Adopt a flax tax to avoid chronic budget crises

Tax time has come and gone, and California finds itself in yet another fiscal crisis. Gov. Schwarzenegger proposed 10 percent across-the-board spending cuts to help close the state’s now-$15 billion projected budget deficit through June 2009.

These budget crunches hit the Golden State because of its highly graduated tax code. A flat income tax would free California from this revenue roller coaster and spur both economic growth and job creation.

California can claim great weather and the best beaches, but the state also leads the nation in more depressing ways. With its millionaire’s surcharge, the top tax rate on income soars as high as 10.3 percent, the most of any state. The California income tax code has seven brackets and a dizzying web of loopholes.

Because of this highly progressive and complex structure, California’s income tax receipts are the most volatile in the country compared with other states that rely heavily on income tax revenues in their budgets.

The exaggerated swings in revenue help to explain California’s susceptibility to budget emergencies. When the economy is doing well, state coffers swell, leading politicians in Sacramento to ramp up popular spending programs. Yet when the inevitable downturn occurs, the loss in California revenues is magnified as well.

Things don’t have to be this way. California could scrap its complicated income tax code — along with the estate and gift taxes, as well as the alternative minimum tax and taxes on corporate dividend payments — and replace them with a simple, flat-rate income tax of 3 percent.

Whether a person makes $50,000 or $500,000, she or he would pay the same flat rate. All California taxpayers would be able to complete their return in minutes on a postcard, but the state would benefit as well.

The 3 percent flat tax would yield the state at least the same revenues, on average, as the current setup. The crucial difference is that the revenue would be more evenly distributed between good and bad years.

During good years, California’s current arrangement shoves many taxpayers into higher brackets, where they pay higher rates on their large incomes. But then during recessions, not only are many taxpayers earning less, but they’re paying a lower rate on their incomes as well.

This gives tax receipts a one-two punch during downturns. Thus the California tax code exaggerates the natural ups and downs of the business cycle, and leads legislators to dig themselves into a fiscal hole.

Flat-tax reform has been successful elsewhere. When Russian President Vladimir Putin took office in 2000, he helped enact a 13 percent flat tax on personal incomes. In its first year, the new flat tax yielded a 25 percent increase in revenues, even adjusting for inflation. By the end of 2004, income tax revenues had more than doubled.

Besides Russia, more than 20 other countries are seeing the benefits of a flat tax, including Estonia, Iceland, Lithuania, Macedonia, Montenegro, Romania, Serbia, Slovakia and Ukraine. This is a tested method with proven results. If it’s good enough for Estonia, why not Eureka?

In the case of California, a flat tax of 3 percent would slash the rates on the most productive individuals, small businesses and corporations. By letting people keep more of the money they earn, this tax reform would spur economic growth and job creation. And the rate of 3 percent was specifically chosen to ensure that the state does not lose any revenues from the switch.

Critics of a flat tax charge that it benefits the rich. But who will be hurt the most during the current fiscal crisis? It is not the children of CEOs whose school programs might be eliminated, and it is not upper-income earners who might be laid off by the state because of budget cuts. California’s current revenue roller coaster most hurts the poor, and the tax code stifles job creation for the working poor.

The governor and legislators are understandably concentrating on the immediate crisis. But only through long-term reform, such as a flat tax, will they be able to avoid future crises.

Robert P. Murphy is a senior fellow in business and economic studies at the California-based Pacific Research Institute.

Nothing contained in this blog is to be construed as necessarily reflecting the views of the Pacific Research Institute or as an attempt to thwart or aid the passage of any legislation.

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