PA Pundit

My tax return this year showed me something disturbing about the Pennsylvania Income Tax code:  You cannot use losses in one class of income to offset losses in another class.  Nor can you carry losses forward from one tax year to the next.  One might call this a tax on “long investment cycles.”  Here’s an illustration of why this law is perverse:

In 2008 you invest $100k to start a business, but by the end of the year you have only made $25k from it.  You have a net loss of $75k in the business, but at the end of 2008 that loss evaporates.  If during 2009 you net $150k from the business you pay taxes on the full $150k.  You never get to deduct the $75k you sunk into developing the business in 2008!  If, however, you managed to bring in $100k of income during 2008 you could offset that entirely with your startup expenses and pay no taxes.  I.e., you lose thousands of dollars in taxes just based on the fact that your business requires more investment than you can recoup in the same year.

Or consider the typical investor:  In 2008 you buy a security for $100k.  Like all investments in 2008 it tanks.  You see a more attractive opportunity, so you sell security A for $60k and buy security B for $60k, which you still own at the end of 2008.  You have just realized $40k in capital losses, but those do not reduce your 2008 taxes.  Of course, during 2009 you expect that your investment in Security B will appreciate.  If you sell it during 2009 for $100k you have realized a $40k capital gain.  Yet, again, the $40k capital loss in 2008 does nothing for you.  Because it took you more than one calendar year to recoup your investment the state taxes you on the upside without giving you any credit for the downside.  You’re no wealthier, but the state takes a cut anyway.  In contrast, if you had managed to recoup your loss before the end of 2008 you wouldn’t owe any taxes on the investments!

And then there’s the separation of income classes:  Employment, business, interest, dividend, and investment income are all segregated.  PA creates a total of eight classes of income and, even though the tax rate on each is the identical, a loss in one doesn’t reduce any of the others.  If you made $25k in business but lost $40k in investments and property, you pay taxes on the $25k.  The fact that you’re $15k poorer overall doesn’t matter to the PA DoR!  In essence, the state gets to cut up your gross income into eight separate parts, and then tax you on the positive pieces regardless of what the net is.

The federal tax code, for all its many, many complexity and shortcomings, at least doesn’t penalize individuals who make long-term investments.  You can almost always carry forward losses against future gains for federal tax purposes.  Nor does it compartmentalize income the way Pennsylvania does.

PA could end its bizarre tax on long-term investors simply by allowing taxpayers to carry forward negative numbers from each income class (clearly summarized on lines 1-8 on the front page of their PA-40 forms) to future years.

PA could also avoid taxing people who actually lose money over the course of a year by allowing them to sum their income across all classes — not just those with positive values — to arrive at the line 11 “Adjusted PA Taxable Income.”