California's Non-Comeback

An old adage cautions, "If something seems too good to be true, it probably is." Such is the case with the now-famous "California Comeback."

Faced with a large budget deficit, California passed tax increases on the wealthy, balanced the budget, generated a surplus of more than a billion dollars, and seemingly solved its fiscal woes. But a closer look reveals this to be more hype than reality.

For example, in its budget calculations, California does not include the state's unfunded pension liability -- about $1 trillion. If California used the accounting standards private companies must use and factored in this debt, it would not appear to be in such good shape.

Another main driver of the supposed California surplus is the 50 percent increase in personal-income-tax revenues from 2012. The state used these increased revenues as the baseline for its calculations, but its tax receipts will probably fall soon, for several reasons.

At the end of 2012, investors faced an incentive to sell as much as possible -- if they realized their capital gains before 2013, they would avoid the increased taxes they would face from the combined effects of the Affordable Care Act and the pending fiscal-cliff negotiations. This enormous sell-off triggered a one-time spike in capital-gains revenue, and thus in the capital-gains taxes paid to states and the federal government. Since the state of California does not distinguish between ordinary income and capital-gains income, the revenue spike was particularly pronounced there: All the capital-gains income was fair game for the state's personal-income tax.

A little-known provision in the Proposition 30 tax increases that voters approved in November 2012 contributed to the spike as well. Unlike the vast majority of tax-law changes, Proposition 30 applied retroactively: It was passed in November 2012 but increased personal-income-tax rates on all money earned since January 1, 2012. This ex post facto confiscation of wealth left individuals and small businesses with little time to plan for the changes, and many had to pay the higher rate without thoroughly exploring their other options. Next year, the state won't be so lucky.

Further, California faces structural tax problems that ensure its fiscal woes are far from solved. Over the past ten years, roughly 1.5 million taxpayers have moved out of California on net. This number represents a huge loss to the Golden State's economy for years to come, and now that California has the highest personal income tax rate in the country, it doesn't seem this out- migration trend will turn around anytime soon.

California has fallen into a budget trap that it has found itself in many times before. Because California relies heavily on the personal-income tax -- which supplied 62 percent of the state's total revenue in 2012 -- it experiences extreme revenue volatility. California commits to spending large amounts of money during boom times and then experiences a lack of funding when personal-income-tax receipts inevitably shrink. This perpetual funding crisis inspires calls for higher tax rates and new "temporary" taxes, and it creates uncertainty that further damages the ailing business climate.

Such is the downward budget spiral that California has set itself up for once again. Tax revenues spiked this year, but what about next year, or three to five years from now? The highest personal-income-tax rate in the nation, when coupled with a shrinking tax base, leads to a dire prognosis for California's fiscal health in the future.

In the latest edition of ALEC's Rich States, Poor States, Arthur B. Laffer and his two coauthors examine California's current tax system and offer a solution: a flat-rate personal-income tax. Lowering rates and broadening the base is the cornerstone of good tax reform. And while ultimately moving away from income taxes in favor of consumption taxes is ideal, it will not likely be politically feasible for California anytime soon.

True, structural tax reform is the only real hope the Golden State has left.

Ben Wilterdink is a research analyst at the American Legislative Exchange Council Center for State Fiscal Reform.

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