Hedge Funds vs. Mom-and-Pops: The Truth about Small Businesses and Closing the Capital Gains Tax Break
Special interests that are opposed to closing the tax break on capital gains misleadingly claim that the House’s proposal would harm small, individually- or family-owned businesses, such as restaurants, auto repair shops, gas stations, and family farms. In reality, this common and sympathetic perception of small business owners is being exploited to shield ultra-wealthy shareholders and partners in investment hedge funds, shell corporations, and other elite financial arrangements from paying higher taxes.
Many “small businesses” are very wealthy individuals engaged in finance activities
Historically, small business ownership has been a pathway to prosperity among hardworking lower- and middle-income households striving to build better lives for themselves and their families. But since the 1980s, extremely wealthy households have increasingly pooled their wealth by forming partnerships and small, private corporations called “S corporations.” In many cases, financial advisers and attorneys for the wealthy draw up these business entities for their clients so they can take advantage of significant federal tax benefits allowed for these types of business structures.
It’s important to note that many S corporations and partnerships are rightly considered to be small businesses because they carry out important economic activities, such as hospitality services, legal services, manufacturing, and other traditional small business activities. But the bulk of wealth for these kinds of business arrangements comes from a small number of elite investment partnerships, like hedge funds, that cater exclusively to the richest 1 percent. As of 2011, 70 percent of business income generated by partnerships comes from those engaged in finance and holding companies (shell corporations). (1)
The explosive growth in elite partnerships and S corporations involved in finance activities since the late 1980s has led to an extreme concentration of all small business wealth and income among the very richest households in the United States. As the graph below shows, 69 percent of income from partnerships and 66 percent of income from S corporations now accumulate to the richest 1 percent. As of 2011, someone in the richest 1 percent is 50 times more likely to have any positive small business income than someone in the bottom 50 percent of the population.
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Being linked with genuine small business owners – those who are not engaged in these elite finance activities – has become politically convenient for extremely wealthy people with assets in hedge funds and investment firms. Hedge fund and investment firm partners know they can likely defeat any effort to raise their taxes if the public believes doing so would impact owners of convenience stores, small farms, or auto repair shops.
Most true small businesses don’t receive capital gains as part of their ordinary business activities
Partnerships and S corporations do not directly pay federal taxes on their ordinary business income and capital gains. Instead, ordinary business income and capital gains are “passed through” to the individual partners or shareholders, who in turn pay taxes on them as part of their personal federal income taxes. Under the proposal from House Democrats, wealthy households that live in Washington state who receive pass-through capital gains from exclusive investment partnerships would be taxed on those gains, to the extent they exceed $25,000 ($50,000 for married couples) per year.
But most genuine small businesses don’t receive capital gains as part of their ordinary business activities. Only 3.3 percent of total business income from sole proprietorships comes from finance-related activities, which are the most likely to reap capital gains.(2) And when it comes to partnerships, the overwhelming majority of capital gains (80 percent) accrue to securities brokerages, holding companies, and other high-end financial management firms that cater to the richest households (see graph below). Capital gains are negligible among partnerships involved in farming, retail trade, manufacturing, and other activities not related to finance.
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The current proposal includes numerous exemptions that would benefit small businesses
Finally, groups that advocate for so-called small businesses with investments in hedge funds and other wealth-accumulation vehicles argue that traditional small business owners would pay the proposed capital gains tax when they sell their business. But this claim ignores numerous exemptions that would benefit small businesses in the current proposal – including those on small business equipment, farmland and farm equipment, livestock, timber, and more.
Perhaps even more importantly, by exempting the first $25,000 for individuals ($50,000 for married couples) in all capital gains from taxation, the proposal from House Democrats would prevent capital gains tax increases for many households selling ownership stakes in a partnership or S corporation. That’s because the median gain from the sale of a partnership or S corporation is less than $5,000, well below the proposed exemption threshold, according to 2010 data from the nonpartisan Congressional Budget Office. And 70 percent of capital gains from the sale of a partnership or S corporation in that year went to millionaires and billionaires.
