It’s Getting Crowded At The Top

Loren Kaye
President of the California Foundation for Commerce and Education

“Is that all?”

That’s my guess as what would be the modal response from budget pressure groups, disappointed at the Governor’s less than fulsome funding of various spending programs released in today’s proposed 2017-18 state budget.

Uncertainty about the economy, about federal tax policy, and most importantly about taxpayer behavior, supports a prudent approach from the Governor.

More than ever, the fate of California’s spending plan is in the hands of relatively few taxpayers.

Last November, California voters agreed to maintain California’s highest-in-the-nation income tax by extending the top marginal tax rates, originally enacted in 2012, for another 12 years.

The effect of significantly higher tax rates on taxpayer behavior is difficult to measure. Anecdotes abound of wealthy investors, entertainers and sports figures fleeing the state for the friendlier confines of Nevada, Texas or Florida – states without an income tax. On the other hand, Franchise Tax Board data show that the absolute number of high income taxpayers has steadily increased since the depths of the recession and the imposition of higher rates in 2012. Whether imposition of virtually permanent (2030 expiration) top tax rates will change behavior remains to be seen.

Upon which there is no debate is the volatility of this revenue source and the dependence of the state General Fund on high income taxpayers.

California’s personal income tax is noteworthy because capital gains are fully taxed at the marginal income tax rate. When the economy is booming capital gains income rolls in – from stock market returns, real estate holdings and sales of business stakes. But when the economy dips, capital gains income dives.

Volatility wouldn’t be much of a worry if income taxes on the wealthy weren’t integral to the state’s budget.

As California’s economy has recovered, it’s gotten more crowded at the top. The share of taxes being paid on ever higher income tax collections is concentrating even more the share of taxes on upper income taxpayers.

According to the FTB, state income tax filers with more than $200,000 adjusted gross income increased their share of overall tax payments in 2014 to 70%, up from 55% in 2009.

At the same time, the income tax has become the overwhelming source for the state’s General Fund. The Legislative Analyst projects that next year income taxes will account for 70 percent of all general revenues – a record high dependence on this revenue source. Translation: little more than 900,000 taxpayers (out of 39 million residents) will account directly for 49% of all General Fund revenues.

Tying state finances to such a small number of upper income earners is very risky. As the Governor warned prior to the adoption of Proposition 55, what goes up inevitably will come back down. This trend underscores the wisdom of California voters in adopting the Proposition 2 rainy day reserve in 2014, to hedge against further downturns.

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