After the Recall: Fixing Bumpy State Tax System
By HOWARD FINE
It’s the most vexing financial problem facing California, and it is at the heart of this week’s recall vote: how to bring in more money and not be so dependent on volatile income taxes.
At the peak of the dot-com boom, the state drew more than 20% of its money from the exercising of stock options by wealthy taxpayers. When the bubble burst in late 2000, it created one of the most dramatic revenue swings of any state in history.
“We have these huge peaks and troughs,” state Controller Steve Westly said.
In his State of the State speech last January, Gov. Gray Davis said he wouldn’t sign a budget unless it contained a tax overhaul. When partisan gridlock on the budget intensified, Davis backed off this pledge. He settled instead for the appointment earlier this month of former President Bill Clinton’s budget director, Leon Panetta, to head up a commission to study how to balance out the state’s feast or famine cycles. Panetta said he intends to come up with recommendations by year’s end.
Whatever the outcome of this week’s recall vote, the issue won’t go away. Pressure to reform the state’s fiscal structure actually may grow more intense if legal challenges to the borrowing of $13 billion in bonds are upheld.
Last month, Sacramento Superior Court Judge Thomas Cecil ruled that selling $2 billion in pension bonds violated constitutional bans against such borrowing without a vote of the people. The Davis administration said it intends to appeal.
Also last month, the conservative Pacific Legal Foundation brought a lawsuit on similar grounds against the state’s plan to sell $10.7 billion in “deficit financing bonds,” which was the centerpiece of this year’s budget compromise.
“If all this borrowing is thrown out by the courts, that will force people to take another hard look at the issue of taxes,” said Martin Helmke, tax consultant to the state Senate Revenue and Taxation Committee.
Temporary taxes may be enough to get through the current crisis until the economy picks up and more money comes in. But critics argue there’s no such thing as a “temporary” tax. And such increases do little to ensure similar crises won’t erupt in the future.
There has been intense opposition to higher taxes from Republicans in the Legislature, as well as their antitax allies. They say the problem is not revenue generation but spending. They favor the enactment of strict spending caps and cuts.
But elected officials have been unable to resist the temptation to spend or refund the temporary surpluses, which is one reason why attention now focuses on longer-term fixes.
There is no shortage of proposals to change the way the state collects money. They fall into four broad categories: flattening out the income tax to reduce its volatility, broadening out the sales tax, swapping local sales taxes with either state income taxes or property taxes and removing some or all of the Proposition 13 protections on commercial real estate.
The income tax in California is highly progressive, more so than most other states. Through the mid-1990s, taxes on upper income brackets of up to 11% were among the highest in the country. Gov. Pete Wilson pushed through reductions in these top brackets to 9.3%. No one with income less than $38,000 pays state income tax.
“It definitely makes sense from a public policy standpoint to flatten out this income tax,” said Steven Frates, senior fellow at the Rose Institute at Claremont McKenna College.
But raising taxes on the poorest Californians is political dynamite, Frates said. So it makes more sense to lower taxes on the wealthiest taxpayers and make up for it with other, more stable revenue sources, he said.
Another controversial measure: expanding the sales tax to services.
“If we don’t examine what services are appropriate to tax, our children will be faced with a tax system that won’t be able to provide for the education and other basic needs of Californians,” Controller Westly said.
But what services should be taxed? Odds are the industries that end up being taxed likely will be the weakest politically, not those that actually make the most sense from a fiscal standpoint.
“It may be good policy, but it’s very, very difficult to get anything like this through politically,” said Assemblyman Darrell Steinberg, D-Sacramento, who chairs the Assembly Appropriations Committee. “The only way you might be able to push it through is to lower the actual sales tax rate.”
Altering the way commercial properties are valued and taxed appears to have more political momentum. Under Proposition 13, commercial properties are treated the same way as homes: They are reassessed to market value only when bought or sold or upgraded, which occurs much less frequently than with homes.
Proponents of reopening this protection say corporations see changes in ownership over time that should prompt more frequent assessments. Proposals being circulated in Sacramento call for reassessments of commercial properties once every three or four years.
But business groups have resisted any moves, saying it amounts to an extra tax on businesses. That argument carries more weight today as businesses are reeling from soaring workers’ compensation costs and the prospect of having to provide healthcare for workers.
A simpler but more controversial option is to remove commercial properties from Proposition 13, a procedure known as the “split-roll” tax. This would create a separate tax system for commercial properties in which they are assessed annually at market rates. This would generate more than $4 billion in new revenue. But it has run into stiff opposition any time it has been proposed.
Another concept gaining steam is swapping out certain local and state income taxes. Under the current convoluted system, all income taxes go to Sacramento, as does a large share of property taxes. Meanwhile, a large share of sales taxes, which tend to be more stable, goes to local governments. This has prompted cities and counties to chase after big-box retailers, auto malls and other tax generators.
For the past couple of years, Assemblyman Steinberg has carried a proposal to swap property taxes that now go to the state with sales taxes that go to cities.
“This is absolutely crucial for the long-term development of our cities and counties,” he said. “And it also gives the state a more stable source of funding.”
But opposition from the League of Cities and other local government advocates has been intense. They fear losing the only revenue source now guaranteed to them. And they are wary of promises to replace that revenue with property taxes, especially considering the state took away $3 billion in local property taxes in the early 1990s to balance its own books.
Such swap proposals present another problem: Their very complexity slows them down.
That is the basic underlying problem with almost every change that’s been proposed to the state’s tax structure. With each proposal, there are winners and losers, and the losers exert tremendous pressure to stop them.
But given the unique convergence of the recall vote, the budget crisis and the possible court rulings limiting the state’s ability to borrow, this may be the best time in a generation to make substantial changes.
“There is a window right now with this recall election and the pressure on the state budget to make some of these longer-term changes,” said Kim Rueben, a research fellow with the Public Policy Institute of California. “That window must be snatched.”
Fine is a staff writer with the Los Angeles Business Journal.
