A special commission this week is scheduled to recommend a sweeping overhaul of California's antiquated tax system, a move designed to bring fiscal sanity to a budgeting process plagued by wide revenue swings and perpetual deficits.
State fiscal experts agree generally that California's revenue structure relies too heavily on the wealthy and the whims of the stock market while failing to capture taxes from the now-dominant service sector. The commission, established by Gov. Arnold Schwarzenegger and the Legislature's Democratic leaders, was charged with finding ways to end years of topsy-turvy budgeting that have left the state a financial wreck.
Over the past two years, the state has been forced to make deep cuts in education, health care, parks and other core services while furloughing state employees.
The proposal, laid out by the panel in a series of public meetings, would change dramatically how California's government raises money. The primary changes would reduce taxes on the wealthy and broaden the business tax to capture growing sectors of the economy.
California tax commission proposals at a glance:
Recommendations for reforming California's tax structure from the Commission on the 21st Century Economy:
- Personal Income Tax: Replace the state's existing progressive income tax structure (10.55 percent for millionaires) with a flatter structure.
- The two rates would be 2.75 percent for individuals earning up to $28,000 a year or $56,000 for joint filers, and 6.5 percent for incomes above that amount.
- The standard deduction would be $22,500 for individuals and $45,000 for joint filers. Deductions would be limited to mortgage interest, property taxes and charitable contributions.
- Sales and Use Tax: The state's portion of the sales and use tax would be phased out over five years by reducing it 1 percentage point each year. Local sales taxes would remain in effect.
- Corporate Tax: This business levy would be eliminated.
- Business Net Receipts Tax: At the heart of the commission's proposal would be a plan to replace the sales and corporate taxes with a business net receipts tax, to be imposed on all companies doing business in the state.
- The tax would be calculated by subtracting a firm's purchases from its gross receipts. The commission defines gross receipts as payments a business receives from all sources, such as the sale or exchange of property, the performance of its services or the use of its property or equipment. A yet-to-be-determined tax rate would be applied once the business's purchases are subtracted from that total.
- Commissioners have said the tax rate could be around 4 percent.
They say switching to such a model would capture service sectors that are currently not taxed, such as legal, engineering or accounting services. Critics worry it could be challenged in court and drive up the cost of doing business in California, making the state less competitive.
A group of tax policy experts suggested the commission consider simply expanding the state sales tax to services while at the same time creating a tax exemption for certain business purchases, such as office furniture or factory equipment.
The exemption would be an incentive for the business community to support broadening the sales tax to auto repairs, haircuts and other services currently not taxed, their letter stated.
Rainy Day Fund: The panel recommends increasing the target amount the state sets asides in reserve, from 5 percent to 12.5 percent of the state's general fund. The governor could tap the fund only when revenue is insufficient to provide spending at last year's level, adjusted for population and inflation changes.
When the stock market is booming, the state's wealthiest residents enjoy windfalls in capital gains, with state coffers benefiting. Likewise, when stocks plummet, the state suffers multibillion-dollar deficits.
The state's tax revenue can fluctuate by billions of dollars each year. This year's general fund spending limit is more than $18 billion less than it was two years ago.
According to a draft of the plan, the state's personal income tax structure would be flattened and taxes on the wealthy would be reduced. The state sales and corporate taxes would be replaced with a new business levy that taxes net receipts.
The commission is recommending a simpler income tax to replace California's more progressive structure, in which people who make more, pay more -- up to 10.55 percent for millionaires. The commission is recommending just two rates: 2.75 percent for individuals making up to $28,000 a year and couples making $56,000, and 6.5 percent for those making more.
Personal income taxes would account for about 31 percent of state revenue under the new tax structure, rather than the current 44 percent.
Some question whether that shift represents good public policy. While 62 percent of taxpayers will receive a $4 tax cut each year, millionaires will receive a tax break estimated at $119,000, said Jean Ross, executive director of the California Budget Project, a Sacramento-based nonprofit that advocates for lower- and middle-income families.
"This is taxing groceries to finance tax cuts for millionaires and taxing child care so oil companies don't have to pay a corporate income tax," Ross said.
Taxpayers would be allowed to deduct mortgage interest, property tax and charitable contributions, as they are now, but not health care or child care expenses.
In place of the state sales tax and corporate tax, the commission will recommend a new business tax similar to one that some commissioners say is used in Europe.
The so-called "business net receipts tax" is the centerpiece of the commission's plan. It would apply to all companies doing business in the state, including sectors that are not taxed today. That would include legal, engineering and accounting services.
A business's net tax receipts would be calculated by subtracting its purchases from all its incoming payments. A yet-to-be-determined tax rate -- perhaps 4 percent -- would be applied to the net amount.
Commissioners wanted to find a way to get tax income from the service sector. Taxing net receipts seemed the best way to accomplish that, according to comments during recent hearings.
Commission Chairman Gerald Parsky said the panel did not have enough time to explore all the options, but he emphasized the need for major changes and urged lawmakers to do additional research.
"This Legislature should get a signal from a broad cross section of people that business-as-usual is not acceptable," he said.
Critics worry the new business tax will hinder start up companies that rely on research credits in their first years when they aren't profitable and hurt all businesses by eliminating traditional deductions for wages and benefits.
The tax might be subject to a legal challenge on constitutional grounds because all firms that do business in the state would be subject to the tax even if they are not headquartered in California.
"I am especially troubled by eliminating the corporate income tax, in existence for more than 70 years and used by 90 percent of the states, and replacing it with a totally new, regressive tax, never seen before in either California or the world," wrote Richard Pomp, a commissioner appointed by Democrats.
Michigan, which relies on auto manufacturing, is the only state with a form of the business tax being proposed. A group of tax policy experts wrote a letter urging the commission to look for alternatives, such as expanding the state sales tax to the service sector.
A spokesman for Schwarzenegger said administration officials would reserve comment until they had reviewed the recommendations.