Legislative Analyst Office, January 2001

California's Tax System A Primer Chapter 2

Personal Income Tax

Overview of the Personal Income Tax

• The personal income tax (PIT) was established in 1935 and is the state's single largest revenue source. The PIT:
• Raised approximately $35 billion in 1999-00, accounting for roughly 40 percent of all revenues and half of General Fund revenues.
• Is levied on both residents and nonresidents, with the latter paying taxes on income derived only from California sources. There were over 13 million PIT returns filed in 1998, including 600,000 from nonresidents.
• Applies not only to individuals, but also to sole proprietorships, partnerships, estates, and trusts. In addition, the income "passed through" to individuals by Subchapter S corporations is subject to PIT taxation.
• Taxes all sources of income unless specifically excluded, including wages and salaries, interest, dividends, business-related income, and capital gains.

Filing Status and Tax Rates

Taxes are levied based on the filing status of the taxpayer. California has five filing statuses: single, married filing a separate return, married filing a joint return, surviving spouse, and head of household. There are six tax brackets for each filing status, with marginal tax rates ranging from 1 percent to 9.3 percent, depending on a taxpayer's income level.

California Tax Schedule for Married Couples Filing Joint Returns
2000 Tax Year
If Taxable Income is:			Computed Tax Is:
Over	But Not Over		Base Amount	Plus	Of Amount Over
$0	$10,908		$0	1.0%	$0
10,908	25,852		110	2.0	10,908
25,852	40,802		408	4.0	25,852
40,802	56,642		1,006	6.0	40,802
56,642	71,584		1,956	8.0	56,642
71,584	--		3,152	9.3	71,584

Key PIT Features

The PIT's key features include:

• Single taxpayers account for 45 percent of total returns filed but only 26 percent of tax liabilities, whereas married-filing-joint taxpayers constitute 40 percent of total tax returns but over 68 percent of tax liabilities.
• The PIT's tax brackets and certain credits and deductions are indexed annually to offset the impacts of inflation.
• There are approximately 85 PIT-related tax expenditure programs (TEPs), the sum of which totaled about $20 billion in 2000-01. These TEPs include a variety of income exemptions, income exclusions, tax deductions, and tax credits (the largest of which are shown in the next figure).
• A 7 percent Alternative Minimum Tax (AMT) is levied under certain circumstances. Its purpose is to restrict tax benefits from so-called tax preferences, including deductions and credits. In 1998, the AMT resulted in raising taxes for over 15,000 taxpayers by $128 million.

California's PIT Closely Follows the Federal PIT

The computation of California PIT liabilities is based on federal adjusted gross income (AGI). In turn, federal AGI equals total income from all sources less exempt or excluded income, plus certain federal adjustments. California generally conforms to federal PIT law except in specific circumstances. The procedure for calculating California's PIT is shown in the accompanying figure.

California's PIT Is Highly Progressive

California's PIT is a progressive tax, meaning that the "last" dollar of income earned is subject to increasingly higher marginal tax rates as income increases. As a result, the share of one's income paid in taxes generally rises with income. Put another way, the average tax rate rises with income, causing taxpayers with higher taxable incomes to pay a proportionately larger share of their income in taxes than those with lower incomes. For example, a married couple filing jointly with two dependents and taking the standard deduction would have an effective tax rate of 1.4 percent based on an income of $50,000, versus an effective rate of 4.8 percent based on a $100,000 income.

In 1998:

• Taxpayers earning annual incomes of $200,000 or more accounted for less than 3 percent of returns but almost 50 percent of liabilities.
• In contrast, taxpayers with AGI of less than $50,000 accounted for over 70 percent of returns but less than 10 percent of liabilities.

Wages and Salaries Account for Most PIT Revenues

Of the different types of income subject to the PIT, wages and salaries constitute by far the largest portion. In 1998:

• Wages and salaries accounted for about 61 percent of PIT revenues (traditionally, about two-thirds of PIT liabilities have been associated with wages and salaries, with the lower 1998 share reflecting a historically large amount of capital gains).
• Capital gains accounted for 15 percent of PIT liabilities, having more than doubled its share over the past six years.

Capital Gains Have Been An Increasingly Important Source of PIT Revenues

Although wages and salaries continue to account for the majority of PIT revenues, the share attributable to capital gains has increased quite dramatically in recent years.

The growing importance of capital gains in generating PIT revenues reflects two main factors.

• First, the dollar amount of capital gains has shown rapid growth in recent years, averaging over 11 percent annually since 1993.
• Capital gains accrue disproportionately to high-income taxpayers and, thus, are taxed at higher-than-average marginal tax rates.

The increased role of capital gains also has brought with it certain revenue-related challenges. Most important, it has made the PIT inherently more volatile and difficult to forecast than previously. This is because capital gains themselves are highly variable, due to (1) their dependency on the volatile stock market and housing sectors and (2) the fact that most stock-related capital gains are not taxed in the year of accrual and can remain unrealized for many years.

Comparisons To Other States

A PIT is imposed by 43 states and the District of Columbia. The PIT-related interstate comparisons of greatest interest involve its overall tax burden and its relative marginal tax rates. With regard to the former, the state's overall PIT tax burden--as measured by tax liabilities per $100 of personal income in 1998-99--is $3.74 (see following figure). This is above the average of both all other states ($2.21) and other western and industrial states ($2.81 and $2.95, respectively).

The latter issue of marginal tax rates is of special interest because high-marginal rates may in some situations result in discouraging work. California's highest-marginal rate of 9.3 percent is above that of most other states. Its lowest-marginal tax rate, however, is lower and covers a larger amount of income than in many other states. Of course, the fact that California's total burden for all taxes combined is about average means that its higher PIT burden is offset by a lower combined burden for its other taxes.

Important PIT Policy Issues

Some key PIT-related policy issues facing policymakers include:

• Marginal Rate Structure. Should California's PIT marginal tax rates be reduced, and the cost be financed through base broadening?
• Federal Conformity. Should California more fully conform to federal PIT law in areas where it currently differs, such as capital gains tax rates, depreciation, certain credits, and net operating losses?
• Broad-Based Simplification. Should California move towards a more simplified PIT system with fewer special provisions for particular groups/businesses?
• Targeted Simplification. Alternatively, should California leave its basic system intact, but focus on simplifications in those PIT areas where the greatest complexities for taxpayers lie, such as the AMT?
• Tax Expenditure Programs. Are there certain PIT-related TEPs that are ineffective and inefficient, and therefore in need of elimination or modification?
• Reliance on the PIT. Has California become overly dependent on the PIT, given that it is a somewhat volatile revenue source and now accounts for over half of the state's General Fund total?

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