BILL ANALYSIS Ó AB 1130 Page 1 Date of Hearing: May 16, 2011 ASSEMBLY COMMITTEE ON REVENUE AND TAXATION Henry T. Perea, Chair AB 1130 (Skinner) - As Amended: May 2, 2011 2/3 vote. Tax levy. Fiscal committee. SUBJECT : Personal Income Tax: tax rates. SUMMARY : Establishes a 10.3% personal income tax (PIT) bracket for taxable income in excess of $500,000. Specifically, this bill : 1)Establishes a 10.3% PIT rate for the following: a) Single filers whose taxable income is over $500,000; b) Joint filers whose taxable income is over $500,000; and, c) Head of household filers whose taxable income is over $500,000. 2)Requires the Franchise Tax Board (FTB) to recompute the 10.3% income tax bracket for taxable years beginning on or after January 1, 2011. 3)Applies to taxable years beginning on or after January 1, 2011. 4)Takes effect immediately as a tax levy. EXISTING FEDERAL LAW : 1)Imposes six different income tax rates on individuals, estates, and trusts ranging from 10% to 35%. 2)Provides an AMT rate of 26% on AMT income up to $175,000 and 28% on AMT income exceeding that amount. EXISTING STATE LAW : 1)Provides for six different PIT rates ranging from 1% to 9.3%, AB 1130 Page 2 and for five different filing statuses, including single, head of household, married filing separately, married filing jointly, and surviving spouse. Each rate applies to a different range of income, known as a "tax bracket." Individual tax liability is dependent on one's taxable income and one's filing status. For taxable years beginning on or after January 1, 2009 and before January 1, 2011, each of the six tax rate percentages was increased by an additional 0.25%. 2)Requires the Franchise Tax Board (FTB) to recalculate the tax brackets each year based on the change in the California Consumer Price Index. 3)Imposes an additional 1% tax on the portion of a an individual taxpayer's taxable income that exceeds $1 million and dedicates the funds received to provide mental health services to children and adults, approved by the voters as Proposition 63 in 2004. Disallows any reduction of this additional mental health tax liability by tax credits. (R&TC Section 17043). 4)Imposes an AMT in order to ensure that a taxpayer who can use preferential tax benefits, such as deductions, exemptions, and credits, does not escape taxation completely. California's AMT rate for individual taxpayers equals 7%. Unlike the federal government, California indexes AMT exemption amounts under the PIT Law. 5)Provides for an AMT rate of 7.25% for taxable years beginning on or after January 1, 2009, and before January 1, 2011, and for an AMT rate of 7% for taxable years beginning on or after January 1, 2011. FISCAL EFFECT : The FTB estimates that this bill would increase General Fund revenues by $2.3 billion in fiscal year (FY) 2011-12, by $1.7 billion in FY 2012-13, and by $1.8 billion in FY 2013-14. COMMENTS : 1)Author's Statement. The author has provided the following statement in support of this bill: "The richest one percent of Californians are making an average of $1.7 million dollars. Novel-winning economist Joseph AB 1130 Page 3 Stiglitz states 'the upper 1 percent of Americans are now taking in nearly a quarter of the nation's income every year. In terms of wealth rather than income, the top 1 percent control 40 percent. The recently approved federal tax cut extension gave California's wealthiest citizens $14 billion in tax cuts. The top 1% of Californians received an average of $90,000 in tax cuts. "Recent polls reveal that an overwhelming majority of Californians believe that richest Californians should pay more taxes. Seventy-eight percent of likely Californian voters support a 1 percent increase in the income tax rate for Californians earning more than $500,000 a year. This includes 60% of Republicans. "Historically, even our most fiscally conservative Governors have increased the tax rate in times of major deficits. Governor Pete Wilson increased taxes on the top 1% by including a 10 and 11 percent tax rate. Governor Reagan did the same in 1973. 'This bill would add a 1% tax increase of the richest Californians. Those that make over $500,000 constitute less than 1% of taxpayers but could contribute an estimated $2.3 billion in additional revenue. The proposed tax rate schedule is as follows: --------------------------------- |Tax Rate |Taxable Income | |------------+--------------------| |1.0 |Up to $7,124 | |------------+--------------------| |2.0 |$7,214 to $16, 890 | |------------+--------------------| |4.0 |$16,890 to $26,657 | |------------+--------------------| |6.0 |$26,657 to $37,005 | |------------+--------------------| |8.0 |$37,005 to $46,766 | |------------+--------------------| |9.0 |$46,766 to $500,000 | |------------+--------------------| |10.3 |$500,000 and over | --------------------------------- 2)Argument in Support. Proponents of this bill state, "California currently faces a $15.4 billion budget deficit, AB 1130 Page 4 even after the $11.2 billion recently made cuts" to higher education and social services provided to the sick, poor, and elderly. The proponents assert that recent polls reveal that "seventy-eight percent of California voters support a 1% increase in the income tax rate for Californians earning more than $500,000 a year." The proponents also argue that even "our most fiscally conservative governors have increased the tax rate in times of major deficits." 