I'll be Taxed

Time for me to chime in on the tax reform proposals in the Golden State. California's budget system is broken. The recent patchwork by the legislature failed to fix the fundamental problem in California's revenue system: volatility.

California uses a steeply progressive income tax to generate the bulk of its revenue. In fact, the system is so progressive that:

More than half of California's income tax revenue is paid by those with incomes of $200,000 or more.

That is an awful lot of revenue generated from a very small group of people. That small group ("the Rich") tends to generate their income from volatile investment activities in the form of capital gains (i.e. gains on stocks, bonds, hedge funds, etc.). When asset performance degrades, the Rich tend to take the brunt of the losses and ultimately remit less money to the treasury. Conversely, when assets perform well, the Rich tend to make enormous gains and treasure flows from Sacramento to the rest of the State.

California (and to a similar extent, the federal government) have placed a leveraged bet on the Rich. When their income goes up, the State profits handsomely via capital gains taxes and high marginal rates while sparing the rest of the taxpayers. When the Rich's income declines, however, the leveraged bet collapses (a dollar lost on someone who is taxed at 20% is a bigger hit to the State than a dollar lost on someone who is taxed at 5% or has no capital gains income to tax at all). A downward movement in the Rich's income creates an enormous drop in revenue that devastates the State's finances.

This is exactly what happened this year in California. With the demise of the Rich, so went California's budget.

The proposed solution is a fairly simple one: abandon steeply progressive rates in favor of flatter rates on more types of income (e.g., instead of 20% and 5% income brackets on individuals income, have a 10% flat rate and add a flat tax on businesses). If the State had a broader tax base and a flatter rate, volatility would decline. Of course, the odds of giving the Rich a tax break during a fiscal crisis, particularly in California's notorious Legislature, seem like a snowball's chance in...well...you know.

Perhaps there is a better way. Professor Kirk Stark at UCLA School of Law has come up with a novel suggestion. To reduce volatility, require the State to apportion out capital gains taxes over a period of years. The Professor explains his idea quite elegantly:

But rather than reducing taxes on wealthy investors, why not just unhitch the timing of their tax payments from the boom-bust cycle of the market? This could be done quite simply by giving taxpayers who incur capital gains taxes the option of claiming a "capital gains tax credit" that would be recaptured over the ensuing three years. As an example, let's assume that the amount of the credit is 75 percent of the capital gains taxotherwise owed in the year of the sale. In our example above, Mickey would be entitled to a credit of $1,500 (i.e., $2,000 multiplied by 75 percent) in the year that he sells his Disney stock. His tax liability for the year of the sale would be $500 ($2,000 minus $1,500) rather than the full $2,000. This credit would then be recaptured (i.e., paid back) in three equal installments over the next three years, with the result that Mickey would add $500 to his tax bill for each of the next three years. The bottom line is that a $2,000 tax bill would be paid over a period of four years.

The net effect of this system - i.e., combining an upfront tax credit with a recapture rule - is that capital gains tax revenue would drip into the state in smaller increments rather than surging during the boom years and later drying up completely. It also bears noting that this system offers something of a preference for capital gains, since it operates like an interest- free loan from the state to taxpayers who would otherwise have to pay the capital gains tax upfront all at once.

Tax the rich, reduce revenue volatility, and entice people to invest? I think the Professor is onto something. Perhaps he should run for office.