Tax Breaks Intensify State Fiscal Debate

As Gov. Arnold Schwarzenegger seeks to force down government expenses, his blueprint for long-term reform leaves one area untouched: tax breaks for the wealthy and corporations.

The tax breaks allow yacht owners to avoid paying sales taxes, business partnerships to keep their property tax bills down and large corporations to move money offshore to avoid paying what would otherwise be owed to the state.

Assembly Speaker Fabian Nunez suggests that closing such loopholes could wipe out as much as half of the state’s $8.6-billion deficit. Analysts say such projections are far too optimistic, but they question the governor’s refusal to even look at the tax breaks.

“There are a lot of people in California who are not asked to bear any of the burden of balancing this budget,” said John Ellwood, a professor of public policy at UC Berkeley. “The governor has made a policy choice. He is willing to hit the poor more than the upper-middle class and the rich.”

Administration officials make no apologies. They say businesses and the wealthy are already paying too much, quoting from studies showing that Californians pay more in taxes than residents of most other states.

Not taxing enough is not the problem, according to Finance Director Tom Campbell. The problem, he says, is that when the state was flush with cash, California became overly generous in providing services -- with no plan to cover the bill in a down economy.

Using a windfall to expand ongoing programs, he said, leads to “fiscal disaster” when the money runs out. “The governor is proposing you fight fire with fire” with budget measures that would curb such expansions.

Schwarzenegger’s plan includes tough reductions along with a constitutional amendment that would force across-the-board cuts in services whenever state spending outpaces revenue. The cuts would also take effect if the governor and lawmakers fail to get a budget in place by their July 1 deadline.

But critics, including Democratic leaders, argue the governor’s proposals fail to take on the most extravagant state spending: tax breaks for the rich. Democrats will be focusing on that issue in a series of public budget hearings throughout the state in the coming weeks. And activists have already submitted ballot measures that would attempt to close what they see as unfair loopholes in the tax system.

“We have a major budget problem and they are refusing to look at anything having to do with our tax system,” said Lenny Goldberg, a reform advocate who has filed one such ballot measure. “They are averting their eyes from 50% of the problem.”

California taxpayers and businesses claim some $35 billion worth of tax breaks each year. Much of that is taken up by credits enjoyed widely by the middle class, such as the deduction for mortgage interest payments. But tax experts say others are outdated, ineffective and ripe for review.

One of the only tax breaks the governor is considering scaling back is a renters’ credit for low-income seniors. Under Schwarzenegger’s plan, the credit would be eliminated for elderly Californians earning more than $13,000 per year.

That proposal would save the state $100 million annually.

But the governor’s plan would leave intact the mortgage deduction that the wealthy enjoy on million-dollar vacation homes. The nonpartisan Legislative Analyst’s Office has suggested that removing the deduction could save the state several times the amount gained by the renters’ credit cut.

Another of the governor’s proposals would cut payments to caretakers for the disabled and frail elderly from more than $10 an hour to minimum wage, $6.75. The move would save the state $195 million.

Yet high-end hotels in downtown San Francisco could continue to claim tax credits from an “enterprise zone” that was intended for economically depressed neighborhoods but has now grown to include wealthy urban areas. Studies suggest the state is losing at least $50 million per year on the credits.

Schwarzenegger’s plan to end set pension payments for government workers and replace them with a 401(k)-style system would net Wall Street investment firms hundreds of millions of dollars in commissions.

But there is no plan to collect the tens of millions of dollars in state taxes being lost each year from companies that shelter their income in the Caribbean. Montana has passed a law that will allow that state to begin collecting such money.

There are some loopholes where the stakes are significantly higher.

One allows numerous businesses to avoid paying the tax hike everyone else in California faces when they buy a property. In California, voter-approved Prop. 13 keeps residential and commercial property taxes from increasing more than 2% a year. When ownership changes hands, a property is supposed to be reassessed at market value, which could drive up its taxes by thousands of dollars.

The requirements for what constitutes a change in ownership are vague, however, and partnerships have found they can avoid reporting it when no single investor owns a controlling interest in the new property.

Senate Appropriations Committee Chairwoman Carole Migden (D-San Francisco) says the state loses as much as $1 billion a year as a result.

“Even if there isn’t a fiscal crisis, you should at least be looking at these things,” said Daniel J.B. Mitchell, a professor of management and public policy at UCLA. “The notion that the current tax code is perfect the way it is now and it never has to be revisited again, that is politics, not economics.”

Over the summer, the Legislature passed a bill (AB 2106) to study the effectiveness of each of these and other tax breaks, and the League of Women Voters wrote the governor urging him to sign it.

“Tax incentives tend to be offered with rosy predictions of the benefits they will produce, but with scant evidence supporting those predictions,” the letter said. “We believe it is critical that tax breaks be carefully reviewed as part of the budget process.”

The governor vetoed the measure. He said the information the bill would require the state to study -- such as why each tax break was put in place and how many people benefit -- would be impossible to pin down accurately.

The author of the bill, Assemblyman Mark Ridley-Thomas (D-Los Angeles), said he was “bewildered” by the governor’s move.

Republicans call the loophole argument a red herring. They say the tax breaks Democrats are talking about add up to only a small amount of cash relative to the state’s multibillion-dollar debt.

Companies and entrepreneurs, they say, are already under tremendous financial pressure to move to states where the cost of doing business is cheaper, and making them pay more will only force them out.

State taxes in California as a percent of personal income are the 18th highest in the nation, according to the Public Policy Institute. Republicans say that is high enough.

“All this talk of ‘loopholes’ is just code for their [Democrats’] overall strategy: find small groups of taxpayers and tax them,” said Sen. John Campbell (R-Irvine). “This state is the most generous in the union in terms of health and welfare benefits. We are already paying more than anybody else.”

In some respects, California does pay more than other states. Some of the state’s welfare programs for the jobless and elderly provide among the highest cash payments in the country. But those programs are a relatively small part of the budget.

The overwhelming majority of money in the budget for the poor goes to the Medi-Cal health insurance program, which offers medical care to more than 6 million people. And in that area, California is one of the cheapest states in the country, according to a Kaiser Family Foundation study that ranks how much each state spends per enrollee.

“I don’t view the problem as unbridled spending growth,” said Alan J. Auerbach, director of the Robert D. Burch Center for Tax Policy and Public Finance at UC Berkeley.

“It’s true that spending is growing even as tax revenues aren’t. That doesn’t mean spending is too high.... In order to close the gap in the years to come, the governor is going to need an enormous amount of very good luck or he will have to get some money from the tax side.”