Tax Reformers Propose Fiscal Suicide for California

California’s governor Arnold Schwarzenegger by Executive Order S-15-09 created a Commission on the 21st Century Economy to propose reforms for California’s public finances. The Commission has 14 members, including prominent economist Michael Boskin.

The aim of the Commission is to establish a “21st Century tax structure” that reduces the volatility of the state’s revenues, promotes prosperity, reflects “principles of sound tax policy including simplicity, competitiveness, efficiency, predictability, stability, and ease of compliance and administration,” and that is “fair and equitable.”

The Commission’s proposed tax plan has the following elements, to be implemented in 2012. (Go to meetings and find under “documents” of Sept. 10, 2009, “Description of the Tax Packages” and “Descriptive Information about the Proposed Changes to the Personal Income Tax” and “Updated version of the Business Net Receipts Tax Description.”)

1. The personal income tax would be restructured to reduce the tax brackets from six down to two. Many tax credits and deductions would be eliminated. The top tax rate would be reduced from 10.3 percent to 6.5 percent.

2. The corporate income tax would be eliminated.

3. The sales tax would be replaced by a business net receipts tax. The tax base would be gross receipts minus the purchases of goods, in effect a value-added tax, not including the value added by employee labor.

4. The state would increase its “rainy day reserve fund,” with greater limits on spending it.

The simplification of the state’s income tax and the reduction of its top tax rate would be very good for the state’s economy, and an increase in the states’s “rainy day” fund would also be beneficial. However, the proposed net receipts tax would promote fiscal suicide.

A receipts tax means a tax on the revenue of a business, in contrast to an income tax on the profit, or revenue minus costs. A net receipts tax is better than a gross receipts tax, but it still taxes the revenue of a firm rather than its profit. Even if a firm is losing money, it would still have to pay a tax. Even if the revenue minus the cost of goods purchased is positive, the firm would have a loss if its labor expenses are greater than the revenue net of purchases.

A value-added or net-receipts tax is applied to each stage of production, such as taxing the production of wheat, then flour, then bread baking, and finally the bread selling. European countries have adopted the value added tax because they can then easily subtract it for exports, giving them an artificial competitive advantage to the USA, which is not allowed to provide a tax break for its exports, under the rules of the World Trade Organization.

There is little economic gain from switching from a sales tax to a net receipts tax, and there is an economic loss switching from a tax on corporate profit to a tax on revenue, since the income tax only taxes net gains. Also, the elimination of the corporate income tax would provide a privilege to corporations relative to individually-owned firms subject to the personal income tax. The retained earnings of corporations would be tax free, while a partnership or single owner would have to pay both the net receipt tax and the personal income tax.

Public-finance economist Mason Gaffney has analyzed the quantum leap effect of a receipts tax. In physics, a quantum leap is a sudden large change in energy. The economic analogy is a large change in production when land use changes.

Many firms that operate in national or global markets cannot pass on a sales or receipts tax to the customers. The tax burden is entirely on the profit of the firm, and if it were making only normal profits or less, the tax would wipe out the profitability of the company, and it would then shut down. If the site of the firm were being used in its most productive use before the tax, then the firm that replaces it generates less production, even if it is better able to pay the tax by passing it on to customers.

Therefore the receipts tax result in a quantum leap downward of less production, less investment, less employment, less growth, and less tax revenues. It is fiscal and economic suicide. We cannot know what enterprises would have arisen if not for the tax, but the deadweight loss is much greater than the standard analysis of the excess burden from passing the tax on to consumers, reducing some but not all of the output. The quantum leap effect completely wipes out the firm or even an industry.

Why did the geniuses of the Commission on the 21st Century Economy propose a net receipts tax? Because they dare not propose to reform the state’s dysfunctional property tax. California’s Proposition 13, passed and constitutionalized in 1978, reduced the real estate tax to one percent of purchase price with a maximum annual increase of two percent. The homeowners of the state have become allies of the large landed interests to oppose any change to Proposition 13, which has become California’s state religion, holier than God.

If the Commission were true to its aims, it should have proposed an efficiency tax shift, the replacement of the state’s income, sales, and property taxes with three truly 21st century revenue sources: a pollution tax, a levy on land value, and user fees. These would have no deadweight loss, and the quantum leap of that tax reform would be a volcanic eruption of growth, employment, and higher wages.

If you would like to comment on the Commission’s proposal, go to its contacts site and tell them what you think of their proposals and what you think would be better. You might first look at the already received, but it will not hurt to have more voices in favor of an efficiency tax shift!