No Deficit of Ideas for Reforming Budget

Staff Reporter

It's the most vexing financial problem facing California today and has been at the heart of the recall effort: how to bring more money into state coffers and not be so dependent on volatile income taxes?

At the peak of dot-com mania, the state drew more than 20 percent of its overall revenues from the sale of stock options by high-income taxpayers. When the bubble burst in late 2000, state revenues collapsed, creating one of the most dramatic percentage swings in revenues of any state in history.

"We have these huge peaks and troughs," said state Controller Steve Westly. "The private sector can respond to such swings quite rapidly by laying people off or focusing on different markets. But the public sector cannot, and that's a major reason we find ourselves in the mess we are in today."

As the fiscal crisis deepens, calls have increased for an overhaul of the tax structure so that the state won't have to endure such huge revenue swings in the future.

In his State of the State speech last January, Gov. Gray Davis said he wouldn't sign a budget unless it contained such an overhaul. When partisan gridlock on the budget intensified, Davis backed off this pledge. He settled instead for the appointment earlier this month of former President Bill Clinton's budget director, Leon Panetta, to head up a commission to examine how to balance out the state's feast or famine cycles. Panetta said he intends to come up with recommendations by the end of the year.

Whatever the outcome of next week's recall election, the issue will not go away. Pressure to reform the state's fiscal structure may actually grow more intense if legal challenges to the borrowing of $13 billion in bonds are upheld.

Taxing questions

Last week, Sacramento Superior Court Judge Thomas Cecil ruled that selling $2 billion in pension bonds violated constitutional prohibitions against such borrowing without a vote of the people. The Davis administration said it intends to appeal.

Also last week, the conservative Pacific Legal Foundation brought a lawsuit on similar grounds against the state for its plan to sell $10.7 billion in "deficit financing bonds," which was the centerpiece of this year's budget compromise.

"If all this borrowing is thrown out by the courts, that will force people to take another hard look at the issue of taxes," said Martin Helmke, tax consultant to the state Senate Revenue and Taxation Committee. "Some may look at temporary tax increases, while others will look at ways the system can be changed."

Temporary tax increases may be enough to get through the current crisis until the economy picks up steam and more revenues come into state coffers. But critics note that temporary tax hikes often turn out to be permanent. And such increases do little to ensure similar crises won't erupt in the future.

Also, there has been intense opposition to tax increases from Republicans in the Legislature, as well as their anti-tax allies. They say the problem is not revenue generation but spending, and they favor the enactment of strict spending caps and spending cuts.

"If we just limited the amount of spending that we can do, we wouldn't need to make any changes to the tax system," said David Doerr, chief tax consultant to the California Taxpayers' Association. "The key is to take the one-time money completely out of the system, so it can never be spent for ongoing needs."

But elected officials have been unable to resist the temptation to spend or refund the temporary surpluses, which is one reason why attention now focuses on longer-term fixes.

There is no shortage of proposals to change the way the state collects its revenues. They fall into four broad categories: flattening out the income tax to reduce its volatility; broadening out the sales tax; swapping local sales taxes with either state income taxes or property taxes; and removing some or all of the Proposition 13 protections on commercial properties.

Services, Prop 13

The income tax in California is highly progressive, more so than most other states. Through the mid-1990s, taxes on upper income brackets of up to 11 percent were among the highest in the country. The administration of Gov. Pete Wilson pushed through reductions in these top brackets to 9.3 percent. Meanwhile, no one with incomes under $38,000 pays state income tax.

"It definitely makes sense from a public policy standpoint to flatten out this income tax," said Steven Frates, senior fellow at the Rose Institute at Claremont McKenna College. But since raising taxes on the lowest-income residents is the equivalent of political dynamite, Frates said it makes more sense to lower taxes on the wealthiest taxpayers, and making up for it with other, more stable revenue streams.

Also controversial are two other measures: expanding the sales tax to services and removing Proposition 13 protections on commercial property.

