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    Sunday, April 21, 2024

    'Tax revenue from capital gains is about to fall off a cliff'

    Investors are painfully aware of the plunge in stock and bond markets so far in 2022. Are federal and state officials aware of the damage that plunging markets will soon do to public budgets and finances? Tax revenue from capital gains is about to fall off a cliff.

    The Monthly Treasury Statement for April indicates that capital-gains tax revenue reached record levels in 2021. The markets are telling us capital gains will plunge dramatically in 2022.

    If what the Treasury Statement and the markets are signaling is correct, the reversal of fortune for federal tax revenue could be as much as $250 billion. In Connecticut, the relative impact could be even greater because the state is more reliant on individual income taxes from taxpayers who derive much of their income from investment activity.

    While Connecticut doesn’t have a separate tax on capital gains, the gains are subject to the state income tax. Looking at federal individual income tax data for 2019, the latest year detailed data are available, taxpayers nationally reported capital gains of $865 billion or 7.2% of their adjusted gross income while Connecticut taxpayers reported $16 billion of capital gains, or 8.9% of their adjusted gross income.

    The last time the markets crashed this severely was during the 2007-09 financial crisis, when federal capital-gains tax revenue plummeted 75% in two years, from about $140 billion in 2007 to $35 billion in 2009.

    In the absence of detailed income-tax data for 2021 there is a rough proxy that can give us a picture of where things stand. The Treasury Statement shows federal fiscal year-to-date individual income-tax receipts, split between income tax “withheld” — that is taxes on income earned from salaries and wages — and “other” tax payments, including taxes on all forms of investment income.

    The latest statement shows a gusher of $776 billion of “other” income-tax revenue for the first seven months of the current federal fiscal year. This includes April, which is obviously the biggest month of the year for tax filings. That’s $325 billion more than the next-highest seven-month federal fiscal year total of $451 billion in 2019.

    Historically, the seven-month “other” income figure has averaged a remarkably stable 70% of its full-year total, apart from the disruption in 2020-21 when the market plunged and recovered but with gains that were mostly short-term. Typically, investors don’t sell short-term positions. They wait and hold their gains for at least a year, so that they qualify for advantageous long-term capital-gains tax treatment when sold.

    If the $776 billion in “other” income turns out to be 70% of the full-year figure, then we could be looking at a record $1.1 trillion in “other” income for federal fiscal year 2022. Even if receipts trail off in the last five months as the 2022 market plunge takes effect, it will still be a record year.

    “Other” income tax receipts include many types of investment income, some of which may hold up despite a stock and bond market debacle. Real estate, for example, has been very strong.

    It’s possible to isolate the capital gains component from overall “other” income by looking at Internal Revenue Service data. Capital-gains tax revenue averaged about 30% of “other” individual income-tax payments from 2013-19, a period when the capital-gains tax rate was consistently about 25%. Accordingly, capital-gains tax revenue for 2021 could be as much as $330 billion.

    In turn, the collapse from the 2021 peak could be as bad or worse than the 75% plunge in 2008-09. So far this year, investors have booked sufficient losses to offset future capital gains for some time to come (only net capital gains are taxed).

    Two factors could extend and exacerbate a market swoon and plunging capital-gains tax revenue. First, interest rates on bonds in 2008 were much higher than they are now. This allowed for a post-crash resumption of the decades-long bull market in bonds that continued right up to the pandemic. Substantial capital gains were available in bonds throughout this period. After the super-low interest rates that prevailed during the pandemic, there is nowhere for interest rates to go but up — and for bond prices to fall. Falling bond prices will leave little potential for capital gains on sales.

    Second, in 2009, inflation wasn’t a concern; in 2022 it’s at a 40-year high. The Federal Reserve is expected to raise interest rates significantly in 2022 — and keep them high until the current inflation is tamed. This isn’t a promising outlook for capital gains — nor for the economy.

    While we won’t have definitive tax receipts data for some time, Federal and Connecticut officials be warned: If you wait for confirmation that a major source of tax revenue has dried up, you may have waited too long to begin to make necessary budget adjustments.

    The original version of this column appeared in The Wall Street Journal.

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