State Governments Should Now Consider Partial Wealth Tax Reforms
By David Gamage and Darien Shanske
The COVID-19 pandemic is precipitating severe fiscal crises for state and local governments. This is occurring as businesses throughout the country have shut down, unemployment numbers have skyrocketed, and consumer demand has dropped significantly. The national economy is likely headed for a deep economic recession, and state and local governments are ill-equipped to deal with the fiscal volatility problem that has caused budget crises during past recessions, including the Great Recession of 2008.[1]
This essay is a contribution to Project SAFE (State Action in Fiscal Emergencies).[2] In other essays in this project, we explain steps that the federal government should take to help state and local governments cope with their looming budget crises. The federal government is in a much better position to manage these crises than are state and local governments, and, ideally, the federal government would act sufficiently to prevent the need for state and local governments to either cut spending or raise taxes. However, we fear that the federal government may well fail to act sufficiently, leaving state and local governments with the need to make painful spending cuts, raise taxes, or both. In this essay, we make some suggestions for how state governments should respond if the federal government does indeed fail to act sufficiently (as we fear will be the case).
Specifically, we suggest that state governments consider adopting partial wealth tax reforms, at least as limited temporary measures for raising the revenues needed to weather the current and looming budget crises. Below, we will suggest two promising options for partial wealth tax reforms that could be designed and implemented sufficiently quickly (at least in some states) to potentially make for good policy responses to the current and looming state and local budget crises.
Let us begin with a little more background discussion. It is important to understand that state governments are subject to balanced-budget constraints, which prevent them from engaging in deficit spending during economic downturns, whereas the federal government is not so constrained.[3] Specifically, during economic downturns, state tax revenues tend to fall sharply, and as such, state governments can maintain balanced budgets only by raising tax rates (and perhaps licensing fees), making spending cuts, or both. Conversely, during economic upturns, when state governments receive surplus tax revenues, states typically engage in a combination of tax cuts and spending increases. In particular, social insurance programs such as Medicaid are subject to spending cuts during economic downturns — the very time when they are needed most. The current COVID-19 crisis especially highlights the perils of spending cuts, as Medicaid, unemployment insurance, and other social insurance programs are vital to the millions of people who are currently out of work during the pandemic. Thus, the question remains: How can state and local governments better contend with fiscal volatility, especially in the face of a looming budgetary crisis?
Ultimately, if a choice must be made between harmful spending cuts or tax increases to cope with looming budget crises during an economic downturn, we view tax increases as the better choice by far.[4] Ideally, such tax increases should be targeted at economic actors who are in a relatively better position to weather the economic downturn, and with the tax increases made in a way that minimizes the possibility for tax gaming responses or other taxpayer maneuvers for escaping tax.
Absent administrative constraints, the best solution would be a one-time wealth tax on state residents. A one-time wealth tax is backward looking, in that it taxes wealth accumulated previously, and so is less subject to tax-gaming and other harmful responses by taxpayers. Such a wealth tax should be designed with a large exemption, so that the tax would only apply to the wealthiest, who should generally be in a much better position to weather the economic downturn as compared to state residents more generally and especially as compared top the beneficiaries of major state spending programs.[5]
Of course, administrative constraints make this story much more complicated. States do not currently have a general wealth tax, nor is it likely to be feasible for state governments to design and implement a major new tax quickly enough to offset upcoming budget shortfalls. Moreover, some states face legal prohibitions against levying general taxes on wealth; for instance, New York State’s Constitution, in Article XVI, Section 3, states that: “Intangible personal property shall not be taxed ad valorem nor shall any excise tax be levied solely because of the ownership or possession thereof, except that the income therefrom may be taken into consideration in computing any excise tax measured by income generally.” Thus, because such a large share of wealth consists of intangible personal property (chiefly in the form of financial assets such as stocks and bonds), any meaningful wealth tax reform proposal for New York State would likely require a constitutional amendment.
Nevertheless, these barriers leave open at least two promising reform options. The first would be for state governments to consider levying a new state-wide real property tax, with a large exemption level (or circuit-breaker) so that only the wealthiest state residents or businesses would be subject to the new property tax. Such a new tax (or surtax) could piggyback on the administrative valuations that already exist for existing real property taxes, and so could be designed and implemented relatively quickly. Needless to say, this would only be a “quick” option in states without constitutional limits on property tax rates, and other legal and administrative barriers may also complicate this option in some states. In any case, this proposal could be designed and implemented as a temporary measure, meant for raising the revenues needed to weather the economic downturn.
