Individual Assignment:Conduct a policy analysis of any tax topic that is of interest to you.Use the following template to structure the analysis and argument for your policy paper.Make sure to follow each step in the template for your
analysis.
You can use course readings or independent research.The paper should be a minimum of 5 pages and not exceed a similarity score of 20% on Turnitin.Use APA citations.
Do not leave this to the last minute.
Tax Policy Report
Core Components:
Define the problem or issue. State your issue and explain the importance of your issue.Remember, you are addressing this policy report to a decisionmaker. You want to answer the “Who cares?” question early on.
Analyze—do not merely present—the articles and data.
Step 1: Discuss your research findings.
If you are producing recommendations, explain the need for change and analyze the
options and tradeoffs and assess their feasibility.
Make sure to show how you arrived at recommendations through analysis of qualitative or quantitative data. Draw careful conclusions that make sense of the research and do not misrepresent it. Your data should come from authoritative sources as part of your tax research. Also, be careful not to plagiarize.
Your credibility as a policy analyst relies on your ability to locate and account for counterargument. You should be especially sensitive to the likely counterarguments that a decision-maker would face in implementing or acting on your recommendations or findings.
Step 3: Feasibility of Implementation
Suggest next steps and the implications of the findings or recommendations. You
analysis.
Step 4: Conclusion
State your final recommendations. Provide specific recommendations or findings in response to specific problems and avoid generalizations.
Distill the conclusions succinctly in a concluding section and remind the decisionmaker of the big picture, the overall goal, the necessity of the policy change or of the
urgency for action. This answers the “Who cares?” question that reminds the reader of
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9-710-038
REV: JANUARY 10, 2013
MATTHEW WEINZIERL
JACOB KUIPERS
California’s Budget Crises, Tax Reform, and
Domestic and International Tax Competition
Despite having saved the planet repeatedly from time-traveling warrior machines, Arnold
Schwarzenegger met his match in 2009. As governor of California, “the world’s eighth-largest
economy,” he was responsible for getting a state budget through a tortuous legislative process that
had brought the state to the edge of what the governor termed “Fiscal Armageddon.”1 When the
fiscal year began on July 1 without a budget agreement, California resorted to paying its bills with
IOUs in lieu of cash. Several large banks refused to accept the IOUs as legal tender, leaving their
holders with potentially worthless pieces of paper. Bidders on eBay offered to buy the IOUs for less
than 100 cents on the dollar, and both Fitch and Moody’s severely downgraded the state’s bonds,
reflecting the market’s perception that the chances of a default by the state were real.2 Governor
Schwarzenegger declared a fiscal emergency for the third time in 18 months.3
After a marathon session in late July, the California legislature passed (with the constitutionally
required two-thirds majority) a budget that, once signed by the governor, closed the $26 billion
projected budget deficit that had emerged over the previous six months. While the state sales tax rate
had been raised by one percentage point in April to increase revenues, in July the vast majority of the
deficit was closed with spending cuts, many in social services. The prominent left-leaning blog Daily
Kos reacted with vitriol: “If a budget is indeed a moral document, it would seem from this budget
that the state of California has the heart of a sociopath. . . .” Jean Ross, executive director of the
nonpartisan California Budget Project, echoed this concern: “We’re so far beyond [cutting] meat and
fat at this point; we are well into marrow.”4 The governor acknowledged that “[i]t’s not an easy
budget; it’s a tough budget; but it’s a necessary budget.”5
Although the July agreement closed the current deficit, the outlook for California’s public finances
was grim. The Legislative Analyst’s Office (LAO), the state legislature’s nonpartisan policy analysis
agency, projected annual operating shortfalls greater than $15 billion (equal to 14% of 2008–2009
revenues) through fiscal year 2014–2015 (Exhibit 1a). According to the LAO, “. . . the scale of the
deficits is so vast that [the LAO] knows of no way that the Legislature, the Governor, and voters can
avoid making additional, very difficult choices about state priorities.”6 Although intimidating by
themselves, these deficits excluded the state’s public pension fund, which the governor had estimated
was “$300 billion in the red.”7
________________________________________________________________________________________________________________
Professor Matthew Weinzierl and Research Associate Jacob Kuipers prepared this case. Certain details have been disguised. HBS cases are
developed solely as the basis for class discussion. Cases are not intended to serve as endorsements, sources of primary data, or illustrations of
effective or ineffective management.
Copyright © 2010, 2012, 2013 President and Fellows of Harvard College. To order copies or request permission to reproduce materials, call 1-800545-7685, write Harvard Business School Publishing, Boston, MA 02163, or go to www.hbsp.harvard.edu/educators. This publication may not be
digitized, photocopied, or otherwise reproduced, posted, or transmitted, without the permission of Harvard Business School.
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California’s Budget Crises, Tax Reform, and Domestic and International Tax Competition
What was the source of the state’s budget problems? Leading California policymakers blamed the
state’s fiscal policies. Senator Denise Ducheny, chair of the Budget and Fiscal Review Committee,
emphasized taxes: “In the 70s and the 90s when there was a surplus, instead of putting it away to
save for more difficult times, people insisted on doing tax cuts. Why would you do a tax cut when
you’re rich?”8 In contrast, David Crane, the governor’s Special Advisor for Jobs and Economic
Growth, emphasized a lack of spending restraint: “All the incentives are for [politicians] to spend
without regard to what’s likely going to happen with revenues.”9 An alternative explanation, that the
state’s tax system was hurting its competitiveness and slowing growth, was emphasized by the
governor himself: “To strengthen the economy, which is the foundation of all jobs, we here in this
chamber must reform California’s tax system.”10
To confront the long-run fiscal problems of the state, in October 2008 legislative leaders and
Schwarzenegger had formed a “Commission on the 21st Century Economy” (COTCE, pronounced
“caht’-see”) to propose fundamental changes to California’s fiscal policies. Although large fiscal
reforms were rare, the dire situation in California had created a sense of urgency that many hoped
would be enough to push reform through. Term limits meant that 2010 was Governor
Schwarzenegger’s final year in office. Could he and legislative leaders find a set of reforms that
would fix the state’s fiscal problems while balancing their competing priorities?
California’s Economic History in Brief
Explorers from Spain arrived in San Diego Bay in 1542, meeting the Native Americans who had
inhabited the region for thousands of years. The Spanish named the area “Alta California” and began
establishing settlements between San Diego and San Francisco in the form of Christian missions. In
1821, Mexico gained independence from Spain, making present-day California a Mexican province.
However, this designation was short lived. In 1848 California became the property of the United
States as a concession following the Mexican–American War. That same year, gold was discovered in
the foothills of California’s Sierra Nevada mountains, bringing thousands of settlers from the east.
California was granted statehood in 1850.
To connect the new state to the rest of the country, a transcontinental railroad was completed in
1869. In combination with California’s climate, rail access to the national market made agriculture the
backbone of the state’s economy. The state’s politics were closely linked to the railroad, as well. By
the turn of the twentieth century, “Public policy was dictated primarily by the political machine of
the Southern Pacific Railroad, the most powerful corporation in the state.”11
California’s climate and cheap land attracted the entertainment, defense, and high-technology
industries. Los Angeles became a global center of movie and television production. The military took
advantage of the state’s three large ports (San Diego, Los Angeles, and San Francisco) and arid
climate to develop large naval and air bases throughout the state. The defense industry followed and
helped drive California’s economy in the mid- and late-twentieth century. Advanced technology
firms assisting the military located in the San Francisco Bay Area during this time, as the military had
developed many of its main technology and research centers there. Bay Area universities, including
Stanford, also capitalized on the inflow of federal funds to develop cutting-edge technologies in
electronics, engineering, computer architecture, and defense. The region’s association with the
electronic computing industry was so strong that a portion of it acquired the moniker “Silicon
Valley.”
The rise of the personal computing industry in the 1980s was driven in part by Bay Area
technology companies such as Hewlett-Packard, Intel, and Apple. The software industry followed,
2
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with the firms Electronic Arts, Sun Microsystems, and Adobe all being founded nearby. As the
Internet developed, some of its most important companies were headquartered in the area, including
Google, eBay, and Facebook. Rising in parallel with the computer industry, leading biotechnology
firms—including Genentech—also developed in the Bay Area, supported by the region’s prominent
research universities.
According to some analysts, one factor that played an important but subtle role in California’s
success in fostering innovation and entrepreneurship was its lax enforcement of noncompete clauses
in employment contracts.12 According to these arguments, the free flow of employees between firms
in Silicon Valley allowed for knowledge spillovers and talent to be directed to the most promising
companies more quickly than in other regions where enforcement of employment contracts was
tighter.
Throughout the 1990s and 2000s, the technology industries and the talented workers they
attracted were major drivers of California’s economy. These workers, in turn, drove rapid increases
in the price of housing in California. Between 2000 and 2005, the 10 metropolitan areas in the United
States with the greatest percentage increase in home prices were all in California.13 In 1999 and 2002,
the state ranked second in the Kauffman Foundation’s State New Economy Index.14 By the time of the
2009 budget crisis, California was a powerhouse state economy (Exhibit 1b). It claimed one-quarter
of the patents issued in the United States and nearly half of the nation’s venture capital investment.15
It was not only the largest state economy in the United States, it was more than 50% larger than the
next-largest (New York). It also had the seventh-highest GDP per capita in the United States.16
Current Economic Challenges
Despite its size and prosperity, California’s economy was underperforming for many of its most
vulnerable residents. The state’s unemployment rate was the highest among the six largest statesa in
every year but one from 1992 through 2008. Its poverty rate, though previously on par with these
other large states, had risen to be the second-largest in this group of six by 2008 (only Texas had a
higher poverty rate). The quality of the state’s health care system was rated the worst in the
country,17 and the state’s public schools were considered by some among the weakest in the nation.18
Many of the poor residents of California were unauthorized immigrants. According to the Public
Policy Institute of California (PPIC), a think tank, “most immigrants in California (about 70%) are
either naturalized citizens or have visas,” but approximately 2.8 million unauthorized immigrants
lived in California in 2006—roughly 7.5% of the state’s total population of 37 million and a quarter of
the total unauthorized immigrant population in the United States. A heated debate over whether
these residents were a net burden or benefit to government finances was a persistent feature of
California politics. After reviewing the evidence, the PPIC concluded that “there are no reliable
studies of illegal immigrants’ fiscal effects in California.”19
Regional disparities were also a concern. The coastal metropolitan areas (the San Francisco Bay
Area, Los Angeles, and San Diego) were some of the wealthiest in the United States, while
California’s rural Central Valley lagged behind. In 2006, the poverty rate of the Central Valley (not
counting the Sacramento Metro region) was 20% compared to 13% in the rest of the state. In addition,
only 14% of Central Valley individuals 25 years and older held a college degree, compared to 28% in
a Ranked by gross state product in 2008, the next five largest states were New York, Texas, Florida, Illinois, and Pennsylvania.
