BILL ANALYSIS Ó AB 1239 Page 1 Date of Hearing: May 16, 2011 ASSEMBLY COMMITTEE ON REVENUE AND TAXATION Henry T. Perea, Chair AB 1239 (Furutani) - As Introduced: February 18, 2011 2/3 vote. Tax levy. Fiscal committee. SUBJECT : Personal Income Tax: 10% and 11% brackets. SUMMARY : Temporarily establishes 10% and 11% personal income tax (PIT) brackets for high-income taxpayers and increases the alternative minimum tax (AMT) rate to 8.5%. Specifically, this bill : 1)Declares the intent of the Legislature to reinstate income tax brackets for the highest income earners to address the state's structural budget problems. 2)Establishes a 10% PIT rate for the following: a) Single filers whose taxable income is over $250,000 and equal to or less than $400,000; b) Joint filers whose taxable income is over $500,000 and equal to or less than $800,000; and, c) Head of household filers whose taxable income is over $400,000 and equal to or less than $600,000. 3)Establishes an 11% PIT rate for the following: a) Single filers whose taxable income is over $400,000; b) Joint filers whose taxable income is over $800,000; and, c) Head of household filers whose taxable income is over $600,000; 4)Reduces the amount of income tax imposed on high-income taxpayers by an amount equal to the 1% mental health tax imposed on taxable incomes in excess of $1 million in accordance with Proposition 63 ŬRevenue and Taxation Code AB 1239 Page 2 (R&TC) Section 17043]. 5)Increases the AMT rate from 7% to 8.5% for individual taxpayers for taxable years beginning on or after January 1, 2011, and before January 1, 2017. 6)Is operative for taxable years beginning on or after January 1, 2012, and before January 1, 2017. 7)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%, 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 AB 1239 Page 3 credits, does not escape taxation completely. California's AMT rate for individual income taxpayers equals 7%. Unlike the federal government, California indexes AMT exemption amounts under the PIT Law. 5)Provides an AMT rate of 7.25% for taxable years beginning on or after January 1, 2009, and before January 1, 2011. FISCAL EFFECT : The FTB estimates that this bill would increase General Fund revenues by $950 million in fiscal year (FY) 2011-12, $1.6 billion in FY 2012-13, $1.7 billion in 2013-14, $1.8 billion in FY 2104-15, and $1.9 billion in FY 2015-16. COMMENTS : 1)Author's Statement. The author has provided the following statement in support of this bill: "When then-Governor Wilson unveiled his May Revision in 1991, the updated budget plan was based on a deficit of $14.3 billion. In order to bridge the gap, the 1991-92 budget Governor Wilson signed into law included $3.4 billion in expenditure reductions and $9.1 billion in increased resources. Notably, the increased revenue that Governor Wilson relied on included $5.1 billion in state-level tax increases. "AB 1239 is a less restrictive version of the temporary tax brackets initiated by former Governor Wilson in 1991, and it impacts only those who make more than a quarter million dollars a year. Like the tax brackets established by former Governor Wilson, the tax brackets under AB 1239 are temporary and apply only to tax years beginning January 1, 2012, and through January 1, 2017. "If passed, AB 1239 is estimated to raise almost $8 billion of critical funding over the next five years. Currently, the wealthiest earners pay 7.8 percent of their salary towards the income tax, while the poorest California families pay a disproportionate 11.1 percent of their salary towards the income tax. AB 1239 will only affect the wealthiest of Californians and not low-income or middle class individuals and families that have been hit hard by the recession and the Governor's past budget cuts. Only 1% of single taxpayers and 3% of joint taxpayers would be affected by AB 1239." AB 1239 Page 4 2)Argument in Favor. Proponents of this bill state that, given the scope of California's budget crisis, the state cannot rely on spending cuts alone for a remedy, but must embrace revenue increases as well. The level of services provided by the State for education, public safety, social services, and infrastructure spending on roads, bridges and highways are already at a bare minimum. Any more cuts could cause long-term damage to the state's competiveness in the global economy as our infrastructure crumbles and our schools fail to educate the workforce of the future. The temporary creation of the top income tax brackets will help avert additional spending cuts to important programs that drive California's economy. The proponents assert that, as a society, we can no longer continue to slash programs that help the sick, disabled, blind, poor, children, students and seniors. The way to mend the safety net for those most vulnerable in California is by finding new revenues and not by imposing regressive taxes upon middle class Californians. AB 1239 is a reasonable measure that mirrors actions taken by former Governor Pete Wilson in 1991; it provides a humane solution to the state's budget deficit by fairly spreading the burden of balancing the budget and asking top income earners to pay their fair share. 