Fixing California’s revenue system

It may not have been foremost in the minds of Californians as they completed their tax forms over the last several weeks, but the state has a progressive income tax system, meaning that the marginal tax rate increases as taxable income increases. Everyone is assessed 1% on the first $7,168 of taxable income, then progressively higher rates through six levels of income, up to 9.3% on taxable income over $47,056. Voters in 2004 passed Proposition 63, the “millionaire’s tax” for mental health services, to add a top marginal rate of 10.3% on taxable income of $1 million or more.

It has long been the position of many would-be tax reformers on the left that California’s income taxes must be even more progressive, to pump needed revenue into state programs from the highest earners and to ease the tax burden on the middle class. The very wealthy are a common target for new revenues, in part because, well, they have the money.

But the more progressive an income tax becomes -- or the greater the share of the income tax burden that is borne by the rich -- the more harrowing the revenue roller-coaster ride. That’s because the wealthy get such a large chunk of their income from capital gains and investments. Economic swings have a greater impact on that kind of income than on wages and salaries, which are the typical sources for lower and middle earners.

Would-be tax reformers on the right argue that it follows that California’s income tax should be less, not more, progressive. All earners would share the burden, and state revenues would be less volatile because they would rely less on the year-to-year fortunes of the wealthy.

There are other solutions: increases in sales taxes, which are perhaps the most regressive of taxes and tend to hit low earners hardest; or increases in property taxes, which could take away from the high earners with one hand what a flatter income tax would deliver with the other. California once relied more on sales and property taxes, but today, income taxes account for about 55% of the state’s revenue.

Gov. Arnold Schwarzenegger has long argued for a larger reserve fund, such as the one proposed in Proposition 1A on the May 19 ballot, to soften the volatility of a revenue stream that relies so heavily on income taxes and, in turn, on good economic times. But a reserve is affected by volatility as well; the more the state relies on income tax revenue, the larger the reserve it must have as a cushion in lean years. That complexity makes the job of the Commission on the 21st Century Economy -- distributing the tax burden more fairly -- a little like designing a game in which even the winners are unhappy. Especially every April 15.