GOING BROKE: CALIFORNIA IS A WRECK – CAN IT BE FIXED?

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Richard Costigan, legislative aide to the governor, second from left, huddles
during a break in a legislative hearing with Finance Department officials,
from left, H.D. Palmer, Steve Kessler and Mike Genest.

BY STEVE WIEGAND and PHILLIP REESE
The Sacramento Bee

Three inarguable facts dominate California’s system of financing state government:

• It’s a mess.

• It’s currently a mess in large part due to the deepest and most pervasive global recession since the Great Depression of the 1930s.

• It’s been a mess for much of the past three decades because the combination of an out-of date tax system, reckless spending and fickle voters has made state government extremely vulnerable to the ebbs and flows of the economy.

While there’s not much the state’s elected leaders can do about the worldwide economic woes, they have tried for decades – mostly unsuccessfully – to wrestle with the triple threat of taxes, spending and ballot-box budgeting.

Now a special commission is set to present the Legislature with proposals to dramatically restructure the tax system. Two other reform groups are pushing changes that include, among other things, revising the state’s budgeting process and overhauling the state constitution.

How well any of the reforms succeed in improving California’s financial stew may depend on how much the state has learned from the deficiencies of the current recipe. For example, that stew just doesn’t have enough rich people.

Catching pneumonia

It may seem intuitive that the wealthy pay more income taxes because they have more income, but in California they pay a lot more.

In 2006, according to the Franchise Tax Board, Californians making more than $500,000 a year filed just 1 percent of all state income tax returns – and paid 47.2 percent of the taxes.

That works out fine for the state treasury when the economy is humming along, since wealthy taxpayers derive much of their income from capital gains and investments. But when stock markets sag, so do the incomes of many wealthy taxpayers – and that has a major impact on state income tax revenues.

Since California relies so heavily on those revenues – more than half of general fund income comes from income taxes – it makes state government extremely susceptible to swings in the economy.

“When the market tanks, those taxpayers sneeze,” said H.D. Palmer, the veteran spokesman for the Department of Finance. “And when those taxpayers sneeze, the state budget catches pneumonia.”

Statistics give weight to Palmer’s quip. From 1999 to 2000, for example, state general fund revenues jumped 23 percent as the dotcom boom reached its peak. At the other end of the spectrum, revenues plunged 17.5 percent from 2007 to 2008 when the housing bubble burst.

Unintended consequences

How California came to rely so heavily on its top-income taxpayers is an object lesson on the law of unintended consequences.

In 1987, Congress and the administration of President Ronald Reagan had just overhauled the federal income tax system. California lawmakers determined it was a good idea to “simplify” the state’s system by conforming it to the federal government’s system – and win points with voters by reducing taxes for most of them.

The final bill – approved, as is legislative custom, on the last night of the session – included tax breaks for a relatively small number of businesses, reduced the state’s top personal income tax rate from 11 percent to 9.3 percent and decreased the number of tax brackets from 11 to six.

“This bill does something not seen in California taxes, ever,” declared then-Sen. John Garamendi, the Walnut Grove Democrat who co-authored the measure. “We are achieving simplicity and broadbased tax relief.”

Broadening the brackets meant immediate tax cuts for about 70 percent of California taxpayers – and increases for the rest, mainly families with incomes of more than $100,000.

The lasting result of the 1987 law was a dramatic shift in the income tax burden. In 2006, taxpayers making more than $500,000 paid nearly half of the state’s income taxes.

When adjusting for inflation, taxpayers making the 1980 equivalent had paid only 12 percent of the income taxes.

“That was a pivotal point,” said Fred Silva, a senior fiscal policy adviser with the reform group California Forward, who in 1987 was the Senate’s chief budget consultant. “We said ‘upper income people, you’re going to pay more, and we’re going to rely on you more.’ ” Not everyone thinks that’s a bad thing.

“The state income tax is the fastest growing revenue source, so you don’t want to retard that,” said Steve Levy, director of the Center for Continuing Study of the California Economy. “The richest taxpayers pay most of the taxes because they are making most of the money … and that’s an equitable situation.”