3
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California’s Budget Crises, Tax Reform, and Domestic and International Tax Competition
the rest of the state. Median household income in San Francisco County in 2008 was $73,127, more
than 50% greater than the average across the eight counties of the Central Valley.20
Finally, despite its record of attracting leading companies, California was coming under criticism
for creating a difficult environment for business. Chief Executive magazine’s poll of CEOs named
California the worst state in which to do business four years in a row from 2006 through 2009.21 The
Kauffman Foundation’s State New Economy Index demoted California from second (in 1999 and
2002) to fifth in 2007 and eighth in 2009. Leading policymakers, particularly Republicans, echoed
these concerns. “California is not competitive in its business climate, in its tax climate, or its
regulatory climate,” said Senate Minority Leader Dennis Hollingsworth.22 Senator Roy Ashburn,
member of the Senate Committee on the Budget and Fiscal Review, concurred: “The dysfunction of
the structure that we have; the disincentives within our current tax approach are obvious.”23 David
Crane, the Special Advisor to the Governor, said: “We have a very distortional tax system. . . . We
penalize people for being here. That’s costly for economic growth. . . . Our corporate tax is
particularly detrimental to growth in the Central Valley, which traditionally has the highest
unemployment.”24 As evidence, these critics noted that California’s tax rates on large personal incomes
and corporate income were among the highest in the country and that California had the sixth-highest
state-and-local tax burden as a share of income in the United States in 2009 (Exhibits 2a and 2b).
Fiscal Imbalances
The state’s most pressing weakness, however, was its persistent fiscal deficit.25 Of the 50 fiscal
years from 1959 through 2009, California ran overall budget deficits in 38 years, or 76% of the time.
Moreover, the situation was not improving: of the 30 fiscal years after 1979, the state ran deficits in 25
years, or 83% of the time (Exhibit 3). Although accounting details make cross-state comparisons
difficult, one analysis suggested that California’s deficits were relatively large when compared to the
five next-largest states.26
The enormous underfunded future liabilities for public-sector pensions added to concerns over
the management and long-term health of the state’s fiscal situation. The estimated $300 billion
shortfall in funding for the three public employee pension systems was equivalent to more than three
years of overall General Fund expenditures by the state government and represented a liability of
$23,852 per household in California. Ratings agencies took note of these problems, resulting in
repeated periods of weak state bond ratings (Exhibit 4).27
Mechanically, California’s recurring fiscal imbalances reflected a gap between the growth rates of
the state’s expenditures and revenues. From 1978 through 2008, expenditures grew at a compound
annual growth rate of 7.7% per year, while revenues grew at only 6.9% per year.28
Democrats and Republicans acknowledged that the state’s revenue and expenditure policies had
become decoupled. “Californians want services without paying taxes for them,” said one leading
Democratic policy advisor. He argued that Californians had created rigid and expensive programs—
the legislature through laws and voters through propositions—that had no “revenue mechanism
associated” with them.29 For example, the 1988 passage of Proposition 98 set a minimum annual
funding level for education that was determined only in part by the overall economic environment.
Senator Ashburn viewed such spending requirements as key to the state’s fiscal imbalances: “It’s
extraordinarily difficult to cut spending for half the general fund. . . . [These requirements] are in
essence a giant Pac-Man.”30 However, the argument that voters had wrested control of the state
budget from their representatives was controversial. The state’s nonpartisan Legislative Analyst’s
Office opined that “the Legislature remains in control of the vast majority of state spending . . .
4
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California’s Budget Crises, Tax Reform, and Domestic and International Tax Competition
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decisions are often more restricted by the lack of political consensus as opposed to any structural
budgetary constraint.”31 Regardless of the reason, expenditure shares were remarkably stable starting
in the mid-1970s (Exhibit 5).
Rigid spending requirements stood in stark contrast to increasingly volatile tax revenue. While
California’s tax revenue was 16% less volatile than the average of the five next-largest states from
1978 through 1998, it was 11% more volatile than that average from 1998 through 2008.32
Contributing to this volatility was California’s shift toward the personal income tax, which was a
more variable source of revenue than the motor vehicle–related fees and retail sales taxes it
supplanted (Exhibit 6). In one dramatic example, personal income taxes fell by 26% in one year and
went from 47% of total revenue in fiscal year 2000–2001 to only 27% in 2001–2002. The shift from
motor vehicle33 and sales taxes to personal income taxes was due to both the growth of services,
which were untaxed, and the especially rapid growth of incomes among those taxpayers in the
highest personal income tax brackets (Exhibit 7a).
The progressivity of the personal income tax further magnified this volatility, as a greater share of
revenue was raised on highly cyclical capital gains, bonus, and stock options income. While the top
5% of taxpayers paid 17.6% of the total personal income tax revenue in 1975, they paid 53% of it in
2009 (Exhibit 7b). Across the political spectrum, policymakers agreed that the state’s reliance on
highest-income taxpayers had reached unhealthy levels. Republican Senator Ashburn stated,
“California’s tax structure is failing, and the burdens are not appropriately placed on the most
productive. [This] is an automatic limitation on the reinvestment of capital from those individuals.”34
Democratic Senator Ducheny was less critical of the current system but allowed that the personal
income tax “could be flattened a little bit” since it was “a little steep.”35
State Politics
Three characteristics made California’s modern political system unique: a supermajority
requirement on fiscal legislation, strict legislative term limits, and direct democracy through voter
referendums. Each was blamed by some for the economic and fiscal problems that the state faced.
Put in place in 1978 as part of a voter referendum, the so-called “supermajority requirement”
mandated that any net tax increase and every final budget at the state level be approved by a twothirds majority of the legislature. This “supermajority” could be difficult to achieve in a two-party
system even in a state such as California where a single party was politically dominant (Exhibit 8a).
As a result, in the words of a Democratic leader’s senior policy advisor, “Issues get hijacked. It
doesn’t matter how good the policy is . . . you have to put something else in to get it.”36
California had some of the strictest term limits in the nation: Assembly members were limited to
six years and senators to eight years. Assembly Member Noreen Evans, chair of the Assembly
Committee on the Budget, outlined the problem: “In any given two-year period, a third of the
legislature is leaving or is new . . . the grown-ups have to leave. I have been here for five years and I
am now in charge of helping craft the response to the historic budget crisis in the state of
California. . . . This makes the lobbyists and the staff the people that actually run this house. And as
good as they are and well intentioned as they are, they know that. It makes the legislature low man
on the totem pole.”37
Some analysts claimed that the state’s most serious obstacle to reform was the referendum process
by which California voters decided some issues directly rather than through elected representatives.
5
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California’s Budget Crises, Tax Reform, and Domestic and International Tax Competition
Beginning in 1911, California allowed an initiative to be included as a “proposition” on an election
ballot if enough signatures were raised in support of its inclusion. Most U.S. states used some form of
direct democracy. [Exhibit 8b] California was exceptionally active, however, with the greatest
number of initiatives of any state from 1958 through 2008.38
The original argument for the propositions process was to allow voters to bypass a distrusted
legislature, but direct voter control came with its own risks. Assembly Member Evans said: “Because
of the initiative process, and these lockbox initiatives, so much of the state budget is now out of our
control. When we run into times like this when our revenues are down 25% compared to the previous
fiscal year, it makes it hard to do the job.”39 As the Economist magazine wrote in 2009, “. . . budget
holes often result from the cumulative consequences of voter initiatives as much as from economic
slowdown. Since the 1970s voters tended to like initiatives that promise better schools, new hospitals
or tougher prison terms, but they are oblivious to the costs involved. At the same time, they loathe
taxes. . . .”40
Analysts and policymakers emphasized that one consequence of these three factors was the
substantial influence of concentrated interests in state politics. Charles Calderon, chair of the
Assembly Committee on Revenue and Taxation, argued, “. . . it is ironic that the very process
intended to protect the electorate from the special interests has been perverted into a system that
provides direct democracy to the people with the most money, allowing them to evade the
deliberative process of the Legislature and the constitutional system of checks-and-balances.”41 David
Crane, the governor’s advisor, said, “It’s a very small group of special interests that have power. . . .
[Tax reform] is nothing like I thought it was going to be. There’s very little attention on policy and it’s
all about power and politics.”42
Fiscal Reforms in California, Past and Present
One of the most prominent propositions approved by the voters of California was designed to
impose discipline on state spending. Proposition 13, approved in 1978, made it more difficult
(through the supermajority requirement described earlier) for the state legislature to increase overall
tax revenues. Supporters hoped Proposition 13 would force the state government to spend less by
slowing the growth of tax revenue. Bruce Bartlett, a former senior official in the Ronald Reagan and
George H. W. Bush administrations, wrote: “A key rationale for Proposition 13 . . . was that spending
would never be cut until taxpayers cut up the politicians’ credit cards. This idea evolved into
something called starving the beast—just cut taxes and the fear of deficits will force politicians to cut
spending.” 43
Whether Proposition 13 had its intended effect on spending was debatable. On one hand, the
weakness of the state’s education and healthcare systems suggested limited funds. In fact,
California’s per-pupil spending fell substantially relative to the national average after Proposition 13.
[Exhibit 9a] Moreover, the spread of propositions similar to Proposition 13 across many other states
suggested that voters considered them a potentially effective tool.44 On the other hand, California’s
spending continued to outpace its tax revenue, in part because the state chose to compensate
localities for the drop in revenue they faced due to Proposition 13’s severe limits on local property
taxes. To pay for this spending, taxes other than property taxes assumed a greater role in California
than in the United States on average (Exhibit 9).
Aside from Proposition 13, Californians attempted to commit to a more sustainable fiscal path in
other ways. In 2004, California passed Proposition 58, which constitutionally required the
government to balance its budget each year. Specifically, it required state legislators to limit General
6
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Fund expenditures so as not to exceed estimated General Fund revenues, and it forbade the sale of
general obligation bonds by the state government in order to fund deficit spending.45 However, it
soon became apparent that the proposition had several loopholes. Most important, the legislature
was required only to pass a balanced budget: that is, there was no requirement that the implemented
budget be in balance. As a result, deficit spending not only continued but reached new highs just a
few years after the passage of Proposition 58.46
In the same Proposition 58 of 2004, Californians tried another tactic for avoiding large future
deficits, establishing a “rainy day” fund to cushion state finances. Though policymakers across the
political spectrum supported a rainy day fund in principle, many expressed skepticism over its
practicality. Senator Ducheny summarized the problem: “[the fund ] doesn’t have time to fill up. . . .
