A Capital Idea

Repealing State Tax Breaks for Capital Gains Would Ease Budget Woes and Improve Tax Fairness

Institute on Taxation and Economic Policy
Washington, DC

March 2009

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EXECUTIVE SUMMARY
At present, nine states – Arkansas, Hawaii, Montana, New Mexico, North Dakota,
Rhode Island, South Carolina, Vermont, and Wisconsin – offer substantial tax breaks for
income derived from capital gains. In tax year 2008, these nine states are expected to
lose a total of $663 million due to such misguided policies, with losses ranging from
$10 million to $285 million per state. Consequently, repealing capital gains tax breaks
could be an important response to projected state budget deficits.

Capital gains are the profits one realizes from the sale of an asset, such as stocks,
bonds, investment or vacation real estate, art, or antiques.

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. In fact, in the nine states highlighted
in this report, 94 to 97 percent of the additional tax revenue generated by repeal
would be paid by the richest 20 percent of taxpayers in those states.

Claims that capital gains tax breaks help to promote economic growth – and that the
repeal of such breaks would impede an economic recovery – are without merit.
Extensive economic research demonstrates that there is little connection between
lower taxes on capital gains and higher levels of economic growth, in either the shortrun or the long-run.

Concerns about the volatility of capital gains income – and, by extension, the revenue
derived from such income – are understandable, but are no reason to preserve such
inefficient and inequitable tax breaks. Rather, concerns about the predictability of
state revenue streams can best be addressed outside the income tax – either by
reforming state budget processes or by expanding the bases of the other taxes that
states typically levy.

Capital gains tax preferences are costly, inequitable, and ineffective. They deprive
states of millions of dollars in needed funds, benefit almost exclusively the very
wealthiest members of society, and fail to promote economic growth in the manner
their proponents claim. In the current fiscal and economic climate, state policymakers
can not afford to maintain these tax breaks any longer.

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