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Big Thinking on Tax Reform in California -- But Not Big Enough

David Callahan

A ferocious fight over taxes is shaping up in California, where Governor Jerry Brown is supporting a ballot initiative that would raise $6 billion by hiking tax rates on the top 1 percent of earners. Another proposal, developed by a billionaire-backed bipartisan group called the Think Long Committee for California would raise $10 billion by imposing a new 5 percent tax on services and closing various tax loopholes.

Both proposals have merit, but the Think Long Committee is far more ambitious, and not just in terms of revenue. The Committe's tax proposal, outlined in a 23-page report, would substantially restructure the state's tax code and introduce the closest thing to a Value Added Tax (VAT) that exists in the United States. It also explicitly links higher taxes and tax reform with investments in the foundations of wealth creation, with the Committee proposing to provide billions in new funding to public schools and the state university system.

The proposal has good and bad elements, and who knows whether it will go anywhere. But one thing is clear: It is required reading for anyone wondering where the debate on tax reform may ultimately be headed and how moderate elites are thinking about taxes and public investment.

A major goal of the Committee's tax proposal is to lower the state's reliance on personal income taxes. The Commmittee argues -- rightly, I think -- that this form of revenue is too volatile. For instance, during the dotcom boom, the state's tax revenues rose by 23 percent in a single year (2000) and later fell, during the crash of 2008-2009, by 19 percent. The result: Overspending when times are flush, and draconian budget cuts during recessions.

In addition, the Committee makes the point that nearly half of the state's economic output -- services and information activities -- are not taxed:

While we tax the sale of a donut eaten in a coffee shop, we don’t, for example, tax the sale of legal, consulting, accounting or architectural services. In essence, those who produce goods such as donuts or machinery are subsidizing those who produce services and information.

The Committee would remedy this by reducing personal income taxes for all Californians while phasing in a a 5 percent tax on all services. The service tax "would apply to all services, to businesses as well as to consumers, except for health care and educational services." Meanwhile:

there would be no personal income tax on joint filers with incomes up to $45,000 because of the standard deduction ($45,000 joint; $27,500 for single filers). A tax rate of 2 percent would be applied to income of joint filers up to $95,000, and a 7.5% rate would apply to incomes above that amount. The 1% surcharge for mental health on those with incomes over $1 million would remain, making that effective rate 8.5%. . . . Low-income households would receive a sales tax rebate offsetting most of the direct and indirect impact of the new sales tax on services on the average household with similar income. . . . The tax rate on corporate income would be reduced from 8.84% to 7% – below the national average.

Another feature of the plan would be to phase out many of the deductions and special breaks that now litter the California tax break -- "except for mortgage interest, property taxes, charitable contributions and R&D."

The result of all this would be to generate more revenue, while maintaining the overall progressivity of the tax system:

On average, households with adjusted gross incomes up to $1 million would pay additional direct and indirect taxes ranging from $71 to $806 per household. Households earning more than $1 million would pay an additional $11,478. The Committee’s proposal would maintain the state’s progressive tax structure with the top 5 percent of earners paying 62 percent of all personal income tax collected by the state.

Not bad, overall. But just to be clear: it appears that this proposal doesn't go far enough in terms of making the California tax system as progressive as it should be.

The important figure for measuring progressivity is not what share of taxes the top 5 percent pay, but rather what percent of their income this group pays in taxes compared to other groups. And the news here isn't good. According to a 2009 report by the Institute for Taxation and Economic Policy, the top 1 percent of households in California paid 7.4 percent of their income in various state and local taxes in 2007 after factoring in federal deductions. (The next top 4 percent paid 8.2 percent). In contrast, the lowest 20 percent of Californians paid 10.2 percent of their income -- the biggest share of any group. The 20 percent just above them paid 8.7 percent.

California's tax system is more progressive than many states. In Pennsylvania, for example, the bottom 20 percent pay 11.2 percent -- compared to 3.9 percent of the top percent. But it is still backwards in key respects and not as progressive as it could be or should be. It doesn't appear that the Think Long Committee's proposal will remedy that. 

The Committee is on the right track in many ways. But they are still not thinking long enough.