Commentary

Fixing California

This article was published in the Washington Times, Aug. 24, 2003.

The Washington Times’ columnist Don Lambro recently wrote that some supply-siders (not me) were wary of Arnold Schwarzenegger because adviser Warren Buffett said it makes no sense to pay more property taxes on his $500,000 house in Omaha than on his $4 million house in Laguna Beach.

The Buffett remark bothered many but just struck me as naive. Having lived in California for 27 years, I assumed a half-million bucks in Omaha probably buys a much nicer place than $4 million in a California beach town. Mr. Buffett has owned that California house for decades, so he didn’t pay much for it.

Ever since the 1978 Proposition 13, California’s constitution requires that property taxes be initially based on what you paid for a house (not on what you might sell it for) and annual increases are limited to 2 percent. Since all houses eventually are sold, this works out surprisingly well. The assessed value of California property rose 4.8 percent a year from 1990 to 2002, virtually identical to the 4.9 percent annual growth of personal income. Mr. Schwarzenegger obviously understands this, though Mr. Buffett did not.

What made no sense was for Mr. Buffett to even hint about a policy change that would require an unlikely change in the state constitution. There are much easier and quicker chores to attend to. Mr. Buffett’s blunder demonstrated it made no sense for Mr. Schwarzanegger to go all the way to Nebraska in search of economic advice from a noneconomist. The tens of thousands who flee California taxes each week are not heading for Nebraska, which the Tax Foundation rates as having the 45th worst tax climate in the nation (California is 49th).

If Mr. Schwarzenegger were looking for economic advice from a Democrat, he could have called Robert Hall at Stanford University, co-architect of the Hall-Rabushka flat tax. If he would settle for a Republican, he could have asked Mike Boskin, David Henderson, Art Laffer or Ben Zycher. There’s plenty of local talent, and not just among such older giants as George Shultz. Indeed, Mr. Schwarzenegger himself seems fundamentally sound on the critical tax and spending issues, and so do rivals Bill Simon and Tom McClintock.

The trouble with California taxes is not that property taxes are too low, but that income and sales taxes are way too high. The personal income tax rates are high enough to provoke an exodus of skilled people — a “brain drain.” Corporate tax rates are high enough to provoke an exodus of business capital — “capital flight.” Sales tax rates are high enough to provoke wholesale tax avoidance.

California’s tax revenue per capita ranks as “only” the sixth-highest in the nation, but comparing tax revenues understates the damage. The state’s uncompetitive tax rates ultimately yield more economic distress and less revenue because they erode the tax base. Profitable companies leave the state, while companies with chronic losses stay. People in top tax brackets leave the state, while nontaxpayers who expect to gather tax-financed benefits arrive in droves.

In 1991, as State Sen. Tom McClintock recently recalled, “An 18 percent increase in the sales tax and a 15 percent increase in upper brackets of the income tax were supposed to produce a net of $7 billion of new revenues. But they didn’t. … We didn’t take in $7 billion more — we took in $1 billion less. We lost another $1 billion the next year.”

Indeed, real per capita personal income fell 5.6 percent during the three years following the 1991 tax increase, even though the national economy was recovering. Californians now arguing for another tax increase — notably Lt. Gov. Cruz Bustamante — are conveniently forgetting what happened after that was tried in 1991.

There is obviously plenty of room for spending cuts, since California’s budget grew by 44 percent in the past four years. The appearance of tiny spending cuts in the new July 29 budget was a fraud. The state’s legislative analyst’s office reports, “Most of this increase can be explained by four factors: the [vehicle licensing fee] rate increase … new federal funds, borrowing to cover the state’s 2003-2004 pension obligations and the MedicCal accounting shift from an accrual to cash basis.”

There was predictable whining after fees at the California State University and University of California were finally raised a bit after remaining unchanged for eight years. California has long been overtaxing some residents so people like me could get a valuable college education almost for free. Once that education begins to raise our future income, however, many of us leave the state to avoid steep taxes.

The 9.3 percent income tax also applies to capital gains (though Bill Simon wants to cut it to 5 percent), which is one reason aging investors like me could never be enticed to bring our capital back to California. Sell stock, and the state will hit you with a big tax — don’t sell, and they’ll get you with an estate tax. But that only works if intended victims don’t know how to vote with their feet.

California’s personal income tax is 9.3 percent on income above $38,291 — a definition of “rich” that could only make sense to Hollywood liberals. That brutal tax rate makes it difficult for companies to recruit and retain skilled people without paying higher salaries. That, in turn, raises the cost of doing business for skill-intensive industries and makes them uncompetitive until they move jobs out of California.

California’s corporate tax is above 8.8 percent — much higher than any nearby state. The corporate tax in Washington and Nevada is zero. Companies with chronic losses don’t mind staying in California, but many profitable firms become much more profitable (after taxes) by relocating.

The sales tax varies locally from 7.25 to 8.5 percent, which is high enough to foster significant tax avoidance (e.g., shopping in Oregon, which has no sales tax, or ordering from another state). States with lower sales tax rates than California collect more money from this tax. They also collect more income taxes because a lower sales tax helps in the building of profitable retail businesses, who hire more people.

California never will be able to compete well for new businesses and the skilled people those firms require until its tax system becomes reasonably competitive. At a minimum, that means sales and income tax rates no higher than 6 percent.

A state with no sales tax like Oregon can get away with a higher income tax. A state with no income tax like Washington can get away with a higher sales tax. But Sacramento’s politicians have been foolishly rapacious with both income and sales taxes. That is killing the state economy, and it has to stop.

There are two or three gubernatorial candidates who seem to get it. I suspect or at least hope Arnold Schwarzenegger may be one of them.

Alan Reynolds is a senior fellow with the Cato Institute and a nationally syndicated columnist.