Kersten Communications

 In October 2008 Governor Schwarzenegger and legislative leaders created a bipartisan commission to “re-examine and modernize California’s tax laws” but after a year of work the commission has failed to produce anything of real value for consideration by the Legislature. 

The Commission on the 21^st Century Economy was supposed to release its final report on Sunday but asked the Governor for a few additional days, which he granted, to finalize a few peripheral details. 

The 14-member Commission is preparing to release the final report later this week, however, the report is already as good as dead in this legislative session (The final report will be available here).  The major components of the recommended package have been known for weeks—the enactment of a new “business net receipts tax”, a less progressive state income tax, and the elimination of the state sales tax and corporation tax.   

The Commission held its final meeting last week.  The only thing that remains to be seen is how many of the 14-commissioners will sign onto the proposal, which is currently being circulated for signatures.  At least two commissioners, Fred Keeley, a former Democratic Assemblyman, and Richard Pomp, a tax expert, have rejected major components of the plan. 

Governor Schwarzenegger has announced that he will call the Legislature into a special session immediately after the commission submits its report. 

This analysis seeks to summarize the problems with the commission’s proposal and examine why the commission was destined to not produce a politically viable plan from the very beginning. 

Commissioners Admit Proposal Not Ready For Prime Time, Business Groups, Tax Reformers Agree

Even the strongest proponents of the reform package, commissioners John Cogan, a Schwarzenegger appointee and Hoover Institution fellow, and UC Berkeley Law School dean Christopher Edley, admitted to the Sacramento Bee last week that the proposal is not ready for an up-or-down vote by the Legislature.

A consensus of tax reform advocates and business groups agree that the proposal, at minimum, raises a number of serious questions that need to be answered before moving forward.  Several tax reform experts have flat out opposed the concept of a “business net receipts tax” (BNRT) and rejected the plan because it reduces the progressivity of the state’s tax system.

“Given the monumental changes that the BNRT would bring to the state’s tax system, we believe more time is necessary to study the BNRT and to receive public input once the details of the BNRT are provided,” wrote Teresa Casazza, president of the California Taxpayers’ Association in an August 21, 2009 letter to Gerald Parsky, chairman of the commission.  In a September 3, 2009 letter, the California Chamber of Commerce and a series of major business groups submitted a long list of concerns about the BNRT that need to be addressed before any vote is taken.   

The California Budget Project  (CBP) and California Tax Reform Association (CTRA) have also submitted letters (links to CBP letter and CTRA letter) opposing the commission’s recommendations to eliminate the state corporation and sales tax and reduce the progressivity of the personal income tax.

Tax Commission Founded Upon Assumptions That Conflict With Democratic Support For A Progressive Tax System

The main reason that the Commission on the 21^st Century Economy failed to produce anything of value is that the Governor and Legislative leaders set the commission up for failure from the very beginning.  In a nutshell, the Governor and legislative leaders essentially asked the commission to come up with a plan for making the state’s tax system less progressive–an outcome which Democratic leaders are hard pressed to support because it is unpopular with the public and violates core Democratic values of progressivity in the state’s tax system.    

In October 2008, when the commission was first formed by Executive Order S-12-08, its primary charge “re-examine and modernize California’s out-of-date revenue laws that contribute to our feast-or-famine state budget cycles…[the commission] will suggest changes that will result in a revenue stream that is more stable and reflective of our economy.  This long-term action will help avoid the extreme revenue swings that have caused crippling deficits while maintaining a fair and equitable revenue structure that will ensure our continued competitiveness and attraction to employers and workers,” states an October 2008 press release by Governor Schwarzenegger.

It is true that California’s tax system is volatile and outdated, but the primary reason for this is that the system is progressive.  Lenny Goldberg, executive director of the California Tax Reform Association, in a recent letter to the commission states that “volatility is a function of income distribution” and the “volatility problem is an income distribution problem, one which tax policy cannot change.”

California’s overall tax structure is progressive due to the personal income tax, which raises a large amount of revenue from a relatively small number of persons.  This progressivity has increased over time as more and more of the state’s wealth has become concentrated in the hands of very few taxpayers.  According to the Department of Finance (DOF), the share of state personal income taxes paid by the top 1% of taxpayers has grown from 33% in 1993 to 48% in 2006.  Click here for a presentation to the commission by Phil Spilberg, DOF chief of financial research, on volatility in the state’s tax system. 