It is undeniable that the bulk of capital gains taxes would be paid by the powerful few, who have manipulated the tax code in their favor to the detriment of traditional small business owners who serve our communities through their businesses. On balance, small business owners will benefit from investments in strengthened public services that reinforce their businesses and their communities – and these improvements would be made possible by eliminating the tax break for capital gains enjoyed by the very wealthiest Washingtonians.
1. Michael Cooper, et al., "Business In the United States: Who Owns It, And How Much Tax Do They Pay?" National Bureau of Economic Research, 2016, http://eml.berkeley.edu/~yagan/BusinessOwnersTaxes.pdf.
2. Washington State Budget & Policy Center Calculations; data from the Internal Revenue Service, Statistics of Income, Sales of Capital Assets, long-term capital gains, 2014.
We can’t get something for nothing: More tax cuts for the wealthy will have to be paid for by growing the deficit or by more cuts to critical federal programs like health care, emergency response services, and child care for working families.
Four of the proposal’s most egregious tax cuts that would line the pockets of the ultra-wealthy at the expense of our communities are:
- The total repeal of estate tax, which is currently only paid by the wealthiest 0.2 percent of estate owners;
- The reduction of the federal tax rate on capital gains, which are profits from the sale of stocks and bonds, by 3.8 percent;
- A nearly 5 percentage point cut in the income tax rate for individuals in the top income bracket; and
- A cut in the top rate on “pass-through” business income, which is currently taxed at the business owner’s individual income tax rate, to 15 percent (which would overwhelmingly benefit wealthy investors while leaving out most small business owners).
Washington state already has the most upside-down tax code in the nation, in which everyday Washington families pay up to seven times more in taxes as a share of their income than the top 1 percent. Giving new federal tax breaks to the wealthiest 1 percent further stacks the tax code against middle- and lower-income Washingtonians, who will have a harder time getting ahead. This is bad policy for the country and for our state.
Lack of a State Capital Gains Tax Means Wealthiest 1 Percent Get a Huge Tax Break in Washington State
Currently, our state tax code caters to the wealthiest Washingtonians by giving them generous tax breaks on their capital gains – which are the profits they make from the sale of corporate stocks, bonds, gold bars, and other high-end financial assets. Such financial assets are exempt not only from state and local sales taxes, but also from property taxes, and most business & occupation (B&O) taxes. The simplest and most equitable way to effectively close these state tax breaks is to enact a state excise tax on high-end capital gains. Doing so would generate substantial new resources for Washington state’s schools and other investments that foster thriving communities. Eliminating the tax breaks on profits from capital assets in this way would represent a significant step toward turning Washington’s inequitable, upside-down tax code – in which people with low incomes pay seven times as much in state and local taxes as a share of income as the wealthiest 1 percent – right-side-up.
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Democratic leaders in the state House of Representatives have sensibly proposed to close the loopholes on most profits from capital assets in Washington state’s tax code with a new 7 percent excise tax on capital gains above $25,000 ($50,000 for a married couple). As the chart above shows, 92 percent of capital gains taxes would be paid by the wealthiest 1 percent of Washington’s families – those with incomes above $600,000 per year. By contrast, virtually none of the additional tax revenue would come from families with incomes below $119,000 per year. Only 0.03 percent of households in that group would pay any additional taxes.
Closing the capital gains tax break would generate more than $700 million per year in new resources for schools, child care, environmental protection, and other priorities that serve Washingtonians. And the additional payments from the few households that would be impacted would be relatively small. As the chart below shows, on average, taxes would increase by only 1.5 percent as a share of annual incomes among the richest 1 percent of households in Washington state. This is a small price to pay for the people who have benefited most from our economy to ensure that all kids have access to great schools and all Washingtonians can have thriving communities.
