The California tax code is like a handyman's rickety stepladder, as untrustworthy as it is essential. It's also proving to be hard to fix. Two blue-ribbon commissions have proposed sweeping reforms to shore up the tax code's weaknesses in recent years, only to get lost amid the Legislature's struggle to make ends meet during the downturn. Nevertheless, there may be no time like the present for lawmakers to try to make the state's revenue more reliable.
California's coffers have long been filled mainly by sales, income and corporate taxes. The balance among these sources has shifted dramatically over the last 60 years, however, as manufacturing and farming have given way to services. Sales taxes, which tend to be steady and predictable, once accounted for more than half the state's revenue; they now make up about a quarter. Meanwhile, personal income tax revenue, which rises and falls much more sharply than the economy, has grown to more than half today from about 10% in 1950.
One reason for the income-tax volatility is that so much of it is derived from capital gains, which fluctuate with the stock market. Here's an example: In the fiscal year that began in July 2008, the state's economy was 3% larger than in the previous year. But state revenue had plunged 19%, reflecting the stock market's collapse in the wake of the subprime mortgage meltdown.
In the throes of the most recent budget crisis, two panels of experts — the Commission on the 21st Century Economy and the Think Long Committee — proposed tax-code overhauls that aimed to smooth out state revenue while also promoting growth. Both sought to tax the services sold and consumed here, which would lessen the state's reliance on personal income taxes. But Gov. Jerry Brown went in the opposite direction in 2012 with Proposition 30, temporarily raising the top income tax rate by almost a third while hiking the sales tax by only about 3%.
California now boasts the nation's highest personal income tax rate and one of the highest sales taxes, which is not much of a welcome mat for entrepreneurs and growing businesses. But reformers face a problem too: Any move to stabilize revenue by de-emphasizing income taxes would appear to shift the burden from the wealthy onto everyone else. In a blue state acutely sensitive to income inequality, that's a non-starter.
Some Democrats also argue that the state's upgraded rainy day fund will help manage the volatility by setting aside money in good times that can be spent in bad ones. And the fund is certainly a good thing to have. But it's no substitute for more stable and predictable revenue, which would make it easier to plan for the long term. More ominously, the savings that accumulate could lead lawmakers to take steps that would defeat the purpose of the fund: Democrats will cite the rainy-day billions as a reason to spend more freely, and Republicans will say they're proof that taxes are too high.
Regardless, events are conspiring to force the Legislature's hand. The sales tax hike in Proposition 30 is set to expire in January 2017, in the middle of the budget the Legislature adopts next year; the income tax hike expires two years after that. Brown has said he opposes any extension, but powerful groups are lining up behind a proposal to renew the taxes anyway. Others are working on ballot measures to raise taxes on cigarettes, oil and gas drilling, and commercial real estate.
Such a scattershot approach might raise more revenue, but it won't solve the volatility problem. That's why the Legislature should try to preempt those measures by moving first to fix the tax code. Granted, that would require some tough votes, because any change would create winners and losers. Nor will it be a simple matter to preserve the progressive quality of the state's tax system, which the Legislature must do. But it can be done; Sen. Bob Hertzberg (D-Van Nuys) has some intriguing ideas on that front, and the Legislature could certainly come up with more if it looked for them.
Now is the ideal time to start that work. The state is climbing out of the deep hole the Legislature dug in the previous decade, and its economy is growing, albeit not nearly as fast as it should be. The election is more than a year away. Lawmakers need to get serious about reform now, before the special interests start pushing their own tax policies on California voters.