3)Argument in Opposition. Opponents of this bill state that California already has the most progressive income tax structure in the United States, with the top 1% of earners paying half the tax revenue California receives, and that is after the sunset of the 2009 income tax increase of .25%. If anything, California needs fewer tax brackets to keep it from becoming over-reliant on one source of revenue. The opponents assert that this bill would negatively impact small business growth during these already trying economic times, will further harm the economy, will contribute to the increased revenue volatility, and will add credence to the notion that California is the most taxed state in the union. 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 AB 1239 Page 5 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% ŬSB 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 $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. ŬABx3 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 AB 1239 Page 6 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. 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 AB 1239 Page 7 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 tax increase. In contrast, AB 1239 proposes to enact a considerably more progressive income tax rates. Instead of increasing the tax burden for all taxpayers, it shifts the costs of financing public services from taxpayers with less income to those with more income. 7)Offset Against the Mental Health Tax . While this bill proposes to create an 11% tax bracket for taxpayers with incomes over $400,000 ($800,000 for married filing jointly), it, at the same time, allows those taxpayers who are subject to the 1% mental health tax to reduce -dollar for dollar - the increased income tax liability by an amount of the mental health tax paid. Under existing law, no such credit is allowed. Essentially, this bill creates the 11% tax brackets for taxpayers with income between $400,000 and $1 million ($800,000 and $1 million for married filing jointly) but decreases it, by virtue of allowing the credit against the mental health tax liability, to a 10% bracket for taxpayers with income over $1 million. 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 AB 1239 Page 8 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 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. AB 1239 Page 9 9)Related Legislation. AB 1130 (Skinner), introduced in the current legislative session, would establish a 10.3% income tax rate applicable to taxable income of over $500,000. AB 1130 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. 10)FTB's Suggested Technical Amendments. On page 2, line 15, strike out "to" and insert "would" On page 7, line 15, delete "(" before "Notwithstanding" On page 8, line 9, insert before clause (iv), "(iv) For any taxable year beginning on or after January 1, 2011, and before January 1, 2012, 7 percent." On page 8, line 9, strike out "(iv)" and insert "(v)" On page 8, line 9, strike out "2011" and insert "2012" On page 8, line 11, strike out "(v)" and insert "(vi)" REGISTERED SUPPORT / OPPOSITION : Support AB 1239 Page 10 Asian Americans For Civil Rights and Equality Asian Health Services American Federation of State, County, and Municipal Employees (AFSCME), AFL-CIO California Allians for Retired Americans California Commission on the Status of Women California Labor Federation California Pan-Ethnic Health Network California Partnership California Professional Firefighters California Teachers Association California Federation of Teachers, AFT, AFL-CIO California United Homecare Workers Congress of California Seniors Glendale City Employees Association (GCEA) Organization of SMUD Employees (OSE) San Bernardino Public Employees Association (SBPEA) San Luis Obispo County Employees Association (SLOCEA) Santa Rosa City Employees Association (SRCEA) PowerPAC University of California Student Association Opposition Howard Jarvis Taxpayers Association California Taxpayers Association Analysis Prepared by : Oksana Jaffe / REV. & TAX. / (916) 319-2098