Tax “Reform”, Terminator-Style

In searching for ways of resolving California’s $21 billion budget “crisis”, some months ago Governor Arnold Schwarzenegger appointed a commission (“blue-ribbon” is obligatory here) to study ways of revamping the state’s tax code. According to him, the current system, which relies heavily on income tax receipts to fund governmental operations, produces a revenue stream that is unreliable because it fluctuates too wildly with the ups and downs of California’s economy.

Duh! Taxes from all sources rise and fall with the level of economic activity and the truth of the matter is that income tax receipts are much less volatile than, say, sales tax receipts.

Be that as it may, and fearing that the tax-study commission’s recommendations may be too timid, Governor Schwarzenegger told the editorial board of the Sacramento Bee recently that he hopes that the commissioners will be bold enough to propose “something like” a flat tax rate of 15 percent on all personal incomes.

There is much to be said in favor of a single income tax bracket—think of all the tax lawyers and CPAs society could do without if tax returns were reduced to the size of a postcard: tell me how much you earned last year, multiply that number by 15% and send it in.

California’s personal income tax tables now contain a mind-numbing seven brackets, starting out at 1 percent on the first $7,168 of taxable income and rising to 9.3 percent on incomes over $47,055. When one adds in a 1 percent surcharge on incomes of $1 million or more (the so-called Mental Health Services Tax that Californians apparently would have been crazy to object to), the top marginal tax rate is 10.3 percent.

The governor’s call for a flat tax of 15 percent on personal incomes thus amounts to hiking the top marginal rate by 50 percent—and applying it to all Californians, rich and poor alike. (Presumably a taxable income threshold would be set below which no tax would be owed, but a flat tax usually implies that no deductions are allowed for things like charitable contributions and mortgage interest payments, meaning that the average Californian’s taxable income would be much higher than it is under the tax code now in force.) Such a “reform” hardly is a sensible path to fiscal responsibility in a state that has been hit hard by the bursting of the housing bubble and is bleeding jobs as companies locate to more market-friendly environments. Rather than sharpening the state’s tax teeth, it would be far better to cut public spending to a level the taxpayers can afford.

I suspect that Governor Schwarzenegger glanced at Californian’s total taxable personal income last year and figured that a tax rate of 15 percent would generate enough additional revenue to claim credit for closing the state’s budget gap. As the Laffer curve teaches, however, higher tax rates can yield less revenue as taxpayers avoid reporting all of their taxable income or simply choose not to work as hard as before.

A flat tax on personal income is a great idea, but not if it raises the average tax rate. Set it at 6 percent or 7 percent and watch California flourish.