KC Fiscal Focus is periodic electronic newsletter that focuses on public policy issues from a fiscal perspective.  KC is a California-based consulting firm which specializes in public policy research and analysis.  To sign-up for KC Fiscal Focus click here.

Finally, we welcome your feedback on this newsletter and our other publications.  To submit your comments click
here.

KC has produced a second report titled “State Legislators Must Get Beyond Partisan Divisions, Outdated and Flawed Understanding of State’s Economy to Improve California’s Economic Competitiveness.”  To view the report click here.

The reports mark the first in a new series of KC reports examining the state’s business climate and what needs to be done to improve the state’s
competitiveness and create jobs in California.

KC Fiscal Focus is periodic electronic newsletter that focuses on California State public policy issues from a fiscal perspective.  KC is a Sacramento-based consulting firm which specializes in public policy research and analysis.  To sign-up for KC Fiscal Focus click here.

Finally, we welcome your feedback on this  newsletter and our other publications.  To submit your comments click here.

A second analysis is titled “Summary of Benefits and Costs of California’s 2/3 Vote Requirement for Taxes or a Budget With Increased Tax Revenues,” shows that the costs of the 2/3 vote requirement far outweight its benefits.  To view the report click here.   These reports marks the second installment in a new series of KC Fiscal Focus articles analyzing structural reform issues in California.   

KC Fiscal Focus is periodic electronic newsletter that focuses on California State public policy issues from a fiscal perspective.  KC is a Sacramento-based consulting firm which specializes in public policy research and analysis.  To sign-up for KC Fiscal Focus click here.

Finally, we welcome your feedback on this newsletter and our other publications.  To submit your comments click here.

This report marks the first installment in a new series of KC Fiscal Focus articles in the coming months that will analyze structural reform issues in California.   

KC Fiscal Focus is periodic electronic newsletter that focuses on California State public policy issues from a fiscal perspective.  KC is a Sacramento-based consulting firm which specializes in public policy research and analysis.  To sign-up for KC Fiscal Focus click here.

Finally, we welcome your feedback on this newsletter and our other publications.  To submit your comments click here.

Another KC report, titled “Brown, Whitman Campaign Proposals Won’t Likely Solve Many Policy Problems But Offer a Glimpse of the Candidates’ Perspectives on Major State Issues Such as Job Creation, Pension Reform, Tax, Budget and Environmental Issues.”  To view the report click here. 

A third report, titled “Proposition 26 May Be a ”Trojan Horse” that Would Prevent Funding of AB 32 Greenhouse Gas Emission Reductions, Federal Health Care Reform Legislation.”  To view the report click here.

Another KC report, titled “Statewide Protests Target Chase Bank and Wall Street Firms, Summary Report Released with Research Support from Kersten Communications,” which summarizes why a group of community activists and labor and education leaders staged a series of protests on August 10 to call attention to a $17 billion bill itemizing the ways Wall Street banks are shortchanging California residents and state and local governments.  To view the report click here.  

A third report, titled “State General Fund Spending Has Dropped by $20 Billion Since 2006-07, Major Decreases for Every Major Program Area,” provides new KC analysis of Department of Finance data which illustrates how the three state budgets passed since 2007-08 have significantly ratcheted down state spending on major state programs such as education, higher education, and health and human services, despite the increasing needs of a growing state population.  To view the report click here.     

KC Fiscal Focus is periodic electronic newsletter that focuses on California State public policy issues from a fiscal perspective.  KC is a Sacramento-based consulting firm which specializes in public policy research and analysis.  To sign-up for KC Fiscal Focus click here.

Finally, we welcome your feedback on this newsletter and our other publications.  To submit your comments click here.

Another KC report, titled “New Report Finds Major Shift in Property Tax Burden From Commercial to Residential Property Since Prop. 13, Describes Loopholes In System,” summarizes a new report which was co-authored by Lenny Goldberg, executive director of the California Tax Reform Association, and David Kersten, with Kersten Communications.  To view this report click here. 

The full report, titled “System Failure: Califonria’s Loophole-Ridden Commercial Property Tax,” is available by clicking here.   

KC Blog Briefs:

“Summary of Analyses of the Governor’s May Revised Budget Proposal.”

“House and Senate Reach Compromise on ‘Job Creation’ and ‘Tax Loophole Closure’ Legislation.”

The following KC analysis shows that both candidates’ tax plans would provide very marginal economic benefits to the State of California at best and only really serve to benefit the wealthy and ultra rich.  Most of the tax cuts proposed in each plan would accrue to the state’s wealthiest taxpayers—the top 1% of the state’s earners. 