There’s this political tendency of well, the government has too much money, you have to give it
back.”47 In fact, the fund established in 2004 accumulated positive balances until 2008, when it was
emptied to pay for state spending. The size of the fund when emptied, $1.4 billion, was only a small
fraction of the annual deficits that the state faced in 2008 and 2009. COTCE estimated that a rainy day
fund large enough to counteract cyclical deficits would “approach almost $30 billion. . . . This would
be unsustainable politically.”48
These attempts to impose fiscal discipline left unaddressed, and perhaps exacerbated, California’s
widely-criticized tax system.
The Commission on the Twenty-first Century Economy (COTCE)
Governor Schwarzenegger and legislative leaders established COTCE in October 2008 to study
and propose specific reforms to California’s tax system. Officially a bipartisan effort, COTCE was
made up of 14 members, 7 appointed by the Republican governor, and 7 appointed by the
Democratic-controlled legislature. Its chairperson was a Republican financial sector executive, and it
included prominent private sector leaders, academics, and political figures (Exhibit 10).
The governor mandated that COTCE develop tax reforms that were “revenue neutral,” that is,
that would generate the same revenue as under current law.49 The objective of COTCE was to change
how tax revenue was raised, not how much. Under existing law, an 8.84% tax rate on corporate
profits made up 9% of the state’s total tax revenue. Personal income was subject to a tax with six
brackets, with marginal tax rates rising with income from 1% to 10.55%, and it made up 46% of
revenue. Most of the remaining revenue was raised through a state sales tax of 5% (temporarily
raised to 6% as part of the resolution of budget gaps in 2009).
Over the 11-month period during which the commission deliberated reform, it developed two
main proposals, each of which would have substantially changed the structure of tax revenue in the
state.50 In September 2009, COTCE issued its final recommendation, settling on a proposal that
combined the two reform packages. Under its proposal, both the corporate tax and sales and use tax
would be eliminated, while personal incomes would be subject to two brackets: 2.75% on incomes up
to $101,000 and 6.5% on incomes above that level. To replace the revenue lost due to these changes,
COTCE introduced a Business Net Receipts Tax (BNRT). This tax, economically similar to a valueadded tax (VAT), would impose a uniform tax rate on a firm’s revenues less its nonwage expenses.
COTCE estimated that a BNRT no greater than 4% would be sufficient to achieve revenue neutrality.
VAT taxes were widely used outside the United States, but the slightly different BNRT would prove
highly controversial in COTCE’s proposal. The governor announced his support immediately.51
COTCE’s final report cited three main benefits from its reform proposals. First, the shift away
from personal and corporate income taxes would “Improve Revenue Stability.” Second, the shift
7
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California’s Budget Crises, Tax Reform, and Domestic and International Tax Competition
away from highly progressive income taxes would “Increase [the] Scope of Taxes,” causing a higher
share of the state’s residents to pay taxes to fund the activities of the state and, therefore, “be invested
in California’s future.” Third, the reduction of corporate income taxes and marginal personal income
taxes at high incomes would “enhance competitiveness and growth,” by “[putting] the state’s
economy in the best position possible to compete with other states and nations for jobs and
investment.”
COTCE elaborated on this third benefit: “As part of the sweeping economic changes that have
occurred, capital and labor have become vastly more mobile than they have been in the past. This has
occurred mainly as a result of technological advances, the elimination of institutional barriers, and
the globalization of markets. As a consequence, California faces more competition than ever from
other states and nations at a time when it is easier than ever to shift investments and create jobs
anywhere. One of the Commission’s primary goals is to improve California’s tax system so that the
state is better positioned to prosper economically in the future.”
The COTCE proposal was not unanimous, however. Only 9 of 14 commission members endorsed
the proposal, with five of the seven Democrats dissenting. Richard D. Pomp, one of the dissenting
members and a tax law professor at the University of Connecticut, wrote a blistering critique: “When
it comes to tax reform, I subscribe to the equivalent of the Hippocratic Oath: do no harm. We are
proposing sweeping and fundamental changes in the State’s tax system….The goal of tax relief for
the well-to-do is not a sufficiently high priority for me that I can support a regressive, flawed,
unprecedented tax, with the potential of harming the California economy.”
The most prominent Democratic criticism of the COTCE proposal was that it would favor the rich
by making California’s tax system less progressive. The flattening of rates on personal incomes would
directly affect progressivity. In addition, because value-added taxes might weigh more heavily on the
poor than progressive income taxes, COTCE’s recommended replacement of corporate income taxes
with the BNRT could be expected to reduce progressivity.52 Assembly Member Evans argued against
these implications of COTCE’s proposal: “This report coddles CEOs and millionaires while kicking
California families to the curb.” Separately, she added, “California has always been a progressive
state . . . and budgets and tax structures should reflect the political and social values of the state.”53
Moreover, critics contended, the evidence that businesses and high earners were leaving the state
due to taxes was weak at best. An influential report by the Public Policy Institute of California
pointed out that the ratio of emigrants leaving California to immigrants entering California was
greater for low earners than for high earners. Although the interpretation of that finding was
debatable, policymakers frequently cited it as casting doubt on the claim that progressive taxes were
discouraging highly skilled workers from living in California.54
One component of COTCE’s proposal was the focus of broader attacks: the BNRT. Allan
Zaremberg, President and CEO of the California Chamber of Commerce, summarized many
commentators’ concerns: “In comparing the BNRT with the existing tax structure for business, the
devil you know is better than the devil you don’t.”53 Critics were concerned about the BNRT’s effects
on both workers and businesses.
First, critics argued that the BNRT would hurt workers. As discussed above, Democrats were
particularly concerned that replacing the corporate income tax with the BNRT would reduce
progressivity. Related, corporate income taxes were widely believed to increase the relative cost of
capital versus labor for firms. To some, this suggested a risk of job losses if the corporate income tax
was replaced with a BNRT, which economic analysis suggested was neutral with regard to capital
and labor.55 This concern was heightened by an administrative difference between the BNRT and a
8
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California’s Budget Crises, Tax Reform, and Domestic and International Tax Competition
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standard VAT. While a standard VAT was applied transaction-by-transaction, businesses would
calculate their BNRT bill at the end of each tax year, much like a corporate income tax. Unlike a
corporate income tax, however, firms would not be able to deduct wage costs from their taxable
income under a BNRT. Critics alleged that firms facing a BNRT that looked so similar to an income
tax but that treated the wage bill as taxable would reduce employment and increase the use of capital
equipment, out-of-state labor, or independent contractors.
Second, the BNRT was also criticized as bad for Californian exporters. The source of this concern
was a complication in implementing a BNRT rather than and a standard VAT. Under a standard
VAT, exporters are usually refunded any VAT paid earlier in the production process, so that no VAT
is embedded in the price paid by consumers out-of-state. In contrast, the BNRT provides no such
rebates, so exporters would be likely to pass on some of the tax to consumers out-of-state.56 This
could, at least in principle, place Californian exporters at a disadvantage relative to others.
Facing harsh criticism from both Democrats and Republicans, COTCE’s recommendations
languished. Responding to the governor’s call for the legislature to enact COTCE’s proposals,
Assembly Member Calderon wrote, “Adoption of the proposal by the Governor’s Commission would
be recklessly gambling with California’s future. COTCE’s proposal has not ‘disappeared somewhere
under this dome.’ It is in my Committee [the Assembly Committee on Revenue and Taxation].” With
COTCE’s recommendations unlikely to become legislation, Calderon held a series of hearings on
alternative reforms.57
Tax Policy in Other States
Despite the negative reaction it received in the California legislature, the push for reform away
from corporate income taxes and progressive personal income taxes recommended by COTCE was
consistent with general trends in state-level taxation in the United States over the previous few
decades.
From the early 1980s to the mid-2000s, the share of state and local tax revenue coming from
corporate taxes fell by one-third, despite rapid growth in corporate profits and steady corporate tax
rates (Exhibit 11). Two reasons why these seemingly paradoxical trends could coexist were the
manipulation of apportionment rules for corporate taxes and the rise of corporate tax credits.
Apportionment rules governed the tax liability of a corporation whose activities were spread
across multiple states. In 1957, the National Conference of Commissioners on Uniform State Laws
drafted the Uniform Division of Income for Tax Purposes Act, recommending that each state tax a
share of a firm’s profits equal to the average of the shares of sales, physical property, and payroll of
the firms that were located in the state. Competition among states for corporate investment and
employment, however, led to changes in this formula over time that reduced the weight given to
property and payroll in most states’ apportionment formulas. By 2007 only 10 states continued to use
this three-factor formula, while most states shifted toward placing greater weight on sales.58 In fact,
although California’s current fiscal crisis had put its implementation in jeopardy, in 2009 the state
adopted an “elective sales factor,” allowing a company to apportion its state corporate tax liability
based entirely on the share of its total sales in the state. As a consequence of these differences in
formulas among states, firms could allocate resources across states to achieve the lightest tax burden,
for instance, by concentrating employment in states with low apportionment weights on payroll.
Tax credits were attractive because they allowed states to treat new corporate investment
differently from existing corporate capital. In particular, investment tax credits reduced the tax
9
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California’s Budget Crises, Tax Reform, and Domestic and International Tax Competition
burden on new investment while leaving in place higher tax rates on the returns to past investments.
According to research by economists Daniel Wilson and Robert Chirinko, only a few states offered
such credits in the early 1970s, but nearly half of all states had some type of credit by the early 2000s.
In addition, the average size of tax credits increased dramatically over this period in the United States
(Exhibit 12).
State incentives for business investment were controversial and had begun to face serious
challenges in court. In 1998, the state of Ohio and city of Toledo had granted investment tax credits
and other incentives to Daimler Chrysler to encourage its construction of a Jeep factory in the area.
