With little drama, but much fanfare, the 21st Century Tax Commission’s report was released yesterday. The panel’s recommendations will receive a pro forma hearing by the Legislature; and in the fullness of time, like many initially controversial ideas that challenge the status quo, they may have a salutary influence on California tax policy.
But the take-away from the Commission’s effort in the short term is less elevating, because it leaves Californians with the impression that the tax system is anachronistic, unfair and broken. That is simply not the case. The Commission purports to “update and improve California’s out-dated revenue system and make it more reflective of our state’s economy” and to “get the state back on track with a more modern, stable and fair tax system to better serve all Californians.” But the Commission failed to make its case that the 70-year-old California tax system is so broken as to justify upending it.
The Commission provides a useful synopsis of the growth and change of the California economy:
In the 1920s and 1930s, when the tax system’s foundation was being set in place, manufacturing and agriculture dominated the state and residents mostly bought and sold tangible goods. Over the past 70 years, the forces of globalization and technological progress have transformed California into a state of not one but many economies.
The Commission then draws the conclusion that the state’s revenue laws are “out-of-date,” but the nub of that argument boils down to the same stew that reformers have attempted to serve for many years now: a higher proportion of transactions in California today are for services, compared to the historic dominance of tangible goods. By attempting to bootstrap the argument over perceived infirmity of the sales and use tax to the entire California tax system, the Commission succumbs to two fallacies:
First, the services economy is taxed in California. Services companies from veterinarians to advertising agencies all pay income taxes, as do their employees and California resident shareholders. They all pay sales taxes for the tangible goods they purchase. Indeed, if California’s economy is primarily services-based, and the services economy is under-taxed, then how to explain that California tax revenues exceeded population and inflation by 40 percent in the 25 years from 1982 to 2007?
The Commission makes much of the phenomenon that personal income tax revenues have overtaken sales tax revenues as the dominant tax source for California, as if this demonstrates the inherent weakness of the sales tax and its orientation to tangible purchases. But they elide the fact that in the hands of the dynamic California economy, the income tax is a powerful tax generator. The Commission dutifully recognizes the revenue volatility that such dependence on the income tax has caused, and it admirably suggests reducing the relative contribution of the income tax to the state treasury. But none of this speaks to the tax system being outdated; if anything, it demonstrates the tax system’s over-responsiveness to the economy.
The second fallacy is the myth of that the sales tax has eroded. I have written on this several times, In fact, the sales tax is not broken, and policy makers should 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. In addition, since the 1991 recession, taxable sales have contributed – year-in and year-out – to about a third of the California economy – apparently unaffected by the boom in internet sales, baby boomer retirements, or proliferation of services businesses. From 1970 through 1990, taxable sales represented on average about 40 percent of the economy. It is just as likely that the decline in the California manufacturing sector is responsible for this decline in taxable sales base as any change in consumer purchasing patterns.
Like any other complicated system, California’s “tax machine” can certainly be simplified and improved. The Commission has made some noteworthy arguments in this regard about the personal and corporate income taxes. But the California tax system is fundamentally sound, and replacing its major components with an unanalyzed, much less untested, new tax scheme at this time is imprudent and out of all proportion to any reasonable definition of the problem.