Perhaps most intriguing is that both candidates would reap significant savings, likely to be in the millions of dollars range, potentially tens of millions of dollars, in their own tax bills from their proposed reductions in the state capital gains tax.  More specifics would be known if Whitman and Poizner release their tax returns.      

Whitman proposes to eliminate the state’s capital gains tax, Poizner proposes to cut it by 50%.  Candidate financial disclosure (Form 700s) filed by both Whitman and Poizner show that both candidates are heavily invested in stocks, private-equity firms, and other investment vehicles that generate income, dividends and other capital gains that are largely taxed through the state’s capital gains tax.  Click here to view Whitman’s Form 700 filing and click here to view Poizner’s Form 700 filing.

Democratic candidate Jerry Brown has not outlined a tax package that he would enact if elected Governor but has stated that he would only support tax increases if they are approved by a vote of the California people.         

This report seeks to summarize and critique both Whitman’s and Poizner’s tax cut proposals and provide a revenue impact analysis for each proposal.  

Summary of Meg Whitman’s “Job-Creating Tax Cuts”

Republican frontrunner Meg Whitman has proposed a package of tax cuts primarily consisting of an elimination of the state capital gains tax, which is estimated to cost the state roughly $11 billion annually (note: capital gains fluctuate with the economy). 

Whitman has also proposed a package of more targeted “job-creating tax cuts” which includes a sales tax exemption or tax credit for manufacturing equipment ($1-2 billion), an increase in the state research and development tax credit ($60 million), a $10,000 tax credit for new home purchases ($100-200 million plus), and a hiring tax credit for green technology job creation ($50 to $100 million estimated) (see full summary chart below, click on chart for clear printable version). 

In total, Whitman’s tax package is estimated to cost $12.4 billion to $13.6 billion a year when fully implemented, according to conservative estimates by Kersten Communications. 

“With California facing a $20 billion budget deficit, we have to be strategic and effective in the tax relief we provide.  While making cuts in marginal tax rates is a very important goal, at this moment we simply cannot afford a big, across-the-board tax cut that would irresponsibly grow the state’s already over-sized debt level and drop our bond rating to junk status,” Whitman states in her policy agenda titled “Meg 2010: Building A New California.”  “I have a road map to help create 2 million private-sector jobs by the beginning of 2015,” Whitman wrote in an April 15, 2010 Desert Sun Op-Ed in support of her tax package.       

 Summary of Steve Poizner’s Tax Cut Proposal

 Poizner proposes a 10% across-the-board reduction in marginal rates for the state personal income tax (PIT), sales and use tax (SUT), and corporation tax (CT), and a 50% reduction in the state’s capital gains tax. 

An analysis by Kersten Communications based on Department of Finance data finds that Poizner’s 10% across-the-board tax reduction would cost $8.2 billion annually and the 50% capital gains tax cut would cost $5.5 billion—for a total of $13.7 billion a year in reduced state tax revenues (see chart below, click on chart for clearer printable window).

“Commissioner Poizner will cut rates in every major category of taxation, fueling job creation and jumpstarting economic growth for all Californians,” Poizner states on his website.  “Economic growth due to the Poizner Jobs Plan, combined with hiring, debt, and spending freezes, closes the $20.7 gap,” Poizner states. 

Specifically, Poizner says his plan closes the state’s $20.7 billion budget gap with “$7.4 billion in added revenues from economic growth and $13.5 billion in reduced spending.”  The tax cuts are keyed as a $3.8 billion revenue gain, presumably from their job-creating benefits, and not as a $13.7 billion revenue loss.

“Based on a careful study of state tax cuts over a fifteen year period, Poizner’s proposed 10% cuts in personal income tax rates, the state sales tax rate, and the corporation tax rate are estimated to grow state revenues by an inflation-adjusted 1.77% in the first year and 4.94% in the second year after the cuts are enacted into law,” states Poizner’s website.

“If implemented immediately, Steve’s proposed tax cuts should generate approximately $3.77 billion in General Fund revenues through the end of the 2010-11 fiscal year.  We posit that the revenue enhancement effects of the proposed tax cuts may even be more robust than the estimates provided, given the 50% reduction in capital gains taxes,” Poizner states.  

Reducing California’s Capital Gains Tax Primarily Benefits the Wealthy and Super-Rich and Very Few Middle Income Taxpayers, But Not Low-Income Taxpayers

Whitman proposes to eliminate the state’s capital gains tax, while Poizner proposes to cut it by 50%.  Research indicates that capital gains tax cuts overwhelmingly benefit the wealthy, primarily the top 1% of taxpayers, and do not have a measurable impact on creating jobs and economic growth.  

