The Law of Unintended Consequences - Taxing The Rich Imperils State Finances

The law of unintended consequences is an interesting thing. Laws are passed with an idealistic expectation of what the effect of the law is going to be, but the real world steps in and turns everything upside down when the law goes into effect. A good example of this is the thought of fixing state and local government financial woes by increasing taxes on wealthy taxpayers. This is something a large group of people, from Occupy protesters to Democratic politicians would currently agree on. Republican politicians oppose such measures, largely on the basis that wealthy taxpayers create jobs and higher taxes are a disincentive for such taxpayers to expand their economic activity. I personally don't buy that argument since at this point in time, marginal tax rates are not so high to cause that effect. It's not like some 50 years ago when there was a 90 percent marginal federal income tax bracket, which bordered on being confiscatory and indeed likely did produce a stifling economic effect on high earnings taxpayers

Which brings us to the recent news that Gov. Brown hopes to close the ongoing California budget shortfall by a combination of an increased sales tax and an additional state income tax on millionaires. This was then followed up by the news that an analysis by the nonpartisan budget legislative analyst concludes that the amount of money that would be raised by the millionaires income tax is not what its backers claim it would be. The problem is that California's richest taxpayers already pay a disproportionately high share of the state's personal income tax collections. Prior to the recession, the top 1 percent earning California taxpayers paid a stunning 50 percent of the state's personal income tax revenues. And it's not like they earned 50 percent of the state's personal income or anything close to it. Far from it, as many lower income Californians pay no state income tax and many others pay at miniscule rates.

Now the issue from a fiscal point of view isn't that rich taxpayers pay disproportionately more income taxes than lower income taxpayers. The problem is that the amount of income that rich taxpayers earn is extremely volatile. When times are good people cash in stock options and earn huge profit based bonuses, but when things turn bad, these taxpayers have a larger proportionate drop in income than lower income taxpayers. In just the first year of the recession, the income of rich taxpayers in California dropped by 16 percent, while the income of average taxpayers dropped by only 4 percent. Since the personal income tax rate levied on rich taxpayers is much higher than the rate paid by average taxpayers, all an increased tax on rich taxpayers does is ensure an even larger budget shortfall the next time the economy turns down.

Now you can't expect people like Occupy protesters, who think Bank of America and American Airlines are rich and powerful corporations, when in real life they are hanging on for dear life, to understand this relationship. However, you would think that the politicians know enough to catch on. But you would be wrong. Back in the days of the dot com boom, when tax revenues soared as internet millionaires and others in Silicon Valley and throughout California rode the wave to prosperity, Governor Davis and the Legislature made a commitment to spend these windfall revenues on a permanent basis. This was done largely with generous increases in the pensions paid to state and local government workers, which may now be as much as double the pension earned by a comparable federal government worker. (And many people think that pensions for federal government workers are excessive.) Pensions for state and local government workers is a large contributing factor to the huge budget shortfalls in state and local government. And it should be pointed out that at the time California increased its pension benefits, no objection was raised by Republican politicians, as these pension increases were essentially approved unanimously, so one cannot put the blame merely on the Democrats.

In any event we see that with California government revenues so dependent on the unstable income levels of its richest taxpayers, California state finances were more negatively impacted than other states by both the dot com bust as well as the recent financial meltdown. Adding an additional tax on wealthy taxpayers only will set California up for an even bigger fall in future downturns.