Review and Overhaul California’s Tax System

The state’s financial malaise is best described by Charles Dickens: “Annual income 20 pounds, annual expenditure 21 pounds, result misery.”

The deficit in the state’s general fund has been given in official statements as $23.6 billion -- a meaningless figure that is nothing more than a hodgepodge of past deficits and future projections. A more reliable number comes from the state controller’s office, which reported that 2001-02 disbursements exceeded receipts by $13.8 billion.

So far, short-term loans have kept the state afloat, and probably will continue to do so through election day. And the recently passed budget contains a variety of revenue enhancements that include borrowing against future income, hoped-for funds from the federal government, reshuffling of money among state funds, and spending cuts. But after election day further changes will be necessary, and they won’t be pleasant.

California’s fiscal misery has many causes. The state relies heavily on volatile taxes on income and capital gains. At the same time, California has a large and growing low-income population with needs for education, health and other services. Even an economic turnaround, which may be slow in coming, will not quickly resolve the imbalance.

Longer-term fixes must be adopted to restore California’s fiscal health as well as the trust of voters and the financial community. The state’s tax system has not been subjected to a thorough review for decades; a review is sorely needed.

As a starting point, the state needs to rethink its focus on capital gains taxes. Almost any alternative tax will provide more stability than one that relies heavily on capital gains; a sales tax on services, imposed at the state level, is one example of a productive and stable revenue source. And although property taxes are protected by the sacrosanct Proposition 13, there is no avoiding the fact that the property tax is also relatively stable since it is based on wealth.

Facing the tough prospect of new taxes or revisions of existing ones must be part of a comprehensive review. But it is possible to live with volatility of receipts as long as the state has a cushion of a substantial rainy-day fund. Such a fund cannot be accumulated, however, unless the Legislature takes steps to ensure that in good times it does not spend every dollar that it receives.

California faces a recession and a “budget crisis” about every 10 years; the current crisis cannot be dismissed as a surprise.

California’s universities and research institutions can help review the tax system and formulate targets for an adequate rainy-day fund. But the leaders of both major political parties must first be willing to put all of the possibilities on the table.

The remaining time before the election offers an opportune moment for the gubernatorial candidates to share their plans for dealing with the state budget. Voters have a right to know.

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Werner Z. Hirsch is a professor emeritus in economics at UCLA. Daniel J.B. Mitchell is a professor in the Anderson Graduate School of Management and School of Public Policy and Social Research at UCLA.