‘Facebook Effect’ Shows California’s Reliance on Capital Gains

The potential for California to see a tax windfall from a Facebook Inc. public stock offering this year demonstrates how much the state relies on capital-gains taxes, a volatile revenue stream that hampers its credit rating.

Menlo Park, California-based Facebook, the world’s most-used social-networking site, is considering the largest initial public offering for an Internet company on record, a person familiar with the plans said last year. Estimated at $10 billion, the offering would make instant millionaires of company employees and require the state to adjust its revenue forecast to reflect additional capital-gains taxes they’d pay, the state’s legislative analyst said yesterday.

That kind of unanticipated boost shows the boom-and-bust cycle that capital gains taxes often inflict on California’s budget. In fact, capital-gains tax revenue as a percentage of the state’s general fund plummeted from 12 percent to just 3 percent between 2007 and 2009 as investors pulled away from the stock market, a decline of $9.3 billion, according to state finance department figures.

“It is a significant concern,” said Gabriel Petek, an analyst at Standard & Poor’s, which ranks California’s credit the worst among its peers at A-. “It’s probably one of the things that presents a structural impediment to the rating and makes it hard for the state’s credit rating to move up into the AA range that the typical state is.”

$96 Billion

Governor Jerry Brown proposed a budget that assumes California taxpayers will earn $96 billion in capital gains in 2012, more than three times as much as at the height of the recession in 2009. He also estimates that the state will take in $8.6 billion in taxes on those capital gains, about 9 percent of general fund revenue.

California isn’t alone in its reliance on capital gains. New York in the fiscal year that ended March 31 collected about $2 billion from taxes on capital gains, or about 3 percent of total tax collections, according to figures provided by the state comptroller’s office. Wall Street-related activities accounted for about 14 percent of total state collections.

Brown’s $92.6 billion spending plan assumes voters pass temporary increases in sales and income taxes in November. If voters reject the taxes, the lack of revenue would trigger $4.8 billion in cuts to schools. Even with the higher tax rates, the most populous state would cut $4.2 billion from social programs such as welfare-to-work and health insurance for the poor under the proposed budget for the fiscal year beginning July 1.

Income Taxes

Income taxes on individuals accounted for 43.5 percent of California’s tax revenue in 2010, the ninth-highest proportion among states, according to U.S. Census Bureau data. The national average was 33.5 percent. The bureau didn’t distinguish capital gains from other kinds of income.

When Google Inc. went public in August 2004, selling 19.6 million shares for $1.67 billion, it made billionaires out co-founders Larry Page and Sergey Brin.

Capital-gains earnings in the state jumped 49 percent the year after that offering. Within two years, taxes on those earnings accounted for 11 percent of the budget, up from 8 percent, according to Finance Department figures.

California revenue forecasters assume that at least a few companies will float offerings each year. At least 14 other Web-related companies, including San Francisco-based Yelp Inc., are considering IPOs totaling $11 billion this year, according to data compiled by Bloomberg.

The size of Facebook’s possible offering, which would value the company at about $100 billion, makes it unique in terms of its impact of revenue forecasts, Legislative Analyst Mac Taylor said.

‘Sheer Size’

“It’s just the sheer size of it,” Taylor said in a question-and-answer session with reporters yesterday. “It could be huge.”

Jonathan Thaw, a Facebook spokesman, declined to comment on the company’s plans.

Brown’s budget assumes that reductions in marginal tax rates permitted by President George W. Bush in 2001 and 2003 will be allowed to expire at the end of this year and that higher-income earners would accelerate their capital gains into this year to take advantage of the lower tax rate.

Brown also counts a portion of capital gains expected in 2013 this year instead, assuming that investors will try to shield income from higher Medicare taxes scheduled to take effect next year.

Taylor hasn’t made either of those assumptions in his forecast and estimates that capital gains income will reach $64 billion this year. He said he’s concerned Brown’s method of forecasting high-income filers’ income -- especially capital gains -- overestimates state revenue growth.

“We can’t predict taxpayer behavior,” he said.

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