With the state facing what is now a $19.1 billion budget shortfall, as we sit here now over a month into the fiscal year without a state spending plan, you can expect to see a lot of “creative” ideas coming out of liberal politicians who are desperately trying to close the budget gap while minimizing more cuts to state government spending. That having been said, virtually all of the one-time gimmicks and accounting tricks have already been used before reaching this point.
No one should be surprised that the latest “creative idea” to come out of the Capitol, purportedly floated by State Senate President Darrell Steinberg, is – you guessed it, another tax increase. His proposal is to raise most income tax rates for Californians, while lowering sales tax rates. The basic idea is that income taxes are deductable on itemized federal tax returns, and the swap in taxes would shift a few billion bucks from the coffers of the federal government into state government. John Myers of KQED Public Radio has an excellent summary and analysis of this proposal on his Capitol Notes Blog. I am excerpting some of it below, but you can read the whole thing here.
Several legislative and lobbyist sources who spoke only on background (as with most budget rumblings) confirm that such proposal is being talked about, and that it’s purported selling point is that it might not cost many Californians any money.
That’s because state income taxes are deductible when it comes time to pay Uncle Sam. So, the theory goes, any hike in state rates won’t actually hurt the pocketbooks of millions of Californians once they file their federal taxes. And the proposal would be sweetened by then lowering the state portion of the sales tax — thus perhaps saving money for many folks (given that sales taxes are not deductible).
It’s hard to get a precise estimate about how much gross income tax revenue would come in from this proposal, which apparently calls for bumping up all state income tax brackets except the current top bracket of 9.3% (remember that millionaires in the state pay an additional 1%). But remember that the income tax windfall would be offset by the subsequent loss in sales tax revenue — hence the figure of $2 billion-$3 billion as a net infusion into state coffers.
While the proposal might sound interesting at first (especially when you consider that California desperately needs to flatten its tax base, moving away from an extreme reliance on the state’s wealthiest residents), it takes about a second of real thought to figure out how flawed this proposal is, and why it is just a flat-out tax increase.
First and foremost, in order to deduct state income taxes, one would have to itemize their deductions. According to our friends at Americans for Tax Reform (who would consider this proposal a violation of their No New Taxes Pledge) over 60% of Californian’s do not itemize their deductions. So they would all pay higher state income taxes, without any relief on their federal taxes.
Second, if you are a Californian who pays the federal Alternative Minimum Tax, you do not even qualify to have your state taxes deducted from your federal taxes at all.
Third, let’s remember that itemized deductions “phase out” for taxpayers as they make more money, including the deductibility of state income taxes.
Finally, it is significant (and sobering) that, according to the Internal Revenue Service, 33% of income tax returns have either zero or an actual negative income tax liability. The Congressional Budget Office estimates that slightly less than half of families have no federal income tax liability at all! It stands to reason that this represents a huge percentage of California returns – and if you have no federal tax liability, then you can’t benefit from being able to deduct more state income tax.
It’s worth noting, as an aside, that this proposal also presumes that the federal policy makers will not, at some point, reduce or eliminate the deductibility of state income taxes.
Given the resolve of the Governor and legislative Republicans to solve this year’s budget crisis without further punishing California taxpayers (remember, last year the legislature hoisted the largest single tax increase in the history of any state on us), I think it is fair to characterize this latest “creative” tax increase dead on arrival.
(A big shout out to Ryan Ellis, the Tax Policy Director at Americans for Tax Reform, for helping walk me through some of these details.)
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