Friday, June 27, 2014

California Dreamin'

I just got back today from five days in the San Diego, California area.

LaJolla, California

I love to visit California. It has spectacular weather, stunning views and splendid places to see. I just could not live or work there due to its current tax, business and political climate. Ironically, if it were not for its other climate factors-sun, surf and Silicon Valley- I am not sure where California would be right now. I can assure you it would not be good.

I can predict with reasonable certainty that California is facing very dire financial problems at some point in the future. It has built a governmental edifice on a foundation of tax policies that is weaker than the San Andreas fault. It is just a matter of time before it breaks.

Today it is hard to believe that California was where the modern tax revolt began in this country over 35 years ago with the passage of Proposition 13 that limited increases in property taxes in the state. Proposition 13 was enacted through initiative in California and it also marked the beginning of increased voter activism through the initiative process.

Prop 13 was the defining moment when citizens stopped trusting their elected officials to represent them and recognized that most of the time politicians were only taking care of themselves and their special interests.  Politicians are not naturally disposed to want to limit taxes.  After all, tax revenues are their lifeblood. Without tax dollars to pass out and redistribute, politicians have no power.

The problem with Prop 13 in California was that it was limited to property taxes. It did not place any direct limits on income, sales or other taxes (although it does require a 2/3 vote to increase taxes via the legislature). You see the results in California today.

The top individual income tax in California is now 13.3%.  The tax brackets are extremely progressive (matching the political environment).  Income tax rates are 1% for the first $7,582 of income but a single filer is taxed at 9.3% of adjusted gross income on anything above $49,774. This means that most working households are paying almost 10% in marginal income tax rates.

Compare that to Ohio were I live where the top marginal rate is now 5.92%. The rate is 4.11% for a single filer with $50,000 of income.  Sales tax in the county where I live is 6.75%.

I paid 8% in sales tax on several purchases while I was in the San Diego area (anything I can do to help out).  However, in some cities in California the total sales tax is as high as 9.5%.  Therefore, middle class households in California are shelling out almost 20% of their marginal income just for state income and sales taxes!  That is about twice as much as the middle class household in Ohio.

Combine that with sky-high housing costs in California and you can readily see the exorbitant cost of living with all that sun, surf and some Silicon Valley millionaires close by.

Speaking of millionaires it was amazing to drive down along the coast through Carlsbad, Del Mar, LaJolla, Pacific Beach and Coronado and see the construction and remodeling work being done. If you want to see trickle down economics it was there to see.  People want to complain about the rich but I saw scores of plumbers and carpenters on those sites working and I also saw tons of people at bars and restaurants redistributing money through the private sector while I was there.

A major problem for California is that it has become increasingly reliant on that progressive income tax system and a dwindling number of rich taxpayers to foot the bill for most of the state's services.  For example, nearly 50% of income tax collections are for those in the top 1% of income earners and 67% of all of the state's tax revenues are coming from the personal income tax.

For those who want to argue that they are "rich" so it is only fair that they pay more, consider the following chart that shows that the top 1% in California consistently have paid double their share of income in taxes. In other words, the top 1% are earning about 20-25% of total income but are paying 40-50% of total income taxes in any given year.

California Legislative Analyst's Office

How many people is that?  Less than 150,000 taxpayers.  The population of California? 38 million. That is a very big burden placed on a relatively small number of income earners.

Personal income taxes in California have also become the most significant revenue source in the state over the years. They now represent about 2/3 of all revenues to the state-almost triple their share compared to 1970.

California Legislative Analyst's Office

California State Controller's Office

California has also become dangerously dependent on those top income earners pulling in large capital gains and income from stock options.  You can see that in the spike in incomes of the top 1% in 2000 and the 2005-2007 period.  The reality in California is that the share of income of the top 1% is very volatile in that it is so dependent on stock options, the stock market, real estate investments and capital gains.

You can also see it in the recent trend in income tax collections compared to sales tax and corporate income taxes.  It is very telling that sales tax collections in California were essentially the same in 2013 as they were in 2003 but income tax collections more than doubled.

California State Controller's Office

Thank you Google, Facebook, Amazon and many others who made it happen.  Thank you Ben Bernanke and Janet Yellen and low interest rates.

However, can California keep the people in the state who made these ideas a success?  Can they attract new talent and capital to the state over the long term with the tax, regulatory and political climate they currently have in place?

And what happens to California if interest rates climb and tech stocks fall?

As the Mama's and Papa's put it in their song, California Dreamin', it will be a winter's day but I doubt you will be safe and warm in L.A.

All the leaves are brown 
And the sky is grey 
I went for a walk 
On a winter's day 
I'd be safe and warm 
If I was in L.A. 
California dreamin' 
On such a winter's day 

At that time it might also be time to stop in the church and do something more than pretend to pray.

I stopped into a church (stopped into a church) 
I passed along the way (passed along the way) 
You know, I got down on my knees (got down on my knees) 
And I pretend to pray (I pretend to pray) 
Oh, the preacher likes the cold (preacher likes the cold) 
He knows I'm gonna stay (knows I'm gonna stay) 
Oh, California dreamin' (California dreamin') 
On such a winter's day 

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