An education autopsy for Steinberg’s tax swap

The tax swap proposed by Senate President Pro Tem Darrell Steinberg may be dead, but it can still help educate legislators in their quest to fix the budget, currently about $20 billion in the red, and restore prosperity in California.

Steinberg advanced a plan to cut the sales tax rate while hiking income tax rates. Proponents claimed the plan would reduce the total tax burden for everyone while providing a more stable flow of revenue. The true result would likely be far different.

He wanted an increase of 1 percentage point in the personal income tax rate of every bracket except the top bracket. Also, the plan would extend the 0.25 percent surcharge scheduled to expire in 2011. The net result is an income tax rate hike for everyone, but a shallower hike for those in the top bracket.

For example, people who currently expect a 4 percent rate in 2011 would instead owe 5.25 percent under Steinberg’s proposal.

Yet, people in the top bracket, who currently expect a rate of 9.3 percent in 2011, would instead pay 9.55 percent under the new plan. To offset the hikes, the Steinberg plan would reduce the state sales tax rate twice during the next two years so that in fiscal year 2011-12, the California sales tax rate would fall to 3 percent.

According to the plan’s sponsors, the state would forfeit about $8.4 billion in sales tax revenue, but proponents argue that this would be offset by a comparable increase in income tax receipts. In fact, they claim that California taxpayers would gain, because they can deduct the higher state income taxes when filing their federal taxes.

As an added bonus, the plan’s sponsors claimed these changes would reduce the volatility in personal income tax receipts by flattening the income tax code. These claims omit important considerations.

More than 12 percent of California workers are unemployed and not earning any income, and the number could go up if the economy falls back into recession. This is one reason the tax swap could lead to a reduction in total revenue. Increasing income taxes to penalize work effort is always a bad idea, especially amid a recession.

Also, it’s easier for many individuals to alter the timing of their income than it is to alter their overall spending on goods and services. For example, if a homebuilder knows that income tax rates are going to rise in 2011, they can try to rearrange projects in order to officially receive payment on as many as possible in 2010. But, it would be impractical for the same homebuilder to rearrange their purchases of clothes, restaurant meals and other items subject to the sales tax.

Analysts often underestimate the impact of these considerations. It’s likely that Steinberg’s proposal would have raised less from new income tax receipts than it loses in sales tax revenue, thereby increasing the deficit. Worse, the Steinberg plan could make total revenue even more volatile.

California’s current income tax code, under which higher-income earners pay higher rates, tends to exacerbate underlying trends in the economy. When times are good, revenue surges because people are both earning more income and are pushed into higher tax brackets. In recession, however, tax revenue crashes more than the economy because people are earning less and being taxed at a lower rate.

Steinberg wanted to mitigate this problem not by lowering the top rates, but by raising the bottom and middle rates. Thus, California’s tax revenue will become more dependent on income tax receipts overall, which are more volatile than sales tax receipts. Even though the variation in income tax receipts itself may be dampened slightly, the variation in total tax receipts — sales plus income — would likely go up.

Steinberg’s plan claimed to solidify California’s tax revenue while raising everyone’s after-tax income, but these projections are likely mistaken. In reality, the plan would likely lead to lower and more-volatile revenue because it violates the principles of pro-growth tax reform.

Legislators should not lament or try to replicate the Steinberg swap. Instead, they should cut spending and taxes in general. That’s the best way to solve the Golden State’s budget crisis.

Robert P. Murphy earned a doctorate in economics from New York University and is a senior fellow in business and economic studies at the California-based Pacific Research Institute. He’s co-author, with Jason Clemens, of “Taxifornia,” available on the institute’s website. Contact him at [email protected].

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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