The Metropolitan Forum Project Reviving Citizen Civic Engagement

Davis' tax plan could leave state more vulnerable to next downturn

By Mark Gladstone

San Jose Mercury News

March 2, 2003

With the state budget hemorrhaging red ink, Gov. Gray Davis in January floated a controversial plan to raise taxes by more than $8 billion to help balance the books.

But while Davis' plan would raise heaps of cash, it fails to address many of the weaknesses in California's tax structure that helped trigger fiscal disaster in the first place.

Though he preaches the gospel of tax reform, Davis is proposing that the state rely even more heavily on volatile sources of revenue -- especially income taxes on the highest wage brackets, which are subject to steep drop-offs when the economy flattens. And he is leaving intact numerous loopholes and breaks embedded in the state tax code for reasons of politics, not economics.

The result: California could be even more vulnerable to the next downturn.

``While tax reform is mentioned by the governor, the proposals he made are not really reforms,'' said Steve Sheffrin, an economics professor at the University of California-Davis.

In releasing his budget, Davis broached some tax reform ideas -- such as reviewing tax breaks every five years. He also talked of the state's need ``to achieve a more stable mix of major revenue sources.''

But the governor believes that revamping the system -- which he'll detail in April and May -- must occur after the budget is fine-tuned.

``This is sort of like a horse race,'' he told reporters last week. ``One horse gets out in front and another horse catches up later.''

Davis' tax proposal unveiled in January would raise $4.6 billion by adding 1 cent per dollar to the sales tax; $2.6 billion by increasing the income tax on the wealthiest Californians; and $1.1 billion by hiking the cigarette tax by $1.10 per pack.

Under his scheme, a Santa Clara family with a household income of $75,000 would pay, on average, $188 a year more in sales tax; a San Jose smoker who puffs a pack of cigarettes a day would spend $400 a year more; an Atherton resident who earns a million a year in taxable income would pony up an extra $27,000 in income taxes.

Income tax

• Plan would hike levy on the wealthiest

At the height of the economic boom in 2000, income tax revenues from capital gains and stock options quadrupled to $17.6 billion. But the economy collapsed and those revenues plunged to around $5.7 billion.

The wild swing is at the crux of the state's $34.6 billion budget problem.

Now, Davis proposes duplicating a deal worked out a decade ago by his Republican predecessor, Pete Wilson, who also faced a huge deficit. He would increase taxes on the wealthiest Californians -- a solution that may be politically palatable and socially sensitive, but one that some critics question because it relies even more greatly on the incomes that fluctuate the most.

``If he's just looking for dollars, increasing the personal income tax is one way to go, but it's not a long-term fix,'' said Annette Nellen, a tax professor at San Jose State. ``One problem is it's so progressive. We've got so few individuals paying a large amount of tax. When their income drops, we feel it.''

In 2000, when the state took in $40 billion in income taxes, 54 percent was generated by taxpayers who earned $300,000 or more -- and nearly 38 percent was paid by millionaires, who file less than one-third of 1 percent of tax returns.

Elizabeth Hill, the non-partisan legislative analyst, last month suggested alternatives to Davis' proposal, including a 5 percent flat tax on all earners.

Her proposal would lessen the state's dependence on the wealthiest taxpayers -- thus providing stability -- but it also would spread the burden to lower-income taxpayers.

Sales tax

• Consumers spending more on services

In the past two years as the economy has sunk, sales tax revenues have dipped slightly statewide, and dropped more significantly in the Bay Area. In San Jose, for example, the city estimates that it will fall more than $30 million -- 19.8 percent -- from the level two years ago.

But it's not just the economy that has made sales tax revenue more volatile over the past decade. Consumers also are spending a greater percentage on services, such as health club memberships and tax advice, which are not subject to the sales tax. They're also buying goods online, which in many cases lets them avoid the tax.

The services share of California's gross state product -- the value of goods and services produced in the state -- climbed from 17 percent in 1980 to 24 percent in 2000, according to the state Department of Finance.

