Experts Say California Needs Tax Reform; Differ on Methods

LOS ANGELES — Despite efforts by California Gov. Jerry Brown to rein in spending and reduce what he calls the state's "mountain of debt," the state retains the second lowest general obligation bond rating in the 50 states from rating agencies.

Some speakers at The Bond Buyer's California Public Finance conference here last week discussed why the state retains single-A level general obligation bond ratings and suggested tax reforms to stabilize the revenue volatility seen as contributing to the low ratings.

The majority of the state's revenue comes from progressive taxes on income and capital gains, which target the rich and cause volatility, because those sources have bigger swings in revenue than sales taxes during booms and busts, panelists said.

Mary Colby, who heads the Municipal Fixed Income Research Group for Charles Schwab, asked Emily Raimes, a Moody's Investors Service analyst and a panel moderator, why New York has a much higher rating than California when the state's tax structures have so many similarities.

Raimes agreed that the states have similarities such as a heavy reliance on personal income taxes. New York also made some late payments to school districts, but nothing like California's IOUs, she said.

"California had a big housing boom and crash," Raimes said, also saying New York's revenues are driven more by the downstate New York City region.

New York went into the recession later than California and the impact was shallower, Raimes added.

New York also maintains a large rainy day fund and has been very careful about tapping into it and replacing it quickly when it does dip into the fund, she said.

Raimes said Moody's assigns New York GO bonds an Aa2 rating with positive outlook. It rates California A1 with a stable outlook.

David Crane, who was an economic advisor to former Gov. Arnold Schwarzenegger, compared the ratings to a security blanket for investors saying investors know they are going to get their money, but there is a greater risk of default.

Raimes responded that ratings are not a binary probability of default saying the issuers will or will not default, but instead indicate the probability of default based on where they fall on the scale.

"If you look at California in 2004, the state owed $14 billion in short-term notes," Raimes said. "We did not think they would default, but there is a greater probability than with a triple A-rated state."

Crane said the last people who need to be worried about California's revenue volatility are the people in the room at a Bond Buyer conference.

"Debt is senior in California," Crane said. "When California suffers from revenue volatility, it goes to from six times or eight times coverage to maybe five or seven times coverage - but in all cases the debt is paid."

The state's volatility works in favor of the out-of-state investors, because the yields are better, he said.

Panelists said Proposition 30, which temporarily increased income taxes on the state's wealthiest citizens and temporarily increased the state sales tax by a quarter cent, added to California's revenue volatility. The measure, passed in the November 2012 election, is expected to bring in $6 billion in annual revenue, and was partly credited in improved outlooks by analysts on the state's rating.

If it had not passed, schools and colleges would have suffered significant cuts in state appropriations.

Detractors of Proposition 30 said that higher income tax combined with the state's tax structure in general would cause affluent Californians to flee the state.

Christopher Thornberg, a panelist with Los Angeles-based Beacon Economics, said that has not occurred.

"It's not rich people fleeing the state, it's the middle class," Thornberg said. The idea that California's wealthy are fleeing because the tax structure overemphasizes income taxes on affluent Californians and capital gains taxes is false, he said.

That doesn't mean California shouldn't change its tax structure, he said.

"We're not a high tax state -- we're a dumb tax state," he said.

"It's a crazy system we have in California," Thornberg said. "We tax some people way too much and others not enough. I would flatten the personal income tax, because we get way too much from top income earners."

But the property tax system is the real elephant in the room, he said. Proposition 13 caps the rate property tax assessments can grow on properties between sales, so long-time property holders typically pay far less than owners who have purchased recently.

"I would toss Proposition 13 out the window," Thornberg said adding that he would cap it at a level rate for all real estate. "I wouldn't have it based on how long folks have been sitting in the chair."

Proposition 13 was originally sold as an aid to keep retirees in their homes, but applies to commercial real estate as well as residential.

"Property taxes are a huge part of government revenues," Thornberg said. "In most of the country, higher home prices mean higher taxes, because they don't have Proposition 13."

Former Gov. Gray Davis, another panelist, said a sales tax is the answer to curing California's revenue volatility.

Davis, a member of Think Long, a think tank formed in 2012 to reform the tax structure, said if a 5% sales tax were implemented, the state could lower income taxes for everyone by 30% and lower capital gains tax to the national level.

California already has a 7.5% sales tax, which tops 10% in some localities after local taxes are added, but the tax excludes large portions of the economy.

Davis said the sales tax should be imposed on the 50% of the economy he said is not being taxed, such as service sectors like law firms.

"The problem is that people in this state don't want to lower taxes on the wealthy," Davis said. "They want their taxes to go down, but not taxes for the wealthy."

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