States Face Budget Holes If U.S. Capital-Gains Tax Doesn't Rise

California and New York, after closing budget deficits of more than $27 billion this year, may face $1.3 billion in combined new gaps if the federal capital- gains tax rate doesn’t rise as scheduled, state documents show.

Both count on increased revenue -- $1.1 billion in California and as much as $225 million in New York -- as investors rush to sell assets before the federal capital-gains tax rate goes up to 20 percent, set for Jan. 1. Currently it’s 15 percent.

Nationwide, realized capital gains may jump $122 billion, or 29 percent, to $540 billion this year, according to the Congressional Budget Office. In 2003, Congress temporarily cut the federal tax on profits from assets held at least a year. Last month, lawmakers put off action on whether to extend the expiring lower rate beyond December until after the Nov. 2 elections.

Surging asset sales ahead of the pending increase “could fuel an inflow at the state level,” said Scott Pattison, executive director of the National Association of State Budget Officers. If the rate doesn’t change, then states may not see a jump in related revenue, he said.

Enough Democrats joined Republicans in opposing increases in capital gains and other federal taxes, as favored by President Barack Obama, that in September the House of Representatives delayed a vote until next month at the earliest.

Extension Likely

“I expect the Bush tax cuts will be extended,” said Mark Bloomfield, president of the Washington-based American Council for Capital Formation, a group that advocates for lower capital gains taxes. He said the economy would be hurt by an increase and the public favors lower taxes.

It isn’t clear whether an extension would be permanent or temporary, Bloomfield said. Either way, an additional 3.8 percent capital-gains tax is scheduled in 2013, under the health-care law passed by Congress and signed by Obama earlier this year, he said.

Seven states, including Florida and Texas, don’t have an income or capital-gains tax, while others, such as New York and California, treat the profits as ordinary income.

In California, lawmakers closed a deficit of $19.1 billion earlier this month with a budget that projects an extra $1.1 billion in revenue as investors accelerate their capital gains and dividends. Revenue in 2011 is estimated to decline by the same $1.1 billion, according to state budget documents.

‘Educated Guess’

“It’s obviously an educated guess,” because of pending congressional action, said Phil Spilberg, the chief of financial research in California’s Finance Department.

California, the state with the biggest economy, projects taxpayers’ capital gains will grow 40 percent this year. New York, the third-most-populous state, forecasts a 59 percent increase.

Because of weak prices for equities and homes in the past few years, U.S. income from capital gains in 2010 is projected to be 42 percent less than the $924 billion peak of 2007. Stocks, measured by the Russell 3000, are 5.3 percent higher than the average of the past 10 years. Home prices are 5.8 percent lower than the 10-year average.

New York expects $200 million to $225 million in additional revenue from investors accelerating their sales to take advantage of this year’s federal capital-gains rate, according to Erik Kriss, a state Budget Division spokesman. The Division of Budget projects a surge in realized capital gains, to $57.7 billion in 2010 from $36.4 billion in 2009.

Ready to Adjust

“It’s happened before when there was a tax-rate change,” Kriss said. “If circumstances change, we would adjust our forecast,” he said.

While state tax collections are rising in the U.S., according to the Nelson A. Rockefeller Institute of Government in Albany, revenue growth in California and New York might not match projections, regardless of levies on capital gains.

New York’s tax revenue for the past six months trailed forecasts by $529 million, according to an Oct. 19 report by Comptroller Thomas DiNapoli.

California may face a mid-year deficit of at least $5 billion, according to Moody’s Investors Service. The state may not receive all the $5.4 billion of additional federal aid it included in its budget, and its revenue assumptions, apart from capital gains, may be too optimistic, Emily Raimes, a Moody’s analyst in New York, said in an Oct. 18 report.

California and New York both expect that 2010’s accelerated capital gains will come at the expense of future years.

Longer-Term Gains

New York projects a $27 billion decline in 2011 from investor profits, assuming the U.S. levy rises. “If federal action results in complete or partial continuation of lower rates for all or a portion of taxpayers, these gains will be realized over the long run, not in 2010-11,” according to the state’s spending plan.

“A problem arises when legislators use the additional funds to support spending and ignore the fact that it’s an increase that won’t necessarily last,” said E.J. McMahon, executive director of the Empire Center for New York State Policy. The Albany group advocates for lower state spending.

At least 31 states and Puerto Rico project fiscal 2012 deficits totaling $73.5 billion, according to an April report by the Denver-based National Conference of State Legislatures.

“States are looking at big budget problems all the way into 2012 and probably 2013 as well,” said Nick Johnson, director of the State Fiscal Project at the Center on Budget & Policy Priorities, a research and advocacy group in Washington. As for revenue surges from taxpayers trying to avoid a higher federal-tax rate in January, “any gain they get in fiscal year 2011 will be offset by a loss of revenue in the following year,” he said.

To contact the reporter on this story: Michael Quint in Albany, New York, at mquint@bloomberg.net.

To contact the editor responsible for this story: Mark Tannenbaum at mtannen@bloomberg.net

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