Buy a new suit in California, you pay sales tax. Take it to a dry cleaner, and the transaction is tax-exempt.
With the state's budget deficit at $15 billion, some state officials argue it's time to end the tax-free ride on dry cleaning and many other services.
Ideas are circulating in the Capitol to overhaul the state's tax structure as California's latest budget standoff drags on. The goal isn't simply to raise more money. Officials also are trying to smooth out the revenue fluctuations that can turn California's treasury into a cash gusher when times are good and a desert when the economy falters.
Advocates say much of the problem lies with California's huge reliance on personal income tax. It's notoriously volatile. A huge decline in 2002 led to the budget battle and recall of Gov. Gray Davis a year later.
This time around, things haven't been as dramatic. Income tax payments have continued to grow, but at a much slower rate than three years ago, when the real estate and stock markets generated big windfalls. Revenue hasn't kept pace with spending growth, and legislative Democrats and Republicans are at an impasse that has left the budget more than two weeks overdue.
"It's not the first time the state's been in this situation," said Terri Sexton, a California State University, Sacramento, economist who advises the state on fiscal policy. "I think everybody agrees about the volatility of our income tax base, and here we are going down this same path again."
Sexton and some elected officials want California to rely more heavily on sales tax, which is more dependable. Instead of raising rates, which now top out at 8.75 percent, some officials are urging the Legislature to start imposing the tax on a broad range of services that are currently exempt. California taxes fewer services than most other states.
Quick fix unlikely
A quick overhaul of the tax structure isn't likely. Although Gov. Arnold Schwarzenegger and Assembly Speaker Karen Bass want to form a blue-ribbon commission to study the tax code, that won't happen until after the current budget is passed.
And even once the commission gets going, history says a thorough revamp won't pass easily. The idea of broadening the sales tax base has been floated before without much success, and may face fierce resistance in the Legislature.
Service providers such as lawyers and accountants will lobby hard to keep their professions tax-exempt, arguing that some corporate clients would try to avoid the tax by outsourcing those functions to other states. Republicans want to focus more on spending cuts but might go along with a sales tax overhaul if the overall rates are lowered, making the changes "revenue neutral."
Complicating matters, experts say the Democrats' plan to close the current deficit – by raising personal income taxes on the wealthy – would probably make the system more volatile, rather than less. That's because wealthy individuals' incomes usually fluctuate madly from year to year. Republicans have vowed to oppose the Democrats' idea.
For now, Schwarzenegger wants to plug the deficit in part by borrowing against future lottery revenue and sticking the cash in a rainy-day fund. If his plan isn't approved by voters in November, he would call for a temporary 1 percent hike in the sales tax.
Fewer peaks and valleys
Beyond that, some momentum is building for a more substantial overhaul and creation of a system with fewer peaks and valleys. "No other big state has seen such volatile ups and downs in revenues," Schwarzenegger lamented in May.
California's addiction to personal income tax revenue is greater than most states' and has crept up over time. The governor's proposed budget for the new fiscal year would rely on personal income taxes for 52 percent of the general fund's revenue. In 1980, personal income tax accounted for barely a third of the pie.
With a top rate of 9.3 percent – plus another 1 percent for those earning more than $1 million – the income tax structure places an ever-increasing reliance on the rich. In 2005, the latest year available, the top 0.3 percent of Californians paid 37 percent of all the income tax, according to the Franchise Tax Board. In 1990, they paid 24 percent.
Much of it is tied to capital gains, particularly profits from the stock market and real estate. "If Google has a good year, we have a good year with the budget. If Google has a bad year, we're in the red," said Steve Maviglio, who was Davis' spokesman and is Bass' deputy chief of staff.
Maviglio said "everything's on the table" but said the blue-ribbon commission would probably not tinker with Proposition 13, which limits increases in property taxes. "It's the third rail of politics in California," he said.
Revamping the sales tax
That helps explain the movement toward revamping the sales tax. The Democrat who chairs the Board of Equalization, the agency that collects sales taxes, is advocating a broader system to cover things like sports ticket sales and auto repair. The chairwoman, Judy Chu, told legislative leaders that California could raise $2.68 billion a year charging sales tax on services taxed by a large number of states.
Experts say California's sales tax made sense when it was instituted in the 1930s, when the economy was largely about producing goods. But now "much of our disposable income goes to services," said Fred Silva, senior fiscal policy adviser at California Forward, a bipartisan budget policy group led by former White House Chief of Staff Leon Panetta.
While the service sector has grown, California's tax structure hasn't kept up. The state has one of the highest basic rates in the country, at 7.25 percent, but its base is among the narrowest. Sales tax accounted for only 27 percent of general fund revenue in the just-completed fiscal year. A decade ago, it was 35 percent.
Other states, meanwhile, have moved in recent years to broaden the sales tax base. Texas taxes pet grooming and plumbing, Hawaii taxes haircuts and fur storage, Delaware taxes investment counseling, diaper delivery and shoe repair. California taxes none of those. Only 10 states tax fewer services than California, according to a 2005 study by the Federation of Tax Administrators.
California does tax 23 services, the federation said. They include gift wrapping, tuxedo rentals, graphic design and tire recapping, said Board of Equalization spokeswoman Anita Gore.
Splitting tax hairs
Sometimes the distinctions about what is or isn't taxable are almost comical. Currently in California, alterations performed on new articles of clothing are taxable. Alterations or repairs to old garments are tax-free.
Similar hairsplitting took place when the Legislature taxed snack food sales in 1991. Regulators went into overtime figuring out what to tax before deciding that muffins, for instance, were exempt. A year later, voters repealed the whole law, even though it raised more than $300 million.
Lawmakers can expect more resistance if they try again to broaden the sales tax base.
"At a time with the economy the way it is now, this just adds one more burden on the consumer," said Jim Douglas, owner of Prestige Cleaners in Sacramento and a board member of the California Cleaners Association.
"It certainly would be detrimental, no question."
Plans for major changes to the sales tax have surfaced off and on for 20 years. A two-year-long study, ordered by the Legislature and completed in 2003, advocated a major broadening of the tax base – and was promptly ignored.
In 2005, a bill by Assemblyman Joe Coto, D-San Jose, to tax services to help pay for education was effectively killed by lobbyists.
"We've got a pretty big lobby," said Sacramento accountant Michelle Elder, president of the Society of California Accountants. "Between the attorneys and the accountants, just the two of us alone, we said, 'Not a chance.' "
She believes taxation might prompt some clients to take their accounting business out out of state.
"I don't think the public is ready to pay tax on services," she said.
Call The Bee's Dale Kasler, (916) 321-1066.