California Moves toward Major Tax Overhaul

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.

Despite high expectations, the proposal by the Commission on the 21st Century Economy already is being met with skepticism before it has even been delivered to Schwarzenegger’s office. The hand-off was expected Sunday but the panel, which has been meeting since January, said it would not turn in its report until later in the week.

Union leaders worry the policies might drive down wages, while businesses fear being saddled with larger tax burdens. Economists say more study is needed to determine what effect the overhaul will have on the world’s eighth-largest economy.

“It’s a phenomenally brief period of incubation for something as significant as what they’re suggesting,” said Kirk Stark, a law professor at the University of California, Los Angeles who is not on the commission. He noted the problem has been studied for decades.

Even some members of the 14-member panel have expressed unease with the latest version of the proposal. One legislative leader has indicated he will take his time and likely make changes to the commission’s recommendations during an upcoming special legislative session.

“The idea that we were going to vote up or down, that’s not going to happen,” said Senate President Pro Tem Darrell Steinberg, D-Sacramento. “What we need to do with an issue of this magnitude is take our time.”

California’s manufacturing-based sales tax system has failed to keep pace with growth in the service industries, while its progressive income tax structure is often blamed for wild fluctuations in state revenue. The top 1 percent of income earners, for example, pay roughly half the state’s personal income taxes.

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 and has analyzed the plan.

“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 startup 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.

9/20/2009 5:18 PM JUDY LIN, Associated Press Writer SACRAMENTO, Calif.