These incentives were challenged in court, eventually reaching the Sixth Circuit Court of Appeals for
the United States as Cuno vs. Daimler Chrysler. The Sixth Circuit Court ruled that the incentives
violated the Commerce Clause of the U.S. Constitution, which allowed the federal government to
regulate interstate commerce and prevent states from interfering in it, by treating economic activity
differently when it occurred within the state than when it did not. The Sixth Circuit ruling was later
overturned by the U.S. Supreme Court on technical grounds, but the future of state tax incentives was
uncertain.
Over the same period, states also moved away from progressive personal income taxes.59 Though
the average top marginal tax rate across states was volatile and rose during recessions, it had fallen
by one-tenth overall from 1977, when the unweighted average top rate was 5.7%, through 2005, when
the average was 5.22%.60 Another measure of the income tax system’s progressivity, the difference
between the level of income inequality in a state before and after taxes, declined by approximately
the same fraction from 1980 through the early 2000s for the United States on average.61
Several small states marketed themselves as particularly friendly to business and high-income
individuals. Notably, Delaware had actively and successfully pursued a strategy of offering easy
regulations on corporations to attract business headquarters.62 The home of 0.3% of the U.S.
population, Delaware had become the legal home of “more than 50% of all U.S. publicly traded
companies and 63% of the Fortune 500,” according to the state’s Division of Corporations.63 Several
other states, such as Nevada and Wyoming, had followed suit with strategies such as zero corporate
tax rates, generous investment tax credits, and tailored regulations. Other states focused on attracting
individuals, with no state personal income tax being assessed in 2009 in nine states: Alaska, Florida,
Nevada, New Hampshire, South Dakota, Tennessee, Texas, Washington, and Wyoming. As an article
in the magazine Trusts and Estates put it, “Florida has evolved into a U.S. tax and creditor protection
haven, seducing wealthy individuals to migrate south. One of the biggest draws is that Florida
imposes no income tax on individuals and trusts. As of Jan 1, 2006, there’s also no state estate tax, gift
tax or inheritance tax.”64
Such shifts away from state corporate income taxes and progressive personal income taxes may
have been due to a variety of factors. States may have felt these changes were needed to compete for
geographically-mobile companies and high-income individuals. Evidence on the true mobility of
these tax bases in response to tax differences across states was mixed, as leading studies of the issue
came to dramatically different conclusions. For example, two prominent analyses in the late 1990s
summarized their findings with the statements: “[t]axes do not appear to have a substantial effect on
economic activity among states,” and “the emerging consensus among economists now says that
taxes do matter.”65 Related to concerns about geographic mobility, corporate and high-income
10
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personal tax bases were thought to be highly elasticb, as taxpayers could avoid these taxes by
choosing alternative uses for their financial or human capital. Raising tax rates on a highly elastic tax
base was a relatively inefficient way to raise revenue, because doing so yielded a smaller increase in
tax revenue for a given increase in rates. Moreover, if investment in these forms of capital was
discouraged by higher taxation, overall economic growth could be lower than otherwise.66 Finally,
these tax bases tended to yield volatile revenue streams, as both corporations and high-income
individuals had incomes that closely tracked the macroeconomy.
While these factors may have helped explain the general shift in the structure of state taxation, the
alignment between theory and reality was far from perfect. In fact, in the years leading up to
California’s 2009 debate over reform, some states moved to raise tax rates on corporations and highincome individuals. The Center on Budget and Policy Priorities listed 30 states as having raised taxes
in 2009 alone, including 11 increases on corporate income and 11 on personal income.67 The tax
increases of 2009 may have simply been politically feasible ways of closing recession-induced budget
gaps, but they reinforced a more fundamental puzzle: regardless of the trends toward lower taxation
of corporate and large personal incomes, in most U.S. states these taxes remained higher than the
forces of competition and tax efficiency suggested they would (see Exhibit 2a).
Several factors were behind the positive, and in some cases increasing, tax rates on corporate and
high-income personal taxes seen in some states. First, companies and highly skilled individuals could
not migrate to lower-tax jurisdictions without incurring costs, so regional groups of states acting in
concert could keep rates high by reducing the variation in taxes between them, thereby limiting the
mobility of their tax bases.68 Second, the evidence was unclear as to how and whether companies and
high-income individuals took into account a state’s tax policy when deciding where to locate. In fact,
opponents of tax reductions argued that taxes funded public goods (e.g., infrastructure, education,
health care, public safety, environmental quality) that attracted talented workers and entrepreneurs
and raised the productivity of businesses. Third, polls across the nation showed that public opinion
was in favor of higher corporate and progressive income taxes.69
Tax Policy in Other Countries
The free movement of goods, capital, and people across the borders between U.S. states could be
seen as an extreme version of the global economy of the early twenty-first century. While barriers to
trade, investment, and migration between countries were still common in 2010, these barriers had
been falling for decades.
Policymakers were aware of these trends. For example, three future officials of the Obama
Administration—Jason Furman, Lawrence Summers, and Jason Bordoff—wrote in 2007 that “the
same dynamic forces of technological change, financial innovation, and globalization that have
contributed to rising income inequality also present new challenges for progressive taxation. . . . And
as capital is able to move ever more quickly and easily across borders, corporate income becomes
increasingly elusive of taxation.”70
Consistent with this increasing mobility of tax bases, national tax systems exhibited trends similar
to those in U.S. states. Developed economies lowered statutory corporate income tax rates steadily
from the 1970s through the 2000s and broadened the definition of taxable corporate income.71 These
b The elasticity of one economic quantity, x, to another, p, is the percentage change in x due to a one percent change in p.
Quantities with elasticities greater than one are called elastic, those with elasticities equal to one are called unit elastic, and those
with elasticities less than one are called inelastic.
11
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California’s Budget Crises, Tax Reform, and Domestic and International Tax Competition
changes combined to keep the ratio of total corporate taxes paid to corporate income roughly
constant over this period.72 (Exhibits 13 and 14) But, as standard economic analysis suggested, if the
discouragement of economic activity due to taxes increased more than proportionally with the tax
rate, this combination of policy changes likely increased the efficiency of corporate taxes. Taxpreferred special economic zones flourished around the world, paralleling the increase in tax credits
by U.S. states. These special zones separated the treatment of new and old investments, allowing
countries to retain higher rates on existing capital while competing for new capital.73 Despite these
trends toward a lighter tax treatment of corporations, the corporate tax remained well above zero in
most countries, as in U.S. states.
Personal income tax progressivity generally declined around the world over the same period. Top
marginal tax rates on personal income fell, as did the marginal rate paid by a worker earning 250% of
the average income.74 Furthermore, the spread between the tax rate paid by this high earner and a
worker earning only 67% of the average fell from 22 percentage points to 18 percentage points across
the Organization for Economic Cooperation and Development (OECD) countries from 1981 to 2006.75
Finally, as the COTCE report recommended for California, value-added taxes had taken on an
increased role in developed countries over the preceding three decades, replacing excise taxes on
specific goods. (Exhibit 13) One analysis showed: “Combined, the increase in countries using a valueadded tax and the increased rates in countries that already had a value-added tax have led to a near
doubling of the share of tax revenues (on an unweighted average basis) collected by general
consumption taxes in the OECD from 1960 to 2003.”76 In contrast, California replaced its decreased
excise tax revenue with increased personal income taxes.
The leading edge of international tax competition was occupied by so-called “tax havens.” Tax
havens were countries (or regions within countries, such as U.S. states) that competed for economic
activity by offering exceptionally low taxes along with, in most cases, easy regulation and extensive
privacy protections. Experts identified around 45 major national tax havens operating in the mid2000s (Exhibit 15).
Tax haven countries were generally small in population and physical size, but they played an
outsized role in the global economy because of the many creative ways in which they could be used
by corporations and wealthy individuals to avoid taxes. Although data on the economic activity in
havens is inherently difficult to gather, in 1999 they hosted 16% of foreign assets and 30% of the
foreign income of American multinationals despite making up only 2.3% of global GDP and 0.8% of
global population.77 These data led many to blame tax havens for accelerating a race to the bottom in
tax policy.
No global government existed to regulate tax havens or tax competition in general, so concerned
countries organized cooperative initiatives to address them. Most prominently, the OECD issued an
influential report in 1998 that began its aggressive effort over the next decade to limit the extent of
what it defined as “harmful tax practices.” The OECD eventually obtained reform commitments from
43 of the 47 tax havens it originally identified, a record seen as a success by many. Critics argued,
however, that the requirements for being deemed “cooperative” had been made too weak and had
allowed the havens to continue competing on taxes nearly as aggressively as before.
Efforts such as those by the OECD were generally uncontroversial when aimed at combating
illegal tax evasion, but the question remained as to whether the practice of legal tax avoidance
through tax havens was good or bad for economic policy. On the one hand, by forcing countries to
recognize the elasticity of their tax bases, havens might have been accelerating inevitable and even
desirable changes in tax systems. Some analysts argued that havens’ positive effects were more
12
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California’s Budget Crises, Tax Reform, and Domestic and International Tax Competition
710-038
subtle, in that they made it possible for countries to raise revenues through positive corporate tax
rates while providing a release valve, reducing the tax burden on investment that would otherwise
have located elsewhere. On the other hand, the shifts in policy coinciding with the rise of havens
reduced the progressivity of tax systems, cutting aid to lower-earning households whose incomes
were already under pressure from the increasingly global production process.78
One positive view of tax havens stressed that they forced countries to convince taxpayers that
their taxes were justified by the benefits of the state services they funded. Since the 1950s, analysts
had noted that easy migration and small jurisdictions provided for just such discipline at a local level.
For example, individuals paying high property taxes in the United States (which are assessed at the
local level) expected to receive proportionate benefits in exchange, such as good public schools or a
good commuting location. Was local public finance in the United States foreshadowing the future of
countries in the globalized economy? Would businesses and individuals demand that taxes be based
not on how elastically they responded to the taxes or on their abilities to pay, but rather on how much
they valued the goods and services the taxes funded?
California in 2010
In October 2009, Governor Schwarzenegger received a disappointing report from his budget team:
the state’s budget deficit was back. State tax revenue had dropped by over $1 billion in the third
quarter, yielding 5.3% less revenue than had been projected and reinvigorating concerns over the
sustainability of the state’s finances. Meanwhile, the governor’s preferred tax reforms were being
battered in the state legislature.
By January 2010, when the governor submitted his budget for the coming year, the situation was
dramatically worse, with a $20 billion deficit predicted for the coming fiscal year. To close the gap,
the governor stressed spending cuts, pay cuts for public employees, and a plan to push the federal
government for support. The governor said of his plan: “I know many of these cuts are painful. . . .
