Thursday, November 16, 2017

Don't Hold It Up for Me

Because both House and Senate versions of the new tax law eliminate the deduction for state and local taxes (SALT), the tax on long-term capital gains will go up for individuals in high-tax states:[bold added]
New York City residents, for instance, pay a top income-tax rate of 12.7%—8.8% to the state and 3.9% to the city. In California the top rate is 13.3%. Absent the deduction, then, New York City and California investors in the top bracket would pay a total—federal, state and local taxes—of 36.5% and 37.1%, respectively, on their capital gains.

The top federal rate on ordinary income is 39.6%, so deducting state and local taxes reduces their burden by that proportion for high earners. In theory that should lower the total capital-gains tax to 31.5% in New York City and 31.8% in California. In practice the figures are somewhat higher, since other provisions of the federal tax code—the alternative minimum tax and the Pease phase-outs of deductions—reduce the value of the SALT deduction for high-income taxpayers. But every investor who itemizes and lives in a state that taxes capital gains would face some increase under the GOP plans.
Higher taxes on capital gains cause taxpayers to be hesitant to take gains at the margin---from personal experience and that of acquaintances I believe this effect on behavior for certain individuals to be noticeable----and result in capital being being "locked in", i.e., appreciated assets are held onto longer.
The lock-in of capital gains reduces the mobility of private capital—and, more important, its flow to the new, small and rapidly growing companies that create the most jobs.
(Business Insider graph)
Two comments:

1) Despite the authors' claims, the lock-in effect on capital markets cannot be large. Two-thirds of equity investors (see chart) don't pay taxes; mutual funds, hedge funds, international, and other institutional investors are legally exempt or can afford the expertise to structure around taxes. Of the remaining third, i.e., households, only a small percentage reside in high-tax states. Only a subset of this subset are in such a high bracket that State taxes are the deciding factor against a capital asset sale.

2) Possible estate-tax repeal, and even high estate-tax exemptions, are a much more powerful inducement to hold onto appreciated assets than the lack of a SALT deduction. If a well-off taxpayer can afford to live the rest of her life without selling her home or her Alphabet stock, those assets will be "stepped up" to Fair Market Value at her death. There won't be much, if any estate tax because of changes to the law, and her heirs will pay much less income tax because the stepped-up basis will have shrunk the gains dramatically when it comes time for them to sell the assets.

BTW, your humble blogger lives in high-tax California and is sitting on some assets (hey, I mean that figuratively) that have grown fatter in recent years; I won't sell them unless it's an unexpected emergency, so go ahead and pass the d*** law already, Republicans, don't hold it up for me.

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