Business Climate in California

Last month, the Tax Foundation released its 2009 State Business Tax Climate Index. Once again, California ranks 48th among the states. The low ranking is due to qualities of California's individual and corporate income tax and its sales tax as measured by the Tax Foundation. California ranks higher is only looking at its property tax or unemployment insurance tax.

The Tax Foundation analysis favors tax systems with low rates and broad base without credits or an AMT. For example, the research tax credit is viewed as complicated and distortive relative to a low rate tax without credits. Their index also favors net operating loss carryovers and tax brackets adjusted for inflation.

The competitiveness of states in attracting capital and jobs leads to some of the traits that the Tax Foundation index rates low. However, high rates, which it ranks as poor, harm a business climate. Yet, in tough budget times, states, including California, tend to look at raising rates since it is the easy thing to do. This is a particularly unfortunate approach in California since the state already has the highest individual income tax rate (10.3%) and is among the highest for its corporate income and sales tax rate.

I've written on possible reforms already - click here. The key point I like to make, in red at that page, is that the weaknesses in California's tax system are mostly in the tax bases. Thus, they can't be fixed with a rate increase, which actually makes most of the problems worse. For example, California's sales tax base is fairly narrow, only including most tangible personal property (other than most grocery store food). This is a 1930s tax base; it omits most services and intangibles, such as digital downloads even though they are a type of consumption. California's sales tax base is eroding as consumption of tangible goods decreases and consumption of personal services and digital downloads increases. Apple iTunes is now the largest music retailer - its product though isn't subject to sales tax even though its customers get the equivalent of a taxable CD. The base needs to be updated. AND - updating the base would allow for a lower rate. This would make the sales tax more equitable (fair) by taxing the consumption of individuals in all income groups. Today's system that taxes clothes but not a personal trainer benefits higher income individuals. Raising the tax rate just makes this equity problem worse.

What do you think California should do to improve its business climate and address an $11 billion budget shortfall?