“Upper income persons tend to receive a disproportionate share of income that is volatile, such as dividends, interest, and capital gains,” states Commissioner Richard Pomp in correspondence to the commission.  Pomp is a nationally recognized tax expert who serves as a consultant to the Multistate Tax Commission and is chairman of the Board of the Institute on Taxation and Economic Policy.  Pomp goes onto say that earned income, such as wages and salaries, tends to be much less volatile that unearned income such as capital gains and dividends.

“The commission has expended much effort discussing volatility…or more accurately, the inability to predict volatility.  From the outset, I have argued, and continue to believe, that volatility, which is a feature of every state’s tax system, is a spending problem and not a tax problem,” states Pomp.

Thus, it follows that one cannot reduce the volatility of the state’s tax system without reducing its progressivity—shifting the existing tax burden from the rich to poor and middle-class taxpayers.   

Commission Recommends Making State’s Tax System Less Progressive To Reduce Volatility

Over the course of nine months, the commission heard from a number of tax experts and produced a plan designed to reduce the progressivity of the state’s tax system by implementing a new business net receipts tax and reducing personal income taxes of the top 3% of taxpayers by an estimated $7.5 billion, among other things.  Click here to see all the testimony and presentations heard by the commission over the course of its nine months of review of the state’s tax system.    

The proposal would implement a new tax structure that would rely on a new “business net receipts tax” to raise just under 50% of the state’s general fund revenue.  Under current law, the state raises its tax revenue from the following sources:  personal income tax (44%), sales tax (34%), other excise, motor vehicle, and insurance taxes (13%), and the corporation tax. 

Under the alternative system proposed by the commission the state would be estimated to receive its tax revenue from: a newly implemented net receipts tax (47%), a less progressive personal income tax (31%), significantly reduced sales tax (9%), and other excise, motor vehicle, and insurance taxes (13%).

The business net receipts tax is “designed to tax the value a business adds to its production of products and services in California and thus attempts to approximate the benefits of services and programs utilized by the business,” according to commission documents.  The base on which the tax is imposed is the net receipts of a business which would be calculated by adding all the receipts the business receives from all sources such as sale or exchange of property, performance of services or the use of property or capital in a trade or business.  All purchases from other businesses would be then subtracted from gross receipts, resulting in the business’s net receipts.  This amount would then be multiplied by the BNRT rate (estimated to be 4.5%) to calculate the tax liability of the business.

The BNRT was selected by the commission because it would broaden the state’s tax base, grow with state economic growth, enable the reduction in the marginal rates of the California personal income tax, eliminate the corporation tax, and reduce volatility by reducing the state’s reliance on more volatile sources of revenues (i.e. the personal income tax, corporation tax).

The commission proposes to flatten the state’s personal income tax by implementing two rates: 2.75% for income of up to $28,000 for single taxpayers and $56,000 for joint filers, 6.5% for taxpayers with incomes above those levels.  The state’s current top income tax rate is 9.3% with a 1% surtax for adjusted gross income of above $1 million.

The proposal would allow a standard deduction of $22,500 for single taxpayers and $45,000 for joint taxpayers and allow itemized deductions for mortgage interest, property tax, and charitable contributions.  For a chart showing the the estimated tax reductions for each class of taxpayer under the personal income tax click here.  The tax changes would be phased over five years.  The final proposal is also expected to recommend an expansion of the state’s rainy day fund to smooth out the budget cycle.      

Comparison Of Current Income Tax Brackets To Proposed Income Tax Brackets 

**The standard deduction for single taxpayers in 2009 is $3,637, compared to $22,500 under the proposed plan, which means most taxpayers making under $22,500 a year will not pay any income taxes under the proposed plan.      

 Summary of Problems With Commission Proposal

There are a number of issues with the commission’s proposal that have been widely noted by businesses, tax reform groups and other tax experts.  Two of the most comprehensive critiques of the proposal were completed by Jean Ross, executive director of the California Budget Project and Commissioner Richard Pomp, a preeminent tax expert.  The CBP critique, dated September 9, 2009, is available by clicking here.  Pomp has written at least two major critiques, “Why I Think We Are Heading In The Wrong Direction,” (Sept. 14, 2009), and “The Red, White, and Blue Plan,” (Sept. 4, 2009).      

