California likes to tax the rich. A lot.
The top 1 percent of earners provides about half of personal income tax revenue, by far the largest source of funding for the state government.
The downside is that when the stock market goes bust, so does California’s budget. Experts, from Gov. Jerry Brown on down, are well aware of the problem, yet the politically perilous task of overhauling the volatile tax system has failed to gain traction for years.
Can Gavin Newsom change that? Among a laundry list of other big and ambitious policy goals, the Democratic governor-elect has expressed interest in revising the state tax structure. With revenues booming and a historic Democratic supermajority elected for the next legislative session, this may be his best chance.
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It’s a priority for the business community, which feels burdened by mounting tax proposals as local governments look for ways to close their lingering budget gaps. But Newsom could face immense resistance among liberal supporters, who worry that any changes will push more of the tax burden onto lower-income residents.
“Nothing, nothing, no issue more vexing than this one, because everyone has a trophy on the wall,” Newsom told reporters aboard his campaign bus last month, shortly before his election.
“Gov. Brown had no interest in pursuing it. And I would argue there’s no greater political mind in our lifetime than Gov. Brown,” he added. “So I’m not naive about this, but I am not going to neglect this issue, and I’m going to lean into it and express a desire to see if we can possibly come together across our differences.”
California has passed comprehensive overhauls of its tax system only twice in state history, according to a 2016 report by Controller Betty Yee. The last time was in 1935.
But since voters approved Proposition 13 in 1978, radically limiting property taxes, lawmakers have constantly fiddled with the tax code, looking for ways to make up for the major drop in what was once California’s primary source of funding.
Over the past two decades, the state has increasingly come to rely on personal income taxes, which now comprise more than two-thirds of the general fund, according to the Legislative Analyst’s Office. And because of the progressive tax structure, wealthier Californians pay a larger share of their income than poorer Californians in taxes.
A significant portion of that comes capital gains, such as investment returns from the stock market. So when the economy is doing well, California reaps the reward at higher levels than other states, and when the economy is bad, it suffers disproportionately. The LAO estimated last year that the income for the top tenth of earners in California is seven times as volatile as the remaining 90 percent.
Newsom said he believes in a progressive tax code, but he wants to avoid a repeat of the staggering cuts from the economic recession a decade ago, which he said fell the hardest on those who could least bear it: women, children and minorities reliant on social services.
“Volatility is not our friend, it’s our enemy,” Newsom said.
Previous efforts to even out California’s fiscal fortunes have floundered.
In 2009, a commission formed by then-Gov. Arnold Schwarzenegger in the wake of the recession reviewed the tax code. It recommended scaling back personal income tax rates to just two brackets — 2.75 percent for incomes below $28,000 and 6.5 percent for those above — and replacing the corporation tax and state sales tax with a 4 percent tax on business activity, better capturing a modernizing economy that has shifted away from manufacturing and tangible goods. Criticized from all sides, the proposal went nowhere.
This past legislative session, Sen. Bob Hertzberg, D-Los Angeles, introduced a bill to lower the sales tax by 2 percent and replace it with a 3 percent tax on some business services, such as legal representation and accounting. The measure did not even get a committee vote.
As Newsom prepares to take office, business groups are prioritizing a campaign to flatten the tax burden to a broader spectrum of sources. Bracing for a possible war over property tax limits on the 2020 ballot and a growing number of sales tax hikes in cash-strapped cities and counties, they argue that California’s impulse to raise taxes on corporations to balance the budget is another factor that makes it difficult to operate in the state.
Rob Lapsley, president of the California Business Roundtable, said more certain tax conditions would improve the business climate. He pointed to Newsom’s own history of founding companies, like PlumpJack winery in Napa County.
“His experience is unequivocal in teaching him that. He should know that,” Lapsley said.
The business community wants Newsom to consider an arrangement that allocates a greater portion of the money to the local level, Lapsley said. Most importantly, with state coffers overflowing, it should be revenue-neutral.
“We don’t need any new taxes, period,” he said.
That could be a challenge for Newsom’s policy agenda, which includes such budget-busting goals as universal preschool and health care for all. Liberal groups are also likely to put up a fierce opposition.
Jessica Bartholow, policy advocate at the Western Center on Law & Poverty, said discussion of California’s personal income tax volatility often feels like a roundabout way to advocate for reducing the onus on the rich and corporations.
“Capital gains is money earned by people who didn’t earn it,” she said. “If wealthy corporations and people are having an upswing in their interests, then why shouldn’t the poorest people?”
Bartholow said she is not opposed to overhauling the state tax structure, but changes should aim to even out the impact of a bad economy, through policies like a larger rainy-day fund, rather than fluctuations in revenues.
She said the state should use its tax code to address its “stark inequality.” Bigger tax credits for low-income earners could actually help the economy, she said, since they are more likely to spend that money, rather than save or invest it like wealthier residents.
California “should ride the wave of a great economy,” Bartholow said. “Maybe we could use that as an opportunity to get some of things that the poorest Californians need to reduce the volatility in their lives.”
Newsom has not indicated what direction he would like to see a tax redesign go. He told reporters that “all of that needs to be brought to the table.” But any plan, which would need the approval of two-thirds of the Legislature, will require an enormous expenditure of his political capital.
In a statement, Senate President Pro Tem Toni Atkins said addressing tax volatility is “worthy of additional consideration, but higher taxes on middle and lower income families is not the solution.”
“California is in a much better position than any time in recent history to weather an economic downturn because we have a rainy day fund,” she said. “This has allowed us to take spiking revenues during the good years to fill the valleys in the bad years, and we expect to build on this responsible budgeting practice.”