Looking at it another way, Hill, the non-partisan legislative analyst, recently noted that in the mid-1980s taxable sales represented close to 50 percent of personal income. Currently, they are less than 40 percent.

Hill suggests the state consider broadening the sales tax base. For instance, she said, taxing entertainment activities, such as admission fees and cable TV, could bring in hundreds of millions of dollars.

Davis said he is willing to consider a proposal that would force many online companies in California to charge state sales tax.

There also is a desire among some reformers to revamp the complex inconsistencies in the sales tax on goods.

``If I buy yogurt at the grocery store, there's no tax but if I buy it at a restaurant I pay tax. It could be the same yogurt in the same container,'' said Bill Leonard, a newly minted member of the state Board of Equalization, which administers the sales tax.

``The problem with all law, and sales tax law is the biggest example, is that it's not flexible enough to follow the marketplace,'' said Leonard, a former GOP legislator.

Davis' plan, however, simply raises the rate on existing taxable items -- a boost that Hill worries could prompt more Californians to buy out-of-state and trigger more ``outright tax evasion.''

And some believe such an increase also is economically counterproductive.

``We need consumer spending,'' said San Jose car dealer Steve Lewis who strongly opposes the governor's sales tax idea. ``We need to get this place going. I just don't think a tax that taxes people's spending money is the way to do it.''

Cigarette tax

• Two-prong attack has some benefits

The most popular of Davis' tax proposals is the levy on a pack of cigarettes, according to a Public Policy Institute poll released last week.

Under Davis' plan, the tax would go up from 87 cents a pack to $1.97, partly as a way to curb smoking as well as to raise more than $1 billion annually.

But the cigarette tax has its detractors. It is criticized for disproportionately hitting the poor, and Hill also fears the steep increase -- the sharpest in state history -- could spur smuggling and tax evasion.

And, just like the income and sales tax, the cigarette tax has some built-in instability. Though the tax will raise money, the state also assumes it will curtail sales.

At 58, Charles Janigian has been smoking since he was a teenager. If the $1.10-per-pack tax is approved by the Legislature, the San Jose businessman says it will probably force him to scale back on his puffing.

``Personally, as a smoker, it's probably going to cause me to think twice about smoking a pack a day,'' said Janigian, president of the California Association of Retail Tobacconists. ``It might go down to a pack every other day, but it's certainly not going to stop me from smoking cigarettes.''

But even if smokers cut back and tax revenues fall short of projections, the state still might come out ahead in the long-term because fewer people with smoking-related diseases should cut Medi-Cal costs.

Other proposals

• Property, corporate taxes left alone

Though tough on smokers, consumers and the wealthy, the governor's tax plan would not touch several large but politically-charged pots of money.

Davis did not, for example, suggest tinkering with property taxes, which are a more stable revenue source. He also ignored corporate taxes, which after levies on income and sales brings in the largest source of general purpose revenue, but are also unstable.

There is another possible tax increase on the horizon. Though Davis has vowed to veto it, Democrats in the state Assembly have pressed for fully restoring the vehicle license fee, money that helps local government. In the 1990s, it was lowered by two-thirds as the economy boomed.

That fee -- which would triple if it goes back up -- and the others proposed by Davis face full-throttle opposition from Republicans, casting doubt on whether he'll be able to muster the needed two-thirds support necessary to get legislative approval.

GOP lawmakers assert that before any new taxes are imposed, the state needs to take a fresh look at how it's spending money and possibly place a lid on expenditures.

On Wednesday , GOP Senate leader Jim Brulte of Rancho Cucamonga unveiled the Senate Republican proposal. It included no tax increases, relying entirely on cuts and spending freezes. It also included no tax reforms.

But whether or not Davis and the Legislature revisit reform in the future, many feel it's a foregone conclusion that tough times mean tax increases.

``It's part of the nature of the beast,'' said Harold Alex, 56, an unemployed San Jose technician. ``When things go bad, whether we like it or not, something is going to happen about taxes.''

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