California now has a budget for the fiscal year that started almost a month ago. But for advocates of sustainable tax and spending policy, the hard times are only beginning. As a new report from the California Budget Project explains, lawmakers faced with a $23 billion shortfall chose to rely on spending cuts to close two thirds of the gap.  The list of cuts is grisly.  Health, education, child services, support for the disabled, and just about every other category of state spending will be slashed significantly.  The consequences for Californians are expected to be dire.

Astonishingly, the budget includes virtually no changes on the tax side of the ledger that can meaningfully be described as tax increases. While $3.5 billion of the current-year shortfall will be made up through tax changes, most of this revenue will be realized by accelerating collections rather than increasing the level of taxes. Specifically, $1.7 billion of the "new revenue" for fiscal year 2010 will be realized by accelerating personal income tax withholding so that more income tax will be withheld in the first half of the calendar year. This means, of course, that the legislature has just dug itself a $1.7 billion fiscal hole for the next fiscal year. Assembly Speaker Karen Bass, who's claiming that "in no way should this [budget] be misconstrued as kicking the can down the road,” must not have read this part of the budget agreement.

Bass -- and Governor Arnold Schwarzenegger, who boasted that the budget agreement "puts us on a path toward fiscal responsibility" -- must be equally unaware of a clever provision through which the state is closing $2 billion of the budget gap by forcing local governments to lend the state up to 8 percent of their property tax revenues in the upcoming fiscal year. The idea is that the state will pay back this loan, with interest, by the end of the 2013 fiscal year. In the short run, of course, this move will force local governments to make $2 billion worth of the hard decisions--cut spending or hike taxes and fees--that state lawmakers found themselves unable to deal with this year.

A broad base is an essential element of a good tax system. Fulfilling the principles of "horizontal equity," and "economic neutrality," both depend upon the use of a broad tax base. Unfortunately, the temptation to carve out special tax breaks for politically popular causes, or for powerful constituencies, if often irresistible to lawmakers.

But efforts are currently underway in Michigan to undo some of these special tax breaks, and a tax reform commission in California is at least pretending to consider a reform that would help pave the way for a careful reconsideration of many of that state's tax breaks. Furthermore, policymakers in North Carolina have expressed a strong desire to return to the task of base-broadening this fall, even as efforts to include base-broadening revenue-raisers in this year's budget agreement seem to have failed.

Earlier this month, Michigan Governor Jennifer Granholm stated her desire to eliminate between $500 million and $1 billion in special tax breaks as a way to reduce the state's looming deficit. While accomplishing such a feat will inevitably involve an uphill political battle, Michiganders should be grateful that the Michigan League for Human Services (MLHS) is closely following the action. MLHS Chairman Lynn Jondahl hit the nail on the head when he urged lawmakers to ask themselves, in reference to the state's film tax credit, "Would you be willing to appropriate $6 million to MGM, say, to make this film in Michigan? We're paying you to do something in lieu of filling pot holes or funding mental health treatment. Which do we value more?"

In California, a tax reform commission that so far has shown interest mostly in cutting the progressive income tax is at least listening politely to a different idea. The so-called "blue proposal" currently before the commission, presented as a less regressive alternative to the much-ballyhooed flat-tax proposal supported by Governor Schwarzenegger, would require special tax breaks to be presented in the Governor's budget, saddled with a "sunset" provision, and evaluated based on their effectiveness in achieving their stated objectives. Of course, adopting this approach will amount to rearranging deck chairs on the Titanic if the commission acts on its apparent zeal for moving away from income taxes and towards regressive consumption taxes. And the "blue proposal" has its warts as well: provisions that would impose a spending cap and create a new "net receipts" tax in lieu of the current corporate income tax have progressives feeling, well, blue. But the tax-expenditure element of the "blue proposal" is a welcome dose of thoughtful policy at a time when California surely needs it.

Finally, in a recent development out of North Carolina, base-broadening appears to be off the agenda for the immediate future, though policymakers have expressed a strong interest in returning to the issue this fall. When they do return to the issue, they would be wise to review these recommendations, recently released from the North Carolina Budget and Tax Center, explaining how to broaden the state's tax base while simultaneously offsetting any potentially harmful effects on low- and moderate-income families.

Charged with finding a revenue neutral way to reduce the volatility of California's revenue stream, the "Commission on the 21st Century Economy" recently expanded the scope of its study, and announced its plans to seek an extension until the end of September. This extension (the second sought by the Commission) comes after a successful bid by Commissioner Fred Keeley to add a variety of more progressive options to the discussion. The options to be discussed include: retaining the state's progressive income tax, removing Prop 13 limitations on commercial property tax bills, expanding the sales tax to include services while lowering the sales tax rate, taxing carbon based fuels, and making more careful use of a rainy day fund, especially in regard to capital gains revenue. Keeley's goal is to offer solutions to the state's volatile budgetary situation that don't involve gutting the state's progressive income tax.

