State Tax Update – California

State Tax Review:

Given the recent financial events that have hit Wall Street, real estate, and the average American consumer, the purpose of this post is to look at how our largest states have responded to this fiscal crisis with regards to tax policy. Let’s start with California.

For some background – here is a high level overview of state income taxes (circa 2006, hasn’t changed much since then on a relative basis). If you go to this section at LITGM you can see all of the tax posts we have put up over the years that cover similar topics.

California:

California is governed by a solid Democratic majority with a Republican governor. The California situation is different than most states in that a 2/3 majority is needed for tax increases, meaning that tax increases are difficult to pass through the legislature. California also has a “proposition” culture, where items are put directly to the voters (such as the famous “Proposition 13” which limited growth in property taxes).

California has a very high “graduated” state income tax (meaning that it is tied to the Federal tax liability, with some exceptions) and this forms a significant portion of their total tax collections. Per this very helpful site, in 2008 47.5% of their total tax revenues came from the state income tax, above the average of 35.7% for all states as a whole. However, this percentage is lower than its total impact – some states (like Illinois) have an essentially “flat” 3% state income tax (at 32% of Illinois state tax burden), but California’s is graduated so that they are taking 9.3% on all “taxable income” > $47,000 and another 1% on all income > $1,000,000, making their total tax burden at 10.3% for the highest earners. California is proposing to increase this rate (highest in the US of major states) by an additional 0.25% with their latest budget proposals, to a high of 10.55% (the 0.25% increase was part of Proposition 1A, which was defeated).

Reliance on a high, graduated state income tax is a two-edged sword – during “boom” times (such as the latest economic expansion) high income payers contribute a disproportionate amount to the budget (relative to other states) – but when the stock option gains evaporated starting in 2008, this portion of the state receipts is hit harder than other sorts of taxes (sales taxes, property taxes, gasoline taxes) because income and gains can fall rapidly which immediately reduces collections.

California immediate reached for the lever of increasing sales taxes as soon as the recession hit, raising the state portion from 7.25% to 8.25%, with local additions rising it up to 10.25% in some areas. Raising sales taxes is generally viewed as a “regressive” tax measure, because it hits the poorest hardest because they consume a higher percentage of their total earnings than the rich (the 1% increase was also defeated with proposition 1A).

California also has a very high corporate tax, at 8.84%, which makes up 10% of their total tax receipts. This rate is the highest in the nation, making it a dis-incentive for businesses to move into the state (unless they are able to reduce their Federal tax burden, which will result in tax relief, through various tax strategies).

The Tax Foundation (a non-profit group) wrote an excellent analysis of the California tax situation here. Per the Tax Foundation:

These tax increases are estimated to raise $10 billion, with the extensions from Proposition 1A generating a further $6 billion. California has been struggling to close a $40 billion budget gap between desired spending and expected revenues in its $92 billion 2009-10 budget.

Proposition 1A was defeated, leaving the state’s finances in a precarious state as far as balance of payments, although the state faced a huge budget gap in any case.

The overall California situation for taxes is as follows:

1) California is extremely unfriendly to businesses, with the highest Corporate tax rate in the nation. As the Tax Foundation noted, Nevada is next door with a Corporate tax rate of zero, as opposed to 8.84%, along with an infinitely friendlier overall business climate
2) California depends on extremely high individual earners and a high income tax rate for their budget – but these earnings can change rapidly with the evaporation of capital gains and those earners can move their domicile to other states (Nevada, Florida, Texas) with much more favorable state income tax rates
3) the California state sales tax is very high and regressive, since this falls disproportionally on the poor
4) one area of relative favor for California from a state tax revenue perspective is that state property tax collections are low, a legacy of Proposition 13. California was ranked #10 (in 2006) in overall property tax collections, still high relative to other states but less than half of the New Jersey costs

Even with these extremely burdensome tax levels, state government spending galloped far in advance of collections, leaving a gigantic budget deficit. A recent string of proposals to “fix” the budget gap were defeated in May 2009. As of today, the Democratic assembly has decided to push forward a budget that contains tax increases without the required 2/3 votes, which the Governor says he plans to veto, or the state will start issuing IOU’s. Per the article in Business Week

The main culprit is the recession, which caused a 34 percent plunge in personal income tax revenue during the first five months of the year.

California now has an “A” rating on their debt, lowest in the nation, per this Reuters article. The state has $57 billion in bonds outstanding, and one way that they may pay bills in the short term is to go into the bond reserves for debt, which is likely to reduce their debt rating further (particularly for those issues), which also increases their long term interest rate burden since they will need to raise rates to raise the same amount of debt. Per the article, the debt rating agencies (Moody’s and S&P) are on an alert for a “multi-notch” downgrade, if these events occur.

Generally it is safe to summarize that the state has installed an unsustainable array of programs balanced on very high state income, state corporate and state sales taxes. These rates are amongst the highest in the nation and from all outward indications (to prospective businesses or residents) they are going to continue to rise. Their debt burden, per above, appears to be unsustainable and they have the lowest ratings in the nation, with rates subject to fall further should they take steps that amount to “raiding” their pre-funded debt to pay current obligations.

Keep watching to see how this turns out. For US competitiveness, this is a grave threat, because California used to be a driver of entrepreneurship and great companies. While there are many reasons for the decline, an intentionally non-competitive tax policy (driving away businesses and high-income residents) and loading the state with debt to support a massive array of public programs that are unsustainable.

It is also safe to say the for future potential residents the Democratically controlled legislature continues to push for tax increases, meaning that the future will look more and more like the past, and flashing a big red warning light to anyone contemplating an investment or move to the state.

One favorable kudos for California is that they have a great web site and a series of PDF’s and charts for their 2009-10 state budget – go here and read through it if you have the time.

Cross posted at LITGM