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Modernizing California's Tax System

Leonard Gilroy
September 30, 2009, 2:57pm

Yesterday, California's Commission on the 21st Century Economy released its final report outlining a groundbreaking tax restructuring proposal aiming at improving the state's economic competitiveness, simplifying and flattening the tax code and reducing revenue volatility. Key features of the proposal include lowering the state income tax and eliminating both the current corporate income and sales taxes (replacing them with a new, broad-based business receipts tax).

The Wall Street Journal weighs in on the proposal today, giving it mostly high marks:

The heart of the new plan is to broaden the tax base and slash tax rates on personal income, business and sales. California currently ranks at or near the top in all three categories. This has, paradoxically, contributed to the state's inability to pay its bills by driving men and women from the state and leading to revenue boom and bust. We don't agree with everything in this report, but there's no question it would be a huge improvement over the current tax code in its economic incentives, simplicity, revenue stability and fairness.

The commission hasn't recommended a pure flat tax, but something much closer to it. As shown in the nearby table, the income tax rate, which currently tops out at 10.55%, would be chopped to a more reasonable (but still high) 7.5%. (The plan doesn't eliminate the one-percentage-point millionaire income tax surcharge, alas.) Because about 70% of small businesses pay the personal California income tax, the commission found that California's high rate is driving enterprises to the likes of Nevada, Texas and Idaho. The number of tax rates is reduced to three from seven (we prefer one), and thanks to the elimination of credits and loopholes, the new California tax form would fit on a postcard.

Even more impressive is the recommendation to eliminate the corporate income tax and the 5% of the sales tax that contributes to the general fund. These would be replaced by a broad-based Business Net Receipts Tax of no higher than 4%. This taxes businesses on what they produce, minus their costs of purchases from other firms. This is similar to a value added tax. [...]

The commission—chaired by California businessman and former U.S. Treasury official Gerald Parsky—also calls for a rainy day fund by requiring annual revenues above a 10-year rolling average to be put into a reserve fund rather than being spent. [...]

[California's] steeply progressive tax rates are defeating the purposes of progressive government. To wit, only a growing economy can create opportunity for the middle class and enough state revenues to finance schools and health care for the poor. A tax code that depends on 1% of taxpayers, 144,000 filers, to finance 50% of state income tax revenues has proven to be unsustainable, notwithstanding the liberal dogma that says tax rates don't matter.

Tax rates do matter, and on balance, the proposed restructuring would go a long way towards enhancing the state's economic competitiveness. That is, unless other states were to follow California's lead and start slashing their own business taxes...

But let's not put the cart before the horse yet, as the political machinations are only getting started on this proposal. There are some positive early signs, with the bipartisan nature of the proposal and early support from Governor Schwarzenegger and prominent Democrats. However, as the Los Angeles Times reports today, unions and other opponents are already aligning against the proposal.

As they consider this proposal, policymakers need to ask themselves a fundamental question. The state is in an epic fiscal crisis and depends on a volatile, boom-n-bust revenue system that's slowly strangling the state's economy. Can California afford not to pursue sensible revenue reform? Can California do any worse than the system it already has? I think not.

» Reason Foundation's California Research and Commentary


Leonard Gilroy is Director of Government Reform


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