California Tax Changes: Math versus Strategy

Here are examples of how the strategy approach could identify tax system changes that help generate the requisite revenue while also helping California reach its goals in three key areas: economic, societal and environmental.

Economic: States want good-paying jobs and that requires a favorable business climate. In judging a business climate, one of many factors a business considers is taxes. At 10.3%, California has the highest individual income tax rate among the states. And, California ranks in the top ten of states with the highest corporate income and sales tax rates. These high rates harm California’s business climate.

The math approach easily leads to tax rate increases to address a budget shortfall while ignoring the harmful effects to the business climate. In contrast, the strategic approach looks for ways to lower high tax rates. Rates could be lowered without creating new budget shortfalls by eliminating special deductions, exemptions and credits that are outdated, favor one group over another or are overly complex. Such changes also help improve the business climate by making the tax system more simple and fair.

Societal: States want a decent standard-of-living for their residents. To help achieve this, tax systems should be designed to be fair. Challenges that hinder decent living standards for Californians include high living costs and millions living in poverty.

The math approach of tax rate hikes moves California farther behind in reaching its societal goals. For example, a higher sales tax rate is more detrimental to lower income households than higher income ones.

The strategic approach examines current tax structures for inequities. For example, rather than increasing the sales tax rate, it should be lowered while broadening the base to include personal services, entertainment and intangibles. The present exemption for these items, which are more likely to be purchased by higher income households, creates inequities that are made worse with a rate increase.

A strategic approach might also consider a refundable tax credit to assist low-income households. Currently, the federal government and many states use an earned income tax credit to improve living standards.

Environmental: California has established aggressive goals for reducing greenhouse gas emissions. The tax law can help in reaching these goals. Burning fossil fuels is the chief cause of greenhouse gas emissions. Taxes that increase the cost of fossil fuels will decrease their consumption (a phenomenon recently illustrated when gas prices increased). Such taxes also cause polluters to pay for the damage they cause.

While the math approach could lead to an increase in the gas tax rate, the strategic approach would also consider new taxes, such as an oil severance tax (currently proposed by Governor Schwarzenegger to bring California in line with other states, not necessarily for its relevance to California’s environmental goals) and some type of carbon tax. For example, instead of increasing an already high income or sales tax rate, a utility tax could be imposed on households that use utilities beyond what is used for a 1,200 square foot home with four inhabitants. Or a gas guzzler tax could be imposed on vehicles that get less than a specified number of miles per gallon.

While the math approach can address California’s budget problems in the short-term, it will not resolve them for the long-term or improve our tax system. Changes to our tax system must be identified using the strategy approach so that the system helps rather than hinders achievement of state goals and provides an appropriate and sustainable fiscal structure for the state.

Annette Nellen, CPA, Esq. is a professor of accounting and taxation at San José State University. For more information on California and federal tax reform, see www.cob.sjsu.edu/nellen_a/TaxReform/21st_century_taxation.htm