How California Can Get Its Groove Back

A tax reform that can promote economic growth and steadier state revenues.

MICHAEL J. BOSKIN JOHN F. COGAN

For many decades California residents enjoyed a rising standard of living, an outstanding education system, and unprecedented upward mobility. Yet now, despite state leadership in technology, agriculture and entertainment, California's economy radically underperforms. The unemployment rate, 12.2%, is the nation's third highest. Residents are leaving the state—144,000 more than entered last year—for better opportunities elsewhere. And the state's bond rating is dead last.

While uncontrolled spending, excessive regulation and litigation have helped create a dismal business environment, the tax system is central to the state's economic woes. The top personal income tax rate (also levied on capital gains), the sales tax rate, the corporate tax rate, and the gas tax are all at or near the highest of any state. And the top 1% of the state's income earners pay almost half the income taxes: Thus the state experiences boom-bust cycles of exploding revenues and spending in the good times, followed by a collapse in revenues and emergency retrenchment in recessions. Ironically, California's progressive tax and spending policies now threaten the state's ability to fund everything from parks to prisons, education to health.

The excess spending during booms is never entirely cut back during the busts. Instead, the state also raises taxes and borrows temporarily. If spending had increased at the rate of population and inflation since 1996, recession-level revenues plus reserves would now be more than sufficient to balance the state budget, which is now back in the red, despite temporary tax hikes and spending cuts.

Recognizing the problem, Republican Gov. Arnold Schwarzenegger and Democratic legislative leaders Darrell Steinberg and Karen Bass appointed a bipartisan Commission on the 21st Century Economy in December 2008 to provide recommendations for a reformed tax code that would be far less volatile and substantially more competitive and pro-growth. While the two of us believe California needs to control and reform state spending, and to reduce as well as reform state taxes, we and the commission's other appointees were limited by the executive order creating the commission to changes on the tax side of the state budget that would neither raise nor lower the state's revenues on average over the business cycle.

The commission's majority report recommendations were made public yesterday. They include a sweeping overhaul of the personal income tax code that reduces tax brackets to two from six; eliminates all deductions and credits other than for charity, mortgage interest and property taxes; and cuts the top statutory income tax rate to 6.5% from 9.3%. Most taxpayers would receive a 25%-30% tax cut and all would pay less. The commission also recommends abolition of the state's corporate income tax and the elimination of most of the state sales tax that finances the state's general revenue fund (as opposed to special funds for transportation, etc.). Finally, to replace the lost revenue, the commission recommends a broad-based, low-rate state value-added tax (VAT), collected on business net receipts (revenues less purchases from other businesses, including immediate expensing of capital), that is capped at 4%.

These reforms will reduce the volatility of state revenues by 40% (using commonly accepted measures) mostly by reducing the reliance on personal and corporate income taxes, and moderate the current tax code's extreme progressivity. They also will result in a $7 billion net tax cut per year for Californians without raising taxes on any income group, as some of the new VAT would be borne outside the state and more of Californians' taxes would be deducted against federal taxes.

Proposals to scale-down existing taxes and replace revenues with a new tax raise legitimate concerns. The same political process that erodes the base and raises rates for income taxes might be repeated for a VAT. Such taxes have been used to grow government (for example, in Western Europe) with new taxes added without reducing others.

Some protection against this outcome is provided by California's wise constitutional requirement for a two-thirds vote for the budget and tax increases, and by the commission's recommendation of immediate abolition of the entire corporate income tax as the new business tax begins phasing in. A hard spending cap would be still better.

California can once again lead the nation, this time in moving away from ever-higher personal and corporate tax rates and excessive roller-coaster spending. If not, California and then the nation will lose the dynamism, growth and opportunities for rising living standards that once were the state's hallmark and crowning achievement.

Mr. Boskin is a senior fellow at the Hoover Institution and a professor of economics at Stanford University. Mr. Cogan is a senior fellow at the Hoover Institution and a professor of public policy at Stanford University. The commission's report is available online at www.cotce.ca.gov.