the very programming it is designed to fund.
The ability to foresee that some things cannot be foreseen is, as Rousseau once observed, a very necessary capacity. That no one can reliably foresee what capital gains taxes will raise in a given year is the one thing about them that we can foresee.
Can Washingtonians afford to tie education spending to such an unstable tax?
Jared Walczak is a policy analyst with the Center for State Tax Policy at the Tax Foundation, a Washington, D.C.-based think tank with a stated mission to educate taxpayers about sound tax policy.