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The excise tax on capital gains proposed by House Democrats is the most sensible way to address the numerous tax breaks for capital assets on the books in Washington state, which include exemptions and exclusions from the sales tax, property tax, and B&O tax (Washington's three major revenue sources). When it comes to the sales tax, for example, people don't have to pay it when they buy or sell stocks, bonds, and other high-end financial assets (or intangible goods). But Washingtonians do pay sales tax when they buy tangible goods, like cars, appliances, soap, and toothpaste. Because stocks and other financial assets are heavily concentrated among the wealthiest households, their exclusion from taxes gives a huge advantage to wealthy Washingtonians.
The capital gains proposal in Washington state would be simple for taxpayers and cost-effective for the state to administer because it would be based on the federal capital gains tax. Further, it would be almost impossible for the few wealthy households subject to the tax to evade it. That’s because liability for the tax would be based on where the taxpayer lives, not where their stock trades occur.
As the regular legislative session comes to an end, the budget writers in Olympia who are seeking to fund schools and other key priorities need to close the capital gains tax break.
The package of tax reforms included with the budget proposal from Democratic leaders in the Washington state House of Representatives would provide nearly $3 billion in the coming 2017-19 budget cycle in equitable, ongoing resources for schools and the other foundations that foster thriving communities. Because of these important reforms, the budget proposal from House Democratic leaders is the only sustainable two-year investment plan currently under consideration in Olympia. The House’s plan would also begin to take important steps toward flipping Washington’s inequitable, upside-down tax code right-side up.
While Republican leaders in the state Senate also have a budget plan, it does not take meaningful steps toward cleaning up the state’s flawed tax code, and it pencils out only with the help of unsustainable accounting tricks, harsh cuts to critical state programs, and empty promises to our kids.
Washington state has the most upside-down tax code in the nation. Families with middle and low incomes pay up to seven times more in state and local taxes as a share of their incomes than the wealthiest 1 percent. The House Democrats’ proposal shows that it doesn’t have to be this way. The revenue package they propose would raise resources to invest in the foundations that let us all thrive, and it would do so equitably and sustainably by beginning to clean up the tax code so that everybody pays their share. Here’s how they would do it.
Closing the tax break on profits from the sale of high-end capital gains ($715 million in 2017-19). Every year, Washington leaves hundreds of millions of dollars on the table by giving a tax break to those who profit when they sell their corporate stocks and bonds. House Democratic leaders propose to eliminate this tax break by enacting a new tax on capital gains – profits on the sale of corporate stocks, bonds, and other financial assets – above $25,000 ($50,000 for married couples) at a rate of 7 percent. If our state joined the 42 other states that tax capital gains, as the House proposes, we could instead put those resources into the foundations that help our communities flourish, such as recruiting the best educators to teach Washington’s kids and maintaining the beautiful state parks we all enjoy. The tax would not be levied on common middle-class investments. Capital gains within retirement and college savings accounts would be exempt, along with those from the sale of family homes, timberland and farmland, timber, livestock, and small business assets.
Curtailing or eliminating wasteful tax breaks ($144 million in 2017-19). Washington’s tax code is riddled with tax breaks, some of which are outdated, and others of which only benefit the powerful few who have manipulated the tax code in their favor. Limiting or closing some of the most wasteful tax breaks would begin to clean up our tax code and turn it right-side up. The House Democrats’ plan would allow our state to put resources to good use in our communities instead of providing giveaways to special interests. The plan proposes to close the following breaks:
- Sales tax break on bottled water. The negative impacts of bottled water on our environment are well documented, so there’s no good policy rationale to incentivize the purchase of bottled water by providing a tax break for it. Under this proposal, the tax break on bottled water would remain in place for those who don’t have access to potable water.
- Sales tax exemption claimed by oil refineries on fuel used to power their operations. This exemption was originally enacted to help the timber industry when companies used their own “hog fuel” in their operations, but now this break goes almost exclusively to the big oil industry.
