Roger Niello

Tax Reform is an essential Budget Reform

In the national debate over the debt and budget deficits, reforming our tax system is an important, if not the key, part of the solution. Well, as there seem to be similarities between California and Beltway budget battles, there is definitely a similarity in the importance of tax reform. It may even more important in our quest to regain the Golden in our State.

Here’s the problem. We are dependent upon a system of taxation that is overly reliant upon burdening the productive sector of our economy and is so highly volatile that it makes rational budgeting very difficult.

The best – or, perhaps I should say, the least bad – system of taxation is one with the broadest possible base, the lowest possible rate and brings along with it the built-in ability to pay. The broad base is to appropriately share the burden of public services. The lowest possible rate is to minimize the drag on the economy. The built-in ability to pay is to provide equity in the exaction.

Almost all of California’s tax revenue comes from three sources: income taxes (personal income tax – or PIT – and corporate income tax – or CIT), sales taxes and property taxes. There are problems with each.

The income tax burdens those who produce. That’s obviously a drag on the economy. In California we maximize that drag by imposing higher rates on higher incomes. That provides the maximum drag on the most productive sector of the economy: high income earners. Since the income of higher earners tends to vary more than lower income earners, this also causes a very volatile tax source, making budget writing so much more difficult from year to year.

The sales tax is a burden on consumption. Discouraging consumption obviously also dampens economic activity. Being perfectly consistent in its tax system dysfunction, California complicates this component of taxation by discriminating against one sector of the economy in favor of another: sales of hard good are taxed while services are traded free of tax. Government policies should never pick winners and losers, but this is exactly what the sales tax does.

The problem with the property tax is that it violates my third tenant of rational tax policy: that the source should bring along with it the ability to pay the tax. Income and sales activity are based upon cash transactions and therefore at least provide the funds to pay the assessment. The mere ownership of property carries no guarantee of cash to pay a tax. While property tax arguably does not provide as much a drag on economic activity as sales and income taxes, it is probably the worst source of tax because of the inherent lack of liquidity.

So what to do? Well, as I stated at the outset, broaden the base and flatten the rates. Taxes should be assessed such that as many people as possible pay for the benefits of public services and that the exaction should provide the least possible burden on the economy.

First of all, don’t mess with Proposition 13. For reasons stated, property is the worst source of taxation and should be kept to a minimum. Existing rules in accordance with Prop 13 accomplish this. Don’t change a thing.

We should adopt a flat income tax. Ideally that would be one rate with no deductions. A recent paper has demonstrated that such an approach using a 4% rate could be revenue neutral. This would reduce volatility greatly and would be a considerably lower burden on the economy in the aggregate. A rather significant side benefit would be decidedly easier tax return preparation.

It would also make sense to extend the sales tax to services and lower the rate. This would reduce the economic discrimination of the existing system. Lowering the rate to maintain revenue neutrality would serve to lessen the inevitable blow that any taxes impose upon the economy.

On that last point, it is important to acknowledge that any taxes do have an economic cost. But it is important also to acknowledge that services are provided as a result. It is the job of the political system and the budget writing process to insure that the services are worth the cost. That is a whole separate discussion and is not the subject of this essay, but its importance is implicit in the significance of tax policy.

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