Broke States Or Stock Selloff: The Capital Gains Tax Dilemma

With just two months until the end of the year, the one most important issue facing the US economy, which incidentally is not how many trillions in new, never to be used (or used only upon the case of hyperinflation) dollar bills Ben Bernanke will issue on November 3, but what the fate of the Bush tax cuts will be, and especially that of capital gains tax, remains still unresolved, Bloomberg has done a good analysis that frames the dilemma for the crippled administration: insolvent states or a market sell off. One would hope that with Geithner's track record vis-a-vis taxes, the former would take precedence, although as Blankfein has been rumored to seek the capital to expand his 15 CPW duplex into a triplex, the final outcome is pretty much clear, and it likely means little if no change to cap gains taxes, and thus no sell off in stocks. The problem is, however, that California, the state with the biggest economy, projects taxpayers’ capital gains will grow 40 percent this year while New York, the third-most-populous state, forecasts a 59 percent increase, or roughly 24% from the current 15%: an event which would have rather dramatic implications on investors desire to close out positions well before January 1. Should these states not be able to recoup revenues from actual capital gains receipts, then a federal bailout is virtually assured.

Bloomberg explains further:

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.

We doubt the insolvency of states will cause many sleepless nights to those barons of Wall Street whose net worth is most closely tied to the S&P. Furthermore, California, with its $19 billion deficit is a lost cause: a few billion here or there won't do jack to improve its position. Yet, various states will be quite disappointed and petition the Fed even harder to make up for the shortfall with even more unlimited taxpayer funded bailouts.

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.

Not surprisingly, it's not only California. New York State, where Wall Street is located, reported a material miss to budget "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. "

And here is where Keynesianism raises its ugly heads: there is always the possibility that even with new funds, these will be used to support a bloated state-level infrastructure instead of going to filling deficit holes:

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 the end of the day, none of this will do anything to prevent a domino-like financial collapse of US states. 

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.

Which is why the administration, which as Neil Barofsky demonstrated earlier is only preoccupied with making Wall Street whole at the expense of 99% of the population, will likely not only not increase capital gains, but in fact lower these, to prevent the widely expected tax-predicated sell off at the end of 2010. Then again, who knows. The level of chaos in the halls of the White House is currently at record levels, as nobody has any clue what on earth they should be doing to prevent the depression from accelerating. Finally, the only thing that does matter, is what Ben Bernanke will decree. After all, he is the only true high priest of the world's biggest economy.