Riding the Revenue Rollercoaster – Pacific Research Institute

Riding the Revenue Rollercoaster

After a record impasse, the sages of Sacramento have finally agreed on a budget for California, a $144-billion bonanza with unprecedented general fund spending but without structural reform in the state’s finances.

The boom-bust revenue rollercoaster is still in place, and Californians can expect a bigger budget crisis in a few years. The governor’s office, however, is spinning the announcement as a victory for reform.

Their Web site press release devotes an entire section to the proposed “Rainy-Day Fund With Teeth,” an idea that sounds good in theory. During good times, transfer three percent of General Funds into the expanded Budget Stabilization Account. The BSA would then provide a backstop for lean years. However, to ensure the money is saved for a true emergency, the state could only draw on the BSA when actual revenues fall below the prior year’s spending, adjusted for population and income growth.

Fiscal conservatives should applaud anytime politicians admit that the current system is geared toward overspending during good times, which leads to chronic deficits during bad times. However, the new rainy-day mechanism still leaves temptation for future politicians. They will still see a huge spike in tax revenues when the economy is booming, and only time will tell whether they respect the constraints laid out by today’s politicians. Experience shows that the government can cook the books to get almost any outcome.

Trusting the government to police itself is naïve. Just look at what the Supreme Court has done with the rules laid down by the Founding Fathers. A much more realistic solution to California’s boom-bust revenue rollercoaster is a flat income tax. Currently, California has the most punitive tax code in the country, and also one of the most volatile streams of tax revenue. This is no coincidence.

The steeply graduated tax code exaggerates revenue swings. During good times, there is a double effect, because people are earning more (i.e. the tax base is larger) and people are bumped into higher tax brackets, meaning that the larger tax base is hit with a larger rate. So in periods of prosperity, California tax revenues respond more than proportionately. During an economic downturn, the opposite happens.

In the case of a downturn, not only are people making less income in general, but many of them are also taxed at a lower rate, since they fall into a lower bracket. Tax revenues shrink more than proportionately. Generous spending programs that were put in place during the preceding boom period now threaten to bankrupt the state.

A flat income tax—where everyone pays the same rate, regardless of income—would change all that. Tax revenues would still rise and fall with the general economy, but the effect wouldn’t be magnified, as under the current system. Rather than trusting politicians to act responsibly and put money aside during the good times, a flat tax would automatically smooth out the revenue rollercoaster. No trust in the politicians would be needed, because they wouldn’t see the money in the first place.

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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