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California Dreaming: An Irresponsible Tax Increase

4 min readBy: David Block, Scott Drenkard

Governor Jerry Brown recently signed a new California budget which introduced $15.7 billion in new taxA tax is a mandatory payment or charge collected by local, state, and national governments from individuals or businesses to cover the costs of general government services, goods, and activities. es in order to meet expected expenditures for 2012-2013. The budget signed by Governor Brown counts on voters to choose in November to raise the California sales taxA sales tax is levied on retail sales of goods and services and, ideally, should apply to all final consumption with few exemptions. Many governments exempt goods like groceries; base broadening, such as including groceries, could keep rates lower. A sales tax should exempt business-to-business transactions which, when taxed, cause tax pyramiding. to 7.5 percent for 4 years, while raising income taxes on those making above $250,000 for 7 years. The income tax increase is retroactive, and would apply to all income earned after January 1, 2012.

The new revenues from the tax increases are estimated to total $8.5 billion, with $2.9 billion being spent on new funding for schools. The remaining $5.6 billion is meant to be used in the state’s general fund to help pay off the deficit. Roughly $8.1 billion of budget cuts, along with $2.5 billion in other measures, are meant to close California’s remaining budget deficit.

Though by law the state must balance their budget, there are several problems with doing so in this fashion.

First, as we have pointed out in previous posts, retroactive income tax hikes distort economic planning and disrupt income tax withholdingWithholding is the income an employer takes out of an employee’s paycheck and remits to the federal, state, and/or local government. It is calculated based on the amount of income earned, the taxpayer’s filing status, the number of allowances claimed, and any additional amount of the employee requests. schedules, meaning that taxpayers who are affected by the tax increase will write hefty checks next April when they file.

Second, while Governor Brown’s budget claims to strike a balance between tax hikes and spending reduction on paper, California has a poor record of accomplishing these goals in practice. California’s spending has increased from $98.9 billion in 2002-2003 to a projected $142.4 billion in 2012- 2013. Despite the façade of belt tightening in California, the budget signed by governor Brown increases year to year spending by 7 percent, reinforcing the states long established failure to achieve this balance. California already maintains the second highest top income tax rate in the country, and ranks 48th out of 50 states in our 2012 State Business Tax Climate Index. If they enact this income tax increase, they will surpass Hawaii as the highest top income tax bracketA tax bracket is the range of incomes taxed at given rates, which typically differ depending on filing status. In a progressive individual or corporate income tax system, rates rise as income increases. There are seven federal individual income tax brackets; the federal corporate income tax system is flat. in the nation at 12.3 percent.

New income tax rates for singles under the proposed change (increases in bold):

Rate Bracket
1.0% > $0
2.0% > $7,124
4.0% > $16,890
6.0% > $26,657
8.0% > $37,005
9.3% > $46,766
10.3% > $250,000
11.3% > $300,000
12.3% > $500,000
13.3% > $1,000,000

Note: Included in this tax bracket is California's 1 percent "Mental Health Services Tax Rate" for taxable incomeTaxable income is the amount of income subject to tax, after deductions and exemptions. For both individuals and corporations, taxable income differs from—and is less than—gross income. above $1,000,000. Some sources do not include this when reporting California's bracket.

California’s income tax collection in recent years has been significantly more volatile than its economy. Economic trends largely caused by globalization, coupled with changes in corporate pay structure over the past 30 years, have made both the top income earners and their incomes increasingly volatile and dependent on both the stock market and the broader economy. In years where both the economy and the stock market grow, this allows states like California to obtain a significant amount of tax revenue from these high income earners. But the same trends also make California’s state finances highly susceptible to large deficits when there is a drop in the stock market or the economy enters a period of anemic growth. California, which gets 43.5 percent of its state tax revenue from the highly progressive state income tax, has seen its state budget’s fortunes become increasingly dependent upon earners with incomes greater than $200,000. In 2009, earnings above this level accounted for 54.5 percent of all income tax revenue. Broadening the tax baseThe tax base is the total amount of income, property, assets, consumption, transactions, or other economic activity subject to taxation by a tax authority. A narrow tax base is non-neutral and inefficient. A broad tax base reduces tax administration costs and allows more revenue to be raised at lower rates. and decreasing dependence on the income tax would help to alleviate volatility associated with a progressive income tax.

Finally, Governor Brown may be playing a political game by linking tax increases to funding for education. The Governor is using a significant portion of the tax increases not to curb the budget deficit, but to increase education spending an additional $2.9 billion. If the tax increases are not approved by the voters in November, there will be $5.4 billion in trigger cuts to these popular programs, a political charade known as the Washington Monument Ploy.

Jerry Brown, nicknamed “Governor Moonbeam” in another life for his outside the box thinking, should use his creativity to help reform the California tax code. Californians would be better served by a bold attempt to re-structure the California tax code in order to make revenue more predictable and stable than by this political maneuver which only further endangers California’s fiscal future.

More on California here.

Follow Scott Drenkard on Twitter @ScottDrenkard.