Levy is not entirely right. According to figures from the Franchise Tax Board, while Californians making more than$500,000 a year were paying 47.2 percent of the income taxes, they were earning 24.8 percent of the adjusted gross income.

Even so, those who support the current system and oppose “smoothing out” the income tax burden by increasing the proportions paid by middle- and low-income earners contend that the current system’s benefits outweigh the problems caused in bad-economy years.

“Do you kill the golden goose that lays eggs four years out of five?” said Jean Ross, executive director of the California Budget Project, a nonprofit group that advocates for the interests of the poor and middle class.

“The personal income tax – that part of the system works.”

‘A penny for Jimmy’

Like the income tax, the other major component of California’s tax system is also a child of the Great Depression. In July 1933, prodded to action by temperatures that climbed to 107 degrees in the legislative chambers – which then lacked air conditioning – state lawmakers adopted a sales tax.

The rate, initially applied to food as well as other goods, was set at 2.5 percent. That was a hefty figure back then, when the average family’s monthly income was $125.

Resentful Californians disdainfully called the tax “a penny for Jimmy,” referring to then-Gov. James “Sunny Jim” Rolph.

Two years later, legislators approved a personal income tax with rates ranging from 1 percent to 15 percent.

For much of the past 75 years, the two taxes tended to balance each other in terms of their impact on taxpayers.

(The sales tax is “regressive,” meaning everyone pays the same rate no matter what their individual financial status is. The income tax is “progressive,” meaning that those who have more income generally pay at a higher rate.)

While the state’s tax structure has remained largely unchanged, tectonic shifts in the economy, as well as changes in tax laws, have affected the role each tax plays.

Taxing doughnut holes

For the first 50 years or so of its existence, the sales tax chugged along pretty steadily as state government’s dominant source of income.

Then, as the building blocks of California’s economy shifted from the production and sale of goods to a heavier emphasis on services – instead of buying a lawn mower, you pay someone to mow the lawn for you – sales tax revenues became less vital.

In 1984, revenues from personal income taxes surpassed the sales tax as the state revenue’s top dog. That caused two things to happen.

One was that the state now counted on a less reliable tax as its main source of revenues, since income taxes tend to swing more wildly than sales taxes with changes in the economy.

The second has to do with doughnut holes.

For decades, legislators and governors have tried to figure out ways to extend the sales tax to untaxed goods and services – taxing both the mower and the mowing service – while drawing the least amount of squawking from consumers and industries that might be targeted.

In January, for example, Gov. Arnold Schwarzenegger floated a proposal to impose sales tax on a variety of services, from veterinary care to washing machine repairs, as well as entertainment venues such as golf courses and amusement parks.

An avalanche of protests from the affected businesses promptly buried the idea.

But even extending the sales tax to currently untaxed goods has proved to be an iffy proposition. In 1991, lawmakers desperate for revenues extended the sales tax to snack foods, bottled water, and newspapers and magazines.

Defining exactly what constituted a snack food, however, became a daunting task for tax officials. Tortilla chips, peanuts, granola and whole apple pies, the state Board of Equalization decided, were not taxable. Doritos, pretzels, granola bars and slices of apple pie were taxable.

“Doughnuts aren’t taxable, but doughnut holes are,” fumed Assemblyman Mickey Conroy, R-Orange. “I think it’s a disgrace.”

So did voters. The following year, they decisively repealed the “snack tax.”

While there’s no shortage of ideas about how to fix the state’s tax system – most of them centering on increasing taxes only if absolutely necessary and only if they’re imposed on someone else – there is an equally vociferous argument that the tax system isn’t even the state’s biggest fiscal headache.

“It’s not the tax system that is causing the problem,” said David Doerr, the senior tax consultant at the California Taxpayers Association and the man who literally wrote the book (“California’s Tax Machine”) on the history of the state’s tax system.

“The tax structure has been pretty consistent in providing income,” Doerr continued. “It’s spending.They (elected officials) just can’t say no.”

See Related: BUDGET CRISIS

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