Replies

California Commission on Tax Policy in the New Economy

Senator Tom McClintock
Date: March 12, 2003
Publication Type: Speech or Statement

Thank you for the opportunity to address your commission on the future of tax policy in California. I would like to focus on two general themes - one is the natural limitations that operate upon any system of taxation, and the other is a few general principles that I believe would produce great improvements to the state's overall structure of finance.
Let me begin with the natural limitations that act upon our tax system. I know that there is a great deal of pressure on this commission to raise revenues to deal with the state's budget deficit. But it is important to recognize that raising tax rates is quite a separate thing from raising tax revenues - one does not necessarily follow from the other.

California found that out the hard way when it attempted to increase tax revenues by raising tax rates in 1991. The increases in tax rates that year, principally an 18 percent increase in the sales tax and a 15 percent increase in upper brackets of the income tax, were supposed to produce a net of $7 billion of new revenues. But they didn't. In fact, total general fund revenues dropped by $1 billion after the tax increases were instituted. We didn't take in $7 billion more - we took in $1 billion less. We lost another $1 billion the next year.

Great concern has been expressed over the tax revenues lost to the Internet. This is not a problem - it is a symptom of a problem - and that problem is an excessively high tax rate. Commerce in the new economy can move with increasing ease around any obstacles - and it is.

When taxes are uniform and low, tax compliance is high. But when those taxes become excessive or disproportionate, an increasing incidence occurs first of tax avoidance, then tax evasion and then finally tax flight. There are natural bounds upon any tax system. To the extent the taxes are deemed uniform, people do not resent paying them; and to the extent the taxes are deemed moderate, people do not resist paying them.

But a disproportionate tax system loses its moral authority and an excessive tax system inspires tax revolts. A disproportionate tax destroys the taxpayers' willingness to pay and an excessive tax destroys their ability to pay.

I spoke to a woman two weeks ago who told me that she and her husband had just sold their business in San Diego. But before they did, they, like so many others, took the necessary legal action to assure that it was a Nevada corporation and that they were legal citizens of Nevada. All the expense and inconvenience to do so was worth it to them to avoid California's excessive taxes. California received none of the proceeds; Nevada got everything.

And she said, "Have you seen Reno recently?" And she described in vivid detail the economic explosion taking place there today - the construction, the investment, the booming job market - all fueled by a steady stream of California ex-patriots like herself.

It put me in mind of an observation Alexis de Tocqueville made during his travels in America in the 1830's.

He wrote of the Ohio River Valley and the remarkable difference between what he saw on the left bank, in Kentucky and on the right bank, in Ohio - one slave and one free. And he wrote, "The traveler who floats down the current of the Ohio … may be said to sail between liberty and servitude, and a transient inspection of surrounding objects will convince him which of the two is more favorable to humanity.

"Upon the left bank of the stream the population is sparse; from time to time one descries a troop of slaves loitering in the half-deserted fields; the primeval forest reappears at every turn; society seems to be asleep, man to be idle, and nature alone offers a scene of activity and life.

"From the right bank, on the contrary, a confused hum is heard, which proclaims afar the presence of industry; the fields are covered with abundant harvest; the elegance of the dwellings announces the taste and activity of the laborers; and man appears to be in the enjoyment of that wealth and contentment which is the reward of labor."

I am becoming concerned that a similar demarcation between liberty and servitude can now be glimpsed by floating down the current of the Colorado River. And I offer this as a sobering reflection upon the incessant efforts to take from Californians more and more of "that wealth and contentment which is the reward of labor."

And that concludes my first theme, that anyone who aspires to just governance must take fully into account the natural limitations into which any successful tax system must fit - moderation and uniformity must be the abiding principles.

And this brings me to my second theme: that California's structure of finance and taxation suffers from four fundamental flaws, which we must repair.

Those four flaws are: first, a reliance on asset taxes that place undue burdens upon people when they can least afford them; second, a highly disproportionate structure of taxation; third, a commingling of revenue streams -- and therefore functions -- between state and local governments; and fourth, the combination of the powers to spend and to tax.

