California’s tax-the-rich folly

The California Legislature is back from its summer recess and has frantically resumed its quest for new revenue sources.

One of the latest ideas is Assembly Bill 1253. This proposed legislation would add new income tax brackets for high earners on top of the existing ones.

Income between $1 million and $2 million would receive a one percentage point surcharge, bringing the marginal rate to 14.3 percent. Those earning between $2 million and $5 million would pay an additional three percentage points, and those earning over $5 million would pay an additional 3.5 percentage points, bringing their marginal rates to 16.3 percent and 16.8 percent respectively.

This plan constitutes a continuation of California’s soak-the-rich approach to raising revenues.

While some seem to believe that high earners can provide unlimited resources, the evidence from prior tax hikes suggests that the introduction of these tax rates is not even likely to raise revenue for the state. At the same time, it will hammer job creation.

The problem is that high earners do not simply sit there and take it when the state goes after their income.

In a detailed study of the 2012 California ballot measure that raised the top state rate to 13.3 percent, Ryan Shyu and I found that just two years later, the state was only collecting 40 cents of every dollar that it had hoped to raise from the tax increase.

The reason?

High income taxpayers affected by the 2012 tax increase suddenly began to flee the state at higher rates, especially to zero tax states like Nevada, Texas, and Florida.

Even more importantly for the state budget, those that stayed began declaring considerably less taxable income than they would have otherwise, apparently either scaling back their productive activities or engaging in tax avoidance.

The economist Arthur Laffer has famously argued that there is a tax rate beyond which a government’s revenue will decline if it raises taxes further, due to the disincentive effects of high taxes.

While the federal government may be helped by limits on what American citizens can do to escape federal taxation, state governments tread on much thinner ice when faced with the ability of taxpayers to move their residences and their earnings generation to other states.

In 2012, California was at least still at the point where raising top income tax rates led to some increase in near-term revenue, albeit with grave long-term consequences.

Today, however, the state is starting from a 13.3 percent tax rate that is the highest in the nation.

Furthermore, Congress has since moved to protect federal taxpayers against bloated state spending by placing a $10,000 cap on state and local tax deductions as part of the 2017 Tax Cut and Jobs Act.

So while the blow of a 3 percentage point tax increase in 2012 was strongly cushioned by deductibility against top-bracket federal rates, California taxpayers today would feel the full force of this proposed round of increases.

Once taxpayers have responded by voting with their feet, reducing their business activities, and re-upping with their tax attorneys, the state will likely lose revenue if it attempts to increase rates.

To make matters worse, Sacramento’s narrow focus on tax revenues ignores that fact that this tax avoidance behavior will lead to job losses. These rates also apply to business income to non-corporate entities (such as partnerships and LLCs) which account for over half of all employment in the US.

In another study, Xavier Giroud and I found that each percentage point increase in individual tax rates that the average state implements leads to losses of up to 0.4 percent of all non-corporate jobs in the state.

Starting from California’s already astronomical top rate, the impact would be expected to be even larger.

These job losses will negatively impact the well-being of Californians and further reduce state tax revenues.

California’s approach to relying on the taxation of top earners has sown the seeds of its own destruction. The top 0.5 percent of taxpayers pay over 40 percent of individual income taxes in the state.

Officials are blaming COVID-19 for the budgetary havoc, but this structure means that in any downturn, California revenues will tank due to the excessive reliance on both the ordinary income and capital gains of top earners.

If the Legislature is interested in promoting economic growth and prosperity in the California, and securing the state’s own fiscal future, it should reject further top income tax rate increases.

Instead, it should work towards putting the state back on a path towards being a competitive place for high-income individuals and businesses to locate their economic activity.

Joshua Rauh is a Senior Fellow at the Hoover Institution and the Ormond Family Professor of Finance at the Stanford Graduate School of Business.

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