Business Net Receipts Tax (BNRT) Unproven And Risky To Implement In California.  Perhaps the biggest problem with the commission’s proposal is that the business net receipts tax (BNRT) is experimental and, with the exception of Michigan, has not been tried anywhere in the world.  Michigan implemented a business net receipts tax a year and a half ago but still does not have any estimates on how much the tax has raised.  “The problems with the tax will be more important in California than in Michigan because the suggested rate for the NBRT is likely to be at least four times that of Michigan,” stated Pomp in recent correspondence to the commission.  It would be extremely risky for a state as large as California to implement a new tax, that would be estimated to provide half of its General Fund revenue, without the tax having been fully implemented or studied anywhere in the world.

Proposal Would Reduce Growth In State Tax Revenues That Would Lead To Larger, Not Smaller, Budget Gaps In The Future.  The California Budget Project and others tax experts have pointed out that the proposal would reduce reliance upon, or in the case of the corporate income tax, eliminate the two taxes that have posted the strongest average annual growth rates over the past four decades and replace them with taxes that are likely to grow more slowly.  “Documents prepared by Commission staff clearly show that the changes under consideration would lower the growth of revenues relative to the state’s existing tax structure.  This report estimates that the revenues raised by California’s current tax system would rise by 40.2 percent between 2012 and 2016, while the options under consideration by the Commission would increase revenues by 32.4 percent or 35.6% over the same period.  In dollar terms, the difference translates into $4 billion to $7 billion at the end of the five-year period,” according to a September 2 letter by Jean Ross, executive director of the California Budget Project to the commission chairman Gerald Parksy. 

BNRT Would Make California Businesses Less Competitive With Those In Other States and Nations.  Commissioner Pomp noted that several aspects of the BNRT are likely to make California businesses less competitive with other states and nations.  Pomp notes that “although the new tax has been described as a “value added tax (VAT),” it is not the kind of VAT used in Europe and throughout the world.  The VAT tax is collected at the time of each sale, and widely viewed as a tax on the consumer or a retail sales tax collected in stages, Pomp writes. 

The European VAT has two features that are critical to the proper operation of a value added tax that cannot be incorporated into the BNRT.  First, imports are taxed, which “maintains neutrality between the sale of domestically-produced goods and foreign produced goods… so that domestic producers are not put at a competitive disadvantage.”  Pomp says this feature cannot be used under the NBRT for two reasons:  1) under the U.S. Constitution producers cannot be brought under the NBRT unless they have nexus in the state, and 2) the draft proposal explicitly excludes foreign corporations from the tax by adopting the same water’s edge limitation now existing in the corporate income tax.  The result is that California producers will be placed at a competitive disadvantage. 

Pomp states that a second feature of the VAT which is critical to not putting domestic producers at a disadvantage is a rebate of the tax on exports.  European countries exempt exports from the VAT because they will be taxed when they are sold in the county to which they are imported.  “Under a transactional VAT, the amount of tax previously paid by the exporter is known and thus can be rebated,” Pomp states.  With the BNRT, on the other hand, the amount of tax previously paid by the exporter is unknownable, thus making it impossible to rebate that amount.  “Consequently, California exporters are put at a competitive disadvantage in competing outside the state,” Pomp states. 

Pomp argues that it is different to impose a VAT in a common market such as the European Union in which the member states have a similar value added tax, but it is a much different environment from the United States where only Michigan and California would have NBRTs.  “This latter point is critical to understanding the possible harm that could result to the California economy from adopting this tax,” Pomp writes.  

BNRT Proposal Would Be Difficult To Implement Without Being Riddled With Loopholes And Special Interest Tax Breaks.  “The unfamiliarity with the concept of the NBRT will virtually ensure that the tax will be riddled with special provisions,” Pomp writes, noting that legislators will have a difficult time resisting please by lobbyist and special interests for special tax breaks.  Pomp notes that the NBRT is an “opaque and nontransparent tax that defies easy characterization” and talking about the proper treatment of specific industries such as financial institutions would “quickly deteriorate into an esoteric and fairly inaccessible discussion.”  “I have no confidence that the integrity of the NBRT will remain intact.  Indeed, one can easily imagine an incentive introduced for salary paid to employees, special rules for the payment of interest, the wholesale exclusions of certain industries or types of services and so forth,” Pomp writes.             

