The looming possibility of a federal tax increase if Congress allows the Bush administration’s tax cuts to expire offers the states an opportunity to protect investment. By lowering the capital gains tax rate, Georgia could earn a much-needed economic boost, inspiring confidence that it is fertile ground for capital investment and is dedicated to economic growth.
At 6 percent, Georgia’s long-term capital gains tax rate equals the state’s top income tax rate and is second highest in the Southeast. Nationally, it is 20th highest. Why would potential investors see this as anything but an unfriendly environment for capital investment?
The tax has several disadvantages. First, capital gains are not adjusted for inflation when they are taxed. An item that cost $1 in 2000 cost $1.23 in 2009 because of inflation. The seller is paying tax above the real purchasing power gains on the asset, an argument for capital gains taxes to be lower than income tax rates on wages.
Second, the tax ignores investment losses above a certain level. This distorts the market for investment; those on the fence are steered away from taking a risk. The economy is built on risk-takers trying to fill the voids of supply in response to consumer demand. A high capital gains tax rate restricts the economic engine.
Further, capital gains taxes produce an unstable revenue stream that fluctuates enormously with the health of the economy. Looking at the last 10 years, the capital gains tax base in Georgia has fluctuated by more than 15 percent either way in eight of those years, compared to zero years for the income and sales tax base (see graph). In 2001 and 2008, the capital gains tax base decreased by 40 percent and 53 percent respectively; in 2004 it increased by 51 percent and in 2005 it increased 42 percent.
Such fluctuations produce huge headaches for the state’s financial projections. States that rely highly on capital gains taxes, such as California, spend these excess funds in the good years, overinflating their budgets, and face major budget crises in the down years. Reducing reliance on the capital gains tax to fund the state will result in a steadier, more predictable revenue stream. In Georgia, net capital gains tax revenue has averaged about 5 percent of total state tax revenue.
Researchers have found that cuts in capital gains taxes do not cost as much to government revenues as other tax cuts. The National Bureau of
Economic Research found that evaluating tax cuts using dynamic scoring (factors in resultant economic growth) shows 50 percent of a cut in capital gains is recovered by higher economic growth in the long run. For labor taxes, the figure is just 17 percent.
Essentially, each dollar of capital gains allowed to remain in the investor’s hands costs the government only 50 cents in revenue. This is a small price to pay for economic growth, increased investment and job creation.
In the short run, capital gains tax cuts have shown to actually increase revenues as investors become much more active. The cuts at the federal level in 1980, 1997 and 2003 all increased revenue in the years following.
One potential benefit of lowering the capital gains tax rate is to incentivize investment in higher-risk startup companies, typically in high-tech industries with large potential payoffs. Coupled with state pension reform that allows for venture capital fund investment, a cut in capital gains tax rates could help retain companies formed at Georgia’s world-renowned research institutions and attract greater outside investment to further the state’s prowess as an incubator for ground-breaking businesses.
The recently formed Special Council on Tax Reform and Fairness for Georgians will examine the entirety of the state’s tax code. Early comments indicate that the Council will look seriously at trying to lower income tax rates in a revenue-neutral manner. It should also consider lowering the capital gains tax rate to half of the decided-upon income tax rate. This policy change will spur investment and market activity in the short-term while developing the infrastructure for Georgia to lead this nation out of the recession as a hub of innovation.
Mark King, who is completing his master’s degree at the University of Georgia, is a summer intern with the Georgia Public Policy Foundation.