Will CT plunge with the stock market?

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

The monthly Treasury statement for April indicates that capital gains tax revenues hit record highs in 2021. Markets tell us that capital gains will fall dramatically in 2022.

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

Although Connecticut does not have a separate capital gains tax, gains are subject to state income tax. Looking at federal personal income tax data for 2019, the latest year’s detailed data is available, taxpayers nationwide reported capital gains of $865 billion, or 7.2 % of their adjusted gross income, while Connecticut taxpayers reported $16 billion in capital gains, or 8.9% of their adjusted income. gross revenue.

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

In the absence of detailed income tax data for 2021, there is a rough approximation that can give us a picture of the current situation. The treasury statement shows personal income tax revenue since the beginning of the federal fiscal year, broken down into “withheld” income tax – i.e. taxes on income derived from wages and salaries – and “other” tax payments, including taxes on all forms of investment income.

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

Historically, the seven-month “other” revenue figure has averaged remarkably flat at 70% of its full-year total, apart from the disruption in 2020-21 when the market dipped and recovered, but with gains that were mostly short term. Typically, investors do not sell short-term positions. They expect and hold their gains for at least a year, so they receive favorable tax treatment on long-term capital gains when sold.

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

“Other” tax revenues include many types of investment income, some of which may persist despite the stock and bond market meltdown. Real estate, for example, has been very strong.

It is possible to isolate the capital gains component from all “other” income by looking at data from the Internal Revenue Service. Capital gains tax receipts averaged around 30% of “other” personal income tax payments from 2013 to 2019, a period when the capital gains tax rate was consistently around 25 %. As a result, capital gains tax revenue for 2021 could reach $330 billion.

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

Two factors could extend and exacerbate the market slump and falling capital gains tax revenue. First, bond interest rates in 2008 were much higher than they are now. This allowed for a recovery from the decades-long bond bull market crash that continued until the pandemic. Substantial capital gains were available in bonds throughout this period. After the extremely low interest rates that have prevailed during the pandemic, interest rates can only go up – and bond prices fall. Falling bond prices will leave little potential for capital gains on sales.

Second, in 2009, inflation was not a problem; in 2022, it is at a 40-year high. The Federal Reserve is expected to raise interest rates significantly in 2022 – and keep them high until current inflation is brought under control. This is not a promising prospect for capital gains – nor for the economy.

While we won’t have definitive tax receipt data for some time, federal and Connecticut officials should be warned: if you’re waiting for confirmation that a major source of tax revenue has dried up, you may have -to be waited too long to start making the necessary budgetary adjustments. .

Red Jahncke is chairman of Townsend Group, a management consultancy in Greenwich. The original version of this column appeared in the Wall Street Journal.

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