3)Argument in Opposition. Opponents of this bill assert that the "tax increase on higher income tax brackets ? will hit California's small and medium sized businesses especially hard, as many of them do not organize as corporations and therefore pay personal income taxes in lieu of corporate tax." The opponents state that California already has the most progressive income tax structure in the United States, with the top 1% of earners paying more than 75% of state's income tax revenues. Opponents argue that progressive income tax structures "cause individuals and small businesses to change their income-earning and tax-planning behavior "the create "a drag on the economy and may ultimately result in fewer tax revenues." Finally, the opponents believe that this measure will further harm the economy, will contribute to the increased revenue volatility, and is unlikely to generate the estimated revenues. 4)Background. Throughout California's history, governors and the Legislature have imposed progressive tax brackets on the highest income earners. Beginning with Governor Ronald Reagan, a 10% tax bracket was enacted in 1967, and later raised to 11% in 1971. In the early 1990s, California faced a severe recession, which resulted in significant shortfalls in the state budget. In response, the State acted to increase revenues and reduce expenditures. The Legislature and Governor Pete Wilson, in addressing the issue, increased the PIT rates by adding a 10% and an 11% tax bracket for the State's highest income earners and increasing the AMT rate from 7% to 8.5% ÝSB 169 (Alquist), Chapter 117, Statutes of 1991]. In 1991, the 10% rate was imposed on filers with incomes over $100,000 (single) and $200,000 (married filing jointly). The 11% rate was imposed on filers with taxable incomes over $200,000 (single) and $400,000 (married filing jointly). These income thresholds were increased for inflation each year, so that by 1995, the 10% rate was imposed on filers with taxable incomes over $109,936 (single) and AB 1130 Page 5 $219,872 (married filing jointly), and the 11% rate was imposed on filers with taxable incomes over $219,872 (single) and $439,744 (married filing jointly). In 1995, supporters of a permanent extension of the tax bracket rates placed Proposition 217 on the ballot. The measure would have continued the 10% and 11% tax rates permanently and allocated revenue from the increase to schools and local governments. Proposition 217 failed narrowly by 2/10ths of one percentage point. In February of 2009, in an effort to deal with a $20 billion budget deficit, the California Legislature voted to add 0.25%, or twenty five basis points, to the tax rate for all brackets for the 2009 and 2010 tax years. ÝABx3 3 (Evans), Chapter 18, Statutes of 2009]. The Legislature also proposed to the voters to extend this 0.25% increase to the 2011 and 2012 tax years, but the voters did not approve Proposition 1A (2009) in the May 19, 2009 special election. 5)Progressive Taxation. California currently has a progressive taxation system. A progressive tax is one where the tax rate increases as the taxable base amount increases. As explained earlier, California has six different tax rates, each increasing as the base increases. There are several schools of thought addressing this issue. Generally speaking, there are those who believe in a progressive system of taxation, and those who do not, preferring other methods of taxation, like a flat tax. The argument against a progressive tax system is similar to the one espoused by Austrian economist and author, Eugen Von Bohm-Bawerk. Addressing the concept in his work, Karl Marx and the Close of his System, Von Bohm-Bawerk focuses his argument on the consumption of goods versus the consumption of capital. Applying the concept of diminishing returns, as income rises, a smaller portion of that income will be used for consumption of goods. By default, a larger portion will be used for capital investments, which will generate more income for more capital investments. By purchasing more and more capital goods, the cost of production begins to fall and begins to elevate the standard of living. A