To solve budget woes, California eyes higher taxes on the rich

For the "have-mores" of California, the tax man cometh.

Facing a $15 billion budget shortfall, Californian legislators are calling for tax hikes on the rich. That's despite the Golden State already having one of the most progressive tax structures, meaning the wealthy pay much higher rates than the poorest.

Top earners here could face a double whammy if Democratic leaders in Washington succeed next year in rolling back President Bush's tax cuts and allow Social Security withholding on income beyond the current $102,000 cap.

Political leaders are zeroing in on the upper echelons of the state's taxpayers because that's where much of the economic growth has taken place in recent years, say analysts. The strategy isn't without risks: Just as globalization has enriched the elite, it has also increased their ability to relocate if the tax climate gets too uncomfortable.

"Structural inequality has been rising at a level we haven't seen since before the Great Depression," says David Gamage, a tax and public-finance expert at the University of California at Berkeley. "And the natural response, both psychologically and economically, is to make the tax system more progressive,"

There's a sense in Sacramento that the state's recurring budget deficit has finally grown so large that it can't be papered over with borrowing and accounting sleights of hand; either spending has to be cut, new revenues tapped, or both.

Gov. Arnold Schwarzenegger (R) has proposed expanding the state's lottery and cutting spending.

Skeptical about lottery revenue, the majority Democrats in the legislature responded with a budget plan that includes fewer cuts and a plan to create two additional tax brackets above the current 9.3 percent ceiling. Joint filers making more than $321,000 a year would pay 10 percent; those making over $642,000 would pay 11 percent. These and additional tax increases would bring in $8.2 billion.

Governor Schwarzenegger hasn't ruled out tax hikes, but many of his fellow Republicans in the legislature – who are needed to pass a budget – have signed antitax pledges. They argue for spending cuts and a spending cap.

Budgetmakers missed the July 1 deadline. Schwarzenegger is threatening to withhold pay beyond minimum wage for all state employees until the budget gets done. The state Senate plans a budget vote on Tuesday.

If tax increases and rollbacks happen here and in Washington, D.C., Californian millionaires would see combined federal and state income taxes jump from a current 41.7 percent level to 51.4 percent. That's according to William Ahern, spokesman for the Tax Foundation, a pro-growth tax-research group based in Washington.

For high earners, the grass may start to look greener on the other side of California's borders, says Mr. Ahern. Arizona's top rate on income is only 4 percent; Nevada and nearby Washington have no income taxes at all.

While California remains extremely attractive to tech barons because of the talent clusters here, he says, advances in telecommunications are eroding that premium on physical proximity.

Others point out that California's overall tax burden is close to the national average, largely because real estate taxes are locked down.

If the venture capitalists and tech entrepreneurs were to flee, it would only be to a place of similar economic caliber, says Mr. Gamage. "They are not moving to Nevada.... The difference between California's tax system and [those in] the other states that people would realistically move to are pretty minuscule."

California's major competitor would be New York City, he adds, but income taxes are higher there if local taxes are included. Austin, Texas, may not tax capital income, but it remains a second-tier technology competitor to Silicon Valley, says Gamage. If New York cut taxes, or Austin matured as a hub, then California should worry.

"Major players seem more than willing to pay the cost of living in California, [because] there is a dramatic difference in the economic resources and opportunities" here versus elsewhere, says Gamage.

Call it the advantage of big economies.

"It's much more problematic for smaller states to raise taxes above the level of similar states," says Gamage. "The US is doing fairly well in maintaining its tax base, really because we are so big. California is also."

Indeed, opponents warned in 2004 that the jet set would leave California if the voters approved a 1 percent surcharge on those making more than $1 million a year. The number of tax returns filed from this group, however, rose 37.8 percent between 2004 and 2006, says Jean Ross, executive director of the left-leaning California Budget Project in Sacramento.

"If the [proposed] income-tax increases are permanent, then that would put us considerably out of whack," says Steve Levy, director of the Center for the Continuing Study of the California Economy, a private research foundation in Palo Alto. "People don't move for taxes that are temporary.... And I don't think they will be permanent."

Most experts agree that further taxing high-income earners will make California's revenues more volatile. Such earners can have fantastic windfalls one year, and comparatively lousy earnings the next.

This already poses a problem in Sacramento. When the wealthy have a good year, legislators see high revenues and raise the spending levels. Then when the rich have an off year, the state's overcommitted.

"Some cynical people think that's good – there's a ratcheting-up effect on spending," says Ahern. "When the budget falls out beneath you, you dig in your heels and raise taxes."

Since some of the best ways to raise revenues on the tax side are nonstarters politically, Ahern and Gammage suggest longer term planning for the inevitable economic slumps that occur.

At the moment, something's got to give.

"I think [legislators] know that one-time fixes and accounting gimmicks have only just gotten them into deeper water in the long run, and that they have to deal with the mismatch between revenues and expenditures," says Paul Warren, a fiscal policy expert at the state's nonpartisan Legislative Analyst's Office.