Believe me, these are the hardest decisions a governor has to make. Yet there is simply no conceivable
way to avoid more cuts and more pain.” Notably, the plan did not raise taxes, and the governor
reiterated his desire for reform along the lines of COTCE’s recommendations.
Meanwhile, leading Democrats opposed the governor’s budget. In direct conflict with the COTCE
recommendations, they supported tax increases to plug the budget gap, asserting that firms and
talented individuals would continue to flock to the state despite, and perhaps because of, higher taxes
to fund public services. “We have to remember that there is a connection between services and
taxes,” said Assembly Member Evans. She continued, “If Californians want these services provided
by the state, then [they] have to pay taxes for them.” However, “because the Governor threatens to
veto anything [the legislature] sends him with taxes, it has become impossible” to raise the required
revenue.79
Term limits meant that 2010 would be Schwarzenegger’s last year in office. At the start of the year,
he weighed his options for making progress toward ensuring California’s long-term fiscal health. He
could push for the policy he believed best for the state, involving fundamental reform that was
deeply unpopular with his Democratic counterparts and even some Republicans. He could allow the
status quo to persist, postponing a resolution of the fiscal imbalance to a time when the economy was
healthier and the resistance to reform potentially weaker. Or, he could search for a compromise with
lawmakers that would reconcile his vision with theirs.
13
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California’s Budget Crises, Tax Reform, and Domestic and International Tax Competition
Exhibit 1a
California’s Projected Annual Operating Shortfall, General Fund ($ billions)
0
-5
-10
-15
-20
-25
FY 2010-11
FY 2011-12
FY 2012-13
FY 2013-14
FY 2014-15
Projections ($ billions)
FY 2010-11
FY 2011-12
FY 2012-13
FY 2013-14
FY 2014-15
General Fund Revenues
$88
$84
$92
$99
$106
General Fund Expenditures
$102
$106
$115
$119
$124
$20
$21
$23
$20
$18
Projected Deficit
(includes $6
carryover)
Source: “The 2010–2011 Budget: California’s Fiscal Outlook,” California Legislative Analyst’s Office, http://www.lao.ca.gov/
2009/bud/fiscal_outlook/fiscal_outlook_111809.aspx, accessed April 2010.
14
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1%
–10%
–
0.8%
4
–
0.1%
Foreign imports of goods and services ($billions)
–
0.8%
29
27
–3%
–0.6
6.8%
3.4%
848
324
1980
–5.5%
62
32
2%
0.6
7.2%
4.5%
1,057
528
1985
–3.6%
97
69
–5%
–2.1
5.8%
4.2%
1,299
788
1990
–5.3%
165
117
1%
0.3
–7.4%
244
149
3%
2.7
4.9%
4.6%
7.9%
1,609
1,284
1,287
2000
–0.2%
909
1995
–6.7%
214
127
–9%
–8.0
5.4%
–1.7%
1,582
1,301
2001
–8.0%
218
111
–11%
–9.4
6.7%
1.4%
1,604
1,340
2002
–8.7%
237
114
–11%
–11.0
6.8%
2.9%
1,650
1,411
2003
–
10.0%
274
123
–8%
–7.9
6.2%
4.9%
1,732
1,519
2004
–
10.8%
306
130
–3%
–3.1
5.4%
4.0%
1,800
1,633
2005
–
11.2%
343
148
–1%
–1.3
4.9%
3.4%
1,861
1,742
2006
–
10.8%
356
160
–8%
–9.3
5.4%
1.2%
1,883
1,813
2007
Sources: “Gross Domestic Product by State,” Bureau of Economic Analysis, http://www.bea.gov/regional/gsp/, accessed April 2010.
“Local Area Unemployment Statistics,” Bureau of Labor Statistics, http://www.bls.gov/lau/, accessed April 2010.
California Employment Development Department.
“Budget Summary—Schedule 6,” California Department of Finance, http://www.ebudget.ca.gov/pdf/BudgetSummary/BS_SCH6.pdf, accessed April 2010.
“Foreign Trade Through California Ports – Table K-10,” California Department of Finance, http://www.dof.ca.gov/html/fs_data/stat-abs/tables/k10.xls, accessed April 2010.
Foreign trade balance as share of GSP
12
4
Foreign exports of goods and services ($billions)
10
0.1
–0.6
State budget balance ($billions)
Budget balance as share of total revenue
9.9%
7.3%
Unemployment
716
2.8%
623
Real gross state product (billions of $2008)
179
1975
Real GSP growth rate (average between years)
112
1970
Selected Macroeconomic Indicators for California
Gross state product ($billions)
Exhibit 1b
–
10.0%
356
171
–9%
–10.9
7.2%
–1.9%
1,847
1,847
2008
2009
-15-
277
137
–15%
–16.1
11.7%
710-038
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710-038
California’s Budget Crises, Tax Reform, and Domestic and International Tax Competition
Exhibit 2a
Combined Top Marginal State Personal and Corporate Income Tax Rates, 2010
25
Corporate Income Tax
Personal Income Tax
20
15
10
5
Iowa
New Jersey
California
Oregon
Rhode Island
District of Columbia
Minnesota
Vermont
Maine
Hawaii
New York
Wisconsin
Delaware
Idaho
West Virginia
North Carolina
Nebraska
Maryland
Massachusetts
Louisiana
Connecticut
Montana
Arkansas
Pennsylvania
New Mexico
Missouri
Georgia
Kentucky
South Carolina
Indiana
Virginia
Arizona
Alabama
Oklahoma
North Dakota
Kansas
Illinois
Mississippi
Utah
Alaska
Michigan
Colorado
New Hampshire
Tennessee
Ohio
Florida
Nevada
South Dakota
Texas
Washington
Wyoming
0
Sources: “State Corporate Income Tax Rates,” Tax Policy Center, http://www.taxpolicycenter.org/taxfacts/display
afact.cfm? Docid=244, accessed April 2010.
“Individual State Income Tax Rates,” Tax Policy Center, http://www.taxpolicycenter.org/taxfacts/display
afact. cfm?DocID=406&Topic2id=90&Topic3id=91, accessed April 2010.
16
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California’s Budget Crises, Tax Reform, and Domestic and International Tax Competition
Exhibit 2b
710-038
State and Local Tax Burden (tax rate in percent), 2008
13%
12%
11%
10%
9%
8%
7%
New Jersey
New York
Connecticut
Maryland
Hawaii
California
Ohio
Vermont
District of Columbia
Minnesota
Pennsylvania
Rhode Island
Wisconsin
Idaho
Arkansas
Maine
Georgia
Nebraska
North Carolina
Oklahoma
Virginia
Kansas
Utah
Delaware
Massachusetts
Indiana
Kentucky
Michigan
Oregon
Illinois
Iowa
West Virginia
Missouri
North Dakota
Colorado
Mississippi
Washington
South Carolina
Alabama
Montana
New Mexico
Arizona
Louisiana
Texas
Tennessee
South Dakota
New Hampshire
Florida
Wyoming
Nevada
Alaska
6%
Source: The Tax Foundation, http://www.taxfoundation.org/taxdata/show/335.html, accessed April 2010.
Exhibit 3
California State Budget Balance as a Share of Revenue, 1950–2009
15%
10%
5%
0%
-5%
-10%
FY 50-51
FY 52-53
FY 54-55
FY 56-57
FY 58-59
FY 60-61
FY 62-63
FY 64-65
FY 66-67
FY 68-69
FY 70-71
FY 72-73
FY 74-75
FY 76-77
FY 78-79
FY 80-81
FY 82-83
FY 84-85
FY 86-87
FY 88-89
FY 90-91
FY 92-93
FY 94-95
FY 96-97
FY 98-99
FY 00-01
FY 02-03
FY 04-05
FY 06-07
FY 08-09
-15%
Source: “Budget Summary—Schedule 6,” California Department of Finance, http://www.ebudget.ca.gov/pdf/
BudgetSummary/BS_SCH6.pdf, accessed April 2010.
17
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710-038
California’s Budget Crises, Tax Reform, and Domestic and International Tax Competition
Exhibit 4
Credit Ratings of California General Obligation Bonds
4.5
4.0
3.5
3.0
2.5
S&P
Fitch
Moody’s
2.0
1.5
Feb-08
Mar-06
Feb-04
Mar-02
Feb-00
Mar-98
Feb-96
Mar-94
Feb-92
Mar-90
Feb-88
Mar-86
Feb-84
Mar-82
Feb-80
Mar-78
Feb-76
Mar-74
Feb-72
Mar-70
1.0
Source: California State Treasurer; http://www.treasurer.ca.gov/ratings/history.asp, accessed April 2010.
Note:
Authors converted each agency’s ratings scale into a four-point index, with each step in ratings corresponding
to a numeric step of one-third. For instance, AA– in S&P and Fitch ratings was classified as 3.0, while AA was 3.3.
18
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Source:
-0.2
0.0
0.2
0.4
0.4
0.2
–
(0.2)
0.4
0.2
0.0
-0.2
Source:
0.6
0.6
“Budget Summary – Schedule 6,” California Department of Finance, http://www.
ebudget.ca.gov/pdf/BudgetSummary/BS_SCH6.pdf, accessed April 2010.
0.8
0.8
Other
Retail Sales Total
Personal Income Tax
Motor Vehicle Taxes Total
Estate, Inheritance & Gift Tax
Corporation Tax
Sin Taxes Total
Budget balance/Revenues
2009-10
2007-08
2005-06
1997-98
1995-96
1993-94
1991-92
1981-82
1979-80
1977-78
1975-76
1973-74
1971-72
1969-70
1967-68
1965-66
1963-64
1961-62
1959-60
1957-58
1955-56
1953-54
-0.2
0.0
0.2
0.4
0.6
0.8
1.0
“Budget Summary – Schedule 6,” California Department of Finance, http://www.
ebudget.ca.gov/pdf/BudgetSummary/BS_SCH6.pdf, accessed April 2010.
1983-84
0.6
Other
State and Consumer Services
Environmental Protection
Resources
Corrections
Tax relief
Business, Transport, Housing
Health and Human Services
Higher education
K-12
Budget balance/Revenues
1985-86
0.8
1.0
1.0
1987-88
1.0
1976-77
1977-78
1978-79
1979-80
1980-81
1981-82
1982-83
1983-84
1984-85
1985-86
1986-87
1987-88
1988-89
1989-90
1990-91
1991-92
1992-93
1993-94
1994-95
1995-96
1996-97
1997-98
1998-99
1999-00
2000-01
2001-02
2002-03
2003-04
2004-05
2005-06
2006-07
2007-08
2008-09
2009-10
California’s State Revenue Shares and Budget Balance
1999-00
1951-52
Exhibit 6
1989-90
California’s State Expenditure Shares and Budget Balance
2001-02
Exhibit 5
2003-04
710-038
-19-
For the exclusive use of A. Alcivar, 2024.
