When the Governor and Assembly Speaker created the Commission on the 21st Century Economy, aka, “Tax Commission,” their main concern was, in the Governor’s words, “basically just looking for one thing, and that is to create stability.” Indeed, the Governor specifically charged the Commission to “Stabilize state revenues and reduce volatility.”

To assist the Commission in its efforts, the California Foundation for Commerce and Education prepared a brief policy paper examining the state’s tax system to determine if it is broken, and what we are trying to fix. Our conclusion was simple: if you want to fix budget volatility, look no further than Proposition 1A on this May’s statewide special election ballot. But if you want to fix the state’s tax system, you’d better get agreement on defining the problem.

Much is made in the Executive Order and testimony to the Commission about the volatility of the state’s tax system, in particular the Personal Income Tax (PIT). It’s obvious that the tax system is volatile, and that, in combination (but only in combination) with poor Legislative decision making, it contributes to budget crises. But there are only three solutions to tax volatility, of which only one will work:

1. Creating a mandatory budget reserve. “Smoothing” revenues by requiring that “peaks” be saved to be spent during “troughs” manages volatility, rather than attempting to abolish it. This approach has been endorsed by the Governor and Legislature and will be presented to the public for approval as Proposition 1A at the May 19 special election. It seems logical that this option be tried and tested before considering more radical options.

2. Modifying the personal income tax. Volatility of the PIT could be reduced by flattening its progressivity or deemphasizing its dependence on capital gains, stock options or other income that is highly correlated with economic cycles. While this could work in theory, it would likely over the long term produce less overall revenues for the State. It also would reverse the historic principle of progressivity in the income tax system.

3. Diluting the personal income tax. The PIT now constitutes about 55% of General Fund revenues. Fifteen years ago it was 46%; 30 years ago it was 34%. Increasing other, less volatile revenue sources would reduce the impact of PIT volatility, but those sources would have to be substantially increased to make any difference. To reduce the influence of the PIT from 55 percent to, say, just 50 percent of General Fund revenues would require either raising other taxes by about $10 billion or replacing $5 billion in PIT taxes with $5 billion in other, new taxes.

In fact, policy makers must be careful what they wish for: over the past 35 years, the taxable sales base has been more volatile than personal income. PIT revenues have been more volatile because of capital gains and stock options, but both major revenue bases – not surprisingly – react to the economy. There is no such thing as a countercyclical revenue source.

The Foundation also took a close look at the trendy notion to broaden the sales tax base to include services, which has been a matter of intense discussion by the Commission. We found:

1. A services tax is not needed to change the responsiveness of the sales tax to the economy. The current taxable sales base is already very sensitive to the economy, and adding services would not materially change that.

2. Taxing the services that would most likely be added to the sales tax base would only provide minimal opportunity to reduce sales tax rates in a revenue-neutral manner. Increasing the price of a haircut by 9% in return for a ?% or ?% reduction in the price of a shirt seems to be an odd trade without much economic gain.

3. Increasing taxes on selected (and likely the most politically vulnerable) services would be unfair, discriminatory and economically harmful.
4. Imposing a services tax would increase the cost of labor, which sends the wrong signal when the economy needs to produce jobs.

As they say, read the whole thing.