California’s current treatment of capital gains and dividends was enacted into law in 1987 as part of a tax package passed by the Legislature and signed into law by Governor Deukmejian (R) to conform to President Ronald Reagan’s 1986 federal tax reform package.

Under current state law, California taxes capital gains through the state’s personal income tax, which means that capital gains—from the sale of a home, stocks, or other investment vehicles—is taxed according to California’s marginal income tax rates.  California’s top income tax rate is 9.3%. 

“In all the years since we conformed with the Reagan treatment of capital gains as ordinary income (Tax Reform Act of 1986), tax treatment of capital gains in California has been essentially a “non-issue” among those who do tax legislation in California,” according to Martin Helmke, former chief consultant to the California Senate Revenue and Taxation Committee. 

Helmke said several bills have been introduced since 1986 to reduce the state’s capital gains tax but none of the bills went further than the Revenue and Taxation Committee in either house.   

In 2003, George W. Bush’s 2003 tax act lowered the top tax rate on corporate stock dividends from 35% to 15%, and reduced the top capital gains tax rate from 20 percent to 15% for gains realized after May 5, 2003, according to Citizens for Tax Justice (CTJ).

Contrary to Whitman’s and Poizner’s assertions that reducing the capital gains tax will increase revenues, and jobs information released by the Internal Revenue Service shows that the Bush tax cuts on capital gains and dividends reduced federal tax revenues by $91.7 billion in 2005, according to Citizens for Tax Justice. 

A 2006 study by the Congressional Budget Office (CBO), titled “A Dynamic Analysis of Permanent Extension of the President’s Tax Relief” (which includes Bush’s income tax cuts and other tax changes), found that under the best possible scenario, making the Bush tax cuts permanent would increase the economy “over the long run” by 0.7%.  Since the “long run” is not defined, economists have suggested that 20 years be used, which would make the best case scenario GDP growth equal to 0.04%.  Previous CBO estimates identified the tax cuts as costing the equivalent of 1.4% of the GDP in revenue—meaning the tax cuts would still cost the equivalent of 1.27% of the GDP, according a report titled “Treasury Dynamic Scoring Analysis Refutes Claims by Supporters of the Tax Cuts,” by the Center on Budget and Policy Priorities.

 An analysis by CTJ found that “the 67 million tax filers who reported adjusted gross incomes of less than $30,000—half of all filers—received virtually none of the benefits of the capital gains and dividends tax breaks.  In contrast, the 0.6 percent of all filers with reported incomes above $500,000 received 73.4% of the total tax reductions, saving an average of $81,204 each,” states CTJ report.

“Most amazing, the 13,776 tax filers with adjusted gross incomes in excess of $10 million—a mere 0.01 percent of all filers—received 28.2 percent of the total tax savings.  Their average tax break was $1.87 million each,” states the CTJ report (see CTJ summary chart below).  

“I have no doubt that for many who favor eliminating or sharply reducing California’s income tax on capital gains, the real motivation is that they simply favor lower taxes on the rich—even if that means higher taxes on everyone else,” stated Robert S. McIntyre, executive director of CTJ, in his testimony before the California Commission on the 21^st Century Economy.

Two Additional Reasons Why Reducing or Eliminating the State Capital Gains Tax is a Bad Idea

Reducing or Eliminating California Capital Gains Tax Would Create A New Tax Shelter for the Super Rich:  “Lots of income that is called “capital gains” is really ordinary income that has been converted into capital gains to minimize federal taxes,” stated McIntyre.  Private-equity managers report a significant amount of income as capital gains to take advantage of the lower marginal federal tax rate.  Reducing or eliminating the state capital gains tax would only exacerbate this problem.  In 2007, almost 40% of the income reported by the top 1% of California taxpayers was capital gains.  “For this small, wealthy group, income taxes paid on capital gains represented 44% of their total 2007 California income taxes paid,” McIntyre stated.

Reducing or Eliminating California Capital Gains Tax Would Not Stimulate Economic Growth or Investment in California:  Whitman and Poizner argue that reducing the state’s capital gains tax would result in significant economic growth in California.  “Careful research by non-partisan analysts shows that there is no connection between lower capital gains taxes and higher economic growth, in either the short run or the long run,” McIntyre states.  In 2002, the CBO released a report titled “Economic Stimulus: Evaluating Proposed Changes in Tax Policy,” which found that “capital gains tax cuts would provide little fiscal stimulus,” since most of the benefits of such cuts would accrue to high income households which are much more likely to save than spend.”  “Indeed, the CBO determined that, of the range of approaches examined, capital gains tax cuts were among the least effective,” according to McIntyre. 

