In summary

Conventional fiscal wisdom says the state’s progressive income tax structure is too volatile, but our experience since the pandemic suggests that it is both efficient and moral.

By Patrick Murphy, Special to CalMatters

Patrick Murphy is a public finance expert and research fellow at The Opportunity Institute, patrick@theopportunityinstitute.org.

With the passage of the budget Monday for the fiscal year, California legislators will be hammering out the details over coming weeks. With revenue abundant, we can expect to hear more about the problem of California’s volatile revenue. This is the time to recognize that volatility is not a problem — it is the price the state pays for a progressive tax system. That system emerged as a positive this past year.

Conventional fiscal wisdom has declared tax revenue volatility bad: The roller-coaster ride of receipts makes it difficult to plan, and when revenues drop, program cuts follow. Public higher education, for example, has paid a dear price during economic downturns as policymakers reduced general fund support and the universities raised tuition to cover costs.

The experience with the pandemic suggests it is time to challenge that conventional wisdom. It would be a mistake, however, to make spending decisions that don’t take the volatility into account. 

California’s tax revenues are expected to top $179 billion, a $35 billion (25%) increase over last year. These record revenues are the combined effect of an influx of federal dollars and California’s progressive income tax structure. In California, personal income taxes, with tax rates that increase the further up the income scale you go, rise and fall more dramatically than other taxes. Capital gains (the income an individual realizes by selling an asset, such as stocks) in particular drive much of the changes.  

The Pew Charitable Trusts report that California’s revenue ranks as sixth most volatile, citing the income tax system as the reason. Energy-producer states such as North Dakota and Alaska occupy the top spots. The states that offer the most stable source of revenue year over year — South Dakota, Kentucky and Arkansas — rely more on sales and property taxes than income taxes.

California’s economic recovery from the pandemic, like that of the nation, has seen those who earn more getting back to work much more quickly than lower-income residents. Taxing wealthier workers at a higher rate has given the state the resources to pay for benefits it has provided to individuals who couldn’t work or didn’t have a job. That is a positive, both in terms of efficiency and morality. 

In fact, the Institute on Taxation and Economic Policy reports that California’s tax system does the most of any state to alleviate inequality – while taxes in most states serve to widen the gap between rich and poor. 

Consider South Dakota, a state that also saw its revenues increase over the pandemic year. It is one of only three states that tax groceries at the full sales tax rate.  Compared to California, South Dakota’s tax revenues are very stable, but its sales taxes force lower-income residents to pay a much larger percentage of their income in taxes than wealthier residents. 

It will be interesting to note the degree to which California policymakers crafted a budget that is consistent with efforts to decrease inequality while investing resources in a way that ensures sustainability over the longer term. The $25.3 billion rainy-day fund balance in this budget is a step in that direction.  

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