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Legislative Analyst's Office
The 2003-04 Budget Bill:
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SummaryThe 2003-04 Governor's Budget proposes a major tax increase to help address the budget shortfall by using these new revenues to fund the realignment of various programs to local governments. The budget proposes establishing new personal income tax (PIT) rates on high-income taxpayers, increasing the sales and use tax (SUT) rate by 1 percent, and raising the cigarette excise tax by $1.10 per pack. The proposal is expected to result in additional revenues of $8.3 billion in 2003-04. The administration's revenue proposal raises numerous issues relating to the characteristics of the revenue sources that are slated for a rate increase, as well as regarding the impacts of these tax proposals on the state's business and individual taxpayers. In order to assist the Legislature in its evaluation of this proposal, we suggest a number of criteria upon which the assessment of the Governor's plan should be based. Based on these criteria, we discuss the various characteristics associated with the three taxes, especially with respect to their growth and volatility. In addition, we examine the impact of the tax increase proposal on different categories of taxpayers in the state and on individual taxpayers within them. Finally, given the importance of revenues to the Governor's realignment plan—and the budget as a whole—we also identify and discuss a number of other revenue options the Legislature may want to consider in its deliberations. |
As one of his solutions to the budget shortfall, the Governor proposes a substantial tax increase. The tax proposal involves increasing the rates on three major taxes—the SUT, the PIT, and the cigarette excise tax—and earmarking the revenues resulting from these tax increases for the Enhanced State and Local Realignment Fund (ESLRF). As noted in the realignment discussion in this part, the ESLRF is to be used to provide funds for various programs shifted to the local level as part of the budget's realignment proposal.
In the following discussion, we describe the Governor's tax proposals and their likely revenue impacts on the state. We consider the characteristics of the affected taxes, and how these characteristics might affect their suitability both as a partial solution to the overall budget problem, and as sources of revenue for the Governor's realignment proposal. We also investigate the impact of the tax proposals on individual taxpayers. Finally, we identify various revenue alternatives to the above tax changes and compare them to the Governor's proposals.
The Governor's tax proposal consists of three principal components:
The increase in the SUT rate and the cigarette excise tax rate are relatively straightforward, since—in each case—they involve no change in the nature of the tax base and utilize existing administrative procedures. Our understanding is that the additional state administrative and taxpayer compliance costs from (1) requiring registered sellers to collect an additional 1 cent of the SUT and (2) charging $1.10 more for cigarette tax indicia are relatively minor. However, the PIT rate increase proposal is somewhat more complex and involved, from both the state's and the taxpayers' perspectives.
Specifically, the PIT proposal would result in a new tax rate schedule and require additional withholding schedules for certain taxpayers. The PIT increase proposal would also require the Franchise Tax Board (FTB) to separate PIT receipts resulting from the higher 10 percent and 11 percent brackets from the PIT revenues resulting from the existing tax rates and bracket structure. We discuss this issue further below, when we examine the PIT proposal and consider various associated administrative issues.
Overall Impacts on Taxpayers. The Governor's tax proposal would have very different effects on California taxpayers, depending upon their incomes and consumption patterns. For example, the PIT increase proposal would have a direct impact only on a very limited number of high-income taxpayers. The cigarette tax increase proposal would obviously have a direct effect only on cigarette smokers. Only the proposed increase in the SUT would have a broad-based direct impact on California taxpayers. We discuss the impacts of the individual taxes later in this analysis.
Proposition 98 Considerations. In general, state tax increases implemented in 2003-04 have the potential of raising the Proposition 98 minimum funding guarantee for education. Because of this potential interaction, an important issue related to the budget's proposal is the extent to which its new taxes would be available to address the state's budget shortfall (through realignment or some other means) versus how much would instead be required to go to added school funding (see shaded box, next page).
The administration's view is that because counties and courts—not the state—would receive the new tax revenues, they need not be included in its calculations of the state's Proposition 98 minimum funding guarantee. Thus, the administration reflects these tax increases as special fund revenues and excludes them from the Proposition 98 calculation.
Although the interaction with Proposition 98 is certainly a vital consideration for the Legislature, we would also note that the realignment and revenue proposals warrant consideration on the basis of their own merits as well.