Let me take each of them in turn, beginning with our over-reliance on asset taxes. I would offer the observation that there are two general categories of taxes: taxes that are applied to wealth as it is grows, and taxes that are applied to static assets. Let us call these growth taxes and asset taxes.

Growth taxes, unless set at 100 percent, cannot destroy the wealth being taxed. They merely take a slice of an expanding pie. There are only three such measurable points at which these growth taxes are applied: income when it is received, either as salary, wages, dividends or benefits; capital gains when they are realized; and business profit (defined as gross receipts minus operating expenses).

Asset taxes destroy wealth by progressively reducing an asset. A tax on property, for example, eventually will consume the value of that property. A tax on the sale and resale of a commodity eventually will consume the value of that commodity. Asset taxes also constitute a double-tax: a dollar earned is taxed as income, and then taxed a second time when it is used to buy a commodity.

The ideal tax system would rely strictly on growth taxes.

Objection will be made that shifting the entire fiscal system to a combination of personal income, capital gains and business profits will create a highly volatile revenue stream, and this is true. It will require greater fiscal responsibility than recent legislatures and governors have demonstrated.

But here is the flip side of the volatility question: a stable tax source takes a huge bite out of taxpayers when they can ill-afford it. A growth tax requires taxpayers to pay more in good times (when they can afford it) and less in difficult times (when they can't). The only objection that can seriously be made to a volatile tax system is that it requires grown-ups in public office who can restrain their impulse to spend in good years so that they can build surpluses for bad ones.

If this doesn't provide sufficient reassurance, a provision can be made requiring a certain percentage of year-over-year revenue gains to be set aside for those periods when revenue declines.

The second point, regarding uniformity, I will mention only in passing since much has been written about it over the years. I believe that the only just tax is a uniform flat rate tax. Variable rates and progressive tax schedules allow one group of citizens to tax another group for their own benefit. We have watched for years as businesses have shifted the tax burden from business profits to sales and personal income taxes. Debates over progressive schedules invariably set rich against poor. With a flat and uniform rate, every single citizen is in exactly the same boat - in exact proportion to their income. Raise the uniform rate on personal income, the rate increases proportionally on businesses too.

This is not to say that provision should not be made for low-income families, and the flat tax can be modified to do so to assure the basic necessities of life are available to all.

The third point is that state and local revenue streams must be completely separated.

It once was clearly understood that taxes paid by state taxpayers would be used for genuine statewide purposes. A prison, for example, removes a criminal from the streets wherever they are in California - a county jail does not. Thus, prisons were funded strictly from state resources and county jails strictly from county resources.

This is no longer the case. Because of the usurpation of local prerogatives by state government that has accompanied a blurring of distinctions between state and local revenue, state government has succumbed to the temptation to rob Piedmont to pay Pasadena. If revenues were again strictly separated -- and unfunded state mandates upon local governments prohibited -- the natural result would be that local taxpayers would be more likely to finance local projects and state taxpayers more likely to finance state projects - because they would be guaranteed of the benefits the proceeds of those revenues.

Fourth and finally, the taxation and spending functions of government must be separated. Charles Adams wrote, "when the power both to tax and to spend resides in the same political entity, whether king or legislature, without controls, the spending power will override the taxpayers' interests." He looks to the model of the Magna Carta. During the reign of King John, spending was brought in line with taxes when the King was made the organ of expenditure, and the Parliament was made the organ of taxation.

This arrangement finds modern expression in Switzerland - where the power to spend rests with the legislature and the power to approve taxes resides exclusively with the people. With the power of taxation back in the people's hands, an equilibrium can be restored between spending interests and taxing interests - the consent of both bodies - legislature and taxpayer - will be required to bring the public appetite back in line with the public's means.

So in short - two themes: First, we must recognize the natural limitations of taxation and work within them. And Second, there are four flaws in our current process that can and should be corrected: First, that we should rely on taxes upon growth and not upon assets; second, that we must seek uniformity among our rates; third, that we must again separate local and state revenues and functions; and fourth, that we must separate the power to spend and the power to tax.

I appreciate your invitation today and wish you good luck in your work.

http://republican.sen.ca.gov/web/mcclintock/article_print.asp?PID=244