The second option would be for state governments to consider levying a new tax or deemed realization measure on the stock of unrealized capital gains. This could be done in a number of possible ways. For instance, the new tax could consist of a deemed realization of a percentage (e.g., fifty percent) of unrealized gains that would then immediately be taxed at the state’s income tax rates, with an exemption built in so that this new tax would only apply to the wealthiest of state residents. This option would be somewhat more difficult to design and implement, and would likely need to rely substantially on self-reported appraisals, backed by auditing and penalties, for valuation purposes. But the revenue potential should still be reasonably large, and because so much wealth is constituted by publically traded securities, neither self-assessment nor auditing ought to be prohibitively onerous.[6]
By taxing these unrealized gains now, states would in effect be accelerating what would otherwise have been future tax payments (at least in theory, as in practice much of unrealized gains are never realized or recognized due to provisions like stepped-up basis upon death). We view this as appropriate, as the effect of taxing unrealized gains now — during the downturn — would be to at least partially counteract the fiscal volatility rollercoaster, by moving revenues to times in which they are most needed. In a sense, then, one might think of the current non-taxation of unrealized capital gains as a sort of emergency rainy day fund that the states should now tap.
It could be objected that either of our proposals for partial wealth tax reforms could cause liquidity problems, even for the wealthy. Therefore, as a matter of design, the tax could permit a payment schedule, much like the deemed repatriation of the TCJA.[7] Note that such a schedule should contain a reasonable interest rate because states should consider then borrowing against this stream of income in order to pay for immediate needs.
Another possible objection to a tax of either type is that the wealthy might simply leave the state. There is a significant economics literature on such questions.[8] We read this literature as implying that migrations from so-called high tax states has so far[9] not represented a phenomenon that should overly trouble states considering more progressive taxation. But, however one reads the literature as to ongoing income taxes, the tax measures we are proposing would be a one-time tax on gains/values already realized. There should thus be a minimal behavioral response.
And the argument for such taxes runs deeper than that they would be broadly progressive and efficient. Consider that income and wealth inequality have become increasingly pressing issues at both the federal and state levels. Accordingly, recent polling from the Pew Research Center reveals that six in ten U.S. adults believe there is too much inequality in the country today, and 84% of those who see inequality as a problem believe that the government should increase taxes on the wealthy. Yet the existing state and federal level tax systems do a very poor job of taxing the true economic income of the very wealthy.[10] In particular, for the top 0.1% of taxpayers and above, whose incomes derive primarily from the returns to owning wealth (rather than from salary or wages), structural features of the existing state and federal level income tax systems make these taxes “so porous as to be largely symbolic.”[11]
In that light, either of the options we propose — a new statewide property surtax on the very wealthy or a new statewide tax on the unrealized capital gains of the very wealthy — would help to ameliorate the lack of effective taxation of the very rich in the years and decades leading up to the current and looming economic downturn. This would have been a good reason to impose such taxes even before the pandemic. In the midst of a pandemic and recession, such taxes are ever more clearly a good idea. Remember, there is a zero sum game here, assuming the federal government fails to act. Either the states and localities must cut vital services and thereby prolong the recession or else avert these cuts by raising tax revenues.
Given the scale of the emergency and the importance of the states not eating their seed corn by engaging in overly destructive cuts, it may ultimately become necessary for states to consider revenue instruments that are much further from ideal (such as even gross receipts taxes!). But before contemplating such measures, the states should start with more targeted and better overall policy options. In that light, we view our proposals for real property surtaxes on the wealthiest or partial deemed realization of the unrealized capital gains of the very wealthy as especially promising.
[1] See David Gamage, “Preventing State Budget Crises: Managing the Fiscal Volatility Problem,” 98 Cal. L. Rev. 749 (2010).
[2] https://www.law.virginia.edu/academics/program/project-safe
[3] Gamage, supra note 1.
[4] For elaboration as to why, see id.
[5] Daniel Markovitz has made a similar proposal at the federal level: see https://www.nytimes.com/2020/04/21/opinion/coronavirus-wealth-tax.html.
[6] Mark Gergen estimates “73% of the total value of income-producing assets” are publicly-traded securities. Mark Gergen, How to Tax Capital, 70 Tax L. Rev. 1, 22 (2016).
[7] IRC 965(h).
[8] https://web.stanford.edu/~cy10/public/Jun16ASRFeature.pdf; https://www.nber.org/papers/w26349.
[9] For example, we are not considering what would happen if states imposed much higher tax rates than they currently do.
[10] See David Gamage, Five Key Research Findings on Wealth Taxation for the Super Rich Gamage, David, Five Key Research Findings on Wealth Taxation for the Super Rich (July 27, 2019), available at https://ssrn.com/abstract=3427827.
[11] Id. (citing Edward J. McCaffery, The Death of the Income Tax (Or, The Rise of America’s Universal Wage Tax), Center for Law and Social Science Research Papers Series №18–25, at 2 (August 31, 2018)).
