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Ranking California

4 min readBy: Scott Hodge

Arnold Schwarzenegger’s ascent to the governorship of California caps the most amazing barrage of media attention to any state election in U.S. history.

With 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 as a major campaign theme, it’s no wonder that the Tax Foundation’s two principal rankings of state tax systems got a lot of play.

Reviewing how we ranked California, and why a commonly cited ranking is wrong, we see how difficult Gov. Schwarzenegger’s mission to tame California’s tax climate really is.

How California Ranks Eighth Every year, the Tax Foundation measures each state’s state/local taxes as a percentage of income, which we call “tax burdens,” based on data from the Bureau of Economic Analysis. We make adjustments for the clever ways that states collect taxes from out-of-staters, and then we rank the states. These rankings have become a staple of tax-related media coverage and tax policy considerations by legislators because they’re more current and useful than other data.

California has ranked eighth highest on this scale for three years running, taking 10.6 percent of income in taxes in 2003, compared to a nationwide average of 9.7 percent.

That’s up sharply in ten years, from a below-average 9.9 percent of income in 1993 (when the nationwide average was 10.3 percent) to an exactly average 10.1 percent in 1996, to an above-average 10.4 percent in 1999 (when the nationwide average was 10.0 percent).

The principal reason California’s tax burden is lower than in seven states is the justly famous Proposition 13, which has limited local property taxA property tax is primarily levied on immovable property like land and buildings, as well as on tangible personal property that is movable, like vehicles and equipment. Property taxes are the single largest source of state and local revenue in the U.S. and help fund schools, roads, police, and other services. collections effectively enough to bring California down to 31st in property tax collections per capita.

How California Ranks Second Our most frequently quoted ranking this year, however, was not the tax burden ranking, but our new State Business Tax Climate Index.

Businessmen, while acknowledging the importance of tax burdens, have often commented that the structure and complexity of a state’s tax system is as important as the amount collected. The State Business Tax Climate Index measures five important features of state-level tax systems: the state’s fiscal balance, the complexity of administration, the corporate income taxA corporate income tax (CIT) is levied by federal and state governments on business profits. Many companies are not subject to the CIT because they are taxed as pass-through businesses, with income reportable under the individual income tax. , the personal income tax and the 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. . It gauges whether a state tax system is administratively simple, economically neutral and efficient.

In short, it answers the question, how “business-friendly” was California’s state tax system at the start of 2003 compared to other states? The answer is that California finished almost dead last. Only Mississippi started this year with a tax system more inhospitable to business than California.

In three of the five important areas, California’s tax system stands out: its fiscal balance is disastrous; only Maine’s is worse. Its 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. has many unique requirements that make businesses jump through hoops; only New York and New Jersey have more; and its personal income tax is a huge economic burden.

California’s personal income tax of 9.3 percent on all income over $38,000 deserves further attention because it is so out of whack. Only two states have a rate on their books higher than that: Montana which charges 11 percent but makes up for it by having no sales tax at all, and Vermont where a 9.5 percent rate doesn’t kick in until someone earns $308,000. That means every Californian with 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. between $38,000 and $308,000 is paying the nation’s highest state income tax.

Many are paying the highest sales tax too. Riddled with special interest exemptions, California manages the remarkable stunt of collecting a fairly low amount of sales tax revenue despite the nation’s highest state-level sales tax rate in the country, 7.25 percent, with local options additional. Naturally, that causes special pain to businesses that haven’t succeeded in lobbying Sacramento for an exemption. A few states have sales tax rates almost that high, like Tennessee’s 7 percent and Washington’s 6.5 percent, but those states have no income tax on wages and salaries. That’s a godsend to small businesses, most of whom who file their business tax returns not as corporationAn S corporation is a business entity which elects to pass business income and losses through to its shareholders. The shareholders are then responsible for paying individual income taxes on this income. Unlike subchapter C corporations, an S corporation (S corp) is not subject to the corporate income tax (CIT). s but on the individual side of the code as sole proprietors, partners or so-called S Corporations.

California Doesn’t Rank 19th Defenders of the outgoing Gray Davis regime have asserted that Davis’s opponents exaggerate the deficiencies of California’s tax climate. A commonly cited statistic to support this claim is a Census Bureau table showing that California ranked 19th highest for combined state/local tax collections in FY 2000. It’s possible for such old data to be the “latest available” because local taxes take a long time to be tallied by Census, but it is obviously not data that can help Californians decide what they should be doing with their tax system.

In FY 2000, the economy was a boom with a bubble on top, with GDP growing nationally at a 5 percent clip. But in FY 2003, growth averaged just 2 percent (which is what makes the new 7.2 percent figure for the third quarter such a welcome relief).

The superhuman feats that Schwarzenegger is known for on screen will have to be replicated in Sacramento to turn California’s tax climate around. A robust recovery nationwide would buy him the time he needs to make California more competitive, and knowing Schwarzenegger, a Hollywood ending is just a matter of time.