Lessons from the $388 million Hyatt case: How current tax policy hurts California

California’s financial problems may have gotten worse by $388 million, according to an August 16 Nevada trial verdict in favor of an inventor mistreated by California’s Franchise Tax Board. The unprecedented case highlights California’s enforcement tactics and points to the solution for state revenue instability.

Gilbert P. Hyatt, an electrical engineer who studied at U.C. Berkeley and USC, invented a microprocessor in the late 1980s. He secured a patent in 1990 and contends that he moved to Nevada, which has no state income tax, before the invention began paying off in the multi-millions. California’s Franchise Tax Board (FTB) charged that Mr. Hyatt was still a California resident at the time, and subject to state income tax. Therefore, the FTB contends, he owed $7.4 million, now up to $49 million with interest and penalties.

Mr. Hyatt says that in its quest to get this money, the FTB harassed and intimidated him. He sued the FTB in a Nevada court and won. Jurors awarded him $138.1 million in compensatory damages and $250 million in punitive damages. The jury award is rather large and may not stand on appeal. Even so, the case remains instructive because the state depends on high earners like Mr. Hyatt for much of its revenue.

According to the FTB, Californians with adjusted gross incomes of $300,000 or more represent fewer than 2 percent of the total returns filed, yet they pay almost 55 percent of income tax revenues. They also pay some of the highest state income-tax rates in the country, which may soon be higher.

One plan being advanced by state Democratic legislators calls for two new tax brackets, a 10-percent rate kicking in for couples making $321,000 and then an 11-percent bracket for those making $642,000. The plan would raise the corporate tax rate from 8.84 percent to 9.3 percent. These changes would give California the highest personal income tax rates in the nation, and the sixth-highest corporate rate.

Those who want higher taxes claim they don’t drive productive people out of the state. Mr. Hyatt’s case confirms that they do. The heavy handed treatment he received is a direct result of current California tax policy, getting most of its revenue from high earners, and it is hardly limited to him alone or the wealthy in general.

California grabs money from bank accounts dormant for only three years – down from 15 years in the late 1950s. In many cases, state officials make no effort to locate the rightful owners of the funds, who last year included more than 20 state legislators.

California also shakes down residents of other states for the “duty days” they spend working in California. This “jock tax” has made news with millionaire professional athletes but also applies to a home-care nurse from Nevada or a salesman from Arizona. The tax prompts retaliation from other states.

So desperate is the state for revenue that during the 1990s California considered taxing editorial cartoons as though they were works of art purchased in a gallery. The “laugh tax” made the state a national joke, but the tax issue is no laughing matter. Neither is the exodus of California’s productive entrepreneurs.

California could eliminate gimmicks and heavy-handed tactics, and raise as much revenue as it does now, with a flat state income tax of only three percent. That would keep productive entrepreneurs such as Gilbert Hyatt in the Golden State.

The Hyatt case has already cost the FTB nearly $9 million, according to news reports. Bill Leonard of the State Board of Equalization is urging the FTB to settle. Leonard told the Sacramento Bee that FTB auditors, “made this into a vendetta on their part, and it backfired big time.”

Given the FTB’s track record, settling with Mr. Hyatt might be the wisest course of action. It would be wiser still for the state to discard the current income tax system, which is punitive and unstable. Better to implement a flat income tax that would treat all Californians fairly and equally, and tame the state’s revenue rollercoaster.

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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