New Taxes and Proposition 98Proposition 98 guarantees a certain level of funding for K-14 education. Given current law, we estimate that this minimum funding guarantee for 2003-04 is $44.1 billion. Should the Legislature wish to increase General Fund taxes to help address the budget shortfall, we estimate that education's funding guarantee would grow by an amount equal to about half of the new tax revenues. Put another way, only half of the new taxes would go towards eliminating the budget gap. The California Constitution allows the Legislature to suspend Proposition 98 in an urgency bill other than the budget bill. Suspension allows the Legislature to fund K-14 education in an amount lower than indicated by the Proposition 98 formulas. The Legislature, for example, could fund education in 2003-04 at the same amount it would have received in the absence of new taxes, or $44.1 billion. Such a one-time suspension of Proposition 98 would not materially alter future state education funding obligations under Proposition 98 relative to what the state's funding obligation would have been without new taxes. Thus, it would allow the full amount of any new General Fund taxes to be applied to addressing the budget problem. |
The proposed tax increases for 2003-04 are estimated to result in total revenues of $8.3 billion, with $8.2 billion to be used to fund the Governor's realignment program. (The remainder of the increase involves cigarette taxes that would be used to compensate special funds for expected revenue losses from consumption declines caused by cigarette tax increases.) Figure 1 indicates the additional revenues estimated for the three taxes through 2005-06. As indicated in the figure, revenue stemming from the high-income tax brackets is expected to decline in 2004-05. This is because in 2003-04—the first year affected by the PIT rate change—there is a one-time "doubling up" of revenues, due to both higher payments for 2003 tax year liabilities and increased withholding for 2004 tax year liabilities. Cigarette taxes are also expected to decline in future years due to ongoing decreased per capita consumption—a trend that has been occurring for some time.
The Governor's proposal to raise tax rates for three of the state's existing revenue sources raises important issues regarding such factors as: the characteristics of the associated revenue streams, their effect on the state's economy, and their impact on the state's taxpayers—both individually and collectively. Some of the taxes' characteristics are of heightened importance due to the fact that their increased revenues are proposed as realignment revenues earmarked to fund particular programs.
In evaluating changes to the state's tax system, there are a number of commonly cited elements that the Legislature should consider. In very broad terms, these elements relate to the efficiency, equity, revenue sufficiency, and administrative qualities associated with the tax system. Given that the Governor's proposal involves increasing the rates for three particular taxes and devoting the revenues raised to particular programs, there are certain other specific characteristics that the Legislature should also consider in evaluating the appropriateness of the revenue proposals. These characteristics—which are incorporated in Figure 2 (see next page)—are of particular importance given the current budget challenge facing the state.
With these criteria in mind, we next discuss the specific individual changes in taxes that the Governor has proposed.
The performance of the SUT and taxable sales (the SUT's primary determinant) has been relatively steady, although on average, their growth has generally lagged that of the overall economy and been a bit more volatile.
Growth. Figure 3 shows the overall growth of taxable sales compared to the state's personal income for the period 1990 through 2003. The annual average growth in taxable sales over this period was approximately 3.7 percent, compared with the overall growth rate in personal income during the same period of roughly 4.6 percent annually.
The reasons for this discrepancy in the two growth rates are partially related to the large increase in personal income that occurred in the late 1990s among high-income taxpayers. Increases in income—particularly for these groups—do not necessarily translate fully into additional taxable consumption. For example, much of the additional earnings may be saved or invested rather than used for current consumption. Furthermore, the lower growth rate in taxable sales (and indirectly, the SUT) is also likely related to some of the structural weaknesses in the tax base, as we discuss below.
Volatility. Taxable sales exhibit moderate volatility, having fluctuated a bit more than personal income over the last decade. They have been less volatile than some other tax bases upon which the state relies—for example, taxable personal income and corporate profits. Figure 4 (see next page) indicates annual percent changes in taxable sales over the last decade or so and the corresponding changes that have occurred with respect to personal income in California. As shown in the figure, taxable sales oftentimes outperform the economy in an expansion period and under-perform during periods of contraction.
Despite this particular quality, the structure of the SUT makes it somewhat more protected from economic variability in some circumstances than it would otherwise be. This is because the SUT is composed of roughly two-thirds retail sales and one-third business-to-business sales, a profile that makes the tax somewhat protected in the event a decline in either consumer spending or business investment alone occurs.
Despite its overall steady growth and moderate volatility, taxable sales do suffer from some basic weaknesses that could adversely affect the SUT's revenue performance in the medium to long term. These features are particularly important to the extent that revenues from the tax are used for particular program financing rather than having such support come from the General Fund at large, with its more diversified tax base. Specifically, these structural issues are:
Incidence of the SUT. How a tax—and the proposed increase in the SUT in particular—affects taxpayers in the aggregate and individually is one of the key questions that policymakers should consider with respect to the Governor's budget proposal. How the burden of a tax affects different groups of taxpayers is referred to as the tax's "incidence," and is typically measured in relation to the proportion of taxpayers' income that goes to paying the tax.
