California Needs A Flat Tax to Solve its Budget Problem

Former Presidential Economic Advisor

Stated succinctly, California’s steeply graduated progressive tax structure is the cause of the state’s current fiscal crisis. California’s highly progressive tax code is itself to blame for i.) the great volatility in revenues, ii.) the inevitable build-up of government spending, which leads to ever-higher taxes, and iii.) the tremendous inefficiency and unfairness—hurting the prosperous is not an honorable objective, and hurting the prosperous does not help the poor, which is an honorable objective.

There is no solution to California’s crisis save redressing the fundamental premise underlying California’s progressive tax codes. Because the tax codes in California are so progressive, the state has long periods of feast followed by periods of crushing famine. Sour economic times and progressive tax codes are a surefire recipe for fiscal crisis.

It is this famine/feast syndrome so characteristic of economies with progressive taxes that has precipitated once again a serious budget problem. And, the resolution is far from certain. The crisis of the late 1970s/early 1980s gave us lower property taxes following the passage of Proposition 13, the abolition of our state’s inheritance tax, indexed personal income taxes and the Gann spending limit—all wonderful. Yet the crisis of the early 1990s gave us personal income tax increases, increases in the gas tax, sales tax increases and a disemboweling of the Gann spending limit—all horrible! Shocking as it may seem to party loyalists, the biggest tax increases in California came under Republican governors, while the biggest tax cuts were under Jerry Brown’s leadership.

Progressive taxes also lead to a higher overall share of output going to government than the electorate would prefer. Tax cuts are never as popular with politicians in good times as are tax increases in bad times. Volatile revenues—the alter ego of progressive taxes—inextricably lead to big government by increasing spending during prosperity and ratcheting up tax rates during slow times. Those who argue that California’s government is more liberal than its electorate are wrong. Big government is a byproduct of a progressive tax code.

Another rather insidious factor in the growth of spending results from the budgeting process. Because of the state’s volatile revenues, California has a longstanding and successful budgetary tradition of overstating projected revenues during times of crisis in order to get higher spending approved by the legislature. Then, when revenues fall far short of projections (surprise!) the politicians turn to taxes to make up the difference. Sound familiar?

With this in mind, juxtapose California’s high tax rates with the fact that there are nine states in the U.S. without a state personal income tax at all—including the biggies of Florida and Texas, in addition to California’s neighbors, Nevada and Washington—and you can see why California once again is facing the very serious prospect of a brain drain. Several years ago we took our family business and left California for Tennessee, a state with no income tax. It is a wonder that there are any entrepreneurs or venture capitalists left in our old state.

And don’t for a moment think that the highly progressive tax structure in California helps the poor, the minorities, or the disenfranchised—it doesn’t. Just on an intuitive level, it should be self-evident that if a government taxes people who work and pays people who don’t work, there will be more people who don’t work and fewer people who do work. The more workers are taxed and the more non-workers are paid, the more people there will be who don’t work. It’s as straightforward as 1-2-3.

The poor, who rely on the state for their sustenance, are having their benefits cut to the bone; because of California’s business-unfriendly policies, the unemployment rate is higher than the national average; because of our bad governance, California has one of the worst K-12 education systems in the nation. I could go on and on, but the point is simple enough: California’s progressive tax structure is not benefiting the truly needy.

Let me put the theorem to you precisely (and I could prove it to you mathematically if need be): By trying to redistribute income, government never, ever succeeds in redistributing income. But what government does accomplish when it tries to redistribute income is the destruction of the volume of income. Government cannot change the distribution of income with taxes, but it always lowers the volume of income with taxes. As we look across the world at the progressive tax structure of California and other economies, it’s amazing how the distribution of income, if anything, is made worse. And that’s where we are today.

If California ever wishes to break out of its fiscal crisis cycle, it must redress the progressivity of its tax codes, pure and simple. Spending controls by themselves won’t work. You can’t expect politicians to set aside and then not spend a rainy day fund of $75 billion or more. And for sure they won’t pass billions of unspent dollars on to their term-limited successors. It just ain’t going to happen. No sooner was the Gann spending limit actually effective than Proposition 111 passed, rendering it totally ineffectual. The best form of spending control is the simplest form of spending control: don’t give government the extra money during good times and don’t shortchange essential programs during tough times. The case for a flat tax is nowhere more compelling than it is in California today.

My preferred flat tax structure would encompass all local taxes as well as state taxes. Today that number is somewhere around $165 billion with approximately $95 billion needed for the state’s general fund, $25 billion for state special funds and $45 billion for local government. “Sin taxes” should be excluded from consideration as part of a flat tax because their purpose is more to alter behavior than it is to raise revenues. Fines for speeding, disturbing the peace and illegal parking, along with court ordered payments and taxes on alcohol, tobacco and firearms, are classic sin taxes and really do make sense. But other than these sin taxes, every state and local tax should be abolished. And I do mean abolished.

In their stead California should enact two single rate flat taxes, one placed on business net sales and one on personal unadjusted gross income. A company’s net sales tax base would simply be total sales less purchases from other companies, i.e., net sales. No other deductions should be allowed, period. For individuals the tax base would be total income minus deductions for home mortgage interest expense, charitable contributions and rent on one’s primary residence (if the taxpayer is not a homeowner). No income should be exempt from taxation just because that income is below a certain threshold. In other words, the first $30,000 of income should be taxed at the same rate as every other $30,000 of income.

With California gross state product averaging some $1.62 trillion per year over the last five years and total state and local tax revenues less sin tax revenues averaging $136 billion per year over five years, to match revenues over time, without presuming a supply-side or Laffer Curve effect, the tax rate on business net sales and on personal unadjusted gross income would be south of 6.00%. Most individuals wouldn’t even have to file a tax return as long as they received all of their income from accredited employers who withheld. All personal taxes would be deductible on federal tax returns, thus providing additional benefit to California taxpayers. But most of all, there would be no state and local sales taxes, no property taxes, no state gas taxes and no state payroll taxes, none, none, none.

Can you imagine the dynamics of California in competition with other states? California’s tax revenues would fluctuate mildly, right in line with the state’s personal income. The incessant urge of government to overspend would be a thing of the past, and the incentives to flee the state for more friendly shores would vanish. California truly would be the Golden State. And who knows, maybe someone in Washington, D.C. would pay notice.

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