Cross posted on New Geography

California has three major problems: persistent high unemployment, persistent deficits, and persistently volatile state revenues.  Unfortunately, the only one of these that gets any attention is the persistent deficit.  It is even more unfortunate that many of the proposals to reduce the deficits are likely to make all three of the problems worse over the long run.

Two major proposals to deal with the deficit will shape the coming debate.  One is from the newly formed Think Long for California Committee; the other from the governor.

Governor Jerry Brown’s plan would increase sales taxes, and would increase the tax rate on the portion of anyone’s income that is over $250,000 (the marginal rate).  It is a general rule of tax analysis that if you want there to be less of something, tax it.  Indeed, this proposal would result in some wealthier people leaving California, and it would accelerate the trend of substituting internet retail purchases for local retail purchases.

It would also increase California’s tax receipt volatility.  California’s tax base is dependent on the income of a relatively small group of wealthy people.  It turns out that this income is more volatile than the economy.  Increasing top marginal tax rates would only increase the volatility of the state’s revenue.

So, why would the governor make such a silly proposal?  I’ve heard a few reasons.

• The government is starving and it needs the income now.

This is nonsense.  Combined national, state, and local government spending is now over 35 percent of gross product.  This is highest it has ever been, including the peak spending years of World War II.

We can disagree on the optimal size of government, but to argue that this is a time of scarce government spending is absurd.

• The wealthy have too much money.  We must increase the progressivity of California’s tax code.

The governor’s proposal will do that.  If implemented, the plan will give California the highest marginal tax rates in the United States.  The problem is that people with high incomes often have more choices than most of us.  They can move.  They can reallocate earnings to other states or into less-taxed activities.  They can just forego earnings if the return is too low.

Most analysts agree that California’s tax structure should be broader based.  The only way to do that is to make the system less progressive, not more progressive.  Increasing taxes on the wealthy may feel good when the law is implemented, but it will eventually lead to lower tax revenues, increased revenue volatility, and slower economic growth.

• There is nothing else we can do.  The political situation does not allow a better fix.

It never will be easy to implement comprehensive tax reform in California.  There are too many groups with too much at stake.  However, it is senseless to argue that we should therefore increase the distortions in an already distorted tax code.  California has been doing this for years, and it just keeps making things worse.  California’s governance is a mess precisely because it is the result of hundreds of ad-hoc decisions.

California desperately needs comprehensive tax reform, “if not now, when?”

Which brings us to the proposal by the Think Long for California Committee.  The Think Long committee is a subset of California’s political elite.  You will recognize many of the names; for a start:  Nicolas Berggruen, Eli Broad, Willie Brown, Gray Davis, Condoleeza Rice, Bob Hertzberg, Eric Schmidt, Terry Semel, Laura Tyson, and George Schultz.  The proposal has three components:

Empowering Local Governments and Regions: Here’s what it says about decentralizing decision-making: “While the committee embraces the principles of de-centralization, devolution and realignment of revenues and responsibilities, we have not endeavored to propose precisely how that should be accomplished.”

That’s a bit like endorsing Mom and apple pie, isn’t it?  The committee has not earned itself any honor or credibility by failing to have a proposal for one of the three major components of its plan, the first that it enunciates.

Improving Accountability: “The Citizens Council For Government Accountability – an independent, impartial and non-partisan body – would be established to develop a vision encompassing long-term goals for California’s future.”

Only, it is not a citizens group at all.  It would be funded by the state, and it would have access to state agencies for support.  Nine of the committee’s thirteen members would be appointed by the governor, two of whom could not be registered in either party.  The Senate Rules Committee and the Speaker of the Assembly would each appoint two members, one from each major party.  The committee would have four non-voting ex-officio members: the director of finance, the state treasurer, the state controller, and the attorney general.

That sounds to me a lot like just another government agency.  Not exactly; this would be a super-committee with broad powers.  It would soon be involved in almost every aspect of California’s government.   The committee would have subpoena power, and the ability to publish on the election ballot its comments and positions on proposed ballot initiatives and referendums, as well as to place initiatives directly on the ballot.

Giving the committee the ability to place initiatives directly on the ballot is a nice touch in a document that elsewhere tries to make it more difficult for others to place initiatives on the ballot.

Restructuring the Tax Code: California’s tax code needs restructuring, no doubt about that.  This proposal doesn’t get us to where we need to be, though.  It reduces sales tax rates, top marginal income and business tax rates, and deductions from personal income taxes, except for education and health care, and for taxing services.

In general, these are steps in the right direction.  However, exempting education and healthcare is a serious, perhaps fatal, flaw.  It amounts to a huge subsidy for those industries, and places an extraordinary burden on the remaining service providers.  The exempted industries are big, and exempting them means higher taxes on other service providers.

Who would actually bear the tax burden?  That depends on the elasticities of supply and demand.  In general, when demand is less elastic than supply (when the consumer is relatively indifferent to price changes), the consumer bears the tax burden, which is what is desired.  However, for many services, it would appear that demand is not that inelastic.

Consumers can easily reduce the frequency of services such as haircuts, lawn maintenance, and the like.  This would shift the burden of the tax from the consumer to the provider, that is, the hairdresser or landscape worker.  In many cases, these are very low-income workers, making the tax extraordinarily regressive.  California’s tax code needs to be less progressive, but this could be a huge regressive swing, one that would create extreme hardships for some of our least advantaged citizens.

Economic theory is clear that there are fewer distortions in consumption taxes than in income and capital taxes.  However, these models assume that the tax burden is squarely placed on the consumer.  It appears that for many services this may be impossible.  Perhaps that is why we don’t observe many service taxes.

It is also the case that, in many services, taxes are avoided by the use of cash transactions.  Estimates of the size of the “underground economy” vary, but most economists believe it is significant.  A tax on services would likely increase its size dramatically.

The Think Long proposal is not the solution to California’s challenges.  It does, however, represent far more thought than went into the governor’s proposal.  It provides a service, in that it provides a starting point for a conversation that California desperately needs.