This delay of the Commission's recommendations means that California legislators will not be receiving any advice from the Commission during this legislative session. This is an unfortunate development, as the legislature is clearly in need of some guidance. California lawmakers recently unveiled a plan to balance the budget by gutting the state's education programs, while refusing to increase any taxes.

Of all Keeley's proposals, the removal of Prop 13 limitations on commercial property taxes has received particular attention as of late, including an LA Times column detailing some of its abuses as well as its high cost.

Corporate lobbyists in Sacramento could be dealt another blow soon. An effort is underway to repeal by ballot (in November 2010) the billions in corporate tax breaks passed by California legislators over the course of the past ten months.

Late last week, California Governor Arnold Schwarzenegger, in a meeting with the editorial board of the Sacramento Bee, floated the idea of adopting a flat tax with a rate of 15 percent as part of a major overhaul of the state's tax system. While it is unclear which taxes the Governor would replace with such a levy, what is clear is that "flat tax" proposals are a bad idea.

As CTJ Executive Director Bob McIntyre made plain in his testimony before the California Commission on the 21st Century Economy recently, a "flat tax" almost certainly means that poorer taxpayers would be asked to contribute more to government finances and that wealthier taxpayers would be required to put far less into state coffers than they do now.

For a more productive approach to reforming California's tax system (and addressing the state's fiscal woes), see this recent commentary by Jean Ross, head of the California Budget Project.

It's no secret that California's budget situation is dire. With that in mind, the decision by California policymakers to enact three corporate income tax cuts over the past 9 months, costing the state as much as $2.5 billion annually, is nothing short of appalling. A recent report from the California Budget Project (CBP) explains these cuts, detailing especially how their benefits will be skewed toward a few of the largest corporations in the state.

The largest of the three provisions examined by the CBP allows corporations to use a "single sales factor" to determine how their profits are apportioned among different states for corporate income tax purposes. You can read the ITEP Policy Brief on single sales factor here. The CBP notes that this provision alone would cause $1.5 billion to flow from already depleted state coffers into the hands of large corporations. At least 80% of the benefits would go to big business, defined generously here as corporations with gross receipts over $1 billion annually.

The second provision is an allowance for "net operating loss carrybacks". This new measure could reduce state revenues by up to a half billion dollars annually. California is now among a minority of states offering this type of tax break. For more on this topic, see this recent report from the Center on Budget and Policy Priorities detailing why states with NOL carrybacks should eliminate them.

The final provision examined by CBP allows tax credits earned by one corporation to be given to related corporations. This is eventually expected to result in losses of up to $400 billion for the state. A lucky 0.03% of California corporations will enjoy nearly 90% of the benefits.

It's hard to believe that California policymakers considered these items to be a priority despite their state's current budget nightmare. Repealing these breaks is the obvious next step in trying to restore fiscal sanity to the state -- though it will by no means end the state's problems. For a more comprehensive solution, Californians should look toward the elimination of the supermajority requirement for tax increases, and the elimination of Prop 13. These ideas seem to be gaining increasing attention, as exemplified in this recent LA Times Business column.

California's special election this week came with no surprises. Just as the pre-election polling had predicted, California voters roundly rejected most of the ideas sent to them by their representatives -- save the proposition limiting pay increases for elected officials. The most important consequence of the vote was the defeat of a cap on state spending, hastily placed on the ballot as a means of securing the Republican votes needed to pass a budget with two-thirds legislative support.

The rejection of this cap, however, brings with it the early expiration of a variety of recently enacted, but temporary tax increases. Instead of expiring in early to mid 2013, those increases will now cease to exist in early to mid 2011. This development does deal a sizeable blow to California's fiscal outlook, though even with the full tax increases an immense budget deficit would have remained.

Talk over the last few days has focused largely on themassive cuts that will be needed to bring the state's budget into balance. Additionally, the state would like to borrow to fill much of the gap. It hopes to have its loans guaranteed by the federal government in order to avoid the consequences associated with lost confidence in California's ability to pay back those loans.

Unfortunately, at least as of today, responsible, broad-based, progressive tax increases appear to be off the table. With California's budget in shambles for the foreseeable future, however, it's hard to think that the opportunity for meaningful, revenue-raising tax reform is completely out of the question. Such reform, of course, should start with the elimination of the two-thirds requirement for enacting tax increases and passing budgets.

