While California's elected officials debate a massive tax increase and spending caps in Sacramento on the Proposition 1a-f measures, neither party is happy with the course of action proposed. This blog was sent to every elected official in the State upon the first round of proposed tax hikes under the headline "Fixing California is easy, Fixing Sacramento is Not," and without fail not a single response. While the legislators are free to ignore reason, the fact that a new budget shortfall exists, even after they increased sales, car and income taxes earlier this year, was predicted in this blog and those emails almost exactly. The legislators of the State of California must learn to embrace the reality that they don't have a tax problem, they have a revenue problem. Now, one may argue, "but doesn't taxes lead to greater revenue?" The answer is yes and no. If nothing else is certain, taxes never earn a dollar for dollar increase in revenue to the State. Behavior is changed, psychological aversion is built, and distrust of government is spawned-none of which is healthy for an economy.
Raising Revenue
Raising revenue is not as simple of a concept as the majority of people think. In fact, many politicians believe that increasing taxes will increase revenue to the State. While this seems intuitive, it is not reality. In fact, such a belief is the equivalent of suggesting a business raise prices to increase its revenue. The reality is that life isn't that simple. According to proven economic principles, raising taxes beyond a certain point, just as a business raising prices beyond a certain level, actually has an inverse effect on revenue as people no longer have the ability or the apatite to pay such taxes or prices. Therefore, there are certain scenarios where actually lowering taxes will lead to greater revenue realized.
This economic certainty, as developed by Arthur Laffer and proved by successful U.S. policy in the 1960s and early 1980s, is unchallenged in theory by any economist despite its critics disputing where the maximum revenue point is in relation to tax rate. In essence, Laffer surmised that the amount of revenue the government collects is a function of the tax rate. In building his model, named the Laffer Curve, Arthur Laffer concluded that a State can raise revenue by raising taxes only to a certain point, at which, any further increase in taxes will actually lead to a fall in total revenue. As a result, there is a point between a tax rate of 0% and 100% where a given tax rate equates to maximum revenue. The debate has always ensued as to where that point actually exists.
While I would argue that the tax rate to generate maximum revenue actually moves depending on the psychology of the market and the position of the economy in the business cycle, few would disagree that temporary identifiable reduction in the price of any good, will cause an increase in sales if the public believes that price reduction is both significant and temporary. If one will indulge that taxes, such as sales tax, are a function of the price paid for goods, then why wouldn't a temporary reduction in sales tax lead to greater sales and more total tax dollars collected?
Especially and more so than before, a reduction in the sales tax would provide the short term boost necessary to carry the 2009 State expenditures until some point in the future when more normalcy exists in the market place. In fact, right now, the legislators want to raise down the road taxes to borrow against today to fund the shortfall that raising taxes didn't cover! With greater sales, the State would receive more total revenue dollars and greater income tax as businesses would encounter more revenue. This doubling of total tax revenue would be substantially greater than an increase in that tax which will discourage spending and dilute the effect of the raised tax. For a perfect example one should research the massive improvement in sales for emergency preparedness in Florida during that State's "sales tax holidays" throughout any given year.
As a result, the first prong to the solution to the budget in the short run is to identify a fixed window, maybe seven months, where purchasers will pay a reduction in sales tax of 1.5%. If this is advertised as significant and is promised as temporary, sales tax total revenue will increase. This principle is tried and true, just ask any retailer about increased revenue during an effective sale. The State also will enjoy the secondary effect of higher employment, and greater income tax revenue during this period.
Spending
While it is true some spending cuts should be made to balance the budget, the State should not cut its nose off despite its face. Spending that is directly converted into income for an individual is the worst place for the State to cut. Why? First, the worker pays taxes on those wages. Second, the worker spends those wages leading to sales tax receipts to the State. Finally, the purchases that those workers make, as a result of the government spending to them in the form of wages, leads to revenues in the general economy that leads to profits, that are taxed, and job creation, that also generate tax. In essence, don't cut spending that leads to revenue.
The State must cut spending that is least effectively turned into personal consumption, at least in the short run. Therefore, immediately the State should forgo any spending that is material intensive. A majority of such spending will be lost in commodity costs rather than spent into the economy with a multiplier. Next, the State in the short run should not expend energy, or spending, on any type of regulation, environmental or otherwise, that inhibits job creation, business creation, and economic growth. The State can always reinstall such efforts when its citizens are in a healthier situation. After all, anyone who states that a two year hiatus from cumbersome State regulation will have a significant effect on the landscape of the State in the long run is simple and short sighted.
Conclusion
There it is, a concise framework for a healthy budget in the short run. This fix will buy legislators time to build a long term sustainable path to prosperity in the State. In the long run, I believe that a strong emphasis should be on revenue creation through economic development and building an attractive landscape of low corporate tax rates and simplified State regulation to attract and maintain employers, manufacturers and business innovation. As the State already has a competitive advantage in living standards, weather and natural beauty, a favorable business environment would create a sustainable and growing tax base.
Conclusion
There it is, a concise framework for a healthy budget in the short run. This fix will buy legislators time to build a long term sustainable path to prosperity in the State. In the long run, I believe that a strong emphasis should be on revenue creation through economic development and building an attractive landscape of low corporate tax rates and simplified State regulation to attract and maintain employers, manufacturers and business innovation. As the State already has a competitive advantage in living standards, weather and natural beauty, a favorable business environment would create a sustainable and growing tax base.
The funny thing is that the short run fix to the budget imbalance is contrary to the beliefs of both parties, Democrats to increase taxes and Republicans to hatchet spending. I am sure that it is no surprise to the citizens that the political parties have improperly framed the arguments of how to resolve the budget crisis, after all they stopped representing citizens in favor of well funded special interests many years ago. That said if we can accomplish the difficult part, convincing the elected officials to act in compliance with proven and established proofs of economics, a solution is literally before us.
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