- Preferential business tax break for international investment management companies. Financial firms in the business of managing international investments receive a preferential business tax rate which is less than one-fifth the general rate paid by other service businesses, such as janitors, dentists, mediators, and optometrists.
- Preferential business tax breaks for prescription drug wholesalers. The tax break for prescription drug wholesalers was originally put in place to lure businesses to Washington state. But because the exemption is available even to companies that aren’t located in our state, it provides no competitive advantage for our state.
- Real estate tax exemption claimed by banks on sales of foreclosed homes. When Washingtonians buy a home, they pay a real estate excise tax (REET). But when a piece of property is sold as part of a debt proceeding, such as a foreclosure, the REET is not applied. Closing this break would put investors and banks that buy up foreclosed homes on equal footing with everyday homebuyers.
- Sales tax giveaway for out-of-state shoppers. Our state currently allows shoppers who come from no- or low-sales-tax states to shop in Washington without paying our sales tax. The original purpose was to encourage shoppers in border counties to choose to shop in Washington instead of going across the border to avoid sales tax. But the data shows that this break is claimed most often in King County, which isn’t a border county – strong evidence that the break is being wasted on tourists who would shop in Seattle anyway. The plan from House Democrats would convert this to a rebate program, under which qualifying shoppers could apply once a year to have their sales tax reimbursed. This change from an automatic break to an application process would shrink the sales tax giveaway significantly.
Reforming business taxes ($1.2 billion in 2017-19). The House proposal would eliminate business & occupation (B&O) taxes for about 260,000 small businesses in Washington state with annual gross business incomes below $250,000. Another 33,000 small businesses with between $250,000 and $500,000 of gross income would be able to reduce their tax bills by exempting their first $100,000 in income from the B&O tax. In addition, a 20 percent B&O tax surcharge would be applied to a broad range of businesses categories, mostly impacting larger businesses. This reform would not only help small businesses by providing a targeted B&O deduction, but it would generate over $1 billion per budget cycle in new resources for schools and other priorities.
Reforming the 1 percent property tax levy growth limit ($128 million in 2017-19). As we’ve written about in the past, the 1 percent levy growth limit artificially holds down state and local property tax revenues. The cap starves communities across our state of the resources they need to maintain basic services, like providing 24-hour police and fire services. Lifting this limit would allow towns and cities, especially those in small and rural communities, to raise resources in a way that allows them to meet essential community needs.
Creating a more equitable Real Estate Excise Tax ($435 million in 2017-19). Under current law, a flat, 1.28 percent REET is applied to the total selling price of most real estate sold in Washington state. This proposal would change the tax from a flat rate to a progressive rate, resulting in a higher rate for the very highest-valued properties, and a lower rate for the lowest-valued properties. This would help create a more equitable tax code by requiring those who can afford to buy properties worth more than $1 million to pay a little more to support schools and other important community investments.
- For properties selling for less than $250,000, the rate would be reduced to 0.75 percent.
- For properties selling for between $250,000 and $1 million, the rate would remain at 1.28 percent.
- For properties selling for between $1 million and $5 million, the rate would be increased to 2 percent.
- For the most expensive properties – those selling for more than $5 million – the rate would be increased to 2.5 percent.
Creating a more level playing field between in-state and out-of-state retailers ($330 million in 2017-19). Because of a United States Supreme Court decision, many out-of-state internet retailers are not required to collect sales taxes on purchases made to Washington state residents. While these retailers can voluntarily collect sales taxes, few have chosen to do so. As a result, Washington communities lose out on hundreds of millions of dollars in resources, because our state doesn’t receive sales tax revenue on a significant portion of purchases made by Washingtonians. House Democrats propose to follow actions taken by Colorado and other states that would encourage these businesses to change their ways and start collecting sales taxes on goods sold to Washingtonians. Under their plan, out-of-state businesses that choose not to collect sales taxes would be required to send information on each taxable sale to their customers (and the state Department of Revenue). Then the onus would be on the customers themselves to pay the sales taxes not collected by the company. If enacted, many businesses would choose to simply start collecting the taxes rather than placing that responsibility on their customers.