California has an important special election coming up in just a few weeks. After a lengthy struggle over how to fill the state's immense budget gap, a compromise was reached when legislative leaders and the Governor agreed to place on the ballot a measure to cap state spending growth (using a formula based on inflation and population growth).

The most recent numbers suggest, however, that Californians aren't enamored with the idea, and for good reason.

As Jean Ross of the California Budget Project (CBP) put it, "Though touted as 'reform,' Proposition 1A does nothing to address the fact that the revenues raised by our state's tax system are insufficient to fund our current programs and services, much less the level that Californians want and expect... By adding more formulas on top of the state's already hamstrung budget, Proposition 1A will make it even more difficult to balance future budgets." Instead, as Ross points out, California's budget problems would be better addressed through a modernized tax system, and an elimination of the requirement that two-thirds of the legislature approve any tax increase -- an idea that has steadily been picking up some support.

It's hard to believe, but there may actually be a trend in state tax policy more prominent than increasing cigarette taxes. Business tax credits aimed at spurring economic development have been among the most popular ideas in statehouses scrambling for ways to reduce unemployment. Just last week, we described a plan in Minnesota to boost investment tax credits and a budget in California containing a few credits of its own. This week, proposals to do the same in Iowa, Kentucky, and Missouri are under discussion.

In Iowa, Republican lawmakers have suggested paying (via tax credit) half the salary of each new job created by private businesses. Oddly, because this payment would be administered through the tax code rather than as a direct grant, the debate has become confused to the extent that this policy has been labeled as a way to return to a "market-based, capitalistic system".

An excellent op-ed out of Kentucky helps clear things up a bit, noting that Gov. Beshear's proposed expansion of business tax incentives would be a costly, nontransparent, and likely ineffective way of encouraging job growth. The op-ed goes on to argue that a "broader" approach, including better targeted and more closely scrutinized spending programs, could do far more good than creating more tax credits.

Finally, as an expansion in economic development tax credits works its way through Missouri's legislature, the admission of at least one legislator that he is a "recovering tax credit addict" helped to shine some light on the unfortunate politics behind these types of tax credits. These programs can cost a state enormously, and are rarely defensible on principled tax policy grounds. Instead, they constitute a type of spending done through the tax code -- commonly referred to as "tax expenditures" -- which add complexity, shrink the tax base, require higher marginal rates, and offer little if anything in terms of making the system more responsive to individuals' and businesses' ability to pay.

As we mentioned last week, California enacted, as part of its budget compromise, a change in the rules determining what share of a corporation's income is taxable in the state. To be specific, California adopted an optional "single sales factor" apportionment formula, which multi-state corporations support -- because it will help them avoid taxes. Virginia appears to be following suit this week. Both of the state's legislative chambers have approved optional single sales factor apportionment, though only for manufacturers. The Governor has yet to sign the measure, and he has reportedly taken no position on the bill. You can read the ITEP Policy Brief explaining how single sales factor apportionment can reduce the fairness and adequacy of state corporate income taxes here.

Six Holdouts Realize State Budget Shortfall Could Not Be Fixed with Cuts Alone

The governor of California has finally signed a budget. After a prolonged struggle to convince a handful of anti-tax lawmakers that the state's problems were too large to be fixed without additional revenues, a package of spending cuts and tax increases was finally cobbled together. On the tax side, the most notable provisions include a temporary one percent sales tax increase, a temporary hike in state income tax rates, a temporary increase in the vehicle license fee, and a temporary cut in the dependent exemption credit. That's a lot of temporary help for a problem that's not likely to go away.

Negating some of the usefulness of these revenue gains are temporary tax credits for businesses, home buyers, and movie and TV production. Even worse, a permanent tax cut for multi-state corporations was enacted in the form of an optional single sales factor apportionment method. Nonetheless, securing a budget with any additional revenues at all was an important (and difficult) first step.

But the drama in California isn't over. One of the major compromises used to secure the supermajority needed to pass a budget was the inclusion of a provision placing a spending cap on the ballot for a May 19 special election. If voters reject the spending cap, the temporary tax increases will expire in early to mid 2011. If the spending cap is approved, however, the increases will be allowed to continue through early to mid 2013. Needless to say, you can expect plenty more coverage of the California saga as the story develops.