Research by Len Burman, the director of the joint Brookings Institution-Urban Institute Tax Policy Center, shows that over the last 50 years real GDP growth has not varied in response to changes in the capital gains tax rates, even when the possible lag between the rate cut and subsequent economic activity is accounted for.  “The relationship between rates and growth is not statistically significant,” according to McIntye. 

A capital gains tax cut would also not encourage additional investment in California, as opposed to companies in other states or nations, because California-based investors would receive the same tax treatment if they invest in-state, out-of-state, or abroad.  Investors will continue to seek out the highest rate of return on their investment, without regard to location, just as they would in the absence of a state tax break for capital gains, McIntyre concludes.

Critique of Select Whitman “Job-Creating” Tax Cuts

Sales Tax Exemption or Tax Credit for Manufacturing Equipment Will Not Create New Jobs, Only Serve to Significantly Increase State Budget Deficit ($1-2 billion/yr. revenue loss):  This is perhaps the most justified on policy grounds of all of the tax cut proposal, although the state can ill-afford this tax cut at this time given the $20 billion budget deficit.  A sales tax exemption is preferred to a credit given the administrative nightmare of the now expired manufacturers’ investment tax credit (MIC) for both taxpayers and tax administrators.  The MIC was enacted in 1994 with a promise by proponents that it would create 390,000 new jobs by 2004.  The MIC expired at the end of 2003 because it failed to meet even a minimum threshold of 100,000 new manufacturing jobs that it needed to create to stay in effect.  The truth of the matter is that  U.S. manufacturing jobs are going overseas due to market conditions, not state and federal tax rates.  A marginal tax break of 6% of the value of purchases of equipment used in manufacturing will do extremely little, if anything, to stem the flow of U.S. manufacturing jobs overseas.   

Elimination of $800 Minimum Franchise Tax (MFT) for New Corporations Is Unnecessary, Not Fiscally Prudent ($60 million revenue loss):  Whitman proposes to eliminate the $800 limited liability company (LLC) filing fee that new corporations pay to incorporate as an LLC.  Under current law, the MFT is already waived for a C Corporation’s first two years of existence.  Many LLCs currently pay no additional taxes because they are set up as holding companies or take all of their profit in the form of executive compensation and therefore pay no corporation tax.  The $800 tax, which has been in place since the 1987 federal tax reform conformity legislation, is a nominal and fair amount for the privilege of conducting business as an LLC in California.

Tax Credit for Water-Conservation Technology Would Not Increase Development of Such Technology, Only Serve to Widen State Budget Gap (Unknown Revenue Impact, Estimated at $10-20 million/year minimum):  Investors will invest in water conservation technology if it makes economic sense to do so.  While Whitman has not specified the amount of the tax credit, enacting a state tax credit of say 6% would only marginally reduce the costs of producing such technology and would not have a measurable or significant impact on the development of additional water-conservation technology in California.  The escalating prices of water, especially in Southern California, has created a growing market for this technology.  It does not make sense for the state, at significant cost of lost revenues, to reward entrepreneurs for developing products for which there is a thriving market.  The economic benefits of selling such devices is reward enough.

Increasing State Research & Development (R&D) Tax Credit from 15% to 20% of Qualified Expenses Further Expands an Already Generous Tax Credit at Great Cost to the State ($60 million/yr.):  California already has the most generous research and development credit in the country.  It is so generous, relative to the amount of corporation tax, that many companies already zero out their entire tax liability.  Adding more to that makes no economic sense.   The September 2009 budget agreement permitted the sharing of these credits among affiliates, which means much more income can now be sheltered than ever before through use of the R&D tax credit.  The state corporation tax is ¼ the federal rate, which is why state R&D tax credits are usually so much lower than the 20% federal rate.  If California’s corporation tax rate was anywhere near as high as the federal rate, presumably there would be an argument for raising it, but, as noted, it is disproportionate to the corporate income which is sheltered by the credit.  There has been no evidence presented that the current R&D rate is somehow ineffective in increasing R&D in California.  In order to provide an additional credit, there should presumably be some evidence that this is necessary beyond the generous credit we already have in place.  Otherwise, increasing the credit at the margin merely deprives the state of tax revenues which would be better invest in such things as education, universities, community colleges, transportation, and for other purposes that enhance workforce development and R&D activity in California.    

