Legislative Analyst's Office
February 22, 1995

The Governor's Tax Proposal


The 1995-96 Governor's Budget proposes a 15 percent across-the-board income tax cut for both corporations and individuals, along with maintaining the high-income tax rates scheduled to sunset in 1996 . The plan's stated purpose is to reduce the tax burden on individuals and businesses in California so as to stimulate business location and expansion in the state, thereby improving the economy.

The plan's net cost to the state is estimated in the budget to be $225 million in 1995-96 and $7.6 billion over the four-year period ending in 1998-99. A more recent analysis by the Franchise Tax Board (FTB) estimates the four-year cost at $7.3 billion. Two-thirds of the cost comes from reduced personal income taxes and the remainder from reduced bank and corporation taxes. Benefits to individual taxpayers will vary widely, with lower income individuals receiving no savings and high- income taxpayers initially paying more in taxes. After it is fully implemented, though, the plan will benefit most taxpayers, and will produce a more progressive personal income tax structure.

The proposal will reduce California's tax burden modestly. A number of measures suggest that California's current tax burden is about average when com pared to other states. The proposal will not change this result dramatically. How much of a stimulative effect this decreased tax burden will have on California's economy is open to debate. Economists disagree on what its net impact will be, and no model currently exists that has a proven track record in accurately predicting the effect of a change of the type and size that the Governor is proposing.

Ultimately, whether the Governor's tax proposal is adopted is a legislative policy choice. Important policy decisions will need to be made regarding the tradeoff between reducing taxes and funding state services. The distributional consequences of any tax change and the resulting change in the mix of public versus private spending also would need to be considered.


One of the key features of the Governor's 1995-96 budget is a proposed tax reduction for businesses and individuals. The proposal, which retains the two highest individual income tax brackets while phasing in an across-the-board rate reduction over three years, was developed with the view that California's tax rates are too high and that reducing them will stimulate the economy and attract more businesses to California.

In this analysis, we examine the arguments for adopting a tax cut and what its fiscal impact would be on the state and on individual taxpayers. We discuss how the tax burden would change under the proposal and what its effects would be on the progressivity of California's tax structure. We also consider California's tax levels, whether a tax cut will stimulate the economy, and the overall fiscal implications of the proposal. Lastly, we discuss some options available to the Legislature if this particular tax reduction plan is not adopted but a tax change of some other type is desired.

What Is the Governor's Proposal?

The Governor's tax proposal contains two key parts:

Why Has a Tax Cut Been Proposed?

In January 1994, during his State of the State Address, the Governor requested that his Council of Economic Advisors organize a task force to study and advise him on how to reduce taxes so as to stimulate job growth in the state. The resulting Task Force on California Reform and Reduction reviewed the state's fiscal structure in light of historical trends and present forecasts. It also focused on the reasons behind the decline of the state's tax revenues in the early 1990s. In late December, the Task Force presented its findings and recommendations on how to reduce taxes so as to spur employment and economic growth.

Findings of the Task Force

California's Tax Burden Is High. According to the Task Force, one of the key reasons for the decline in California tax revenues in the early 1990s was that California's tax rates had reached levels where they were inhibiting revenue growth. In particular, it concluded that the state's high marginal PIT and B&C tax rates gave individuals and businesses an incentive to locate elsewhere and shift economic activities out of state.

The Task Force emphasized that high corporate tax rates play a part in eroding California's competitive position relative to neighboring states, and that to improve the state's business climate, these rates should be reduced. Moreover, by lowering PIT rates for all Californians, businesses would not have to compensate workers for high taxes with higher wages, thus lowering their labor costs and increasing their profits. In addition, individuals would keep a higher percentage of their income, which would stimulate work incentives and increase productivity.

Reducing Taxes Will Stimulate Employment. According to the Task Force, firms and investors would see the rate reductions as a signal that the state is concerned about its business climate, and it would play a favorable role in business location decisions, both attracting new firms to California and encouraging already-established firms to remain and invest additional monies in the state. As more firms locate and expand in California, more jobs would be created, which in turn would benefit both individuals and the state's economy in general.

Government Funding Will Still Be Adequate. The Task Force concluded that total funds available for spending on state programs would grow a little faster than needed to compensate for population and inflation, even with a tax cut in place. The Task Force acknowledged that spending restraint would be re quired, but noted that the state could provide public services more effectively and efficiently than it does currently.

A top-down budgeting approach was suggested by the Task Force. This approach takes the tax revenues that are available (in this case, reduced for the proposed tax cut) and then sets aside funds for certain spending requirements (Proposition 98 and debt service). It then marks all remaining funds for discretionary use. As noted above, the Task Force acknowledged that because discretionary revenues would be limited, hard choices would have to be made regarding the funding of the remaining program areas in the budget.

What Is the Cost of the Governor's Tax Proposal?

Costs to Reach Over $7 Billion by 1998-99. Figure 1 shows the budget's estimate of how the state would be affected by the Governor's proposal. The cumulative cost by 1998-99 to the state of the rate reduction alone is $10.6 billion. However, this amount is offset by $3 billion due to retention of the high-income PIT rates. Thus, the budget estimates that the net state four-year revenue reduction would be $7.6 billion.

Since the budget was released, the Franchise Tax Board (FTB)--which administers both income taxes--has made its estimate of the proposal's fiscal impact. The FTB's estimate for the first four fiscal years is $7.3 billion, or $300 million less than the budget's estimate.

Individuals Receive Over Two-Thirds of Benefits. Figure 2 shows the share of the net tax savings going to PIT filers versus B&C tax filers. Based upon the budget, over two-thirds of the net revenue benefits go to individuals and the remainder to corporations. The share that corporations receive is a bit larger than their share of tax liabilities in recent years. This is because certain individuals do not receive the full amount of the rate reduction because of the retention of the 10 percent and 11 percent rates. In the following section, we show that these individuals initially pay more under the proposal than under current law. Absent these high brackets, the distribution of the tax reduction between the PIT and the B&C tax would be similar to their tax shares in recent years.

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