By Samantha Young
Associated Press
July 28, 2010

SACRAMENTO, Calif.—Republican Meg Whitman wants to eliminate the capital gains tax in California if she is elected governor in November, a key part of her plan to boost state employment.

Her sales pitch: Cutting taxes for the wealthy will encourage them to create private-sector jobs.

Yet economists say that doing so will leave a hole in California's budget, which this year faces a $19 billion deficit, unless she raises revenue from other sources or imposes more spending cuts.

Over the last decade, California has collected between $2.6 billion and $10.8 billion a year in capital gains taxes when individuals sold stocks, real estate investments and other assets, according to the state Franchise Tax Board.

"You rip a hole in the state budget, which is already in deficit," said Henning Bohn, a professor of economics at the University of California, Santa Barbara. "How do you make up the revenue hole?"

A former chief executive of eBay, Whitman said the lost tax revenue would be replaced entirely by the new economic activity the tax cut would generate. For example, Californians would have an incentive to sell their assets and use the profits to invest in startup businesses that give the state more jobs—and thus, more taxpayers.

Eliminating the state tax also would help level the competition with Nevada and other states that have no income or capital gains taxes, Whitman spokeswoman Sarah Pompei said.

"In turn, this will lead

to increased state revenues, which will help to end our persistent budget problem," she said.

Alan Auerbach, a professor of economics and law at the University of California, Berkeley, agrees that some additional tax revenue could flow into state coffers from new business investments, but he said it would be far from what is needed to overcome the lost tax collections.

"If they say it's all going to come from additional capital gains investments, they are going against the evidence," said Auerbach, who has studied California's tax system. "It is true some of it will come back. It's wrong to count on that as being enough."

Capital gains taxes are a volatile source of revenue in California, as are overall income taxes. Yet the state relies on income taxes more than most other states, in large part because Californians capped property tax assessments in 1978, Auerbach said.

That means swings on Wall Street hit not only California investors, but also the state's budget, which has been running massive deficits the past several years.

When the economy was humming in 2007, the state collected $10.8 billion in capital gains taxes, mostly from wealthy individuals such as billionaire Whitman, according to the California Franchise Tax Board.

But revenues dropped by more than half the following year when the recession set in, contributing to ongoing cuts in public education, health care and other state services.

Much of the capital gains tax, about 92 percent, was paid by individuals who reported more than $200,000 in taxable income in 2008, according to the Franchise Tax Board. That has led critics of Whitman to say she is promoting a tax that would benefit her family and wealthy friends.

"She's not talking about an overall lower marginal tax rate," Democratic gubernatorial nominee Jerry Brown said in a July interview on MSNBC. "She has a lot of little picky, little tax break for this group and a little break for that group."

Whitman also has proposed eliminating state taxes on manufacturing equipment and creating tax credits for agricultural water conservation, homebuyers and job hires in the green-technology industry.

Capital gains taxes have long been a favorite target of Republicans. President George W. Bush successfully lowered the federal rate from 20 percent to 15 percent in 2001. The rate is scheduled to go back up in 2011 unless Congress extends the break.

Californians pay among the highest capital gains tax rates in the country. That's because California taxes overall income at a higher rate than other states, said Kathleen A. Thies, a state income tax analyst at CCH Inc., a national tax and accounting firm.

The nine states that don't have an income tax also don't tax capital gains.

"I think overall the business climate in California is difficult because your overall tax rate is higher than other states," Thies said. "I think it would be far more impactful to work on your overall tax rate than to just slash capital gains."