Tax Analysts Blog

A California VAT: Sweeping Reform for a Troubled State

Posted on Sep 30, 2009

The Parsky Commission has just released its much awaited tax reform report. Governor Schwarzenegger has called (yet another) special session of the legislature in hopes of getting the reform plan, which he says he will sign, enacted before the end of this year.

The centerpiece of the commission's plan is a new Net Business Receipts Tax. Call it what you like, this is a type of value-added tax. The revenues from the new tax would be used to eliminate the state corporation income tax, dramatically cut the state sales tax rate, and flatten the progressive rate structure of the income tax.

Value-added taxes are consumption taxes and therefore they generally place a disproportionate tax burden on low-income families. When a VAT is proposed as a replacement for existing taxes (as is the case in California), predictable politics follow: the new tax is favored by pro-business conservatives and opposed by liberal Democrats and unions. And that is generally what you are seeing in the Golden State.

The more thoughtful argument against the new VAT is that the specific proposal as drafted is flawed and it would be better to reform corporate income taxes, sales taxes, and individual income taxes--the revenue sources that would be cut back or eliminated when the new VAT is instated. It would be a very nice thing to reform the existing tax system. But after decades of trying and making only negative progress, that is not a realistic possibility.

Of course any VAT that makes it through California's legislative meatgrinder would no doubt be a far cry from the textbook ideal. Economists know that a VAT (in theory) is superior to a corporate income tax (in theory) and a sales tax (in theory). Details matter, but it is probably safe to assume that a VAT (in practice) is economically superior to a corporate income tax (in practice) and a sales tax (in practice). Most attractive is that the VAT tax base is hugely broader than the corporation tax or even the sales tax. That means rates can be kept low and there is less opportunity and incentive to game the tax.

The main political problem is the partial replacement of the personal income tax and the significant redistribution of the tax burden that would result. This should be remedied not by punting on the VAT but by making the residual income tax more progressive---with higher rates for upper incomes and/or more tax credits for lower incomes.

It is important not to forget that the catalyst for the commission's report was California's crippling budget crisis--not the usual high-minded appeals for tax reform. The revenue from a VAT would not fluctuate as much as that from personal and corporate income taxes. That gives California something it desperately needs (because it must balance budgets and because "rainy day" funds are always raided): more revenue stability over the business cycle. Moreover, it is lower income households that are going to be hurt by budget cuts if California's finances do not stabilize. Recognizing that reality should do a lot to blunt criticism about the burden shift under the commission's plan.

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