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710-038
California’s Budget Crises, Tax Reform, and Domestic and International Tax Competition
Exhibit 7a
Percentage Change in Family Income Relative to 1970, by Income Percentile
70%
60%
Income percentile
Percent Change Since 1970
50%
90th
75th
Median
25th
10th
40%
30%
20%
10%
0%
-10%
-20%
-30%
2000
1998
1999
1996
1997
1994
1995
1992
1993
1990
1991
1988
1989
1986
1987
1984
1985
1982
1983
1980
1981
1978
1979
1976
1977
1974
1975
1972
1973
1970
1971
-40%
Source: Adapted from “Poverty in California,” http://www.ppic.org/content/pubs/cacounts/CC_506DRCC.pdf,
accessed April 2010.
Exhibit 7b
Distribution of Personal Income Tax, by Income Percentile
100%
90%
95th to 100th percentile
Share of personal taxes paid
80%
70%
80th to 95th percentile
60%
50%
60th to 80th percentile
40%
30%
40th to 60th percentile
20%
10%
20th to 40th percentile
0%
1975
0 to 20th percentile
1980
1985
1990
1995
2000
2005
2009
Source: “California’s Changing Income Distribution,” California Legislative Analyst’s Office, http://192.234.213.2/2000/
0800_inc_dist/0800_income_distribution.html, accessed April 2010.
20
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California’s Budget Crises, Tax Reform, and Domestic and International Tax Competition
Exhibit 8a
710-038
Control of the California Government, 1955–2009
Legislature=R,
Governor=R
7.3%
Legislature Split,
Governor=R
7.3%
Legislature=D,
Governor=D
38.2%
Legislature=D,
Governor=R
47.3%
Source:
Casewriters’ calculations, based on E. Dotson Wilson and Brian S. Ebbert, California’s Legislature
(Sacramento: The State of California, 2006), p. 277.
Exhibit 8b U.S. States that allow voter “initiatives” and year when they first allowed them.
From Christopher Berry “Direct Democracy and Redistribution” (2009)
21
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710-038
Exhibit 9a
California’s Budget Crises, Tax Reform, and Domestic and International Tax Competition
Spending per pupil (K-12) in California relative to the National Average
Source: “California’s K-12 Public Schools: How Are They Doing?” RAND, 2005.
22
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California’s Budget Crises, Tax Reform, and Domestic and International Tax Competition
Exhibit 9b
710-038
Components of State and Local Taxation, 1977–2007
California State and Local
100%
90%
80%
70%
60%
50%
40%
30%
Other Taxes
Corporate Net Income Tax
Individual Income Tax
Total Sales Tax
Property Tax
20%
10%
1983
1984
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2002
2004
2005
2006
2007
1977
1978
1979
1980
1981
1982
0%
State and Local Average across United States
100%
90%
80%
70%
60%
50%
40%
Other Taxes
Corporate Net Income Tax
Individual Income Tax
Total Sales Tax
Property Tax
30%
20%
10%
1977
1978
1979
1980
1981
1982
1983
1984
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
0%
Source: Casewriters’ analysis of data from the U.S. Census Bureau, Government Finances Database, http://www2.census.
gov/pub/outgoing/govs/special60, accessed April 2010.
23
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California’s Budget Crises, Tax Reform, and Domestic and International Tax Competition
Exhibit 10
Members of the Commission on the Twenty-First Century Economy
Governor’s Appointments
Gerald Parsky [Chair]
Ruben Barrales
Michael Boskin
John Cogan
William Hauck
Rebecca Morgan
Curt Pringle
Chairman, Aurora Capital Group
President and Chief Executive Officer, San Diego Regional Chamber of
Commerce
Senior Fellow, Hoover Institution and T. M. Friedman Professor of
Economics, Stanford University
Senior Fellow, Hoover Institution and Professor of Public Policy, Stanford
University
President and Chief Executive, California Business Roundtable
President, Morgan Family Foundation
Mayor, City of Anaheim
Legislature’s Appointments
Edward De La Rosa
Christopher Edley, Jr.
George Halvorson
Jennifer Ito
Fred Keeley
Monica Lozano
Richard Pomp
Founder and President, De La Rosa & Company
Dean and Professor of Law, Boalt Hall School of Law, University of
California, Berkley
Chairman and Chief Executive Officer, Kaiser Foundation Health Plan
and Kaiser Foundation Hospitals
Director of Research, Strategic Concepts in Organizing and Policy
Education (SCOPE)
Treasurer of Santa Cruz County, Professor of Political Science, California
State University, San Jose
Publisher and Chief Executive Officer, La Opinión
Alva P. Loiselle Professor of Law, University of Connecticut
Source: California Commission on the Twenty-First Century Economy, Report, September 2009.
Exhibit 11
State Corporate Taxation, Totals across United States
16%
14%
Corporate income as a share of total GDP
12%
10%
8%
Total (GSP-weighted) state corporate tax rate
6%
4%
State corporate taxes as a share of total tax revenue
2%
0%
1975
1980
1985
1990
1995
2000
2005
2010
Sources: Bureau of Economic Analysis, Chirinko and Wilson (2006), and author’s calculations
Sources: Bureau of Economic Analysis; Robert Chirinko and Daniel Wilson, “State Investment Tax Incentives: What Are
the Facts,” Federal Reserve Bank of San Francisco Working Paper 2006-49, 2006; and casewriters’ calculations.
24
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Exhibit 12
710-038
Investment Tax Credits
Source: Robert Chirinko and Daniel Wilson, “State Business Taxes and Investment: State-by-State Simulations,”
Federal Reserve Bank of San Francisco Economic Review 2010, Figure 1.
Exhibit 13
Corporate Income Tax Rate (unweighted OECD average)
Personal income tax
Corporate income tax
Social security contributions *
Other payroll taxes
Property taxes
General consumption taxes
Specific consumption taxes
Other taxes
1975
1985
2009
26
9
18
1
8
12
24
2
30
8
22
1
5
16
16
2
25
8
27
1
5
20
11
3
Note *Combines employer and employee contributions. Source: Adapted from OECD
25
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710-038
California’s Budget Crises, Tax Reform, and Domestic and International Tax Competition
Exhibit 14 Corporate taxes and corporate tax revenue in selected OECD countries
Total (national and state)
corporate tax revenue as % of
GDP
Australia
Austria
Belgium
Canada
Denmark
Finland
France
Germany
Greece
Ireland
Italy
Netherlands
New Zealand
Norway
Spain
Sweden
Switzerland
United Kingdom
United States
Combined national and
state corporate tax rates
1965
1985
2008
1985
2009
3.4
1.8
1.9
3.8
1.4
2.5
1.0
2.5
0.3
2.3
1.8
2.6
4.9
1.1
1.4
2.0
1.3
1.3
4.0
2.6
1.4
2.2
2.7
2.2
1.4
1.9
2.2
0.7
1.1
3.1
3.0
2.6
7.3
1.4
1.7
1.7
4.7
1.9
4.8
1.7
2.5
3.4
2.3
2
1.5
1.3
2.5
2.8
3.1
2
3.5
9.1
2.2
3.0
3.0
2.8
1.8
46.0
55.0
45.0
49.4
50.0
61.8
50.0
60.0
49.0
50.0
46.4
43.0
45.0
50.8
35.0
56.6
31.9
40.0
49.8
30.0
25.0
34.0
31.0
25.0
26.0
34.4
30.2
25.0
12.5
27.5
25.5
30.0
28.0
30.0
26.3
21.2
28.0
39.1
Source: Adapted from OECD (Includes all the countries for which all five of these statistics were available)
26
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California’s Budget Crises, Tax Reform, and Domestic and International Tax Competition
Exhibit 15
710-038
Tax Havens (population in thousands shown after name)
Andorra
84
Grenada
91
Naura
14
Anguilla
14
Hong Konga
7,055
Netherlands Antilles
227
4,203
Niue
1
77
Panama
3,360
a
Antigua and Barbuda
86
Ireland
Aruba
103
Isle of Man
a
Bahamas
308
Jordan
6,269
Saint Kitts and Nevis
40
Bahrain
729
Lebanona
4,017
Saint Lucia
140
Barbados
285
Liberia
3,442
Saint Vincent and the Grenadines 105
Belize
308
Liechtenstein
35
Samoa
220
Bermuda
68
Luxembourga
492
San Marino
30
British Virgin Islands
24
a
Macau
560
Seychelles
87
Cayman Islands
49
Maldives
396
Singaporea
4,658
a
Channel Islands
158
Malta
405
Switzerland
Cook Islands
12
Marshall Islands
65
Tonga
7,604
121
Cyprus
1,085
Mauritius
1,284
Turks and Caicos Islands
23
Dominica
73
Monaco
33
Vanuatu
219
Gibraltar
29
Montserrat
5
Virgin Islands (U.S.)
110
Source: D. Dharmapala and J. Hines, “Which Countries Become Tax Havens?” 2006, http://www.aei.org/docLib/20061212_
hines.pdf, accessed April 2010, and CIA World Factbook.
a Indicates the country was not listed in the OECD’s list of tax havens.
Exhibit 16
Policymakers and Analysts Quoted in Case
Name
Position mid-January, 2010
Ashburn, Roy
Member, Senate Committee on the Budget and Fiscal Review
Calderon, Charles
Chair, Assembly Committee on Revenue and Taxation
Crane, David
Governor’s Special Advisor for Jobs and Economic Growth
Ducheny, Denise
Chair, Senate Committee on the Budget and Fiscal Review
Evans, Noreen
Chair, Assembly Committee on the Budget
Hollingsworth, Dennis
Senate Minority Leader
Ross, Jean
Executive Director of the California Budget Project
Taylor, Mac
Legislative Analyst’s Office
Source: Compiled by casewriters based on public records.
27
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710-038
California’s Budget Crises, Tax Reform, and Domestic and International Tax Competition
Endnotes
1 Governor’s Radio Address, April 2, 2010, http://gov.ca.gov/press-release/14739, and James P. Sweeney,
“Governor: Fiscal Armageddon Near,” San Diego Union-Tribune, December 11, 2008, http://www3.signon
sandiego.com/stories/2008/dec/11/1n11budget7642-governor-fiscal-armageddon-near.
