Proposed Tax Increases in California: Overlooking the 21st Century

California legislators continue to struggle with how to close the $15 billion budget gap even as the year has begun and the budget deadline has passed. On July 8, the Budget Conference Committee developed a plan that restores some proposed cuts and proposed a package of six tax increases. Five of the increases involve the individual income tax and corporate franchise tax while the sixth calls for efforts to collect some of the state's uncollected taxes (reduce the tax gap).

A problem with aiming to close a specified budget shortfall is that it is too easy to look at the amounts various changes could raise and massage it until you hit your needed number. Math wins out over strategy. while the committee has reasons for each of the five tax increases, they are fairly weak, such as - we had these high rates in the past. Why does that mean they make sense for California's economy and society now? What about cutting back on tax deductions, exclusions and credits that are too generous or poorly targeted such that they benefit taxpayers who don't need a benefit? What about shaping our tax laws to support our economic, societal and environmental goals? For example, policymakers are working to find ways to get California to reduce its GHG emissions. So, why not enact a carbon tax?

While a primary purpose of this tax increase package is to help get a discussion going and to push Republicans to come up with an alternative plan, some of these tax proposals could remain. We'll have to see. Here's my thoughts on each of the proposals and if they are moving California's tax system into the 21st century.

Proposal 1: Add two new tax brackets to the individual income tax. The 10% rate would apply to joint returns with income above $321,000 and the 11% rate would apply to joint returns with over $642,000 of income. We have had these high rates before. Without the change, this income would be taxed at 9.3% and 10% if over $1 million.

Comments: California is already a high income tax rate state. Our income tax is very volatile because the bulk of it is collected from a small number of high income individuals. When their income goes down, in essence, the entire state feels it. This is also because the personal income tax is about 50% of our general fund revenues. California law is designed such that, for example, a family of 4, no income tax would be owed until their income was over $44,000. I've got more information on this volatility in a 2007 report.

There are flaws with many of the tax deductions, credit and exclusions in the personal income tax. For example, CA follows federal law in allowing mortgage interest to be deducted on a primary and second residence and on up to $1.1 million of debt. This tax break is worth more to high income individuals. Why is the state subsidizing home purchases beyond the median home price and on a second home as well? This rule is provides too generous of a benefit to high income/wealthy individuals. It should be cut back and perhaps even converted to a tax credit to eliminate its skew to higher income individuals.

Raising the rate rather than fixing the base just leaves Califorrnia labeled as a high tax state, gives high income individuals pause to question if they should live elsewhere, makes tax planning more attractive and continues to leave the base problems for another day.

The California Budget Project notes that in an economic downturn, tax increases are better than spending cuts. But I don't see any reason to get that tax revenue in such a way that increases the volatility of tax collections and doesn't help California's economy. I think we need to replace part of the PIT with an environmental (polluter pays) tax and broaden the sales tax base to bring in the items higher income individuals tend to be the buyers of (personal services, entertainment, digital downloads). A polluter pays tax could be a carbon tax, it could be a utility tax on bills above what the average would be for a family of four living in a 1200 square foot house.
This is a poor proposal.

Proposal 2: Suspend use of corporate NOLs for 3 years.

Comment: The committee's write-up describes this as closing a "tax loophole for large corporations." But, corporations of all sizes are allowed to carryover NOLs and the committee provides no information about any corporations using the carryover provision in any way other than how intended. Thus, it is not a loophole.

[Two of the proposals were described as closing loopholes and neither one is a loophole. For more on this - see my op ed in the San Diego Union Tribune (7/11/08)]

Instead of completely denying corporations use of their NOLs for 3 years, it should be more helpful to the business (and the state) to instead provide that in any year, an NOL carryover cannot reduce taxable income by more than 70% (or some other percentage). This means that when a corporation has positive income, it will pay some level of tax even though it has an NOL carryover. It still gets full use of its NOL, it will just take longer to use it.

This proposal could be improved.

Proposal 3: Suspend the indexing of the individual income tax brackets, apparently, just for one year.

Comment: This is a disguised tax rate increase. For example, if an individual's 2008 income goes up due to a cost-of-living raise, they may end up in a higher tax bracket. Even if this is for just one year, it is a disguised tax rate increase. Also, even if the suspension of indexing is just for one year, the effect will last forever because higher rates will kick in at lower income levels and those are the brackets that will be indexed going forward.

This is a poor proposal. There are more transparent ways to generate additional tax revenues.

Proposal 4: Reduce the dependent credit for individuals with AGI above $150,000. A few years ago, to benefit families, the credit amount for dependents was raised to $294 while the personal credit is $94. A key purpose of these credits is to help measure ability to pay.
Comment: This changes was also described as closing a tax loophole for upper-income income. However, it is not a loophole (see article). There isn't really any strong reason why the dollar amounts of these credits should be different. Also, for high income individuals, the amount of the credits is phased out. However, these are high income levels, such as about $150,000 for single taxpayers.

Proposal 5: Increase the corporate franchise tax rate from 8.6% to 9.3%. This rate had been in place a few years ago and so is described as restoring the franchise tax.

Comment: California already has high tax rates. Rather than making them higher, consideration should be given to broadening the tax base and perhaps lowering the rate.

Proposal 6: Increase tax enforcement efforts to help generate about 1.5 billion.

Comment: This is great. It is always good to be sure the tax gap (amount of tax owed, but not collected) be kept to a minimum. Rather than increasing a tax or creating a new tax, see about collecting more of the taxes already on the books.

Given the push to make changes that lead to closing the $15 billion shortfall, math won out over making tax reforms that would help our economic, societal and environmental goals. But, it is likely just a start to further budget debates. We'll see what other tax increases are proposed and which, if any, of the ones from July 8 are continued.

What do you think?