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 do to budgets and public finances? Tax revenue from capital gains looks set to fall off a cliff.
The monthly Treasury statement for April indicates that capital gains tax receipts hit record highs in 2021. Markets tell us that capital gains will decline significantly in 2022. If what the statement and markets are signaling is correct , the reversal of fortune for federal tax revenue could reach $250 billion. In New York, Connecticut and other states that rely heavily on personal income tax for income, the reversal could be devastating.
The last time markets crashed so badly was during the financial crisis of 2007-2009, when the tax rate on long-term capital gains was 15%, well below the rate current 23.8%. Federal capital gains tax revenues fell 75% in two years, from about $140 billion in 2007 to $35 billion in 2009.
Income tax data for 2021 is not yet available, nor is capital gains tax data. There is, however, an approximate indicator that can give us an idea 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 – that is, 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.
The collapse of the 2021 peak could be as bad or worse than the 2008-09 plunge.
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. 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 economic and financial outlook for capital gains.
We’ll know better where we stand by mid-July, when the monthly Treasury statement shows income tax receipts through June. It will include “other” tax receipts, including estimated quarterly income tax returns in June with updated estimates of capital gains for 2022. A low quarterly figure for “other” will mean the death of receipts capital gains tax.
Federal and state officials be warned: if you’re waiting until July or later for confirmation that a major source of tax revenue has dried up, you may have waited too long to start making fiscal adjustments. required.
Mr. Jahncke is President of Connecticut-based Townsend Group International LLC.
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Appeared in the print edition of May 17, 2022 under the title “Fainted markets will crush government budgets”.