California Wants a Federal Bailout? Tax Reform Must Come First

Here We Go New California!!!

Washington can help fill Sacramento’s budget hole, but the money should come with strings attached.

California is facing a $54 billion budget deficit—equivalent to 37% of the total budget. To help address the shortfall, Gov. Gavin Newsom wants billions of federal dollars. Not so fast. Any bailout should come with strings attached. Washington should tie assistance to tax reform, putting the Golden State’s finances on stable footing while also stimulating investment and growth.

California’s economy has taken a beating from Covid-19. The unemployment rate is officially 16.3%, but Mr. Newsom has projected it will rise as high as 24.5%. Further, his administration projects personal income to decline by about 9% this year.

Mr. Newsom has also warned that the downturn will lead to a $41 billion decline in revenue, which will be a devastating blow to the state’s finances. But even if the pandemic hadn’t happened, California would have accumulated a large deficit once the next recession hit. During the 2007-09 recession, the state budget deficit reached $40 billion.

That is because California’s finances are too dependent on the personal income tax, which is the most volatile form of taxation. California’s revenues from personal income taxes amount to about 67% of all state revenues (up from 11% in 1950). Moreover, less than 1% of taxpayers contribute more than 50% of the tax revenue. The result is that when the economy softens and people earn less—or move out of the state—tax revenue plunges.

It is no mystery why people leave. With housing costs at about 2.5 times the national average and a costly regulatory environment for businesses, living and working in California loses its luster. For decades, it had robust population growth rates, and in the 1960s it surpassed New York to become the most populous state in the country. But last year, California’s population grew by only 0.2%, the lowest annual rate since 1900. A survey of California residents showed that 53% of them are considering leaving.

All these developments underscore the need for dramatic tax reform. In 2009, Gov. Arnold Schwarzenegger and the California Legislature created a bipartisan commission, which I chaired, focused on improving the state’s tax code. The goal was to propose changes that would lead to more reliable and stable revenues, encourage growth and job creation, and improve the state’s ability to compete in the new economy. The commission emphasized that California’s economy had changed dramatically from manufacturing and agriculture to services, but the basic tax system hadn’t responded and had become increasingly dependent on a small percentage of high-income earners.

The commission recommended that California reduce its dependence on the personal income tax by lowering rates and broadening the tax base. Specifically we called for dropping the top rate from 9.3% to 6.5% and reducing or eliminating many deductions. The commission also recommended eliminating the corporate and sales-and-use taxes, replacing them with a broad new “business net receipts tax.” As an alternative to this new tax, the sales-and-use tax could be retained and extended to services, with exemptions for things like medical services. Our recommendations were very detailed and contained proposed legislation as well.

A few years later, Gov. Jerry Brown and state policy makers did the opposite of what we recommended. Instead of lowering the personal income-tax rate, they put forward a statewide initiative that raised the top marginal rate to 13.3%, thus making state revenues even more dependent on a volatile tax and California’s income-tax rate the highest in the nation.

I recognize the difficulty in getting tax reform passed. With Mr. Newsom requesting federal funding to balance his state’s books, however, there is an opportunity for the Trump administration to link any federal assistance to an overhaul of the way California taxes its residents.

There is a precedent. In 1975, New York City sought federal assistance to prevent bankruptcy. While the episode is often associated with a memorable newspaper headline—“Ford to City: Drop Dead”—it’s mostly forgotten that the Ford administration approved a financing facility that enabled New York to receive federal aid. Importantly, Washington tied the lending to a requirement that, among other things, New York balance its budget in three years.

As an assistant Treasury secretary, I worked on the development of that financing facility. I saw how New York benefited from having fiscal discipline imposed on it. “Ford was good for New York, because he made us clean up our act,” Henry J. Stern, a former parks commissioner and city councilman, later admitted. The Trump administration should do the same for California.

The Golden State has been a beacon of opportunity for decades, and I have been proud to live here for the past 40 years. While Covid-19 poses a massive and immediate economic challenge, there are deeper long-term issues that threaten the state’s finances and its desirability as a place to live and do business. As the nonpartisan Legislative Analyst’s Office in Sacramento noted recently, “Even if new, flexible federal aid materializes, significant budget problems likely would reemerge in a few years.”

Comprehensive tax reform would be a powerful antidote to those budget problems. It would put the state’s finances on stronger footing and make California a more attractive destination for investment and entrepreneurship.

Mr. Parsky is chairman of Aurora Capital Partners. He chaired California’s Commission on the 21st Century Economy in 2009 and was assistant secretary of the Treasury, 1974-77.