The Personal Income Tax Is Not the Problem

One of the frequently cited causes of California’s budget crisis is “revenue volatility” – the fluctuations in state income tax revenues that occur when income tax collections, primarily taxes collected on capital gains, rise and fall during boom and bust periods. In fact, a key goal of the Governor’s Commission on the 21st Century Economy is to recommend changes to California’s tax system to reduce revenue volatility. But many of those who argue for reducing revenue volatility ultimately seek to reduce taxes on capital gains, which would overwhelmingly benefit the highest-income earners.

Reducing taxes on capital gains would exacerbate an already stunning rise in income inequality. Recently released IRS data show that the average inflation-adjusted income of the nation’s wealthiest 400 taxpayers quadrupled between 1992 and 2006, while that of all other taxpayers increased by just 28.0 percent. While this analysis looks at the nation as a whole, there’s little reason to suspect that California’s trend would differ significantly. What explains this disparity? The highest-income taxpayers derive most of their income – 62.8 percent – from capital gains, which ballooned sevenfold (595.2 percent) between 1992 and 2006, after adjusting for inflation, while the majority of taxpayers’ income comes from wages and salaries, which increased by just 38.5 percent.

Reducing taxes on capital gains would shift the cost of public services from the wealthy to low- and middle-income taxpayers who earn nearly all of their income from work. Moreover, changing the way California taxes capital gains would reduce the rate of growth in personal income tax revenues over time. Far from being the cause of California’s budget woes, the personal income tax has provided the strongest growth over the long haul of any of the state’s major revenue sources. Much of this high rate of growth reflects the significant gains posted by the highest-income earners, which in turn reflects a substantial rise in capital gains and other income from investments. Cutting taxes on capital gains and/or the highest-income Californians would be like killing the goose that laid the golden egg because it only lays eggs four years out of five. Four golden eggs are still better than none.

— Alissa Anderson and Jean Ross

7 thoughts on “The Personal Income Tax Is Not the Problem

  1. The real problem from the personal income tax came when the state used a temporary surge in personal taxes from the internet bubble to cut one of the broadest base taxes we had – the Vehicle License Fee.

    Between the loss of that revenue, the loss from losing our estate tax to the feds, and what we borrowed to replace these two sources of revenue, we’ve had an ongoing revenue problem.

  2. I appreciate the analysis, but question the effectiveness of the argument. With the noisy rhetoric put forth by ” cut taxes ” proponents, we need a more compelling argument for Californians to grasp what these income disparities really mean.

    Pat Neal

  3. Rich people aren’t stupid, though. There is already a net outflow of upper-middle class and rich folks out of California because the tax burden here is too high.

  4. … I’m not at all in favor of slashing the capital gains tax, but I think the period you cite, 1992 to 2006, is at least somewhat anomalous – the “income” gains reference were the product of a sustained asset bubble which is now being viciously deflated. I’m pretty sure that, fourteen years out, a similar retrospective will show something entirely different.

    The problem we need to solve is how to ensure that everyone participates in and benefits from the process of wealth creation. That involves tax policy, regulatory policy, etc. … and of course, much of that isn’t within the state’s purview. We need policies that reduce the underlying causes of the income disparities, not just put bandaids on them through gross redistribution processes.

  5. Put another way: counting on the capital gains tax to continue generating disproportionate amounts of revenue, and disproportionate portions of the increases in revenue, is an implicit concession that the underlying disparities are not going to be addressed… or, retrospectively, if this pattern continues, it will be evidence that the problem hasn’t been solved.

    I agree that we shouldn’t cut the capital gains tax, but we should design policies that will lead to the state’s economy being diversified enough that they lose a significant proportion of their importance.

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  7. We should completely eliminate the capital gains tax.

    All capital gains should be treated as income and taxed at that individual’s income tax rate. Since we now know conclusively that “trickle down” doesn’t, there is no need to give a break to the wealthy for their willingness to gamble in the stock and real estate markets.

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