Most studies have shown that the SUT is a regressive tax—meaning that the proportion of income used to pay the tax decreases as income increases. (In contrast, progressive taxes show an increase in the tax as a proportion of income as income increases.) Thus, economists have found that lower income households pay a larger share of their income in sales taxes than do higher income households.
California's SUT does not levy the tax on food (which accounts for a large share of consumption for low-income households). Even with this substantial tax exemption, however, California's SUT is considered to be generally regressive. Some recent studies have found that the proportion of income spent on taxable purchases ranges from something in excess of 40 percent for households with incomes of $30,000 or less to about 22 percent for households with incomes greater than $100,000. Correspondingly, the percent of income spent on the sales tax for these two groups is about 3 percent and 1.5 percent, respectively. Figure 5 (see next page) shows (using as a guideline the findings of past research) what typical taxpayers in various income classifications would experience due to the change in the SUT rate, given an average level of taxable purchases by each taxpayer.
Overall PIT Growth. Since 1990, personal income in the state has grown rapidly, especially at the higher end of the income spectrum. The annual average growth in personal income in the state from 1990 to 2003 was approximately 4.6 percent. By comparison, the state's income from the PIT has generally grown even more rapidly than overall growth in personal income, largely due to the increased income at the high-end of the income spectrum and the higher average marginal tax rate to which these taxpayers' income is subject. Accordingly, the annual growth in the PIT from 1990-91 through 2002-03 was 5.8 percent. Through 2000-01, the growth in the PIT was significantly higher at over 10 percent, but revenues dropped by over 25 percent in 2001-02.
High-Income PIT Growth. Between 1991 and 1995, California had 10 percent and 11 percent brackets in place similar to those proposed by the Governor. Figure 6 indicates the actual revenue that was raised from these higher income brackets during the fiscal years for which they were in effect (1991-92 through 1995-96) and an estimate of the revenue that would have been raised from these brackets had they continued to exist through 2002-03. The revenue that would have been associated with these high-income brackets grew considerably over the period—at an approximate annual rate of 13 percent through 2000-01. However, revenues from the high-income brackets would have declined significantly in the last two years, making the annual growth rate over the entire period equal to 7.2 percent.
Indicators of Volatility. The above growth rates obscure the significant degree of annual fluctuation in revenues generated from these top PIT brackets. As shown in Figure 7 (see next page), over the entire period of the 1990s high-income taxpayers experienced significant changes in personal income relative to other taxpayers. For example, income increased by 28 percent for high-income taxpayers in 1999, but by about 8 percent for all other taxpayers. Similarly, in 2001, income associated with high-income taxpayers dropped by over 22 percent compared to a decline of only slightly more than 1 percent for all other taxpayers.
What Is Causing the Volatility? The reason for the volatility in the PIT in general, and that for the PIT revenues from high-income taxpayers in particular, are interrelated. First, there has been an increase in the concentration of income at the upper end of the income spectrum over the last decade, resulting in an increasingly larger proportion of the PIT being paid by taxpayers paying at the highest marginal tax rate. This, coupled with the fact that these very taxpayers receive a large proportion of their income from sources which are themselves quite variable, has led to the increased volatility overall in this revenue source.
The greater volatility at the high end of the income spectrum is largely the result of stock options and certain nonwage income received by this group. Many components of nonwage income fluctuate enormously depending upon economic conditions and taxpayer decisions. For instance, those business profits that are taxed under the PIT tend to swing more than most other forms of income. Similarly, capital gains—which comprised a significant component of high-income taxpayers' nonwage income in the late 1990s—are subject to enormous and frequent swings. The volatility of ordinary wage income compared to these more volatile other income sources is shown in Figure 8.
Volatility Will Continue, But Could Lessen. Volatility is likely to be a continuing characteristic of the PIT given the current structure of the tax. Even with the market declines that have occurred, high levels of stock ownership—especially among high-income households—will continue, along with compensation practices involving stock options. Thus, even in a normal market environment, individual company stock performance—along with employee behavior regarding stock options—will have unpredictable impacts on the PIT. These factors, in conjunction with forces underlying the continuing concentration of income in California, make it likely that revenue fluctuations associated with the PIT—especially in the high-income brackets—will continue.
Despite this characteristic, however, it seems likely that future PIT volatility will not reach the extremes of the recent past. Given that the capital gains and stock options gyrations of the last few years have been unparalleled in their magnitude, these fluctuations could prove to be historical anomalies.
