Rich People Underappreciated in Golden State

How can a big windfall be bad news for a financially ill state? California's unexpected $6.6 billion spike in projected tax revenue has many people pondering this imponderable. 

In a Washington Post column about State Sen. Bob Dutton (R-Rancho Cucamonga), George Will explains a point that is crucial to any understanding of the Golden State politics this year:

As a candidate, Brown said he would seek voters' approval for any taxes to close the yawning budget deficit. He wanted a referendum this June on a five-year extension of "temporary" taxes and fees imposed in 2009 and due to expire soon. In an off-year referendum, turnout would be low — and dominated by pro-taxation public employee unions.

Because two-thirds of both houses of the Legislature must vote to put a measure on the ballot, Brown needed two Republican votes in each. As Republicans are doing in Washington about raising the debt ceiling, some California Republicans offered support for a referendum conditional on Brown's agreeing to various reforms, particularly regarding public employees' pensions: This year, more than 12,000 state and municipal retirees will receive pensions of at least $100,000. Brown and the Republicans could not agree, so there is no referendum…

On Monday, Brown reported good news that actually is bad news for his agenda, which he has modified hardly at all. An unanticipated $6.6?billion in tax revenue over the next 13 months will reduce the projected $15.4?billion deficit, but will also reduce the force of his dire warnings about a budget balanced only by spending cuts. Yet he still insists on five-year extensions of higher sales and vehicle taxes. His only concession to the revenue windfall is to propose higher income taxes for four rather than five years.

It doesn't make a lot of sense for Brown and the Democrats to be blaming the Republicans for the budget impasse – particularly when there are so many better reasons to blame Republicans. Since the passage of Proposition 25 last November, the legislative requirement for passing a budget is a straight majority rather than a two-thirds majority. One of several reasons I had for opposing Prop 25 was that it was insulting to the intelligence to say you can separate the power to pass a budget from the power to seize revenue. But in practice, the Prop 25 compromise seems to have held up better than I'd hoped. It still isn't possible to get a large tax increase across without peeling off a few Republicans. (The same can't be said for the many fees and fines the state has always managed to pull in without the supermajority.) 

But what's up with that $6.6 billion revenue increase in these troubled times? It's a reflection of an overly progressive tax structure. For all the soak-the-rich rhetoric you hear from unions, California is unusually dependent on taxes paid by the state's highest earners. The San Francisco Chronicle's Andrew S. Ross explains: 

While working Californians will earn an average of $4,000 more over the next two years, those earning over $200,000 a year, and/or selling a bunch of stock, will account for most of the $6.6 billion increase in tax revenue, according to new budget estimates.

"It looks like the upper-income taxpayers are having a greater gain in their income than previously anticipated," said Brown's budget director, Ana Matosantos, explaining the unexpected windfall. 

Matosantos doesn't mention that high earners also have more income volatility than the rest of us. That's why revenues fell so sharply over the last few years. It's also not quite complete to say rich people are earning more without noting the special, non-repeatable circumstances that have helped the tax haul. Robert Frank in the Wall Street Journal: 

A substantial part of the budget shortfall in New York, California, New Jersey and others states owed to the decline in incomes of the rich–and more specifically, the decline in stock markets and capital gains.

Now, stock markets have recovered and so have the rich. It follows, therefore, that as the incomes of the rich are soaring again (all those Facebook billionaires and hedge-funders), so are their tax payments.  As go the rich, so go the states. (That is simply fact: This is not to argue for lower or higher rates on the rich). Add to this the fears last year of higher capital-gains tax rates–which induced the rich to sell extra stock so they don't have to pay more later–as well as Roth IRA rules and you get a new bulge in tax revenue.

Is the NYSE rally supported by any business or economic fundamentals? I'd say no, but even if I'm wrong, the capital-gains component of the revenue spike (not unlike the great Google windfall of 2006 that gave then-Gov. Arnold Schwarzenegger a chance to go on ignoring the problem) shows why the structural deficit will not be going away anytime soon. The L.A. Times' Evan Halper and Anthony York: 

The dilemma is part of a familiar pattern in California, where state funds are at the mercy of taxes paid by top earners whose bank accounts are subject to unpredictable swings. One bad year for them can, and does, throw state finances into turmoil. Alternately, the accounting misery is quickly forgotten when the economy starts to rebound and tax receipts mushroom.

By this logic, Brown is right not to make any major tax cuts in response to the windfall. To celebrate would go against the governor's austere, pleasure-hating nature. But revenue wasn't the problem over the last few years any more than it's the solution now. California needs to get on a permanent footing of radically lower spending and lower rates of spending growth. (It says plenty that just growing spending at the rate of either inflation or population growth is considered radical.)