Finance & economics | Taxes in California

Stop dreamin’

California’s tax system needs reform. It is unlikely to get it

|SACRAMENTO

NOT long ago, California’s finances were a mess. The state’s tax revenues tanked during the recession of 2008-09. At one point in 2009 it ran out of money completely, prompting it start issuing IOUs and to force employees to take unpaid leave. Revenues have grown only slowly since. But in California, as in every state except Vermont, the law requires a balanced budget. As a result, from 2008 to 2012, politicians slashed spending. So it was testament to the state’s fiscal turnaround when on June 27th Jerry Brown, California’s fiscally hawkish governor, signed a budget without finding the need to veto any item of spending—the first time a governor has held fire on a budget since 1982.

The economic recovery has, for now, filled California’s coffers. Lawmakers are relaxing constraints on welfare spending and have even found some new money for infrastructure. But the Treasury’s long-term health remains uncertain. For that, thank the state’s oddball tax system.

Gag me with a boon

Two things stand out about taxes in California. The first is their progressivity. The top rate of state income tax, levied on incomes greater than $1m, has been 13.3% since 2012, when voters approved a ballot measure raising it from an already steep 10.3%. (These rates come on top of the highest federal levy of 39.6%, though taxpayers can usually knock state taxes off their federally taxable income.) Today the income-tax rate is the highest in the country. As inequality has increased over the past two decades, the state’s fondness for soaking the rich has proved lucrative. Since 1995, while incomes have grown by about 160%, the income-tax take is up 300%. But this has also made the budget reliant on a small number of high earners. In 2014 the top 1% of earners paid 48% of all income tax, up from 36% in 1995.

The second oddity is the set of strict constraints on local property taxes. Because these finance schools, and the state tops up local education budgets when necessary, property taxes affect the state’s bottom line. Proposition 13, a ballot measure passed in 1978, caps these levies at 1% of a property’s value. It also stops the tax bill on a given property from rising by more than inflation unless the property changes hands, no matter how much its value increases. This benefits homeowners but also firms who, on selling a property, can use shell companies to avoid a technical change of ownership. According to one estimate, in 2012-13 nearly 40% of commercial properties were assessed at less than 80% of market value.

Because incomes fluctuate more than property prices, these two features make the tax take highly volatile. Moreover, California taxes capital gains as income, so receipts rise and fall in line with the stockmarket. In 2014 the state set up a “rainy day fund” to guard against volatility. This year the amount stashed away will reach $6.7 billion, or 5.6% of annual revenues. The goal is 10%, but even that may not be enough. In April Moody’s, a rating agency, ranked the 20 most-populous states by the solidity of their buffers against another recession. California came 19th; only Illinois looked less prepared.

Betty Yee, the state’s wonkish financial controller, thinks the answer is comprehensive tax reform. On June 9th she released a report examining the options for change. One idea is to fix the state’s outdated sales tax. Currently, this applies only to goods, but Americans spend an ever-greater fraction of their income on services, in part because trade has kept goods cheap in recent decades. The fact that the federal government allows individuals to deduct either state income taxes or sales taxes from their taxable income, but not both, may have weakened the incentive for California to fix its sales tax. A high income tax and a low sales tax together result in a greater federal deduction than would middling rates for both.

Modernising the sales tax would be sensible, as would taking a second look at property levies. But both are close to impossible politically. “Prop 13 is sacred,” says Scott Drenkard of the Tax Foundation, a think-tank. Many firms would lobby against an expansion of the sales tax to cover services. Fans of high income taxes, meanwhile, think that the problem of volatility is used as cover by those who are mainly interested in cutting, rather than smoothing, the overall tax take. It is better to scale back investment in bad times than never have it in the first place, argues Chris Hoene of the California Budget and Policy Centre.

The immediate question likely to face voters this November is whether to extend the 2012 rise in income taxes on the rich, which expires in 2018, for another 12 years. With few other options, they should probably do so—and press politicians to save still more of the proceeds.

This article appeared in the Finance & economics section of the print edition under the headline "Stop dreamin’"

The Italian job

From the July 9th 2016 edition

Discover stories from this section and more in the list of contents

Explore the edition

Discover more

China’s banks have a bad-debt problem

As is becoming increasingly obvious

Which country will be last to escape inflation?

A new dividing line in the global fight


How the “Magnificent Seven” misleads

Forget the supergroup of stockmarket darlings