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UC Berkeley economists urge California legislature to accept tax increases and revisit Prop. 13

- A group of distinguished economists from several University of California campuses and Stanford University has sent a cautionary letter to members of the California Legislature and Governor Gray Davis. The Feb. 3 letter (which can be downloaded as a PDF) warned that "California must face up to the need for immediate and substantial budget cuts and tax increases and act now." The 14 economists went on to detail both short-term and long-term strategies that would put the brakes on the state's swift slide into the red, such as broadening the tax base via a sales tax increase and reintroducing the 10 and 11 percent income tax brackets. They also called for the legislature to revisit Proposition 13, the 1978 measure to curb property taxes, and for an overhaul of the state budget process to prevent future crises.

The letter's authors included Alan Auerbach, director of the Robert D. Burch Center for Tax Policy and Public Finance at UC Berkeley, and Janet Yellen, a member of the Haas Economic Analysis and Policy Group and a UC Berkeley economics professor. The NewsCenter asked Professors Auerbach and Yellen to elaborate on their economic advice.

Among the short-term solutions you support are the Governor's proposals to raise the state's sales tax by 1 percent and to reintroduce the 10 and 11 percent personal income tax brackets. Are these the best strategies?

Auerbach: We didn't say that we supported it, actually. We said that a combined proposal of raising the state sales tax and reinstituting the top income tax brackets was a reasonable approach to take. We weren't advocating a specific policy, rather a specific type of policy. Those actions fell into a group that we thought should be considered.

A misconception by the press is that we were somehow calling for a tax increase. It would be more accurate that we recognize that a tax increase is inevitable, and that legislators should accept that and move on. It's not as if we have any excitement about a tax increase.

Yellen: But it does seem that a tax increase will be necessary to deal with the current situation, along with spending cuts. It should just be accepted. There are a number of ways that taxes could be increased. We've tried to make the point that they should be broad based, that they should not have an undue negative impact on business activity. Progressivity is an important objective. But the discussion of distributional impacts must take both taxes and spending into account.

Why did you shy away from advocating specific tax increases in the letter?

Auerbach: We weren't trying to say, 'Here's the optimal fiscal system for California. Do it.' There's a short-run problem and a long-run problem. In the long run, California needs to reform its fiscal system in order to keep this sort of thing from happening again. In the short run, we need to raise taxes and raise them soon. Because of the necessity of doing it quickly, it may be the taxes the legislature chooses to increase are the taxes that are already in place. Those might not be the best taxes to increase from an economic perspective, but they won't be the worst - and they have the advantage of being available immediately.

For example, raising the sales tax by 1 percent isn't my favorite proposal. I think we could do better by broadening the base of the sales tax to include things that are currently excluded.

'Prop. 13 is viewed as something of a sacred cow, but it really has a distortionary impact on the state's finances.'
-Alan Auerbach, UC Berkeley economics professor

Like certain services and Internet commerce?

Auerbach: Exactly. That would be a better sales tax, but that can't happen quickly. So I view raising the rate as a compromise between the need to act soon and the desire to have a reasonable tax. But given that compromises are involved, and that these involve political judgments as well about what can be done quickly, I personally didn't feel that I wanted to advocate a specific increase. There are a range of reasonable policies that they could enact; we felt that this combination of sales and income tax was in that group; however, we didn't want to preclude anything else.

For example, we didn't talk about the vehicle license fee in the letter. Now I am not a big fan of the vehicle license fee. But if they find that in the short run they can raise revenues by raising the vehicle license fee again, I view that as certainly better than spending a year arguing about whether to have a tax increase.

In the letter, as part of a broad-based tax reform, you mention the possible necessity of revisiting Proposition 13.

Yellen: That's obviously a longer term reform. An important objective of the letter was to argue for long-term reforms that will result in a better fiscal system for California and prevent things like this from happening again. And reform of Proposition 13 needs to be part of that.

A lot of controversy and misunderstanding surrounds Proposition 13. Can you explain how abolishing it would broaden the tax base and increase fiscal health?

