Fiscal Cliff Jitters Could Boost Early State Tax Revenue

When filmmaker George Lucas sold his company and the Star Wars franchise to Walt Disney Co. this fall, he saved hundreds of millions of dollars in state and federal taxes by not waiting until next year when higher tax rates are anticipated. He’s hardly alone.

Regardless how or even if Congress and President Obama avert the series of federal tax increases and spending cuts set to occur in January, known as the “fiscal cliff,” many states could see wild swings in revenue as taxpayers decide to sell investments before the end of the year.

“You change taxes and you change people’s behavior,” says Donald J. Boyd, executive director of the Task Force on the State Budget Crisis, created by former Federal Reserve Chairman Paul Volcker and former New York Lieutenant Governor Richard Ravitch.

Sometimes those behavioral changes happen after the fact, but often they occur in anticipation of possible changes, and that is what is already going on, he said last week at the National Conference of State Legislatures meeting in Washington, D.C.

As Stateline has reported, state budgets and economies would be particularly hard hit by the $491 billion in automatic tax increases and spending cuts because state tax systems are linked in various ways to the federal system.

If a deal isn’t reached, the tax that people pay when they sell stock, a home or other capital assets, known as capital gains, will rise 20 percent from 15 percent, an incentive to sell this year.

States that could see the biggest impact from this change are those that both rely heavily on the income tax and that have a lot of capital gains among high-income taxpayers. So states with a lot of wealthy people, including California and New York, would be hit, but also states like Idaho and Vermont (see chart). States without any income tax are Alaska, Florida, Nevada, South Dakota, Texas, Washington and Wyoming.  New Hampshire and Tennessee tax only dividend and interest income.

California has already considered the impact.  A report from the California Legislative Analyst’s Office assumes that 20 percent of capital gains that Californians may have otherwise taken in 2013 will be accelerated to land in 2012 because of the lower federal tax rates. That means the state is predicting that capital gains taken by residents will increase nearly 70 percent in 2012.

In California, net capital gains climbed as high as $132 billion in 2007 before the recession and fell to $29 billion in 2009 before rising, along with the recovery in the stock market, to $55 billion in 2010, where it has remained fairly flat. California analysts expect that number to now climb to $93 billion in 2012 due to the lower federal tax rates currently in federal law before the fiscal cliff.

That figure also factors in the tax increase California voters approved in November that raises taxes on earnings over $250,000 for seven years, known as Proposition 30. “Uncertainty concerning the responses of high–income taxpayers to Proposition 30’s income tax increases may make these new revenues particularly difficult to estimate,” the California analyst’s office wrote.

The last time the capital gains tax rate climbed significantly was in 1986 when President Reagan and Congress dramatically overhauled the tax system, including raising the maximum tax rate on capital gains to 28 percent from 20 percent. “People sold their assets like crazy to take advantage of what they then saw as the last chance to beat the high rates,” says Boyd, who also is a senior fellow and the former director of State and Local Government Finance research at the Nelson A. Rockefeller Institute of Government in Albany.

Capital gains in 1986 nearly doubled, spiking to billion from $172 billion the previous year, according to the Tax Policy Center. The taxes paid on those capital gains climbed to nearly $53 billion in 1986, up from $26.5 billion the previous year.