New Reason Study Calls for California Tax Reform

In his State of the State Address last week, California Governor Jerry Brown asserted, “California is back, its budget is balanced, and we are on the move.” Sadly, economic reality belies the governor’s optimism. California still has the third-highest unemployment rate in the nation at 9.8%, a rate 26% higher than the national average of 7.8%. It has the highest income tax rate in the nation, the highest state sales tax, the highest gas tax (tied with New York), and the eighth-highest corporate tax rate (and the highest rate west of the Mississippi River, making it even less competitive with its neighboring states). Add to this the fact that California has the worst credit rating in the nation (now tied with Illinois), mainly due to its significant debt and hundreds of billions of dollars in unfunded pension and retiree health care liabilities, and one of the worst—if not the worst—business climates in the country. The passage of Proposition 30, with its roughly $50 billion in new tax increases over the next seven years, last November certainly won’t help matters. This is certainly not the track record of an economic powerhouse, or even a state on the upswing.

There are many ways to turn around the California’s fiscal and economic fortunes—cutting spending, eliminating burdensome regulations, privatizing government services, ditching boondoggles like the California high-speed rail plan, implementing real pension reform, etc.—but today I would like to focus on how tax reform could help to revitalize the state. In addition to its high general personal income, corporate, and sales tax rates, California’s tax code is plagued by numerous special carve-outs for politically-favored businesses and industries. In a new study by Reason Foundation and the Howard Jarvis Taxpayers Foundation, I highlight some of the more egregious corporate and sales and use tax credits, exemptions, and deductions offered by the state and argue that eliminating such tax breaks and using the “savings” to lower the overall corporate tax rate would promote a better business climate, and thus help improve the state’s economy.

The results of such tax reforms could be significant. The Franchise Tax Board estimates (see page 10 of this California Senate Office of Oversight and Outcomes report) that if the Research and Development Credit alone were eliminated, the overall corporate tax rate could be reduced by about 14 percent, thus improving the business climate for all industries. If some of the other tax breaks discussed in this report were also eliminated—including the Accelerated Depreciation of Research and Experimental Costs, Double-Weighted Sales Factor, Film Credit, Low-Income Housing Credit, Hiring Credit, Percentage Depletion of Mineral and Other Natural Resources, and Expensing of Timber Growing Costs breaks (see Table 1 on page 14 of the study)—the Reason-Howard Jarvis report finds that California could likely reduce its overall corporate tax rate by more than 20 percent.

The infamous Solyndra case is a perfect example of why tax breaks are a bad idea. In addition to the $528 million in federal loan guarantees that taxpayers lost when the company went belly-up, the company also wasted $25 million in California state tax exemptions from a “green energy” tax credit program. Rather than trying to play favorites or cater to special interests through preferential treatment in the state’s tax code, politicians should ensure that the playing field is level, and that tax rates are as low as possible, and otherwise let the free market and the choices of consumers and entrepreneurs—through the forces of supply and demand—determine which businesses and services are most desirable and best meet their needs.

When the state encourages economic activity in one segment of the economy—be it through tax breaks or direct subsidies—it necessarily discourages economic activity in all other segments of the economy by making them relatively less competitive. These opportunity costs are often ignored by policymakers. The error is compounded when you consider that much of the tax breaks end up being used for business activity that would have occurred with or without the tax breaks.

If this were not enough, another negative consequence of such tax breaks is that they breed even more special-interest lobbying. The more industry groups, environmental lobbys, or other special interests see that lobbying “investments” pay off, the more money is directed to lobbying Sacramento and the less is put to productive use in the economy.

If California wants to jump-start its economy and become a place that Gov. Jerry Brown and taxpayers across the state can be optimistic about, a good start would be to simplify and reduce its onerous taxes. The new Reason-Howard Jarvis study offers some recommendations about how to go about this:

  • Eliminate special tax treatment wherever possible, particularly in cases where:

a) The tax break’s purpose is not clearly defined,

b) The tax break is not serving its intended purpose or has outlived its intended purpose,

c) The tax break is narrowly tailored to benefit a specific industry or type of business, or

d) The tax break is clearly an example of the government picking winners or losers for ideological or special-interest reasons.

  • Wherever possible, lower broad tax rates down to tax break levels, rather than raise tax break levels up to broad tax rates.

  • Require a clear statement of purpose and performance measures for each tax break—including existing tax breaks without a clear statement of purpose or relevant performance measures—in order to facilitate evaluations of the impact of tax breaks on taxpayers and the state budget.
  • Eschew static analysis of state tax breaks and return to dynamic analysis of their effects on taxpayers and the state budget.
  • Establish a sunset commission to periodically evaluate tax breaks and other state regulations. A citizen’s commission would aid the legislative sunset commission similar to the state of Washington model. Adopt legislation requiring that both existing and future tax breaks must be evaluated every 5 or 10 years. Tax breaks not acted upon within this period would automatically be repealed.
  • Adopt a BRAC-style commission (similar to that used to close unneeded federal military bases) to evaluate existing tax breaks and regulations. The two-thirds supermajority makes it difficult enough to repeal existing tax breaks. Under such a process, an independent panel of taxpayers, perhaps with additional representatives from the Franchise Tax Board, State Board of Equalization, and Legislative Analyst’s Office, would be appointed to evaluate and recommend tax breaks for elimination. The recommendations, once approved by the governor, would be submitted to the legislature, which would not be allowed to make any amendments and could only vote up or down on the entire package. A simple majority of both houses would be required to approve the recommendations.

See the California tax credits study here.