Auerbach: Well, first of all, Prop. 13 means that there's a ceiling on how high property taxes can be, and second - and this is where we part company from other states, which also have such tax limitations - the tax that you pay is based on what you paid for the property, regardless if that was a very long time ago. This applies to both commercial and residential property. So the ceiling on the tax rate is not based on market value as it would be in other states, but in many cases on a much lower historical price plus a very small inflation factor that doesn't account for what's actually happened.

The state's tax base has really been eroded by that, much more than by the overall limitation of how high the rate can be. In California, the state is much more responsible for the finances of local governments than is true elsewhere. And Prop. 13 is the major reason for that. Property taxes are the key source of revenue for local governments. And because California's property taxes are so limited, it means that the state government has to come in for funding for schools and other local expenditures.

If one were simply to scrap Prop. 13 and replace it with a property tax system as exists in most states, you would have a significant increase in taxes for people and businesses that have owned property for a long time. That would obviously be very difficult to do. A long-run reform of Prop. 13 would have to happen gradually over time and take into account the people whose taxes would be affected by it. Whatever the wisdom of allowing some people to essentially have no property taxes, you can't go to someone who's 70 years old and say, we've decided to triple your taxes.

Yellen: There would be a number of ways of phasing Prop. 13 out gradually over time so as to avoid undue hardship but nevertheless move to a system like other states have.

How likely is it that we'll see the legislature revisit Prop 13?

Auerbach: Well, they haven't done it yet. That's one of the reasons why we put it in the letter. Prop. 13 is viewed as something of a sacred cow, but it really has a distortionary impact on the state's finances. We don't think there's any chance to do anything about Prop. 13 in the short run. But given the severity of the current problem and the fact that it is in part traceable to these quirks in the state tax system and budget process, we just felt that the legislature shouldn't give up the opportunity to address these longer-term problems.

One of the quirks you mention in the letter is the extent to which the state budget is restricted by earmarking revenues for specific programs. Doesn't this just protect vital programs?

Auerbach: It's both restrictive and protective. For example, Proposition 98 earmarks a big chunk of revenue for public K-12 education. Now, I don't think California spends an excessive amount on its public schools. And indeed, one of the things that Prop. 98 allowed during the revenue surge in the late 90s was a significant increase in public education spending. But if you're trying to cut a budget, cutting it in one area because other areas are off the table can be particularly damaging to the area that's unprotected. It makes the remaining areas subject to even worse cuts and that isn't necessarily the overall best outcome.

What are some of the other reforms you'd like to see in the budget process?

'It does seem that a tax increase will be necessary to deal with the current situation, along with spending cuts. It should just be accepted. '
-Janet Yellen, UC Berkeley economics professor
Yellen: Revenue earmarking is the main one, but also the fact that you need a supermajority [two-thirds of the legislature] in order to pass a budget makes it extremely difficult to do so.

Auerbach: It's been pointed out that the Governor needs Republican votes to pass a budget, and you might wonder how that could be, given that he has majorities in both houses of the legislature. And the reason is that it requires more than a majority to pass the budget.

Yellen: The difficulty of getting agreement due to the supermajority rule is a real problem. It creates delays. Last year there were a lot of one-shot measures taken that basically kicked the can down the road to this year.

Anything else on your legislative-reform wish list?

Auerbach: Well, there's always the hope that they would look beyond the current budget year and start thinking about the trends. This would involve things like rainy-day funds, which the Governor has talked about. We've learned that at the federal level you can do long-range projections, but then if you ignore them - or the projections make unrealistic assumptions - they aren't that helpful. I don't know how feasible it is, but I do think at least some attempt ought to be made to see where things are going. That way, if the current problem is perhaps only the beginning of one that's going to last for several years, it might give them an opportunity to take corrective action before things get any worse.

Did you think the letter would inspire more immediate action than it has to date?

Alan Auerbach: I don't think we had any illusions that this was going to translate into action immediately. It was just our way of putting our 2 cents in before the budget got too far along, hoping that we would help push things in the right direction.

Janet Yellen: It's early yet in dealing with this problem, and clearly there will be lots of attention paid to this in the coming weeks and months. We simply wanted to enunciate some principles that we hope will be adopted as ground rules for dealing with the crisis.