Schwarzenegger Faces Toxic Tax System

Schwarzenegger Faces Toxic Tax System
November 1, 2003



California’s October 7 recall election turned the eyes of the nation to the state’s economy and its tax system. Governor-elect Arnold Schwarzenegger and his team face a tax system that, statistically speaking, is one of the worst in the country for business development and economic growth.



Business Tax Climate

Table 1

Taxes as a Percent of State Income
Year National
Average
California
1990 9.9% 9.7%
1991 10.2% 10.1%
1992 10.2% 10.0%
1993 10.3% 9.9%
1994 10.2% 9.9%
1995 10.2% 10.1%
1996 10.1% 10.1%
1997 10.0% 10.1%
1998 10.0% 10.2%
1999 10.0% 10.4%
2000 9.9% 10.5%
2001 9.8% 10.6%
2002 9.6% 10.5%
2003 9.7% 10.6%

California ranks 49th (second worst) in the Tax Foundation’s State Business Tax Climate Index, which measures the impact on business of five major elements of the tax system: the percentage of income taken by all taxes, individual income tax rates, corporate income taxes, sales tax rate, and complexity of the tax system. Only Mississippi has a more unfriendly tax climate for business.

In 1990 California had a slightly below-average tax burden (9.7 percent compared to a national average of 9.9 percent). Since then, state/local tax collections have risen much faster than Californians’ incomes. Estimated now at 10.6 percent of income, California’s state/local taxes are well above the national average of 9.7 percent. (See Table 1.)

Another way to describe California’s tax burden is to calculate Tax Freedom Day, the day when Californians have earned enough money to pay off their total tax bill for the year. In 2003, California taxpayers had to work until April 29 to pay their total tax bill, 10 days later than the national average and later than all other states except Connecticut and Massachusetts. (See Table 2.) California taxpayers must work 38 days into the year just to pay their state and local tax bill. At $3,670 per-capita, that bill is the eighth highest in the nation.

With six brackets and a top rate that kicks in at a relatively low $38,291 of income, California has one of the most progressive tax systems in the nation for individuals and small business owners. For the taxpayer with $40,000 of taxable income, California’s 9.3 percent state income tax rate is the highest in the nation. For families earning between $43,500 and $307,050, only Montana’s tax rate is higher, and over $307,050 of income, only Montana’s and Vermont’s rates are higher.

Table 2: Tax Freedom Day by State and Rank

Selected Calendar Years, 1990 - 2003
  1990 Tax Freedom Day 1995 Tax Freedom Day 2000 Tax Freedom Day 2003 Tax Freedom Day Rank in 2003
U.S. April 20 April 23 April 30 April 19  
Alabama April 11 April 13 April 16 April 06 48
Alaska April 21 April 11 April 15 March 30 50
Arizona April 22 April 25 April 28 April 17 16
Arkansas April 12 April 16 April 21 April 09 40
California April 18 April 22 May 08 April 29 4
Colorado April 20 April 22 May 01 April 21 11
Connecticut April 22 May 05 May 19 May 09 1
Delaware April 13 April 17 April 21 April 09 39
Florida April 16 April 23 April 29 April 15 22
Georgia April 19 April 22 April 27 April 16 19
Hawaii April 26 April 20 April 26 April 13 31
Idaho April 16 April 19 April 25 April 14 25
Illinois April 23 April 25 May 01 April 20 12
Indiana April 17 April 19 April 22 April 14 28
Iowa April 21 April 23 April 22 April 11 35
Kansas April 20 April 22 April 25 April 13 29
Kentucky April 15 April 19 April 20 April 09 38
Louisiana April 13 April 11 April 19 April 07 44
Maine April 18 April 25 May 04 April 22 9
Maryland April 19 April 22 April 30 April 17 17
Massachusetts April 19 April 27 May 11 May 02 2
Michigan April 21 April 21 April 27 April 17 18
Minnesota April 24 May 01 May 03 April 23 7
Mississippi April 11 April 16 April 17 April 07 43
Missouri April 14 April 18 April 22 April 12 34
Montana April 17 April 19 April 21 April 09 37
Nebraska April 18 April 23 April 25 April 12 33
Nevada April 25 April 30 May 03 April 20 13
New Hampshire April 15 April 21 April 29 April 15 23
New Jersey April 25 April 01 May 10 April 27 5
New Mexico April 18 April 18 April 17 April 03 49
New York April 30 April 03 May 09 April 29 3
North Carolina April 15 April 17 April 22 April 13 32
North Dakota April 15 April 22 April 20 April 11 36
Ohio April 14 April 19 April 24 April 14 24
Oklahoma April 13 April 13 April 17 April 06 46
Oregon April 23 April 21 April 25 April 14 27
Pennsylvania April 15 April 20 April 25 April 14 26
Rhode Island April 19 April 23 May 04 April 23 8
South Carolina April 15 April 17 April 20 April 08 41
South Dakota April 13 April 19 April 20 April 08 42
Tennessee April 12 April 13 April 15 April 06 47
Texas April 20 April 20 April 24 April 13 30
Utah April 19 April 24 April 26 April 16 20
Vermont April 23 April 26 May 01 April 17 15
Virginia April 17 April 19 April 28 April 15 21
Washington April 30 May 02 May 09 April 27 6
West Virginia April 14 April 13 April 18 April 06 45
Wisconsin April 25 April 29 May 02 April 19 14
Wyoming April 25 April 26 May 09 April 21 10
District of Columbia May 03 May 02 May 19 May 07 -

