Thanks once again to Laura Mahoney of BNA for her great reporting. The latest is on the progress of the “Tax Commission.” See my earlier post on their proposals here. Video of the September 10th meeting is available here.

Reproduced with permission from Daily Tax Report, 175 DTR H-2 (September 14, 2009). Copyright 2009 by The Bureau of National Affairs, Inc. (800-372-1033) http://www.bna.com.

Commissioners May Endorse Tax Overhaul For California if Specific Elements Included

LOS ANGELES—Some members of a special commission appear ready to endorse a vast overhaul of the California tax system at a final meeting Sept. 14, but said Sept. 10 they must first be satisfied that their fellow members will address specific reservations they each have about the broad plan.

Members of the Commission on the 21st Century Economy also backed off their original plan to ask lawmakers and Gov. Arnold Schwarzenegger (R) to take up their recommendations immediately in the form of proposed legislative language and enact them as soon as possible. Instead, commissioners agreed that the changes require more study.

At a lengthy meeting Sept. 10, Chairman Gerald Parsky suggested the commission introduce its final report to the governor and Legislature with an explanation that members believe the package, which centers around a new net receipts tax on businesses, is promising enough to warrant further study. Commissioners are likely to say that lawmakers and the governor should “proceed with a public process” to fully evaluate the proposals, and enact them upon completion of a more thorough review.

The 14-member commission will meet for a final time Sept. 14 in Berkeley to decide what recommendations will appear in the report, and what form they will take. Parsky has been calling for unanimity, or at least a strong consensus, from members on their final recommendations in the nine months they have been meeting. But with disagreements among members on key elements of the proposals still on the table, it is unclear how many will endorse the final recommendations.

Core Elements of Package

At the core of the package are proposals to eliminate the corporate income tax, mostly or completely eliminate the state portion of the sales and use tax, reduce and partially flatten the personal income tax, and impose a new business net receipts tax.

Members Christopher Edley, dean of the University of California, Berkeley Boalt Hall School of Law; and John Cogan, a senior fellow at the Hoover Institution and public policy professor at Stanford University; spearheaded a more detailed review of the core package in recent weeks. Edley, Cogan, and Parsky led the discussion at the Sept. 10 meeting.

Under the proposal, they explained, the changes would be phased in over five years, beginning in 2012 with elimination of the corporate income tax and partial imposition of the new business net receipts tax at a rate of about 1.6 percent. At the same time, the state portion of the sales and use tax would be reduced by 1 cent in the first year. For each of the next two years, the BNRT would increase incrementally while the sales and use tax would be reduced by another 1 percent.

In the third year of the phase-in, the personal income tax (PIT) would be modified to have only two tax brackets, eliminate credits and most deductions, and include a much larger standard deduction. The PIT rates would be 2.75 percent for income up to $56,000 for joint filers and $28,000 for single filers, and 6.50 percent for incomes above those amounts. Itemized deductions would be limited to mortgage interest, property taxes, and charitable contributions, while the standard deduction would increase to $45,000 for joint filers and $22,500 for single filers.

Midstream Review of BNRT

In the third or fourth year of the phase-in, the commission is likely to call for a formal review of the changes, to determine if the new BNRT is bringing in adequate revenue. Based on that review, the final BNRT rate would be set. To give the state room to make adjustments, the plan calls for further reductions in the state sales tax to be contingent on the revenue generated by BNRT. If the new business tax is not bringing in enough revenue, the sales tax may not be reduced further.

Edley and Cogan explained to members that certain elements of the current corporate income tax would be retained under a BNRT. The current research and development credit would remain available in some modified form, under the belief that the credit is important to encourage start-up companies and is “substantive and politically useful,” Edley said.
In addition, companies that have accrued net operating losses under the corporate income tax could carry them forward for 20 years to be used to offset up to 5 percent of BNRT liability each year.

Edley said the commission heard comments from many business people about the importance of NOLs to start-up companies; he also considered the fact that NOLs are available on the federal return as a reason to retain them.