Establishing Academic Enterprise Zones Near Universities Would Expand the State’s Already Inefficient and Wasteful Enterprise Zone (EZ) Program ($50 to $100 million/yr. annual revenue loss):  The state’s current $300 million EZ program, which provides tax benefits in targeted zones throughout the state, is fraught with waste, fraud, and abuse as well documented by the California Budget Project and others (see California’s Enterprise Zones Miss the Mark).  Unfortunately, all reform attempts have failed in the Legislature thus far.  Expanding a current program that is widely regarded as wasteful, inefficient, and loophole-ridden, is not a smart idea.  Companies, largely specializing in R&D, are already congregated around the state’s premier university campuses.  Most of these firms already take advantage of the state’s generous R&D tax credit.  It makes no economic sense to reward these companies for locating in areas where it already makes economic sense for them to be located. 

Poizner’s Proposed 10% Across-the-Board Tax Cut Serves To Widen State’s $20 Billion Budget Deficit by $8.2 Billion, Misleading “Supply-Side Economics” Math Does Not Pencil Out

Poizner proposes a 10% across-the-board tax cut to the marginal tax rates for the personal income tax, the sales and use tax and the corporation tax at a cost of roughly $8.2 billion in state tax revenue.  Poizner argues that his overall “jobs-package”, which also includes the 50% reduction in the capital gains tax rate, regulatory reform, spending reductions, and a hiring freeze, among other things, would fully close the state’s $20.7 billion budget deficit. 

According to Poizner’s revenue estimates, his total tax package would result in a $3.8 billion revenue gain, as opposed to a $13.7 billion revenue loss as determined by an objective analysis by Kersten Communications—a difference of $17.5 billion or 85% of the state’s current budget deficit.  Assessing the true economic impact of Poizner’s tax cut proposal is key to determining if his deficit cutting proposal pencils out using real math (click here see summary chart of Poizer’s Budget Plan).

It has already been shown that Poizner’s proposed 50% reduction in the state’s capital gains tax would lead to a $5.5 billion state revenue loss without creating any significant economic growth in California. 

The Congressional Budget Office’s (CBO) 2005 study, titled “Analyzing the Economic and Budgetary Effects of a 10% Cut in Income Tax Rates,” analyzed the dynamic effects on economic growth of a hypothetical 10% income tax cut at the federal level and concluded that under various scenarios there would be minimal offsets to the loss of revenue.  “The budgetary impact of the economic changes was estimated to offset between 1% and 22% of the revenue loss from the tax cut over the first five years,” states the report. 

Thus, only under the most optimistic assumptions, a 10% reduction in the state personal income tax could lead to as much as a 25% revenue offset over the first five years—or a $1.2 billion annual offset over the first five years. 

The 10% reduction in the state sales and use tax (SUT) is likely to generate greater revenues than the reduction in the PIT, given the regressive nature of the SUT, and is more likely to be spent by lower-income and moderate income taxpayers. 

But even if it is assumed that 50% of the SUT and corporation tax (CT) cut is returned to the state in offsetting tax revenues—for a total offset of $1.75 billion, even under these overly optimistic assumptions, the cost of Poizner’s total $13.7 billion tax package could be offset by just over $3 billion.  That still leaves a $10.7 billion revenue gap from Poizner’s tax reduction package that is unaccounted for in Poizner’s calculations.

The Poizner campaign needs to explain how his “jobs plan” accounts for this $10.7 billion revenue discrepancy?            

Conclusion

Despite a $20 billion plus looming state budget deficit, both Meg Whitman and Steve Poizner have proposed grandiose tax cut proposals—to the tune of an estimated $13 billion–that the state cannot afford. 

It has been shown that the vast majority of these benefits would accrue to the wealthy, and ultra-rich, which would serve to benefit their own personal fortunes and the fortunes’ of their current and former colleagues and business partners in Silicon Valley.  Specifically, Whitman and Poizner stand to reap millions of dollars in personal tax savings from their proposed reduction in the capital gains tax. 

The proposals would have very marginal impacts on economic development at best and little, if any, tax policy justification for the vast majority of the revenue costs.  Moreover, they would only serve to further increase the state’s ballooning $20 billion budget deficit. 

Voters should not be mislead by their elaborate campaign promises about erasing the state’s budget deficit by using phony revenue estimates, based on faulty supply-side economics.  The real revenue estimates underlying both proposals do not lie.  A $13 billion tax cut means roughly $13 billion less for essential state programs and services such as education, health care, public safety, transportation, and infrastructure.

Other KC Fiscal Focus Reports: 

“Ballot Measures Qualified for June and November 2010.”

“Federal Stimulus Funding Slow to be Spent in California, Other States.” 

“KC Fiscual Focus Guide to Searching for Federal Stimulus Funding in Your Community.”