Since most small businesses are either S Corporations or partnerships or sole proprietorships, they pay their business taxes at the rates for individuals. That makes California’s taxes on small businesses higher than virtually every other state.



Corporate Income Tax

Corporations looking to relocate, or even establish, a business in the West may shy away from California, as the state’s 8.84 percent flat rate is the highest corporate tax rate in the West. Nationally, only 10 states have a higher top corporate tax rate than California. In 2002, corporate tax collections in California totaled $152 per capita, the sixth highest per-capita level in the nation.

California’s tax system is a complexity nightmare for corporate taxpayers because it does not conform with the standards and practices adopted within the Federal tax code or most other states. This adds considerable compliance costs for multi-state companies trying to do business in California. The state also enforces both a corporate and individual Alternative Minimum Tax (AMT). It is widely accepted among tax experts that the AMT imposes a level of tax complexity that is disproportionate to the amount of revenue raised. (See “Alternative Minimum Tax Stalks Millions of Taxpayers,” page 6.) California is among only five states that have enacted both a corporate and individual AMT (14 states have at least one).



Sales Tax

California’s state and local sales tax rate ranges from 7.25 percent to 8.75 percent. Excluding local option sales taxes, California’s statutory rate of 7.25 percent is the highest in the country.

The sales tax affects not only consumers, but businesses as well. The state fails to exempt many business items from the sales tax, including manufacturing machinery, office equipment, and farm machinery. For example, on a $100 million investment in a new plant and equipment, California’s sales tax on machinery could add as much as $9 million in additional costs, depending upon the type of machinery and the plant’s location.

High sales tax rates reduce revenue as consumers seek relief via cross-border shopping (neighboring states Nevada and Oregon do not have sales taxes) or making purchases through catalogs and/or the Internet. High sales taxes, then, hurt the state’s retailers as well as its consumers.



Conclusion

As the new governor of the state with the country’s second-worst business tax system, Schwarzenegger can set the direction and pace for tax reform. Clear priorities should be reducing taxes as a percent of state personal income to the national average or below; flattening a progressive income tax that drives the state’s most productive residents to neighboring states; and reducing the corporate income tax. Lowering sales taxes would stem the flow of retail activity to neighboring states.

If he does not fix his state’s dysfunctional tax system, Schwarzenegger is likely to fail to fix his state’s budget problems. The entire nation will be watching as “The Terminator” grapples with perhaps his most difficult foe ever.


Scott Hodge is president of the Washington, DC-based Tax Foundation.


For more information ...

on California taxes or the work of the Tax Foundation generally, contact Hodge at 202/464-5103, email hodge@taxfoundation.org, or Senior Economist Scott Moody at 202/464-5107, email moody@taxfoundation.org. Or visit the Tax Foundation Web site at http://www.taxfoundation.org.