The Commission on the 21st Century Economy, tasked by the governor to modernize the state’s tax system and stabilize revenues, finally delivered its report this week. The main recommendations are to eliminate the state sales tax and corporate income tax and replace them with a new “net receipts tax” on business.
In addition, the number of statutory personal income tax rates would be reduced from six to two. The personal income tax rates would be 2.75 percent for couples with taxable income (AGI) up to $56,000 and 6.5 percent for those with taxable earnings above $56,000. The standard deduction for couples (joint filers) would be $45,000.
These reforms would shift the tax base from income to consumption. This shift is critical for a more stable system that avoids boom-and-bust cycles. Both theory and economic data indicate that revenues from consumption taxes are not as volatile. Some taxes impose higher costs on society because they create more serious distortions than others. Research has consistently shown that consumption-based taxes impose much lower costs on society than personal and corporate income taxes.
For example, a widely cited study by Harvard professor Dale Jorgensen and Kun-Young Yun calculated different costs of different taxes. They examined the additional costs imposed on society of raising one additional dollar of revenue based on how the different taxes affected economic incentives and behavior such as savings and investment.
They found that corporate income taxes imposed additional costs of $0.84 for one additional dollar of revenue raised. At the same time, a dollar raised through sales taxes only imposed costs of $0.26. The reason for this large difference is how these two taxes influence incentives.
Corporate income taxes create disincentives for investment and business development, which impose large costs on society and workers. Consumption taxes make consumption a little more expensive and savings a little more attractive. This creates incentives for more savings, which leads to higher levels of investment.
The Commission’s report is a good first step toward increasing economic growth, but much more needs to be done to further the incentives for diligence, savings, investment, and entrepreneurship. These are all of the utmost importance to California, which ranked 38th out of 50 states in economic performance over the last five years, according to a recent study in PRI’s California Prosperity Project. There is ample evidence that part of the state’s economic problems are rooted in a tax system that discourages these beneficial and productive activities.
For example, a recent study by the Tax Foundation ranked California’s tax system 48th out of the 50 states in promoting business investment and development. Reforming the tax system will improve on the status quo but it remains important to reduce the overall tax burden, and the reason for it. California maintains the fourth-largest government sector (state and local) as a share of the economy among the 50 states.
The Commission’s report, unfortunately, remains unclear whether the net receipts tax will be visible to consumers at the point of final purchase. This is a critical consideration since evidence from Europe and Canada confirms that a tax visible to consumers will be constrained while an invisible tax will increase substantially over time. There is also a question regarding carve-outs and exemptions for the new tax. One can bet that every industry and advocacy group will be lining up for special treatment. Indeed, the Commission itself recommends exempting businesses with sales of under $500,000.
That said, the Commission should be congratulated for tackling a critical and difficult issue. The report represents a positive first step in re-shaping tax policy, stabilizing revenue, and restoring the economic luster of the Golden State.