The commission is likely to call for enactment of the package as long as it also includes a stronger “rainy day fund” that captures revenue in strong economic times to be used during downturns. By broadening the tax base to create more of a tax on consumption and less of a tax on income, and creating a stronger reserve fund mechanism, the state would reduce revenue volatility by 42 percent, Cogan said.

Lawmakers and budget writers would more easily be able to predict future revenues, making spending plans more reliable. Several other commissioners said they support many of the ideas in the core package, but have some reservations.

Gas Tax Still on the Table

Commissioner Fred Keeley, a former Democratic assemblyman and current treasurer of Santa Cruz County, said he likely would support the package if it also includes his proposal to levy a new tax on purchases of gasoline and diesel fuel.

The tax would start at 18 cents a gallon, and would be indexed each year to end up at about 90 cents a gallon in 10 years. The intent of his proposed tax is to reduce use of fossil fuels and provide a new source of revenue.

Commissioner Michael Boskin, a senior fellow at the Hoover Institution and economics professor at Stanford University, said he likely would support the package only if it also includes some form of minimum tax for low-income earners.

Boskin said he is troubled that the PIT proposals outlined in the plan appear to exempt about 50 percent of income earners from paying any tax at all. Without any contribution, even a nominal one, citizens lose the link between taxes paid and delivery of government services, he said. All wage earners should pay a minimum tax of at least $100, he said.

Commissioner Becky Morgan, a former Republican assemblywoman and current president of the Morgan Family Foundation, also raised the issue of a minimum tax.
“Everyone should have a stake,” she said.

Boskin also called on the commission to endorse his proposal to open the state waters in the outer continental shelf to oil drilling, subject to strict environmental protections.
Royalty proceeds would be placed in a reserve fund that could be used for limited purposes. With the state facing chronic budget deficits, Californians should recognize the offshore oil reserves as a reliable source of revenue just waiting to be tapped, he said.

“It is the height of folly for the state to not even explore this as an option,” Boskin said.

Richard Pomp, a law professor at the University of Connecticut, did not say whether he would endorse the core package or not, but his list of concerns was lengthy.

Elimination of PIT Deductions Questioned

Pomp questioned the proposal’s elimination of personal income tax deductions for medical costs, as well as elimination of the child care credit, at the same time that it would retain the research and development credit for corporations. No evidence exists to suggest that the R&D credit pays for itself, yet the health care and child care provisions are crucial, he said.
The package would skew distribution of the overall tax burden by reducing the burden on the wealthy and corporations, Pomp said.

Meanwhile, the BNRT is untested and raises huge questions, especially the issue of economic nexus, which Pomp called “the 900-pound gorilla in the room.” He pressed the commission to accept his own proposals, such as a new severance tax to be levied on oil extracted in the state, which he said is similar to Boskin’s offshore oil drilling and royalties proposal.

Several commissioners also said they want to craft a more detailed midstream review of the BNRT as it is being phased in. Recommendations for a “safety-valve” to address unintended consequences of the tax, and to set or adjust the tax rate, are likely to include formation of some type of public group to undertake a review, and a maximum rate above which the BNRT should not go. If it appears the tax would need to go above the recommended maximum to bring in enough revenue, the entire system should be reconsidered at that point, several commissioners said.

Agenda for Final Meeting

Parsky said he expects to discuss in more detail at the final meeting Sept. 14 a safety valve mechanism, as well as the tax burden distribution of the overall package. So far, commission staff has provided detailed information about the distribution of the PIT changes, but has not fully analyzed the distribution when all the elements are put together.
The final report is likely to contain three sections: one that lists recommended statutory changes that can be enacted by the Legislature, a second that lists recommended constitutional or other changes that would need approval from voters, and a third that lists other ideas worth further study.

It is unclear whether the commissioners will cast votes on the package, or more informally endorse the final report before sending it to the governor and lawmakers.