2 For details on the facts in this paragraph, see “State Rolls Out $3.36 billion in IOUs Today,” San Francisco
Chronicle, July 2, 2009; “Big Banks Don’t Want California’s IOUs,” The Wall Street Journal, July 7, 2009; “Trading of
California IOUs Catches Regulators’ Eyes,” Los Angeles Times, July 7, 2009.
3 Fiscal emergencies vary depending on the declaration. California governors can use their executive power
to define what a fiscal emergency means for their administration. In addition, fiscal emergencies can have
different meanings for each declaration. However, fiscal emergencies almost always require the legislature to
hold a special session to address the declared problem, which is usually outlined in the governor’s declaration.
4 Jean Ross, interview with casewriters, January 13, 2010 – 4:45.
5
See “California Budget Deal Closes $26 Billion Gap,” The New York Times, July 24, 2009,
http://www.nytimes.com/2009/07/25/us/25calif.html, accessed April 2010.
6
Legislative Analyst’s Office, http://www.lao.ca.gov/2009/bud/fiscal_outlook/fiscal_outlook_111809.
aspx, accessed April 2010.
7 Troy Senik, “Who Killed California?” National Affairs, Fall 2009, p. 55.
8 Denise Ducheny, interview with casewriters, January 13, 2010 – 6:30 and 6:45.
9 David Crane, interview with casewriters, January 11, 2010 – 1:30.
10 “Governor’s State of the State,” speech given on January 6, 2010, http://gov.ca.gov/index.php?/fact-
sheet/14128, accessed April 2010.
11 From http://www.learncalifornia.org/doc.asp?id=1607, a site sponsored by the California Secretary of
State’s office, accessed April 2010.
12 See, for example, Ronald J. Gilson, “The Legal Infrastructure of High Technology Industrial Districts:
Silicon Valley, Route 128, and Covenants Not to Compete,” 1999; 74 N.Y.U. Law Rev. 575.
13 Hans P. Johnson and Amanda Bailey, “California’s Newest Homeowners,” Public Policy Institute of
California, August 2005, http://www.ppic.org/content/pubs/cacounts/CC_805HJCC.pdf, accessed April 2010.
14 Kauffman Foundation, “The 2008 State New Economy Index,” http://www.kauffman.org/uploadedfiles/
2008_state_new_economy_index_120908.pdf, accessed May 2010.
15 Governor’s Office of Economic Development, http://business.ca.gov/WhyCA.aspx, accessed September 2011.
16
U.S. Department of Commerce, Bureau of Economic Analysis, http://www.bea.gov/regional/gsp,
accessed April 2010.
17 Study by the Commonwealth Fund, cited in Senik, “Who Killed California?” Fall 2009.
18 Learning Matters, “First to Worst: An Introduction,” http://learningmatters.tv.
19 See the PPIC documents: Hans P.
Johnson, “At Issue: Illegal Immigration,” PPIC, April 2006,
http://www.ppic.org/main/publication.asp?i=676; and Hans P. Johnson, “Just the Facts: Illegal Immigrants,”
PPIC, June 2008, http://www.ppic.org/main/publication.asp?i=818.
20
“Just the Facts: California’s Central Valley,” Public Policy Institute of California, June 2006,
http://www.ppic.org/main/publication.asp?i=566; and U.S. Census Bureau Quickfacts.
28
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710-038
21 “CEOs Select Best, Worst States for Job Growth and Business,” Chief Executive Magazine, Spring 2009,
http://www.chiefexecutive.net.
22 Dennis Hollingsworth, interview with casewriters, January 11, 2010 – 2:00.
23 Roy Ashburn, interview with casewriters, January 12, 2010 – 9:30.
24 Crane, interview with casewriters, January 11, 2010 – 12:00.
25 California’s revenue and expenditure data can be divided among four funds: the general fund, special
fund, bond fund, and federal fund. The federal fund is usually omitted from state budget calculations because it
reflects transfers from and payments to the federal government. The official budget data reported by the
governor’s office includes revenues from the general and special funds and expenditures from the general,
special, and bond funds. This is consistent with the accounting conventions of the U.S. federal government.
26 See National Association of State Budget Officers, http://www.nasbo.org/Publications/FiscalSurvey/
FiscalSurveyArchives/tabid/106/Default.aspx, accessed April 2010. In the NASBO data, which includes only
components of the official state data for California, the state ran deficits averaging 0.8% of revenue, more than
any of the next five largest states. California’s deficits exceeded 5% of revenue in 6 of the 30 fiscal years after
1979, while the next five largest states ran such deficits in 0, 4, 4, 2, and 2 years over that period (earlier data are
unavailable).
27 Joe Nation, Ph.D., “Pension Math: How California’s Retirement Spending is Squeezing the State Budget.”
SIEPR, December 13, 2011.
28 For 1959 through 2008, these rates were 8.7% and 8.2%, respectively.
29 Senior policy advisor, interview with casewriters, January 12, 2010 – 3:45, 5:00.
30 Ashburn, interview, January 12, 2010 – 4:45.
31 See LAO, http://www.lao.ca.gov/2009/bud/fiscal_outlook/fiscal_outlook_111809.aspx, accessed April 2010.
32 Volatility is measured by the coefficient of variation of the annual percentage change in revenues. The
coefficient of variation is the standard deviation divided by the average. These calculations use data from the
National Association of State Budget Officers cited above.
33 Governor Schwarzenegger had promised when running for office in 2003 to repeal recent motor vehicle
tax increases.
34 Ashburn, interview, January 12, 2010 – 8:00.
35 Ducheny, interview, January 13, 2010 – 48:00.
36 Senior policy advisor, interview, January 12, 2010 – 12:30.
37 Noreen Evans, interview with casewriters, January 14, 2010 – 18:00.
38 Casewriters’ analysis of data from the Initiative and Referendum Institute at the University of Southern
California, http://www.iandrinstitute.org/data.htm, accessed April 2010.
39 Evans, interview, January 14, 2010 – 5:30.
40 The Economist, “The Tyranny of the Majority,” December 19, 2009.
41 Charles Calderon, “Discussion of ACA 21,” July 16, 2009, http://info.sen.ca.gov/pub/09-10/bill/asm/ab_
0001-0050/aca_21_cfa_20090831_192902_asm_floor.html, accessed April 2010.
42 Crane, interview, January 11, 2010.
29
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43 Bartlett, Bruce, “We Need a Party of Fiscal Responsibility,” Forbes, September 4, 2009, http://www.forbes.
com/2009/09/03/fiscal-responsibility-party-opinions-columnists-bruce-bartlett.html, accessed April 2010; and
“Tax Cuts Don’t Starve the Beat,” The New York Times April 4, 2006, http://bartlett.blogs.nytimes.com/
2006/04/04/tax-cuts-dont-starve-the-beast/?pagemode=print, accessed April 2010.
44 See McGuire, Therese. “Proposition 13 and its Offspring: For Good or Evil,” National Tax Journal
52(1),
1999. Also see “California’s K–12 public schools : how are they doing?” Stephen J. Carroll et al., RAND Corporation 2004.
45 California’s state fiscal accounts are made up of a number of funds, the largest of which are the general,
special, and bond funds. The general fund is the main operating budget of the state, the special fund is intended
for matched revenues and expenditures, and the bond fund is for expenditures out of the stock of state-issued
bonds. Despite these formal distinctions, however, money is often moved among the funds.
46 How were these deficits financed if bond issuance was prohibited? According to Mac Taylor, the head of
California’s LAO, “The state has enough balances in other fund reserves, that even through our internal
resources, California can pay for those shortfalls” (Mac Taylor, interview with casewriters, January 15, 2010). He
explained that California can sustain a deficit by paying bills with money from a “pooled money investment
account, where the Treasurer invests whatever idle funds there are … in short-term securities to earn interest”
(Taylor, interview, January 15, 2010). As a result, “[California] typically has enough cash on hand to pay [its]
bills.” David Crane stated simply, “You can balance budgets lots of different ways” (Crane, interview, January
11, 2010).
47 Ducheny, interview, January 13, 2010.
48 COTCE
Final Report, http://www.cotce.ca.gov/documents/reports/documents/Commission_on_the_
21st_Century_Economy-Final_Report.pdf, page 31, accessed April 2010.
49 See COTCE Final Report.
50 Under reform Package 1, the corporate tax would no longer exist, and all personal income would be
subject to a flat tax rate of 6%. To make up for the lost revenue, Package 1 introduced a “business net receipts
tax,” a policy similar to the better known value-added tax (VAT). A VAT is economically equivalent to a uniform
sales tax on all goods and services, though it is often preferred to a sales tax because it is harder to evade.
Package 1’s “net receipts tax” would make up 34% of revenue, replacing most of the current law’s sales tax as
well as the corporate tax. Under reform Package 2, the corporate profits tax rate would be cut to 7% and was
expected to generate 7% of total revenues, while personal income would be taxed at 3.75% up to an annual
income of $50,000 and 7% for income above that. Package 2 would retain the existing sales tax but raise taxes on
specific goods (excise taxes) from 12% to 15% of total revenue.
51 Eric Bailey, “Schwarzenegger Calls for Overhaul of State Tax System,” Los Angeles Times, September 30, 2009.
52 COTCE’s September 2009 report estimates progressivity of Packages 1 and 2 relative to the baseline and
shows a decline in progressivity with the introduction of the BNRT.
53 Noreen Evans, “Tax Reform for Billionaires,” September 29, 2009, http://democrats.assembly.ca.gov/
members/a07/BudgetThoughts/budget0929.aspx, accessed April 2010; and Evans, interview, January 14, 2010 –
3:00.
54 Jed Kolko, “Are the Rich Leaving California?” Public Policy Institute of California, July 2009. Several
policymakers mentioned this study during interviews with the casewriters.
55 “The biggest problem with the BNRT is that it creates a disincentive to employment. . . . If you can’t
deduct the wages, then where is the incentive to hire?”Senator Denise Ducheny. Interview with case authors. 13
January 2010 – 1:30
56 See the letter by Joseph Bankman, et al., to Gerald Parsky, Chair of COTCE, dated Sept 5, 2009, available as of
September 2012 at http://www.cotce.ca.gov/documents/correspondence/public/
30
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710-038
57 Charles Calderon, “Welcome Message,” http://democrats.assembly.ca.gov/members/a58, accessed April 2010.
58 See Mary Bernard, “Trends in Multi-State Income Tax Apportionment,” http://www.cpa2biz.com/
Content/media/PRODUCER_CONTENT/Newsletters/Articles_2007/CorpTax/Apportionment.jsp, accessed
April 2010.
