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California’s Perfect Tax Scam

Article by Ike Brannon September 30, 2013 //   4 minute read

While various conservative organs have lambasted the California government for passing a tax increase in November 2012 and making it retroactive for the previous 10 months, I offer praise to the state for coming up with a perfect tax — one that generates revenue without hurting economic growth.

Pro-growth economists argued that California’s boosting of its top marginal tax rate to over 13% risked exacerbating tax evasion or triggering an exodus of wealthy people from the state. After all, it doesn’t take too much effort for a wealthy LA investor with a condo in Vegas to visit Sin City most weekends and bring back sufficient cash to live off the grid enough to finesse Nevada residency.

The left responded to claims that high taxes may be killing the golden goose by citing research showing that a one-percentage-point tax increase a few years ago didn’t result in any exodus. Perhaps, they reasoned, raising tax rates 1% each year is the way to boil this particular frog.

But the very genius of the California tax increase on the wealthy was its retroactivity: had people known in January 2012 (10 months before the tax hike was passed) that they would be paying the higher tax rate they may well have worked less, invested less, or moved out of the state. Since that fact didn’t become known until November, the state got the best of both worlds — a high tax rate without the disincentive effects.

California then doubled down on retroactive tax increases when the state’s Supreme Court disallowed a capital-gains tax break given to residents who invest in companies located in the state, a provision that had been law since 1993. After the ruling, the state disallowed the tax break on investments made in the last five years, which generated another $200 million in tax revenue, including interest and penalties for being in violation of the law. Again, another patently unfair tax but one that created no disincentives to investment or other economic activity, since people made the investments assuming the lower tax rate would be in effect.

Some people might argue for a more predictable, rational tax code. But a tax code that arbitrarily changes the rules after the game is played makes perfect sense. A high-spending state like California would ideally begin the year with low tax rates and high spending and then raise rates year-end, so that the state pays for its spending without high taxes having any deleterious effect on the economy.

Of course, such a strategy can only work once: In the long run, people will recoil from investing or even undertaking sensible economic decisions and flee the state if they get continuously surprised by the tax code, but the government milked this gambit for all it’s worth.

The next government will have to run a different scam. Or of course it could always try true reform to balance its budget.