Thoughts on the Big Issue on the California Ballot

I've spent the week as a Citizen Leader on Campus at the University of the Pacific.   That involves attending a group of classes and offering a couple of lectures.  I went there as an undergraduate and there are a lot of changes.   Most of them are positive.

One the questions I got in one of my lectures was about why someone who had spent his time in and around education could express doubts about the Governor's proposal to raise income and sales taxes to fill the hole in the budget created by the absurd budget assumptions in the budget that was adopted last year.

California has had a continuing problem in balancing its budget. Some commentators have argued that the problem was created when our former Governor repealed the fee on vehicle licenses that left a gap in the budget.   At the time I argued that the VLF was annoying but unimportant.  In essence what that Governor had done is give each of us a small reduction in taxes (which most of us did not notice) in exchange for a less stable revenue base.  

I was critical of the then Governor because I think he took the short term popular decision which cost us in the long term.   I think the same can be argued for this Governor and Proposition 30. California, before the passage of Proposition 30, has a revenue structure that is volatile in the extreme.   (As illustrated in the two charts to the left - which only go up to 2002-03 - note the volatility in revenues has done nothing but increase.)    The volatility comes from how people at the higher end make their money.   Most people assume that income taxes come from salary.   But as you go up the income scale income becomes more complex.   People begin to earn income from non-salary things like investments.   So income is income right?   Not exactly.   Salaries are pretty stable over time.   But investment income is much more volatile for two reasons.   First, risk capital is just that.  It involves risk.   But second, investors can decide when to claim the income when their investments go up in value.  If I have a big profit I can decide when to realize it.

There are some tax theorists that argue that we should begin to recognize what is called accreted income.  Accreted income includes things like the unrealized value of investments.   Indeed, at the beginning of the 1986 Tax Act discussions, a group of tax economists actually proposed something very close to that as a way to reform taxes.  They relied on an important book called An Expenditure Tax (Nicholas Kaldor) that many of us had to read in graduate school.   When President Reagan saw that proposal coming from his appointed task force he immediately recognized that what might be ideal in theory is often absurd in practice.   In the end, the 1986 tax act lowered rates and broadened the base of the tax system rather than including things like accreted income.  It was a wise decision.

So when you rely on high income taxpayers to bear the greatest burden, you commit to a more volatile revenue system and when planning for long term funding of programs, that is not a good idea.  Remember that under our current income tax system, the highest income taxpayers bear a disproportionate share of the burden (as they should under a progressive system) but since individuals can determine when to take income, the trick is to devise a system that encourages individuals to make more consistent tax payments.    In the end that means making hard decisions about broadening the base of tax systems (with fewer deductions and credits) and lower rates (which encourages more people to simply pay the tax rather than timing decisions in investments based on tax policy).

Governor Brown could have done the brave thing - which would have been to propose tax reform (which admittedly is not an easy task) but which would have reduced the volatility in the system and thus been a better long term fix of our budget problem.  

There are two other burdens created by Proposition 30 which also contributed to my opposition.   First, as you raise rates (to have California become one of the highest rate systems in the country and also one of the most complicated income tax systems in the country) high income taxpayers will make a decision to leave California for fundamentally more friendly tax climates.   Lose high income taxpayers and you reduce volatility, but you also lower the income tax base.   In the long term that does not bode well for the state's revenue structure.  Indeed, in the last few years we have seen a steady stream of very high income taxpayers leave the state.   But the Governor also proposed to increase sales taxes (again making our sales taxes were already among the highest in the nation).  

I understand the revenue models that project how much the state will collect with these new taxes but I am skeptical.  And more importantly, as rates for both income and sales taxes go up, the state becomes less friendly to attract new businesses and residents.    Who knows what the long term will bring?   Last year California actually grew at a slightly higher rate than the rest of the US (2.0 v 1.8%) but over the last decade California's wonderful growth engine has been tarnished.

The supporters of Proposition 30 could argue that our schools are in a horrible place - and indeed California's education system is in shambles compared to where it was earlier in our history.   They could point to the work of Charles Tiebout - who argued decades ago that people choose areas based on amenities not tax systems and better education coupled with our beautiful climate would allow us to have slightly higher tax regimes than less desirable places to live (like our neighbors to the east - Nevada).   But this is an argument about degrees.

From my perspective, Governor Brown took the easier path - ignore fundamental tax reform and tax the "rich."   It remains to be seen whether that easy path will actually solve the long term problems that the state faces.