The Golden State’s Golden Tax Opportunity

Next month, California legislators may have the opportunity for a long-term solution to the Golden State’s notorious boom-bust cycle, currently in its “bust” stage. A state commission launched by Governor Arnold Schwarzenegger may recommend a flat tax on income, which would stabilize revenue and help launch a recovery. If so, it won’t come a moment too soon, since many believe that the state’s recently enacted $84.6 billion budget virtually guarantees another crisis as a sequel.

At least the budget did not raise income taxes any further. California is already a high-tax state, and an earlier budget deal in February hiked the top income-tax rate to 10.55 percent, fourth highest in the country. This time, legislators reluctantly turned to spending cuts totaling $16 billion, including $6 billion from K-14 education (which includes the two-year community college system) and $3 billion from the University of California. Still, the budget is bundled with accounting tricks.

In a move straight out of Gimmicks 101, legislators have bumped back the last payroll of the year from June 30 to July 1, the start of the next fiscal year. This saves $1.2 billion from the current year’s budget, but the “saving” is spurious, as it merely pushes back the problem by a single day. The state has also accelerated its tax collection schedule, forcing taxpayers, in effect, to give the state an interest-free loan. As it happens, California’s complex and punitive income-tax code is the root cause of the budget crisis.

The code incorporates seven tax brackets and a dizzying array of loopholes. A mere 144,000 of the wealthiest Californians, out of a population of 38 million, pay half of the state’s income taxes. Even Assembly Speaker Karen Bass, a liberal Democrat, calls that “a crazy statistic.” During good years, California’s tax regime bumps many taxpayers into higher brackets, where they pay higher rates on their large incomes. When recessions hit, however, many taxpayers not only earn less, but they also pay a lower rate on their incomes. This one-two punch quickly deflates state tax receipts. The California tax code thus exaggerates the natural ups and downs of the business cycle and leads legislators to dig themselves into a fiscal hole.

When in a hole, of course, one should stop digging, but legislators have so far shown little inclination to do so. But with 1 million Californians of all income levels fleeing the state over the last five years, and unemployment in the neighborhood of 12 percent, the severity of the crisis has forced some legislators to recognize the need for tax reform. In late 2008, Governor Schwarzenegger created the bipartisan Commission on the Twenty-First Century Economy, tasked “to re-examine and modernize California’s out-of-date revenue laws that contribute to our feast-or-famine state budget cycles.”

I testified to the commission about the benefits of a flat income tax, based on my 2008 study, Ending the Revenue Rollercoaster. I estimated that 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.

A Californian making $50,000 would pay the same flat rate as a Californian making $500,000. The state would benefit, too: the 3 percent flat tax would yield 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. The only long-term solution to California’s recurring budget crises is to dampen the boom-bust cycle in the revenue stream. Flat-tax reform is a crucial first step to stability and economic growth, without which there can be no recovery.

The Commission on the Twenty-First Century Economy is scheduled to release its report on or before September 20. The Commission is expected to recommend a flatter personal income-tax code—meaning fewer brackets and loopholes, and lower rates on the top brackets—if not an outright flat tax. Despite her traditional support for steeply progressive tax brackets, Assembly Speaker Bass says that she’ll put whatever the commission recommends to an up-or-down vote before the state legislature, because she recognizes that California is in a true fiscal emergency. For the Golden State, this could be a golden opportunity for tax reform.

Robert P. Murphy is a Senior Fellow in Business and Economic Studies at the California-based Pacific Research Institute. He is author of The Politically Incorrect Guide to the Great Depression and the New Deal (Regnery, 2009) and Ending the Revenue Rollercoaster: The Benefits of a Three Percent Flat Income Tax for California. 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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