Tax Policy Center | Urban Institute and Brookings Institution

Capital Gains: Its Recent, Varied, and Growing (?) Impact on State Revenues

Sally Wallace

Published: August 13, 2003
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Note: This report is available in its entirety in the Portable Document Format (PDF).

Over the past decade, state government tax revenues have been strong, with the exception of two major downturns, one in the early 1990s and one beginning in 2001. During the 1990s, total state tax revenues grew an average of 6 percent per year in current dollars (4.2 percent per year in real terms). The good times of the 1990s have faded, and state governments are now facing some of their most difficult budget years in a decade.

For each quarter from fourth quarter 2000 through fourth quarter 2001, state governments posted year-over-year tax revenue growth that was less than 40 percent of the previous years' growth. In the third quarter of 2001, states faced both a nominal and real decrease in quarterly tax collections. It now appears that some of these losses are easing, with a number of states posting nominal increases in some important revenue categories.

State governments rely heavily on two sources of revenue: (1) general sales and gross receipts taxes and (2) the individual income tax. Although the income tax has grown in importance throughout the last century, there was substantial growth in the individual income tax as a state revenue source in the 1990s. In 1980, the general sales and use tax accounted for 31.5 percent of tax revenue and the personal income tax accounted for only 27.1 percent of revenue. Over the past two decades, this mix has changed—in 2000, general sales and individual income taxes accounted for 32.2 percent and 36 percent of total tax revenues, respectively (Table 1, next page).

Individual income tax receipts have been hard hit since the downturn in the economy. (2002) reports that reduced personal income taxes represented some of the largest declines in state tax revenues across the nation. Income taxes tend to respond strongly to changes in economic activity—that is, income tax revenues are income-elastic. The up side to that is that as the economy grows, income tax revenues grow, but as the economy slows, income tax revenues slow as well.

In most states, the base of the income tax includes wage and salary income, some retirement income (such as pension income), self-employment income, and capital income (from interest, dividends, rents, and realized capital gains). The 1990s were marked by fast growth in the stock market and in capital gains, while more recently capital gains realizations have declined. It is natural, therefore, to ask how important were income taxes on capital gains realizations to the downturn in state revenues.

In this report, we analyze the impact of capital gains on the recent fall-off in state individual income tax revenues. Given the growing importance of the individual income tax, we analyze the impact of capital gains on state tax revenues since 1989 to determine whether capital gains have had more or less of an impact on state revenues over time.

The report proceeds as follows. In the first section, we set the stage for why we should expect capital gains realization activity to affect state tax revenues and why this relationship is important. In the second section, we review the basic structure of state individual income taxes and analyze the components of state income tax revenues. The next section presents a discussion of the impact of capital gains realizations on state income tax revenues. A conclusion section completes the report.

Note: This report is available in its entirety in the Portable Document Format (PDF).

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