Why California’s Tax Hikes Will Backfire

by Fisher Investments | November 26, 2012 8:53 am

It’s not uncommon for state and local elections to get lost in the shuffle of a presidential election year. That might alarm America’s Founding Fathers, who no doubt expected us to pay far more attention to local elections than federal, but that’s another story altogether. The reality is that state elections have significant implications for the rest of the country in the way they can affect economic activity and create incentives — both intended and unintended.

It seems California took advantage of the opportunity this year to create some incentives for both businesses and individuals … to move elsewhere. As readers may already know, California voters passed propositions to raise a host of taxes, including income taxes, sales taxes and business taxes (in the form of closing loopholes out-of-state businesses were using to lower their overall tax burden).

Let’s take these in turn, starting with income taxes. Proposition 30 creates four high-income tax brackets with increasing marginal rates: 10.3% on taxable income between $250,000 and $300,000, 11.3% on taxable income between $300,000 and $500,000, 12.3% on taxable income between $500,000 and $1 million and 13.3% on taxable income over $1 million.

At first blush, those rates seem likely to only affect those who truly are among the “wealthy.” But consider: California is one of the most expensive states to live in. Which means overall, per capita incomes are at the higher end rather than the lower end of national averages. That’s because paying employees enough to afford living in California means companies struggle to find employees, particularly quality workers likely to help the company’s bottom line.

In turn, that means those higher incomes don’t have quite the purchasing power they might in states where housing is one-fifth as expensive, say. In short, the new income tax increases likely hurt some relatively middle-class families in California trying to make a living and support their kids, maybe retired grandparents, etc.

The sales tax increase is arguably even worse. Prop 30 raised it from 7.25% to 7.5% statewide (though San Francisco tacks on another 1.25%, which makes the total rate there 8.75%). Why is that worse? Sales taxes are clearly and inherently regressive because they disproportionately affect those with lower incomes.

Finally, Californians voted to change Proposition 39, which requires out-of-state businesses to calculate their state income tax liability based on the percentage of their sales in California. Previously, out-of-state businesses had the option to choose a formula that provided a favorable tax treatment for businesses with property and payroll outside California.

Previously, businesses could reduce their tax liability by not locating facilities or employees within the state, while still doing business there — seemingly a win-win in the sense Californians can still obtain those companies’ services, and those businesses can still do business in the state while ensuring their continued viability and profitability by overall decreasing their tax burden.

All told, sounds rather like California just effectively imposed protectionist measures on businesses from other states. An odd move to say the least, as are the other tax moves as well.

We at MarketMinder have pointed out myriad times: Tax something, and you typically get less of it. Why is that? Well, as folks make more, the greater the chunk they hand over to the government (whether federal, state or local), the less incentive they have to earn more.

Economists boil it down to the concept of marginal cost and marginal benefit: When the marginal cost (in this case, think effort, time, sacrificed family life, etc.) outweighs the marginal benefit (the money you can make and the goods you can spend it on, etc.), most rational folks stop working. Increasing the marginal tax rate paid on those funds earned, therefore, means you probably hit that point where the cost outweighs the benefit that much sooner.

Extend that basic reasoning to many individuals and/or businesses, and you likely end up with a net loss in government revenues — the opposite of what politicians and voters presumably intended. Not to mention some individuals and businesses undoubtedly decide it’s logical to start considering moving to other states.

California residents fortunately have several attractive opportunities in the immediate vicinity: Washington State, Nevada and Texas, which have no state income taxes, and Oregon, which charges no sales tax. A little farther east, Wyoming has neither individual nor corporate taxes, and Colorado charges a flat, relatively low (particularly compared to California) income tax rate.

To be sure, not everyone will move. Some folks will decide the increased cost is worth the benefits of living in California, which is inarguably a lovely state with abundant natural resources and a rich and interesting history. But the state faces some daunting challenges. Few would argue it’s spending at levels that are long-term sustainable.

Unfortunately, increasing taxes will like harm California’s competitiveness with neighboring states, particularly when they have far more attractive tax environments. So, rather than increase rates, I’d recommend California slash them. Dramatically. Make itself competitive with Texas and Washington and others.

Voters may not realize it, but they’ve just passed something much more akin to forfeiting the game altogether than throwing a Hail Mary pass.

–Amanda Williams, Fisher Investments

This article constitutes the views, opinions, analyses and commentary of the author as of November 2012 and should not be regarded as personal investment advice. No assurances are made the author will continue to hold these views, which may change at any time without notice. In addition, no assurances are made regarding the accuracy of any forecast made herein. Past performance is no guarantee of future results. A risk of loss is involved with investments in stock markets.

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