Creation of New Tax Schedule. The Governor's tax proposal will result in two additional brackets for high-income taxpayers. As noted earlier, California previously imposed new brackets for high-income individuals for the 1991 through 1995 income years, in response to the previous recession and accompanying budget crisis. The income earned by these taxpayers is currently taxed at the marginal rate of 9.3 percent; however, the proposal will result in a new tax schedule as shown in Figure 9 (see next page).
Incidence of the Tax Increase. It has been estimated that the PIT rate changes proposed will affect approximately 4 percent of all income tax filers (and about 6.5 percent of those filers with a tax liability). The income categories affected by the tax proposal have been responsible for roughly two-thirds of all PIT liabilities in recent years. The change would result in an increase in the share of the total state liability paid by taxpayers with adjusted gross incomes (AGI) of more than $600,000 and declines in the share of the total PIT paid by all other taxpayers. The percentage of the total paid by taxpayers with AGIs of $1 million or more would increase from 19 percent to 23 percent.
How Will Individual Taxpayers Be Affected? Figure 10 shows average tax liabilities and the percentage change in them due to the proposal for each of five AGI classes. Taxpayers in the upper end of the income spectrum would face an average tax increase of 24 percent, or about $27,000, while those in the lowest income class shown in the figure would experience an average increase of only $2. We should also note that the tax increases are also likely to affect a large number of businesses that file under the PIT, such as partnerships, sole proprietorships, and Subchapter S corporations.
Under most circumstances, some of the increase in taxpayers' state tax liabilities is likely to be offset by reduced federal income taxes due to the deductibility of state and local taxes for federal income tax purposes. For example, as noted above, an average taxpayer with AGI of $1 million or more would have an increased state liability of $27,360 under the Governor's proposal. That taxpayer's federal taxes, however, would decline by $10,561 (due to higher itemized deductions for state taxes). This deductibility feature would result in reducing the additional net taxes to $16,799. We discuss additional issues associated with deductibility below.
Due to a variety of factors, the per capita consumption of cigarettes in California has trended downward over the last 20 or so years. As shown in Figure 11 (see next page), per capita cigarette consumption in the state has declined from 124 packs annually in 1980-81, to an estimated 35 packs annually in 2003-04. The number of packs consumed in California dropped from a peak of 2.9 billion in 1980-81 to an estimated 1.2 billion in 2002-03. This drop occurred despite the fact that California's population grew by roughly 50 percent over the same period.
The main reasons for the over 70 percent decline in per capita consumption are the following:
Figure 11 indicates that if the adverse consumption effects of tax-induced price increases were removed from the calculations, per capita cigarette consumption would still have declined. These declines, primarily due to smoking restrictions and health concerns, have averaged on the order of 3 percent per year.
It should be noted that the data involving consumption are based on actual sales of cigarette stamps sold for tax purposes. To the extent that there has been increased evasion, however, there will be a discrepancy between the apparent consumption, shown in the official tax data, and actual consumption of tobacco products. That is, actual consumption will be greater than that suggested by the data.
The effect of tax evasion (primarily smuggling and stamp counterfeiting) has been of concern to states and federal regulatory agencies for some time, but has increased in importance in recent years as many states and the federal government have raised their cigarette excise taxes. Tax increases—including those proposed by the administration—increase existing incentives to engage in tax evasion and cigarette smuggling activities, leading to additional governmental revenue losses.
While the data on cigarette smuggling and tax evasion activity are sketchy, the BOE puts the total annual state revenue loss due to tax evasion at between $130 million and $260 million, a range that generally coincides with state-by-state estimates reported by the General Accounting Office. We examine revenue impacts and other issues associated with cigarette tax evasion in our write-up regarding the BOE in the Analysis.
Given the above, the administration's estimate of the revenue gain from the cigarette tax increase proposal is subject to a number of risks and uncertainties. One, of course, is that evasion could rise. Another involves price effects. In terms of declines due to price increases (including those arising from higher taxes), most studies have shown that consumption declines by approximately 5 percent for every 10 percent increase in price. These estimates of the consumption response to a price increase (known as price elasticity of demand) have been based on situations where the percentage price increase has been relatively modest.
With larger price increases (such as those that would likely result from the adoption of the Governor's proposal), however, the established price-consumption relationship may not hold. Thus, if there were a larger-than-normal consumption decline due to a significant increase in price from the proposal (assuming the tax is largely passed through to consumers), revenues would be lower than estimated.
In considering the Governor's proposal, a related question that should be addressed is: How much should the state tax cigarettes? This involves considering both the tax's incidence and the social costs (or "externalities") associated with smoking.
Incidence of the Tax. In general, economists have concluded that the cigarette excise tax is a regressive tax, in that it is largely borne by the consumer, and imposes a gre