Moving California's Tax System into the 21st Century

Governor Schwarzenegger has spoken a few times about the need to move the California tax system into the 21st century. This includes creating the Commission on the 21st Century Economy (COTCE) many months ago (their final report was issued in September 2009). Most recently, he mentioned tax reform in his State of the State address (1/6/2010).

A fact sheet accompanying the governor's State of the State address states:

"The Governor today encouraged the legislature to seize the opportunity to modernize and stabilize the tax structure while encouraging economic growth by taking up the bipartisan Commission on the 21st Century’s recommendations to restructure the way California funds state Government.

The current, outdated system produces dramatic fluctuations in revenue – these bust or boom cycles have made budgeting and funding of essential services year after year very difficult. The Commission’s recommendations are designed to broaden the tax base, making revenues less volatile while being fair and equitable for all Californians."

A few observations:

1. What is meant by the 21st century economy?

Well, this really wasn't discussed by the COTCE. Before the COTCE, California had the Commission on Tax Policy in the New Economy which issued a report in 2003. It engaged in discussion of what the new economy is. In addition, the statute that created the earlier commission described key elements of the "new economy." This included the following provision (I have highlighted terms that describe the 21st century economy).

"California’s current tax structure is largely based on a 20th century industrial economy that produced most of its wealth from manufacturing and agriculture. California’s 21st century technology-dependent economy is already based largely on information and services, part of a new global economy that is built on the rapid development of ideas and the exchange of information using multiple communications media. It is characterized by rapid restructuring of business-to-business and business-to-customer relationships in the state and across the world and a shift from production and consumption of tangible goods to use of intangible goods and services."

2. What elements of California's tax structure reflect the 20th century rather than the 21st century?

Here are a few:

• Consumption has changed: Consumption patterns began changing a few decades ago as people's consumption of services increased (likely tied to the increase in dual-worker households and increased wealth). The patterns continue to change due to technology which enables consumption of digital goods and more services (such as web hosting and consulting). California's consumption tax - the sales tax, is very much stuck in the 20th century because it only taxes consumption of tangible personal property. That is, buy your music on a CD and you owe sales tax, but download it onto your mp3 player and you owe no sales tax. The 2003 report of the New Economy commission recommended: "Broaden the sales tax base to include selected services, while lowering the state rate to retain revenue neutrality." I think this is the most obvious modernization needed. Why let the sales tax continue to just apply to 20th century consumption rather than 21st century forms of consumption? (I've written about this one a lot - here)
• Business models have changed: E-commerce enables businesses to have customers in all states even without a physical presence in the customer's state. This challenges 20th century tax models where physical presence and borders were more important. One issue it causes is that consumers have a growing amount of use tax they need to self assess. The New Economy Commission recommended that the Board of Equalization make greater efforts to collect use tax. This is an area where today's technology can help in addition to simplified compliance approaches. (I've written on this one too - here) California should also look into joining the Streamlined Sales and Use Tax Project as that will likely lead to the ability for the state to have remote vendors collect sales tax (rather than rely on consumers to self-report use tax).
• More fierce business and interstate competition for business: All states compete to keep high quality jobs in the US. To that end, lots of incentives are offered. This is often described as a "race to the bottom." The 21st Century Tax Reform Commission in Minnesota, which issued a report in February 2009, recognized this issue as well as the growing complexity of applying the state income tax to multistate corporations. They recommended repealing the corporate income tax. I think that is an idea worth considering. It simplifies the tax system (all of the incentives and efforts to create new ones goes away) and it ends tax planning efforts to move operations around to minimize state income tax. The state would still collect payroll taxes, property taxes, excise taxes and sales taxes.
• Growing income gaps: This seems to be a continuing reality. The California Budget Project has a nice overview of the issue in a June 2009 report. I think this means that overall equity in a tax system needs to be reviewed. This overlaps partly with the need noted above to broaden the base of the sales tax. Much of the consumption that is currently exempt is that of high-income individuals which makes the system inequitable. In addition, income tax structures should be reviewed to see if the income groups makes sense. For example, perhaps those with $100,000 of income should not be in the same bracket as those making over $500,000 (or even more).
• Greater attention being paid to climate change: California probably has the most ambitious targets for reducing greenhouse gas emissions among the states. Some type of polluter-pays tax to encourage people to reduce emissions makes sense, and will generate revenue allowing for some other tax rate to be reduced.

3. Do the COTCE recommendations move California's tax system into the 21st century?

I don't think so. For example, instead of recognizing growing income gaps, the COTCE recommended a significant income tax reduction to very high income individuals with most of that being replaced with a consumption tax which would fall upon middle- and low-income individuals disproportionately (in terms of the percentage of their income being used to pay the tax).

The COTCE's business net receipts tax (BNRT) proposal would likely encourage employers to purchase goods and labor from outside of the state and to try to get more employees to become contractors. The BNRT also relies on the ability to get out-of-state businesses to pay the tax on sales into California. However, a bill before Congress that I think will get enacted sometime in the next few years, would say that California could only collect BNRT if the business has a physical presence in California exceeding 15 days during the year. That would be a big blow to state revenues if the state general sales tax and corporate income tax had already been repealed and replaced with the BNRT. The BNRT has several issues that make it unlikely to be the vehicle to promote 21st century business activity and growth in California. (I've got more on this here and you can do a search using BNRT and economy and find many reasons why this would not be good for California).

The COTCE makes no mention of a polluter pays tax even though there were suggestions from at least one commissioner and public comment.

I hope the legislature will discuss how the existing tax structure both supports and hinders the 21st century ways of living and doing business so it can find the right ways to modernize our tax system so that it can promote a strong economy, society and environment.

What do you think?