Broadening the sales tax to services has become increasingly popular in some circles as the state shifts more towards a service economy.

"If we don't examine what services are appropriate to tax, our children will be faced with a tax system that won't be able to provide for the education and other basic needs of Californians," Westly said.

But what services should be taxed? As Doerr put it, the rallying cry will be reminiscent of the old saying, "Don't tax you, don't tax me, tax that man behind the tree." The odds are, he said, the industries that end up being taxed will likely be those that are the weakest politically, not those that actually make the most sense from a fiscal standpoint.

"It may be good policy, but it's very, very difficult to get anything like this through politically," said Assemblyman Darrell Steinberg, D-Sacramento, who chairs the Assembly Appropriations Committee. "The only way you might be able to push it through is to lower the actual sales tax rate."

Altering the way commercial properties are assessed and taxed appears to have more political momentum. Currently, under Proposition 13, commercial properties are treated the same way as residential properties: they are reassessed to market value only when property is bought or sold or extensively upgraded, which occurs much less frequently than with residential properties.

Proponents of reopening this protection say corporations, especially publicly traded companies, experience changes in ownership over time that should prompt more frequent assessments. Proposals being circulated in Sacramento call for reassessments of commercial properties at least once every three or four years.

But business groups have resisted any such reassessment, saying it amounts to an extra tax on businesses. That argument carries more weight today as businesses are reeling from soaring workers' compensation costs and the prospect of having to provide health care coverage for their workers.

'Split-roll' tax

A simpler, but more controversial, option is to remove commercial properties from Proposition 13 altogether, a procedure known as the "split-roll" tax. Essentially, this would establish a separate tax system for commercial properties in which they are assessed annually at market rates. While this would generate upwards of $4 billion in additional revenues, it's run into stiff opposition any time it has been proposed.

"California has always taxed all property the same, whether commercial or residential," said Doerr. "Changing that now would be a big, big mistake that would make it even more expensive to do business in the state."

Another concept gaining steam is swapping out certain local and state income taxes. Under the current convoluted system, all income taxes go to Sacramento, as does a large share of property taxes. Meanwhile, a large share of sales taxes, which tend to be more stable, goes to local governments. This has prompted cities and counties to chase after big-box retailers, auto malls and other retail tax generators.

For the past couple of years, Steinberg has carried a proposal to swap property taxes that now go to the state with sales taxes that go to cities. "This is absolutely crucial for the long-term development of our cities and counties," he said. "And it also gives the state a more stable source of funding."

But opposition from the League of Cities and other local government lobbies has been intense. They fear losing the only revenue source now guaranteed to them. And they are wary of promises to replace those revenues with property taxes, especially considering that the state took away $3 billion in local property taxes in the early 1990s to balance its own books.

Such swap proposals present another problem: their very complexity slows them down.

"It's so difficult to do these types of complicated swaps, because there are so many winners and losers. You've got one set of winners and losers in the short term and a whole different set in the longer term as you factor in growth," Helmke said.

That is the basic underlying problem with almost every change that's been proposed to the state's tax structure. With each proposal, there are winners and losers, and the losers exert tremendous pressure to stop them.

But given the unique convergence of the recall election, the budget crisis and the possible court rulings limiting the state's ability to borrow, this may be the best time in a generation to make substantial changes.

"There is a window right now, with this recall election and the pressure on the state budget, to make some of these longer-term changes," said Kim Rueben, a research fellow with the Public Policy Institute of California. "That window must be snatched."

Plethora of Proposals

Ideas being floated to stabilize California's revenue flows:

- Extend state income tax to lower brackets

- Boost top income tax brackets

- Extend sales tax to services

- Tax sales over the Internet

- Boost sin taxes

- Tax swap to share income, sales taxes between state and local governments

- Tax swap to share sales, property taxes between state and local governments

- More frequent assessments of commercial property values

- Removing commercial properties from Prop 13 and assessing them at market rates

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