Tax system desperately needs retooling

SACRAMENTO—Gov. Jerry Brown’s proposed rainy-day reserve is better than nothing, but it falls far short of what the state really needs to fix its cockeyed tax system.

The governor is attempting to treat the symptoms of revenue instability rather than attacking the root cause of the ailment.

At the root are two maladies: First, a politically convenient state income tax that leans too heavily on the rich, whose fortunes fluctuate wildly during times of boom and bust. Second, a very old sales tax too narrowly focused on retail goods rather than services.

Brown acknowledged the income tax flaw during the unveiling of his $155-billion state budget proposal last week.

Pointing to a chart that pictured capital gains revenue bouncing year-over-year like a yo-yo, the governor said: “With that zig-zag up and down…the only way to offset that is to have money in reserve. And that’s what I intend to do.”

His budget document notes: “It is clear that capital gains rarely have normal years. Instead, they tend to be extremely volatile—bulleting upwards only to crash dramatically shortly afterward.”

They crashed during the recession, a big reason for the nearly $40-billion state budget deficit in 2009.

Brown’s solution to the revenue volatility is not to change the tax system to make it more predictable, but to hoard any surpluses that are generated so they can be spent during economic downturns.

His proposal—which both the Legislature and the electorate would have to approve—calls for socking away any capital gains receipts that exceed 6.5% of general fund revenue. They currently account for about 10% of the fund, but in 2009 were only 3.5%.

Rainy-day funds have been talked about for eons in Sacramento. They’ve come and gone and mostly been ignored. And that’s the danger here—money rolls in and human nature responds. The politicians either buy a new program or succumb to cries for tax cuts.

As Brown pointed out, when there were money gushers in the past, governors would exclaim: “Hallelujah, let’s spend.”

Like on a bullet train or something. But that’s digressing.

Brown contends, however, that his rainy-day fund would be an improvement over past versions—including a proposal previously passed by the Legislature and set for the November ballot. Democrats, however, now regard that measure as too stringent and prefer the governor’s idea.

The better solution to revenue volatility, of course, is to remove the spending temptation by eliminating the money gyrations.

Brown aggravated the problem in 2012 with his soak-the-rich tax increase, Proposition 30. It raised the top income tax rate from 10.3% to 13.3%. Voters found it relatively easy to tax the other guy.

The State Finance Department estimates that these higher rates on the wealthy will generate $5.6 billion during the fiscal year starting July 1.

Back in 2011, when the highest rate was still 10.3%, the top 1% of earners paid 41% of total personal income taxes. But they only earned 21% of the income. The bottom 40% of earners paid less than four-tenths of 1% of the income tax.

The breakdown for Prop. 30’s tax hike hasn’t yet been calculated.

I don’t know how many million-dollar earners have been driven out of state by Prop. 30. But there are several lovely spots on the Nevada side of Lake Tahoe. And I know some Californians who have recently taken up residence there.

Anyway, California has the highest state income tax rate in the nation. And it’s not the image we should be seeking.

Not only should those rates be taken down a couple of notches—and tweaked upward slightly on lower incomes—but there ought to be a tax break on capital gains. The federal government taxes capital gains at a lower rate than ordinary income in order to encourage investment. And California should too.

Meanwhile, the sales tax rate should be lowered significantly. It hits 10% in some communities and averages around 8.25%. That could be chopped several points if taxes were extended to some services, such as labor on auto repairs or accounting.

True, the sales tax is regressive—poor people pay a higher proportion of their earnings than the wealthy. But the rich, after all, rely more on the service industry than the poor or even middle class.

Because of California’s gradual shift from a retail to a service economy, the sales tax today produces only 23% of the state’s general fund revenue. In 1950, it generated 59%. By contrast, the income tax today accounts for 66% of the take. In 1950, it was just 11%.

So the best way to make the tax system more logical and predictable is to lower rates and broaden the base. But that’s too difficult politically and necessitates much more courage than currently exists, especially during an election year.

For starters, it requires only a majority vote to lower a tax, but two-thirds to raise one—even if the net result is a revenue wash.

Any reform proposal would be a full-time employment act for lobbyists representing interests facing higher taxes.

“Broadening the tax system and lowering the rates is the better answer,” says Senate leader Darrell Steinberg (D-Sacramento). “It’s a tough one. But it’s really important. And I think its time will come.

“Hopefully, it will be a priority of Gov. Brown in his next term.”

Don’t bet on it.

george.skelton@latimes.com