During the first year of Jerry Brown’s first governorship, 40 years ago, the state collected $9 billion in general fund revenues and the sales tax was the biggest source at $3.7 billion.
This year, the state is collecting more than $110 billion in general fund revenues and two-thirds of it comes from the personal income tax. Sales taxes are a distant second, scarcely a fifth of the total.
This dramatic shift in state finances from a reliance on sales taxes to utter dependence on income taxes, particularly those on high-income Californians, didn’t happen overnight. But it did happen, and the gap between the state’s two largest revenue sources continues to widen.
Perhaps the most important factor is a fundamental change in Californians’ personal financial behavior – spending relatively less on taxable goods such as cars and clothes and more on their homes, investments and untaxed services such as health care.
During the 1970s, taxable retail sales equaled well over half of personal income, but today are less than a third.
Concurrently, the progressive structure of the income tax magnified its impact. Personal income, about $7,000 per Californian in 1975, has increased seven-plus times to more than $50,000 today. But income tax revenue, about $75 billion, is 25 times what it was in 1975.
The income tax’s dominance of state finances means more revenue volatility because the incomes of the wealthy, who pay a major share of those taxes, rise and fall sharply.
Last year, voters endorsed a rainy-day fund to soak up some of those capital-gains taxes, reduce volatility and cushion the budget against future downturns. But there’s also renewed interest in the Capitol in broader tax reform to reduce volatility, with changes in the sales tax a major issue.
Widening the sales tax base by applying it to services is one option. The state Board of Equalization estimates that extending the tax, at its current rate, to all services would generate $122 billion in additional revenue for state and local governments, tripling its yield.
An increase that large would be politically unpalatable. A better approach would be to fold in services but cut the sales tax rate deeply enough to make the shift revenue-neutral, thus aligning it with the economy, providing tax relief to low-income families and allowing revenues to grow with consumer spending.
At the same time, comprehensive sales tax reform should close at least some of the loopholes in the current system. It makes no sense, for example, to treat hot food and cold food differently for tax purposes, or to tax off-the-shelf computer software while exempting custom software from taxation.