The Right Way To Cut Taxes

California's new capital gains law gives special incentives to small business.

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California's Gov. Jerry Brown has signed a capital-gains tax bill much more defensible than President Reagan's federal tax package. California's tax approach is designed specifically to benefit long-term investors in smaller businesses and discourage investment in unproductive assets like gold.

The California approach seeks to reward people in proportion to what their investments do for society. California is acknowledging that the people who invest in small companies tolerate greater risk and less liquidity than do big company investors, that they produce more innovation and more jobs and keep the economy competitive, and that therefore they should get especially favorable treatment of their gains.

The California plan will abolish state capital gains taxes on stock held for three years or more in most California companies with fewer than 500 employees. But it will maintain existing tax rates on investments in larger companies and increase them on nonproductive assets like metals, gems, art, antiques, and stamps. The accompanying table shows the overall effect of this new law.

In contrast, the tax cut recently passed by the U.S. Congress cuts capital gains taxes across the board. Whether you use $100,000 to establish a company to develop a computer or use $100,000 to buy a rare postage stamp, the new law cuts the maximum federal tax on your subsequent gain from 28% to 20%.

That may encourage some investors to put their money into useful small companies, but it's just as likely to encourage them to push up the prices of silver, diamonds, and antiques. The federal capital gains tax cut should have been targeted like the California cut.

It's hard to reward investors in proportion to their contribution to society, and to do it at the state level -- without the cooperation of the president or Congress -- is even harder. California may not accomplish much by exempting long-term investments in smaller companies from a state tax of 7.15% or 5.5% when the investor still must pay a 20% federal tax.

MAXIMUM STATE CAPITAL GAINS TAX RATES IN CALIFORNIA

Holding Current law: The new plan:

period all investments small business nonproductive assets everything else

1 year

or less 11.0% 11.0% 11.0% 11.0%

1 to 3

years 7.15% 7.15% 7.70% 7.15%

3 to 5

years 7.15% no tax 7.70% 7.15%

5 years

or more 5.50% no tax 5.50% 5.50%

Moreover, there's always the possibility that a targeted law will miss its target. The California plan requires that, to be tax-free, companies must not be listed on the New York or American stock exchanges or the National Association of Securities Dealers' Automated Quotation (NASDAQ) system, and that no large company may hold more than half of a company's shares at the time the investor acquires his stock. It also limits the portion of a company's business that can involve rents, interest, dividends, land-holding, or sale of its capital assets.

But creative accountants may still find loopholes and create "small businesses" that do nothing but shelter their owner's income from taxes. And unexpected consequences may result from barring small business tax treatment simply because a company's stock price is reported on the NASDAQ system. NASDAQ can currently report on companies with as little as $250,000 in stockholders' equity.

Despite the problems, the potential usefulness of targeting is clear. California may not have developed a perfect targeting system yet, but the new system can always be changed.

The California law carries a nationwide message. Throughout the country, capital gains tax systems probably should be adjusted to aid smaller businesses. And the time to target the federal capital gains tax to aid smaller companies is now.