GOV. Jerry Brown and President Barack Obama are both trying to increase taxes on "the rich."
Brown's November tax initiative would increase income tax rates on those earning more than $250,000; Obama is once again pitching the "Buffett Rule": making sure that those earning more than $1million annually pay "the same tax rate" as Warren Buffett's secretary.
The risk the government faces when it raises tax rates is that it won't get more tax revenues because people change their behavior in response to the raised taxes.
The governor's proposal appears to be less controversial. The state has had to cut expenditures in the past few years and raising revenues would stave off further cuts. The governor's budget office estimated that this tax rate increase will raise $5 billion over the next 10 years. Of course, that assumes everyone hit by the new taxes simply sits there and lets themselves be hit. Suppose not.
Even without the proposed changes by the president, the combined state and federal tax rates on those earning $250,000 will be around 50 percent in California. So would those being taxed stay and pay?
Let's hypothetically vote in a 2 percent higher state tax rate in November and see what could happen. For simplicity, let's say the tax rate on "the rich" goes from 10 percent to 12 percent. Suppose there are 50,000 people who average $500,000 per year in taxable income. They would now pay $60,000 per year in state taxes, up from $50,000. That's $3 billion per year instead of $2.5 billion per year under the old rates. The governor won't have to cut as much, right?
But what if 10,000 of those highly mobile, well-educated people say, "I've had enough I'm moving to Montana"? Obviously, the state wouldn't get the extra tax money from them, but it's worse than that. The state wouldn't get any of the tax money they used to pay, either! Tax revenues from "the rich" would actually fall to $2.4 billion.
The governor's estimators would say that most people wouldn't leave, but the Sacramento gamble is a big one. Illinois tried it. Just as the economy started to recover, they raised state tax rates on the rich. They now lead the nation in state unemployment.
The "Buffett Rule" is a bit harder to discuss. The way we tax regular income is with progressive tax rates. You pay no taxes on the first bit of income you earn. Then as your income rises, higher tax rates kick in. Further, you pay lower tax rates on investment income to encourage savings and investment.
Suppose Warren Moneybags' secretary earns $100,000, and she pays no taxes on the first $50,000, then 30 percent on the next $50,000. Her tax bill would be $15,000, and her average tax rate based on her total income is 15percent.
Warren Moneybags earns $10million, but $9million of it comes from his investments, and, many years ago, when he invested, we said he would only pay 10percent in taxes on his investment income, or $900,000. If he has the same 30percent tax rate as his secretary on regular income after the first $50,000, he will pay $285,000 in regular income taxes, so his total tax bill will be $1,185,000. His average tax rate will be 11.85percent. Warren pays a lower average tax rate than his secretary.
So how are we going to "fix" this?
Suppose we raise Warren's regular income taxes enough to make sure he pays an average of 15 percent. He would have to pay $1.5 million in total taxes to average 15 percent. Holding the $900,000 in taxes from his investments constant, Warren will have to pay $600,000 in regular income taxes, a 60 percent average tax rate. If I were Warren, I would quit working and live off my investment income, in which case the government loses all of his previous regular income tax revenues and gets only the $900,000 from his investment income.
Perhaps the government should go after Warren's investment income instead. Let's leave his regular income tax alone and raise the tax rate on Warren's investments so that his overall, average tax rate is 15 percent. That will mean we raise the tax rate on his investments to 13.5 percent. He will pay $1,215,000 in taxes on his investments and $285,000 on his regular income, for a total of $1.5 million, or a 15 percent average tax rate.
But a lot of Warren's investment income is from selling stock that he made capital gains on. What if he responds to this higher tax rate by not selling $3million in stock this year? His total taxes paid would once again fall to $1,095,000.
If we add the proposed state and federal tax changes together, it's easy to imagine a few thousand people deciding to move to another state or retire. And that will decrease the tax base and tax revenues.
But worse, it will rob California, and possible the country, of the well-educated, hardworking, skilled people and business owners that are its lifeblood.
Jay Prag is a professor at the Peter F. Drucker and Masatoshi Ito School of Management at Claremont Graduate University. Prag also serves as academic director for the school's Executive Management Program, and can be heard weekly on "Inland Empire News Hour" on KTIE-AM 590.