Expert Insight: The Tax Reform Possibilities of California's New Super Majority

The November 6 election resulted in significant voter-initiated statutory tax changes in California and set the stage for a super-majority of Democrats in both houses of the legislature in 2013. In the coming year, California is likely to see fewer lawmakers committed to “no tax” pledges, and more willing to take a crack at significant tax reform.  

But California voters adopted several important tax changes even before some elected lawmakers will take office. Voter-initiated statutory tax changes passed during the 2012 election include :

  • Passage of Proposition 30 means a quarter cent sales tax increase starting in 2013 and lasting for four years. The new state rate of 7.5 percent will be the highest among the states (see FTA table).
  • For upper-income individuals, Prop. 30 adds three new brackets to the personal income tax (PIT) retroactive to January 1, 2012. The top marginal PIT rate in California is now 13.3 percent - highest among all states. These rates are in place through 2018 (7 years).
  • Passage of Proposition 39 ends the apportionment factor choice businesses have had since 2011. Starting in 2013, most businesses will have to use single sales factor apportionment.

The election results also brought about an increased possibility of the enactment of tax legislation in the next two years due to the new makeup of the legislature. Starting in 2013, at least two thirds of the members of both the California Assembly and Senate will be of the same political party (Democrat).

Proposition 13, passed in 1978, requires a two-thirds vote of the legislature for any tax increase.  Proposition 26, passed in 2012, provides that if even one taxpayer might have a tax increase, legislation needs a two-thirds vote. With many Republican legislators at the time pledging to not increase taxes, Prop. 26 made it harder to enact any tax legislation, including conformity bills.

So, with one election, the voters have enabled tax reform legislation to be enacted yet have given lawmakers the added challenge of a tax system more broken than before with the highest personal income tax and sales tax rates among the states.

What tax changes might we see from the newly empowered legislature? Here are some suggestions for them:

  • Create a list of current tax provisions that do not support the state's economic, societal and environmental goals. This will help identify where reform is most needed.
    • Example: Passage of Prop. 39 indicates that voters want businesses to keep their payroll and property in the state. Yet, the state imposes sales tax on manufacturing and research and development equipment. Work is needed to phase out this tax treatment (which also results in pyramiding).
    • Example: California has ambitious goals to reduce GHG emissions. Yet, while the state has the highest gasoline excise tax among states (53.7 cents per gallon according to 2012 research from the Minnesota legislature), it has no oil severance or carbon tax.
  • Review areas of both conformity and nonconformity with federal tax law and make changes. Conformity to federal depreciation rules should be considered. Nonconformity to costly federal subsidies should be reconsidered (such as the mortgage interest deduction on a second home).
  • Tax expenditures should be reviewed to determine if their intended purpose still makes sense today, if that purpose is being achieved, and whether alternatives would be more effective and less costly.
  • Review the tax system to determine where it should be modernized and made to better meet principles of equity, simplicity and neutrality. For example California's sales tax base of tangible personal property, enacted in the 20th century, has eroded and become less equitable and neutral. It should be modernized to also tax personal consumption of 21st century digital goods, entertainment and personal services. Any base broadening should be accompanied with a rate reduction.
  • Some people question the constitutionality of S.B. 1015, enacted in June 2012, to repeal the Multistate Tax Compact that was passed with only a simple majority vote. Re-enact it with a two-thirds majority vote to end this issue.

California's tax system has been neglected, perhaps due to the two-thirds vote requirement and too much focus on solving budget problems with increased rates. Unfortunately, the increased rates brought about by Proposition 30 create challenges for the state. These challenges include a greater volatility problem for the already volatile personal income tax, a more regressive sales tax (due to both the high rate and the exemption of many high-end consumption items such as entertainment and personal services), and a more unfriendly business climate.

Can the legislature improve the system? Can they broaden the base and lower the personal income tax and sales tax rates despite the temporary increase voted on by the people? Can ways be found to improve the business climate despite the high tax rates voted in via Prop. 30? Would reduction of the corporate income tax rate help the business climate, or do the high personal income and sales tax rates cause too much harm to overcome?

The next two years in California have the potential to be different on the tax legislation front. Much work is needed to improve and modernize California's tax system. These two years will likely also be a time for federal tax reform and passage of federal bills that apply to state taxation such as Main Street Fairness and the Mobile Workforce Act (H.R. 1864). There are many tax reform possibilities for the legislature to consider over the upcoming two years. Let's see what happens.

 Annette Nellen, CPA, Esq., a tax professor at San Jose State University, runs the 21st Century Taxation website and blog focusing on tax system weaknesses, possible solutions and the need to modernize tax systems and follow principles of good tax policy (including for California). Annette is an active member of the tax sections of the AICPA, ABA and California Bar.

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