59 With some exceptions, a typical U.S. state assessed tax on all income earned in the state, whether by
residents or nonresidents. In addition, a typical state taxed all income earned by its residents in other states,
although it allowed residents to subtract from their home-state tax liability any tax payments made to other
states in which their income was earned.
60
Source: Casewriter calculations using the NBER TAXSIM database. The top marginal tax rate on
individual income is often used as a rough measure of the progressivity of a tax system, because it is paid by the
highest earners, while the benefits of state expenditures are generally more evenly distributed among the
population.
61 See Andrew Leigh, “Do Redistributive State Taxes Reduce Inequality?,” National Tax Journal, LXI(1), 2008,
especially Figure 2 on p. 86, which shows the effect of taxes on the Gini coefficients within states over time.
62 It allowed the formation of holding companies that could claim the profits on intangible assets such as
intellectual property for a corporation. These holding companies helped corporations avoid state taxes on the
profits these assets earned elsewhere.
63 See http://corp.delaware.gov/aboutagency.shtml, accessed April 2010.
64 See Richard S. Franklin, “Florida, the Tax Haven,” Trusts and Estates, November 1, 2005.
65 For the corporate tax base, an influential review of the evidence by Bartik (Who Benefits from State and Local
Economic Development Policies? W.E. Upjohn Institute for Employment Research,1991) suggested that a 10%
increase in taxation in one state relative to others would lead to a decrease in economic activity in that state of
between 1% and 6%. Subsequent research yielded estimates at both ends of that range: Wasylenko (“Taxation
and Economic Development: The State of the Economic Literature,” New England Economic Review, 1997)
estimated the fall at only 2% and claimed that “[t]axes do not appear to have a substantial effect on economic
activity among states,” while Phillips and Goss (“The Effect of State and Local Taxes on Economic
Development,” Southern Economic Journal, 1995) obtained estimates “on the high side of what Bartik estimated”
and argued that “the emerging consensus among economists now says that taxes do matter.” This conclusion
was consistent with mainstream economic theory, which argued that the net-of-tax return to business investment
would be equalized across jurisdictions in the long run. If a state raised its tax rate on businesses, it would lower
the after-tax return to investing in the state’s businesses. In response, businesses would leave the state or shrink
until corporate profitability was high enough to justify investment despite the higher tax. Similar uncertainty
plagued estimates of the mobility of the personal income tax base. Feldstein and Wrobel (“Can State Taxes
Redistribute Income?,” NBER WP 4785 1998) showed that both theory and data implied that progressive tax rates
on high-income individuals caused substantial emigration of those individuals from U.S. states. In fact, they
claimed that this migration was so large as to make it impossible for states to redistribute income at all. In
contrast, Leigh (”Do Redistributive State Taxes Reduce Inequality,” National Tax Journal 2008) found no evidence
that the movement of individuals in response to taxation offset states’ efforts to redistribute income. Between
these two extreme results, Bakija and Slemrod ( “Do the Rich Flee from High State Taxes,” NBER WP 10645,
2004) found that their evidence was “consistent with the idea that some rich individuals flee states that tax them
relatively heavily, although it may reflect other modes of tax avoidance as well. The estimated amounts of
deadweight loss and revenue loss from the flight are not large relative to revenue collected by the taxes,
however.”
66 These recommendations come from the optimal tax research literature in economics. For the case for not
taxing capital, including human capital, see L. Jones, R. Manuelli, and P. Rossi, “On the Optimal Taxation of
Capital Income,” Journal of Economic Theory 73, no. 1 (March 1997): 93–117. Intuitively, a tax on the returns to
financial or human capital will lower investment in productive physical capital or education and skill-building,
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For the exclusive use of A. Alcivar, 2024.
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California’s Budget Crises, Tax Reform, and Domestic and International Tax Competition
lowering the overall productivity of the economy. In the long run, the economy will be able to produce fewer
goods and services than it would have been able to produce if the same tax revenue had been raised on sources
other than inputs to future production.
67
Center on Budget and Policy Priorities, “Tax Measures Help Balance State Budgets,” July 9, 2009,
http://www.cbpp.org/cms/index.cfm ?fa=view&id=2815, accessed April 2010.
68 Chirinko and Wilson (“State Investment Tax Incentives: What are the Facts?” FRBSF WP 2006-49) found
that “the correlation, in 2004, between a state’s tax wedge and the average tax wedge among its bordering states
(“neighbors”) is 0.24 (p < 0.1).” This positive correlation of 0.24 indicated that 24% of the variation in tax rates
across states could be explained by variation in the rates of states’ neighbors and that states with high taxes
tended to have neighbors with high taxes. The interpretation of this finding was a matter of debate, however, as
the positive correlation could reflect not coordination but other factors (such as the performance of key
industries) that simultaneously affected states located near each other. In fact, some research suggested that a
state suffering an outflow of investment and workers when its neighbors lowered their tax rates may have had to
raise taxes to pay for the public services its residents valued. In the same way, if neighboring states raised their
tax rates, a state may have been able to lower its tax rate and sustain the same level of public services as before.
This logic helped explain the presence of low-tax states near high-tax states.
69 In an ABC News/Washington Post Poll from the middle of this time period, February 1993, respondents
were asked whether they supported or opposed President Bill Clinton’s proposal of “raising the federal
corporate tax on large businesses from 34 percent to 36 percent.” Four times as many respondents favored this
than opposed it (79% as opposed to 20%). In a similar poll later that year, 73% of respondents favored and 25%
opposed “a new federal income tax rate of 36 percent [rather than 31%] for families with household incomes
over $180,000.”
70 Jason Furman, Lawrence H. Summers, and Jason Bordoff, “Achieving Progressive Tax Reform in an
Increasingly Global Economy,” The Hamilton Project, Strategy Paper June 2007.
71 Corporations and individuals were taxed in one of two ways by countries: based on where income was
earned (territorial, or source based) or based on legal location (global, or residence based). For corporate
earnings, of the 30 OECD countries 25 used a territorial system in 2009, while the United States, Ireland, Mexico,
Poland, and Korea used a global system. In the U.S. system, foreign-source profits were subject to local (foreign)
taxes and then were subject, upon repatriation into the United States, to any extra tax that the U.S. corporate tax
system would have assessed. Critics of the global system claimed that it put (for example) U.S. companies at a
competitive disadvantage because they had to pay U.S. corporate tax rates on income earned in all countries
while other nations’ corporations could pay lower, local rates. Supporters of the global system argued that it
prevented the loss of economic activity to tax arbitrage. For individuals, countries’ policies varied but often
struck a balance between territorial and global approaches. The U.S. system, for example, was global with an
exemption for income earned abroad up to a certain level. Both the global and territorial systems were
vulnerable to avoidance. A territorial system created incentives for firms and individuals to locate their profits,
income, or assets in countries with low taxes. For example, companies’ use of internal transfer pricing could shift
profits among jurisdictions, while wealthy individuals could move their investment assets to a country with
lower tax rates on earnings. A global system avoided these problems but could be circumvented by firms and
individuals establishing legal residence in a tax haven even if they engaged in substantial economic activity
elsewhere.
72 A lower tax rate applied to a larger tax base can generate smaller disincentives while raising the same
revenue. See Carey and Rabesona (“Tax Ratios on Labor and Capital Income and on Consumption,” in
Measuring the Tax Burden on Capital and Labor, P.B. Sorenson, ed., 2004) for calculations of the effective tax ratio on
corporate income that show a steady or slightly increasing ratio from the 1970s to the 2000s.
73 See Laura Alfaro and Lakshmi Iyer, “Special Economic Zones in India: Public Purpose and Private
Property (A),” HBS No. 709-027 (Boston: Harvard Business School Publishing, 2009).
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For the exclusive use of A. Alcivar, 2024.
California’s Budget Crises, Tax Reform, and Domestic and International Tax Competition
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74 One particularly vivid example of countries competing for talent with their tax systems was the so-called
Beckham Law in Spain. In 2005, Spain changed its tax laws to allow immigrants to claim nonresident status for
up to five years after immigrating. Nonresidents pay a flat 25% tax rate on their income in Spain rather than the
rate determined by Spain’s progressive income tax. For high earners, a flat 25% rate is much lower than they
would otherwise pay, so the law was seen as intended to attract executives, athletes, and celebrities to relocate to
Spain. David Beckham, the famous English football player, unintentionally became the public face of the law
when he quickly took advantage of the law after he joined Real Madrid (a Spanish football team) in 2003.
75 See N. Gregory Mankiw, Matthew Weinzierl, and Danny Yagan, “Optimal Taxation in Theory and
Practice,” Journal of Economic Perspectives 23, no. 4 (2009): 147–174, who also provide further discussion of the
trends in taxation in the OECD.
76 See Mankiw, Weinzierl, and Yagan, “Optimal Taxation,” 2009.
77 See James R. Hines, Jr., “Tax Havens,” Michigan Ross School of Business, Office of Tax Policy Research
Working Paper 2007-3, May 31, 2007.
78 See Richard H. K. Vietor, Jan W. Rivkin, and Juliana Seminerio, “The Offshoring of America,” HBS No.
708-030 (Boston: Harvard Business School Publishing, 2008).
79 Evans, interview, January 14, 2010.
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Case Study Assignment #1
California’s Budget Crisis, Tax Reform and Domestic and International
Tax Competition
Question #1: From a tax perspective and based on the facts provided in the case, why can’t
California solve its persistent fiscal deficits?
California's struggle with its fiscal deficits is not a recent development but a pressing, longstanding issue that has persisted over the years. The ongoing budgetary difficulties are the result
of a multitude of factors, each contributing to the overall problem. We understand that our tax code
was put into place not only to generate revenue but also to promote particular social and economic
policy outcomes that we, as the people, demand (Class PowerPoint, Tax Police, slide 6-Why do
we have taxes?). However, according to Switching to a Consumption-Based Tax from the Current
Income Tax, “the current U.S tax system fails to satisfy the majority of these goals.” As the case,
California’s Budget Crises, Tax Reform, and Domestic and International Tax Competition point
out, California’s fiscal imbalances have been a recurring issue. The gap between the growth rates
of the state’s expenditures and revenues is a key factor. From 1978 through 2008, expenditures
grew at a compound ann...
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