2/3 Vote Requirement For New Taxes Would Make It Nearly Impossible To Bring Back Corporation Tax Or Sales Tax If Revenues From BNRT Do Not Materialize.  Pomp also notes that it would be next to impossible to bring back the corporation tax or sales tax if the revenues from the BNRT do not materialize as expected or come in below estimates.   “I am especially troubled by eliminating the corporate income tax, in existence for more than 70 years, and used by 90% of the states, and replacing it with a totally new, regressive tax, never seen before in either California or the world (with the exception of Michigan),” Pomp states.  “Revenue projections for a new tax are always tricky, if not wildly inaccurate.  They are especially suspect when they are made before any tax has worked its way through the legislative process and before taxpayers have become familiar with tax minimization strategies,” Pomp writes. 

BNRT Would Tax A Number of Things That Should Not Be Taxed Such As Utilities, Medical Services, Food, Housing And The Sale of Homes.  The BNRT would tax a wide range of goods and services that are currently exempt from state taxation such as utilities, medical services, food, housing, and the sale of houses.  Pomp notes that the NBRT would tax real estate rentals and the sale of homes by businesses.  “As far as I know, it is highly unusual for a state to impose a sales tax on the sale of homes…and I cannot think of a worse time than in the middle of a recession marked by thousands of foreclosures to imposes a new tax on the sale of housing by businesses,” Pomp writes.  The California Budget Project notes that lawmakers have exempted food purchased for consumption at home, prescription drugs, and essential services such as health and child care for taxation.  “All of these items would be subject to tax under the BNRT, which would exacerbate the regressive impact of the tax on lower-income households,” states the California Budget Project.  The proposed changes to the personal income tax would eliminate deductions for medical care and the child and dependent care tax credit, which benefits working families.         

Proposal Would Increase The Gap Between Rich and Poor.  The level of inequality in California is already large and growing larger and the commission’s proposal would exacerbate these gaps, according to the California Budget Project.  Under the commission’s proposal, the top 19% of taxpayers would receive 90% of the tax reductions or roughly $13.5 billion of the proposed $15.1 billion in tax reductions proposed under the personal income tax.  The bottom 81% of taxpayers, those making less than $100,000 a year, would receive only 10% of the reductions or $1.5 billion.  “In absolute dollar terms, the new structure would reduce the amount owed by a couple with an adjusted gross income of $50,000 by $85, while a couple with an AGI of $999,999 would receive a tax break of $21,315, according to the California Budget Project. 

Proposal Would Increase Prices for California Consumers and Place Downward Pressure on Wages.  The California Budget Project notes that documents prepared for the commission indicate that three quarters (71%) of the BNRT would be passed on to consumers in the form of higher prices, and just under one-fifth (19%) would be passed on to workers in the form of lower wages or fewer benefits, while the remainder would be divided between shareholders and business owners (9%) and individuals outside of California (1%).

Major Portions Of Proposal Could Be Found Unconstitutional, At A Cost of Billions Of Dollars To The State Of California.  The California Budget Project notes that a September 5^th letter signed by some of the nation’s most prominent tax experts finds that major portions of the BNRT could be challenged as unconstitutional.  This conclusion is supported by an analysis by the Franchise Tax Board.  The challenge would stem from a so-called “nexus” issue whereby the state would have to levy the BNRT on firms outside California to discourage outsourcing, but the state may not have the authority do so under the U.S. or State Constitution if those firms do not have “nexus” in California, commonly defined as a “physical presence” in the state.  An August 21^st analysis completed by the Franchise Tax Board, concludes that “the BNRT, if enacted presents some novel tax issues that lead to court challenge.  The BNRT relies upon a factor presence nexus standard, the validity of which has not been addressed by the California courts or by the U.S. Supreme Court.  We believe that such a standard should pass constitutional muster, although a favorable outcome is not certain.”  The analysis goes onto say that “there is a risk that the effectiveness of the BNRT could be undermined if the Business Activity Tax Simplification Act of 2009 currently under consideration in the U.S. Congress (or similar federal legislation) were to be adopted.”    

Conclusion

The Commission on the 21^st Century Economy worked hard to produce a proposal that addresses the charge that it was given by the Governor—come up with a proposal to reduce volatility in the state’s tax system—unfortunately the charge that the commission was given was misguided. 

Kersten Communications continues to produce research and analysis that document the myriad of problems with the state’s tax system that need to be addressed.  In short, the Legislature and any future tax reform efforts need to start by fixing what we have–improving efficiency, fairness, and equity in the state’s personal income tax, corporation tax and property tax—instead of starting over with an unproven tax that is fraught with its own host of problems, both known and unknown.

For list of Kersten Communication publications on California tax policy visit:

http://www.kerstencommunications.com/publications.        

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