progressive system of taxation would increase the tax rate on higher income individuals, reducing the amount of income available for capital investments and thereby reducing improvements to the standard of living. AB 1130 Page 6 This argument against a progressive system of taxation, however, fails to address the issue of a growing gap between those who have capital investments generating an exceedingly greater amount of income and those who are just able to pay for life's necessities. Because low income earners spend a larger share of their income on necessities, they have a much smaller portion of income left over to make their own capital investments. The argument also fails to address the elimination of jobs from increased capital improvements. For example, a company employing 10 workers may decide to purchase large capital equipment, eliminating the need for those workers. The machine can perform the same amount of work, but the business will become more efficient by reducing its labor costs in subsequent years. The idea of a progressive tax system has gained acceptance from a wide range of individuals. Writing in The Wealth of Nations, Adam Smith outlined the hardship and burden that lower income individuals have in society. Specifically, Smith focused on the necessities of life, on which low-income individuals spend a much larger percentage of their income. In recognizing the disproportionate impact on the poor, Smith stated, "it is not very unreasonable that the rich should contribute to the public expense, not only in proportion to their revenue, but something more than in that proportion." Other arguments also encourage the use of a progressive taxation system because individuals with greater capital are also more likely to take advantage of societal benefits supported by taxation, such as defense, infrastructure, and the protection of property rights. Individuals who control larger sums of capital are also able to take advantage of economies of scale, a wider range of investment opportunities, and are able to more directly participate in shaping government. By providing a progressive tax system, democracies are better able to enhance economic opportunity for the lower and middle classes. 6)The Recent Temporary PIT Increase . As part of the budget agreement enacted in February of 2009, California increased the burden of PIT that made the state's income tax system less progressive. By increasing each rate by 25 basis points, the Legislature ensured that all taxpayers with income tax liabilities shoulder the burden of a tax increase. In contrast, this bill proposes to make the PIT Law more progressive. Instead of increasing the tax burden for all AB 1130 Page 7 taxpayers, it shifts the costs of financing public services from taxpayers with less income to those with more income. 7)The Recent Public Policy Institute of California's Poll. The survey released by the Public Policy Institute of California (PPIC) on April 28, 2011, found that 68% of Californians believe the quality of K-12 education will suffer if cuts are made (PPIC Statewide Survey, Californians and Education, April 2011). The majority oppose increases in the state sales tax (61% all adults, 62% likely voters) or overall state personal income tax (62% all adults, 66% likely voters) to maintain funding for schools. However, 68% of adults and 62% of likely voters favor raising the top rate of the state income tax paid by the wealthiest Californians to maintain K-12 funding. 8)Revenue Volatility. Revenue volatility is related to both California's economic cycle and its tax structure. As noted in Revenue Volatility in California by the Legislative Analyst's Office (LAO), California's economic cycle has historically been more volatile than the nation's economic cycle due to the presence of high-paying cyclical technology-related industries and the housing sector. In addition to the historic volatility of California's economic cycle, revenue volatility has also been an issue because of California's increased dependency on the PIT. The percentage of state revenue coming from the PIT has increased from 37% in FY 1979-80 to a peak of 57% in FY 2000-01, although it receded to 53.4% in FY 2007-08. Because of the progressive structure of the PIT law, 88.5% of PIT revenue comes from the top 20% of taxpayers by income, with the top 1% of taxpayers - 144 in all - pay almost half of total income tax receipts. Since the income of these taxpayers include a large share from capital gains, which are much more volatile than wages, California has seen changes of 10% or more in total income tax receipts in 10 of the last 13 years. The LAO's report mentioned several ways in which California could reduce the volatility of its revenues. One of the proposed approaches was reducing