Asha Bellduboset just completed her Betty Jane Narver Policy Fellowship with the Budget & Policy Center. She will receive her master’s degree from the Daniel J. Evans School of Public Policy and Governance at the University of Washington this June – with a capstone project focused on assessing the economic impact of the Woodland Park Zoo’s educational, community outreach, and conservation programs and operations in the greater Seattle region. We checked in with her to hear more about her time with us and what her hopes are for the future.
What made you decide to apply for the Narver Fellowship with us?
I became aware of the Budget & Policy Center early into my master’s program at the Evans School through some of the organization’s tax policy analyses and social program advocacy efforts. When I found out there was a fellowship where I could learn from some of Washington’s top researchers and advocates who write and research reports and policies that I avidly support, I knew I had to apply. I really value the policy work that comes out of the Budget & Policy Center, and I wanted to gain a better understanding of what goes into high-level policy analysis and how to effectively impact changes in state level policies. I am very interested in the gambit of topics and policy areas that the Budget and Policy Center works on, so being able to work with everyone has been such a meaningful experience.
What are some highlights of what you’ve learned?
I was lucky to work closely with the center’s senior policy analyst, Jennifer Tran. Working with her provided me with the opportunity to learn strategies for analyzing large data sets, incorporating equity and social justice into these analyses when they are buried in the details, and highlighting the key findings in an informative but not overwhelming way. Gaining real-world and relevant experience in performing this kind of analysis was invaluable to me.
I also learned how the legislative process works in Washington state, who key legislators are, and how to advocate for policies during session. At the same time, the Budget & Policy Center’s collaborative efforts with statewide community advocacy organizations introduced me to a network of regional decision makers and activist organizations. All of which was completely new to me. I now feel comfortable navigating the legislative environment, and I have learned so much about how different institutions throughout the state interact and what the impact on the public can be. The fellowship really impressed upon me the importance of staying informed and working to advocate for all of Washington’s communities.
What were some of your favorite experiences during your fellowship?
I’ve had many wonderful experiences as a Narver Fellow. From the informative panel discussions and networking opportunities at the Budget Matters conference to my experience shadowing Senator Rebecca Saldaña, I gained access and insight to areas of the policymaking and advocacy world that I would not have had without this fellowship.
The mentorship I received on a regular basis helped me understand many aspects of the policy world on a new level, and of course, working with the talented employees at the Budget & Policy Center has been enlightening and impactful. Truly, being able to see how to plan, facilitate, and advocate for a legislative agenda that supports the best interests of all Washingtonians was so valuable.
I also really enjoyed learning how to work with public officials. On one of my most memorable days, I got to learn from Senator Saldaña about what happens on a day-to-day basis at the state capitol and gain first-hand perspective on what it takes to be a devoted public servant at the state level.
Did anything surprise you from your time with us?
I was surprised by how everyone can be working on so many different projects and yet still provide help and insight to other members of the team. The level of camaraderie and professionalism I experienced while working here was such a pleasant surprise. The way everyone works to share important information and pushes for developing policies and analyses that support Washingtonians from many different backgrounds is noble.
A lot of work goes into making sure complex ideas and policies are digestible for a wide segment of the population. And it was great to see how the staff makes sure that anyone seeking to understand tax policy or social program policy can read a schmudget blog post and be informed enough to have a meaningful dialogue with their public officials or colleagues. I was especially impressed with how the policy team organized community meetings to get feedback from different stakeholder groups on some of their research.
What do you hope to do in your career?
