WASHINGTON — California is where the likes of LeBron James and Elon Musk face ultra-high state income tax rates that the government uses to provide money to help the homeless, the poor and the unemployed.
So is California, whose top rates are the nation’s highest, a good model for the rest of the country as President Joe Biden tries to increase tax rates while boosting social services spending?
State Controller Betty Yee says California’s progressive tax system “has been effective at achieving its intended result — reducing the tax burden on those who can least afford to pay.”
Critics counter that higher rates will trigger an economic disaster. “A mortal wound on our still-recovering economy,” T. W. Arrighi, spokesman for the National Republican Senatorial Committee, said of Biden’s ideas.
The president proposed during his 2020 campaign to increase the federal income tax rate on people earning more than $400,000 to 39.6%, up from the current top rate of 37%. He also proposed a higher corporate tax rate.
Joshua Rauh, professor of finance at Stanford Graduate School of Business, co-authored an extensive study of the impact of California’s higher tax rates for the nonpartisan National Bureau of Economic Research.
The report found not only migration of the wealthy since California raised its income taxes in 2012, but also less taxable income from those who stay. People change their financial behavior to adjust to the new tax laws.
“There was a pretty big erosion of taxable income relative to what would have happened had those people not changed their behavior,” Rauh said. “They’re reporting less taxable income. Maybe they’re shifting business activity to other states. Maybe earning less overall. Maybe they’re going offshore.”
Yet the state’s economy is recovering. California is on track to accumulate a budget surplus, giving Gov. Gavin Newsom and lawmakers room to spend on social services and direct assistance to people set back in the coronavirus pandemic.
“Texas says it’s getting California’s people, but they’re not getting all of them,” said Richard Auxier, senior policy associate at the Urban-Brookings Tax Policy Center in Washington. He and two of his colleagues published a study of California’s revenue system last year.
Musk, the Tesla and SpaceX founder, last year revealed that he was one of the Californians heading to Texas.
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Individuals now earning more than $209,425 and joint filers making more than $418,850 pay 2021 federal income tax at a 35% marginal rate. Individuals with incomes of more than $523,600 and couples earning more than $628,300 pay at a 37% marginal rate.
Biden is expected to seek raising those rates to 39.6% for incomes over $400,000, the rate in effect before 2018, when a Republican-authored tax cut law lowered it to current levels.
The increase would hit California particularly hard. The average household income of the top 5% of 2019 earners in the state was $531,014, a figure topped only by Connecticut, New Jersey and New York, according to a survey published last month by GOBanking Rates, a personal finance website that used census data.
California’s top state income tax rate is 13.3% for people with taxable income of more than $1 million. That’s the nation’s highest rate. Second is Hawaii at 11%.
The three top California rates were created in 2012 as a result of Proposition 30, an initiative backed by then Gov. Jerry Brown that was intended to shore up the state’s finances coming out of the Great Recession. Those rates were supposed to be in effect for seven years, but in 2016 the rates were extended by Proposition 55 through 2030.
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A study published by the National Bureau of Economic Research found that between 2012 and 2013, the first full year the higher rates were in effect, an additional 0.8% of those who would have paid the top rate were no longer full-time state residents the next year, compared with the numbers that would have departed in a typical year.
The erosion has continued, said Rauh, one of the study’s authors.
He said employment in the state is “really soft,” and compared California’s tech hubs to other areas where employment is booming, such as Austin, Nashville, Salt Lake City and Indianapolis.
Employment in California, he said, is not as strong as it could be “when we consider the fact that COVID was a major positive shock to business opportunities in the technology sectors.”
The UCLA Anderson School of Management was more optimistic. California may see a significant recovery later than some other states, but “we expect the California recovery to ultimately be, once again, faster than the U.S.,” said Jerry Nickelsburg, UCLA Anderson forecast director.
Over the last decade, Nickelsburg said, California trailed only Washington state in economic growth among states with populations of more than 5 million.
“It is not possible to disentangle how much faster California would have grown, if at all, were income taxes and the services they fund lower,” he said.
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The state’s income tax system “has created tremendous revenue volatility in California, making annual state budgeting a challenge that is necessarily focused on building resilience by increasing reserves,” said Yee.
The study that the Tax Policy Center’s Auxier co-authored made the same point, offering concern that relying heavily on income tax would lead to too much volatility — as illustrated by the 2020 COVID-triggered downturn.
“California’s high and increasing reliance on individual income tax revenue makes the state’s revenue base among the more volatile in the nation,” it found.
Yet the state is not unduly suffering from the high tax. Revenues continue to exceed projections. In the first eight months of fiscal 2021, gross revenue collections ran 12.9% above projections. Most came from stronger than expected personal income tax collections.
The new numbers illustrate how volatility works both ways. While the overall economy endured last year’s coronavirus-induced downturn, high-income people tended to do well. That plus California’s progressive taxes meant California saw large revenue gains while no-income tax states saw losses.
But would a boost in federal taxes, coupled with the high California tax, spur more people to leave?
It’s not clear.
“Some folks seem to be worried about the tax implications of wealthy individuals leaving the state, but our analysis of credit bureau data through December 2020 did not uncover any dramatic evidence that rich households are fleeing California en masse,” said Evan White, executive director of the nonpartisan California Policy Lab, which has studied the issue.
But, he warned, “Because the state relies heavily on income taxes on the uber-wealthy, the departure of even small numbers of wealthy people could negatively impact revenues if they aren’t replaced with new entrants.”