the progressivity of the basic PIT structure, which would involve flattening the PIT structure by increasing the tax rates on lower and moderate income earners and reducing the tax rate on high-income earners. Other suggestions included increasing the State's reliance on alternative tax revenues. Specifically, the State may be able to reduce its dependence on the PIT by extending AB 1130 Page 8 taxes to services, which tend to be relatively stable during a business cycle, or by increasing property taxes. With regard to property tax, revenues generated from the levying of taxes on property tend to be the most stable of the major state and local sources. According to the Commission on the 21st Century Economy, property taxes are more stable because property tends not to fluctuate as much as other tax bases in response to the business cycle, most notably the PIT. Prior to 1978, property tax was assessed at the market value. However, in 1978, voters passed Proposition 13, which limited assessments to the property's acquisition value, plus an annual increase capped at the lesser of 2% or the rate of inflation. Proposition 13 also added a two-thirds vote requirement for raising taxes. After the passage of Proposition 13, there was a dramatic drop in property taxes relative to personal income. Property tax as a share of personal income dropped from 5% in FYs 1977-78 to 2.4% in FYs 2005-06. In terms of preventing volatility in the state's revenue, Proposition 13 made it incredibly difficult to raise revenue from one of the most stable sources. Of course, it is also important to note that volatility is not inherently undesirable; it is only a problem if state government operates with an expectation of stability. If the Legislature properly addresses the issue of volatility within the budget, state funded programs and other costs could be properly managed without having to restructure California's tax system. 9)A "Marriage Penalty: An Unintended Consequence? This measure proposes to increase the highest PIT rate from 9.3% to 10.3% to apply to taxable incomes greater than $500,000, regardless of the taxpayer's filing status. In other words, a single individual with a taxable income over $500,000 would be subject to this new tax as well as a head of household or a married couple with the same amount of taxable income of $500,000. As such, it would encourage married individuals and registered domestic partners to file separately to avoid the so-called "marriage penalty" and to reduce their overall tax burden. The marriage penalty refers to the higher tax liability of married two-worker couples, compared to their non-married counterparts. As explained by the FTB staff in the analysis of this bill, the "marriage penalty" was an unintended consequence of the Revenue Act of 1948, when AB 1130 Page 9 Congress abandoned treatment of the individual as the taxpayer unit and adopted the split-income plan of joint returns for married persons. (Public Law No. 471, Chapter 168, §§301-305, 62 Stat. 110, 114-16). The author may wish to consider amending this bill to equalize the tax treatment of married individuals and registered domestic partners filing separately and those filing jointly. 10)Related Legislation. AB 1239 (Furutani), introduced in the current legislative session, temporarily establishes 10% and 11% personal income tax brackets for high-income taxpayers and increases the alternative minimum tax rate to 8.5%. AB 1239 is set to be heard in this Committee on May 16, 2011. AB 1836 (Furutani), introduced in the 2009-10 legislative session, was similar to this bill. AB 1836 failed passage out of this Committee. SB 96 (Ducheny), introduced in the 2009-10 legislative session, would have added four higher tax brackets with higher tax rates. SB 96 was held by the Senate Committee on Revenue and Taxation. AB 2897 (Hancock), introduced in the 2007-08 legislative session, would have established two additional tax brackets with higher rates, similarly to this bill. AB 2897 failed passage out of this Committee. AB 6 (Chan), introduced in the 2005-06 legislative session, was similar to this bill. AB 6 failed passage on the Assembly Floor. 11)FTB's Suggested Technical Amendments. On page 3, line 6, replace "2011" with "2012" On page 4, line 24, replace "2011" with "2012" REGISTERED SUPPORT / OPPOSITION : AB 1130 Page 10 Support Alliance of Californians for Community Empowerment (ACCE) American Federation of State, County and Municipal Employees (AFSCME), AFL-CIO California Federation of Teachers California Nurses Association Coalition of California Welfare Rights Organizations Congress of California Seniors CREDO Opposition California Chamber of Commerce California Taxpayers Association Analysis Prepared by : Oksana Jaffe / REV. & TAX. / (916) 319-2098