Lawmakers in California just agreed to mixture of tax increases, spending reductions, accounting shifts, and federal stimulus money to close a massive $42 billion budget deficit. The open question remains: Will this be enough, or will the $12 billion per year tax increase, the largest state tax increase in U.S. history, torpedo the struggling Golden State economy, resulting in reduced tax revenue?
Taxes up in Three Areas
California is increasing taxes in three areas: America’s highest income taxes will go up, America’s highest state sales tax rate will go up from a base rate of 7.25% to 8.25%, a 14% increase, and the vehicle license fee will almost double, from 0.65% to 1.15%. Left unchanged was America’s highest gas tax. (A proposal to increase gas taxes by 12 cents per gallon was dropped.)
California has now become America’s most high-stakes and visible experiment in the efficacy of the Laffer Curve and supply side economics.
Why the Crisis?
How California developed such a large budget deficit with insufficient reserves is fairly simple: We spent too much when times were good, setting nothing aside for a rainy day. State spending in California doubled over the past decade–expanding at twice the rate of inflation plus population. Since the historic 2003 recall election, spending increased 40% in five years, with 50,000 new government employees added to the state’s payroll.
Spending Limit on May 19 Ballot
To address this runaway spending, the legislature agreed to place a constitutional spending limit measure on the May 19 ballot in a special election. The constitutional spending limit was demanded by Republican lawmakers while Democrats demanded Republicans “put taxes on the table” in the so-called Big-5 negotiations between Gov. Arnold Schwarzenegger and Democratic and Republican legislative leaders from the State Senate and Assembly. The spending limit, tax increase, and revised budget all required a two-thirds vote for passage, necessitating the controversial support of three Republican lawmakers in each house.
The spending limit is designed to restrain state spending to a formula tied to the average of ten years of revenue. But, it has loopholes that may render it largely ineffective–for instance, new tax hikes serve to boost the spending limit. Further, if voters pass the measure, the tax increases just voted into law will be automatically extended for two years. This places fiscally prudent Republicans in the untenable position of advocating for spending restraint AND higher taxes at the same time.
Spending Limit/Higher Taxes Linked
The spending limit’s tie to two added years of taxes was intended to prevent an expensive and coordinated public sector union campaign against the ballot initiative. So far, it looks like the prospect of higher taxes is causing major unions to take a pass on attacking the flawed spending limit. In 2005, California’s unions spent upwards of $150 million to successfully defeat four special election reform measures championed by Schwarzenegger. Schwarzenegger’s dramatic loss in this special election commonly marks his shift from right-of-center reformer to left-of-center big-government appeaser.
The only major tax limitation group gearing up to oppose the Faustian bargain linking higher taxes to a spending limit is the Howard Jarvis Taxpayers Association. The question is whether Jarvis’s $2 million cash on hand will be enough to get the word out that a vote for the spending limit is a vote for over $20 billion in extra taxes.
Regardless of the outcome of the May 19 vote, sales taxes and vehicle taxes will go up April 1(the joke being on the taxpayer) while income taxes will be higher for the entire 2009 calendar year. In all likelihood, the tax rate increases will not generate the revenue projected. Instead, these tax rate increases will further depress California’s sagging economic activity, potentially even reducing revenue below current levels even with the higher rates.
The California economy is reaching the tipping point versus neighboring states which aggressively advertise to lure away California businesses. Nevada, a state with no income tax, has taken to running full-page ads in California newspapers around April 15. California just handed Nevada powerful new material for this year’s ad campaign.
In a few months California may be faced with the untenable and embarrassing prospect of asking for another round of tax hikes to close a burgeoning budget deficit.
Why I Stepped Down
Lastly, the fallout from six Republicans supporting tax increases is only now being felt. Soon after the details of the tax increases became public, I resigned my position as the Assembly’s Chief Republican Whip in protest and asked the Assembly Republican leader to resign. Days later, the Senate Republican leader lost his position and was replaced by Sen. Dennis Hollingsworth. Recall efforts have been threatened at the six Republicans whose votes ensured the tax hike’s passage. Adding to the tension, the California Republican Party held its regularly scheduled convention in Sacramento days after the tax increase vote. Some party members sought to censure the six. Instead, the state party approved a policy to deny party funds to any of the six GOP lawmakers.
California just passed the largest state tax increase in U.S. history with the support of a nominally Republican governor and six Republican lawmakers in exchange for a spending limit initiative that may or may not pass and, if passed, may or may not be effective. It remains to be seen if this tax increase will produce enough revenue to keep California’s bloated state government solvent. In the meantime, California residents angered at the tax hike appear to be blaming Republicans for not standing firm, even though every one of the 75 Democratic lawmakers voted for taxes while 38 of 44 Republicans opposed taxes.
If the state continues to operate in the red and another tax hike is proposed mid-year, perhaps California’s Republican lawmakers will have a chance to restore their tattered anti-tax banner.