California legislators appear to finally be in the early stages of negotiations over a method to fix the current year's budget shortfall. As has been obvious to most observers for quite some time, California's budget gap is far too large to be fixed with spending cuts alone, and will require some kind of tax increase. Convincing California Republicans to recognize this fact was no easy task, and it now appears that the cost of securing their support could come in the form of a spending cap. Unfortunately, while a tax increase is absolutely necessary to solve California's short-term problems, allowing a spending cap to be slipped into the deal would be nothing short of devastating in the long-term.

The case against the spending cap was articulated brilliantly by Jean Ross of the California Budget Project in a recent op-ed published in the Los Angeles Times. Ross noted that "far from being a cure-all, a hard spending cap would place an arbitrary stranglehold on the state's ability to improve its schools, rebuild its infrastructure, care for its senior population and respond nimbly to future challenges. Disguised as a solution, this cap could quickly become one of California's most serious budgetary problems". She goes on to point out that her organization "found that if this cap had been enacted in 1995, using that year's budget as the base, it would have resulted in a 2008-09 budget $39.7 billion below what was enacted in September. While this would bring the budget into balance, it also would require spending cuts more than twice as large as those proposed by the governor."

Californians familiar with Colorado's TABOR debacle should be especially wary of what Ross points out next: "The hard spending cap also would be incompatible with Proposition 98, which guarantees a minimum level of state funding for K-12 education and community colleges. That guarantee would generally outpace increases allowed under the cap, which would result in education crowding out all other state spending". The parallels with the difficulties created by Colorado's Amendment 23 (which requires increases in K-12 spending of 1% plus inflation each year) couldn't be more obvious.

There isn't any question that California needs more revenue. Just look at the fact that California's bond rating was recently decreased by two grades, or that the state Controller had to start issuing IOU's instead of tax refunds today. But while securing more revenue should be a top priority this year, accepting a spending cap as part of the compromise would be an action that Californians would regret for years.

The news from California just keeps getting worse. Faced with a budget deficit that could reach as much as $42 billion by June 2010 and the prospect that the state will soon deplete its cash reserves, State Controller John Chiang announced last week that the state may have to begin issuing IOU's to state employees and to contractors who do business with the state. There's also the chance that, rather than receive the refunds to which they may be entitled, California taxpayers may receive promises that they'll be paid later as well.

So, while Governor Schwarzenegger is busy vetoing the Assembly's latest budget plan, because, he maintains, it "punish[es] people with increased taxes," millions of Californians must now prepare themselves to pay, in essence, higher taxes than they expected to pay this year. Such an outcome hardly seems justifiable, given the likelihood that those residents entitled to refunds are low- and moderate-income families, families that would almost certainly use those tax refunds to pay off bills or to make long-planned purchases.

In light of these developments, the state's Legislative Analyst, Mac Taylor, is now urging policymakers to put tax increases before the states' voters as early as April, so that they can avoid the supermajority-induced gridlock that has plagued Sacramento in recent years.

Of course, California isn't alone in suffering through fiscal crises brought on by unsound tax limits and undemocratic procedural rules. Coloradoknows them quite well too, thanks to the so-called Taxpayer Bill of Rights (TABOR) approved by state voters in 1992. Unless some major changes are made this year, it will likely endure some considerable woes in the years ahead. Why is that? Well, as Erika Stutzman of Boulder's Daily Camera observes, during recessions, "double-whammy style, [ Colorado hits] the 'ratchet' effect: TABOR's requirement that the previous year's budget be used to determine next year's budget." So, if spending falls this year, that lower level of spending will serve as the baseline for growth in all future years. Quite sensibly then, Ms. Stutzman backs legislative changes to TABOR to prevent that from happening.

As you can see from just a brief skimming of the Tax Justice Digest's California archives, the fight to fill California's enormous budget deficit has been a struggle of epic proportions. Despite widespread agreement among both the Governor and a majority of legislators that some type of tax increase will have to be employed if catastrophic reductions in state services are to be avoided, a minority of tax-phobic legislators have been able to hold hostage the process as a result of California's requirement that all tax increases be approved by a super-majority of the legislature. Having struggled for months under the unworkable limitations of the super-majority requirement, California legislators took the desperate action of cobbling together and passing a (perhaps illegal) budget fix that raises taxes in a manner so convoluted that it may circumvent the super-majority requirement (that is, if it holds up in court).

The gist of the plan is this: raise the sales tax, enact an oil extraction tax, and impose a surcharge on everybody's income tax bill. Then, at the same time, eliminate the gasoline tax so that, on the whole, the proposal produces no increased revenue for the state. But getting rid of gas taxes is hardly something California can afford, especially given the well-publicized suspension of numerous transportation projects this week. In order to fix this, the gas tax is then re-imposed (at a higher rate than before), but is re-labeled as a "fee", rather than as a "tax". Presumably, this is allowed because gas taxes are largely dedicated to the very specific purpose of recovering the costs of providing transportation -- in contrast to taxes which usually finance government expenditures more generally.