I hope to create more space for equity and diversity in the policy arena through policy advocacy, analysis, and education. I want to use the tools I’ve gained through the Narver Fellowship to work on policy in a manner that reflects the community, is useful to community members, and advances social justice and equity. Getting exposure to so many paths toward impacting state policies has invigorated me in my goal of doing policy analyses using a social equity lens.
All of us at the Budget & Policy Center wish Asha the best of luck in the future!
New Research Brief: Early Learning Improves Kindergarten Readiness and Reduces Disparities for Kids of Color
We all have a stake in making sure that from the day they’re born, kids can have the enriching experiences they need to get off to a great start in life. Quality early learning can give children the tools they need to thrive academically and emotionally throughout their entire lives.
This new KIDS COUNT in Washington research brief demonstrates why legislators need to make greater investments in the Early Childhood Education and Assistance Program (ECEAP) – our state’s preschool program that serves children from families living in poverty. Expanding this program to ensure all eligible kids can participate could help more of Washington’s kids show up to kindergarten ready to learn. It could especially help many children of color who haven’t had equal access to opportunities that promote kindergarten readiness.
ECEAP, which serves families with incomes below 110 percent of the federal poverty line ($26,730 for a family of four in 2017), offers many of our state’s most vulnerable children quality early-childhood learning experiences. It has a proven record of improving kindergarten readiness and impacting their long-term academic success. Yet because of inadequate state investments in this program, there are currently about 23,000 unserved children eligible for ECEAP in Washington, 62 percent of whom we estimate are children of color.
KIDS COUNT in Washington, which is a partnership between the Budget & Policy Center and the Children’s Alliance, examined how expanding ECEAP to serve the 23,000 unserved eligible children could impact readiness for kindergarten across the state and help bridge disparities in access to opportunities that promote kindergarten readiness. Our analysis concluded:
- Kindergarten readiness in Washington overall could increase by 20 percent (to 56 percent from 47 percent);
- 7,900 more children could be ready for kindergarten on all six indicators of readiness (1) by the end of their year in ECEAP; and
- The share of Latino, American Indian, and Black children ready for kindergarten could have the largest increases (See chart for more details).
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The Washington State Department of Early Learning has set a goal of ensuring that, by 2020, 90 percent of Washington children enter kindergarten prepared to learn, with race and family income no longer a predictor of kindergarten readiness. A key to delivering on that promise is to make sure all eligible children have access to ECEAP.
See our full research brief for more information on how expanding ECEAP could improve kindergarten readiness for all kids in Washington state and help bridge disparities for kids of color.
For more detailed technical information on our analysis, please contact firstname.lastname@example.org for a copy of our Data and Methods document.
1. The six indicators of readiness refer to an assessment by educators and teachers to measure kindergarten readiness on six developmental domains: social-emotional, physical, language, cognitive, literacy, and mathematics. See the full brief for more information on how the indicators are measured.
The Washington state legislature enacted the WFTR in 2008, but it was never funded. It is one of the most effective ways Washington can work to correct our state’s reliance on regressive sales taxes that overburden lower-income families. The rebate uses the federal Earned Income Tax Credit (EITC) program, a powerful anti-poverty tool, as a basis for eligibility. The WFTR would provide qualifying low-wage workers with an annual boost to their income in the form of a tax credit.
Funding the WFTR would advance racial equity by supporting the economic security of Washingtonians of color who are working in low-wage jobs. Our new WFTR fact sheet shows how the WFTR would benefit families in all of Washington’s 39 counties from all racial backgrounds. For example, our analysis shows that, if the WFTR were funded:
• Recipients would invest $98.5 million back into local economies throughout Washington state, nearly half (49 percent) of which would go to communities of color.
• The rebate would improve the lives of many children of color, given that 51 percent of qualifying children in EITC-eligible households are children of color.
• Approximately 498,000 Washingtonians in all 39 counties of the state would be eligible for the WFTR, which means residents in all counties would see some economic gain.
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Take a look at our fact sheet for more information on how the Working Families Tax Rebate would advance equity for our state and its people.