Given the desperate nature of the situation, the Governor appears to have given his consent to this convoluted technique. But before you start thinking that we've heard the end of California's budget debate, think again; the Governor has already announced his intent to veto this particular proposal because of his belief that it includes too few spending cuts and does too little to stimulate California's economy. Presumably, then, if another similar proposal manages to make it through the legislature that is more tailored to the Governor's liking, we may be set for a court battle over the legality of this revenue-raising scheme.

For now, only one thing is clear: California needs to greatly magnify the amount of attention that has been given to ending the absurd super-majority requirement.

The Newest Version of the California Budget Debacle

With the election out of the way, California Governor Arnold Schwarzenegger is displaying some optimism that Republican legislators will reconsider their opposition to any and all tax increases. So far, Republicans have been content with slashing services, borrowing heavily, and employing clever accounting games to get the current year's budget into balance. With more shortfalls staring the state in the face, however, the Governor has called a special session in which he has proposed a variety of tax increases, as well as spending reductions.

The Governor's previous plan to temporarily increase the sales tax by 1-cent has evolved into a plan to hike the sales tax (still temporarily) by 1.5 cents.

In addition, the Governor proposes:
- closing loopholes in the sales tax that allow a variety of personal services to go untaxed,
- instituting an oil extraction tax (California is the only major oil-producing state that lacks such a tax),
- raising the tax on alcoholic beverages,
- and enacting some modest increases in vehicle registration fees.

His plan would also include sizeable cuts in school budgets and health care services for low-income Californians.

Of course, the sales tax, alcohol tax, and vehicle registration fee increases would all hit low-income Californians hardest just as the budget cuts would. The fact that more progressive options have not yet surfaced is a major disappointment. Nonetheless, it seems clear that the state will have to raise revenue in some way, and the fact that a Republican governor traditionally opposed to tax increases has recognized that is a major step forward.

Unfortunately, though, that step forward has been accompanied by another step backwards, as the governor is simultaneously proposing to give millions in tax breaks to film and television companies.

And making matters even worse, California's budget hole could become deeper if the federal government does not act to reverse a little-noticed IRS ruling on the corporate income tax that we publicized last week.

Tax Commission Likely to Play Major Role in Future of California's Tax System

Alongside the budget struggles sure to dominate California headlines for the next few weeks is another tax story that could ultimately end up being even more important. The Governor, together with House Speaker Karen Bass recently agreed to form a "Commission on the 21st Century Economy" with the explicit goal to "stabilize state revenues and reduce volatility". While the Commission's recommendations won't be made until April 15, 2009, there has already been some speculation about what those recommendations will be. So far, expanding the sales tax base to include more services seems to be at the top of the list. Less encouraging, however, is talk of reducing the progressivity of the income tax.

Enacting an income tax would obviously be a step in the right direction for states like Nevada, New Hampshire, and Florida, but it would only be the first step. As ITEP's latest policy brief explains, states' income taxes must also be progressive, in order to balance out the regressive impact of the other types of taxes that states levy, like sales taxes and property taxes. States that do not have a progressive personal income tax will find it nearly impossible, over the long run, to fund public services in a way that is sustainable and fair.

At the very least, this means states' income taxes should provide meaningful exemptions to poor taxpayers and use a graduated rate structure to ensure that the very wealthy are paying their share. Unfortunately, though, as a new report from the Center on Budget and Policy Priorities documents, some states with personal income taxes are actually taxing the poor deeper into poverty. In fact, the Center's report finds that, in 18 of the 42 states that levy income taxes, two-parent families of four with incomes under the federal poverty level actually paid state income taxes in 2007. It also finds that 15 states make single parents with two children living below the poverty line pay state income taxes.

There are some straightforward solutions to this. For example, 23 states and the District of Columbia offer earned income tax credits (EITCs) which reduce income taxes for poor families and sometimes provide a refundable credit that further offsets the regressive impact of other state taxes. Plenty of states with personal income taxes could also make their rate structures more progressive, which would ensure that high-income families pay a bit more, as a share of their income, than low- and middle-income families.

Also troubling is that some states that do the right thing and use fairly progressive income taxes -- such as Rhode Island and California -- are considering fundamental changes to those taxes. As ITEP's Jeff McLynch observes in yesterday's Providence Journal, policymakers in Rhode Island should be strengthening the progressive character of their state's income tax, rather than seeking to diminish it.