If there's one thing that brings out Arnold Schwarzenegger's action-hero instinct, it's California's so-called balance-of-payments deficit with the federal government. According to the California Institute for Federal Policy, for every $1 in taxes paid to the federal government, California receives 77 cents back. Citing these figures in October, the then-governor-elect promised action: "By the time I'm through with this whole thing, I will not be known as the Terminator; I will be known as the Collectinator!"
The Collectinator needs to brush up on the laws of federal income taxation. In his first act as governor, Schwarzenegger repealed the Davis administration's increase in the vehicle license fee, which was slated to bring in $23 billion over the next five years. What the new governor didn't mention, however, was that the fee was deductible for federal income tax purposes. That means that Californians who file a Schedule A with their federal tax returns could have reduced their federal taxable income by the full amount of the vehicle fee paid to the state.
Though estimates vary, it's fair to say that Schwarzenegger's decision to repeal the fee will cost Californians billions of federal tax dollars -- money that those who itemize would have saved in federal income taxes if they had paid the higher fee. Of course, nobody wants to pay higher state and local taxes and fees just so he or she can claim a federal tax deduction. But at a time when the state is in desperate financial straits, it makes sense to give more thought to which taxes are deductible and which are not. With a little planning, the state could save its taxpayers billions of federal tax dollars per year simply by changing the types of taxes it collects. But doing so requires attention to tax law.
In 1986, Congress repealed the federal income tax deduction for state and local sales taxes; however, it retained the deduction for income taxes, real property taxes and personal property taxes. Depending upon the taxpayer's tax bracket, the payment of these kinds of taxes can result in a federal income tax savings of up to 35 cents for every dollar paid in these categories. By contrast, the payment of a sales tax results in no federal tax savings whatsoever. The lesson is simple: Repeal the sales tax and replace it with some tax, any tax, that is deductible for federal income tax purposes.
There is real money at stake here. According to the California legislative analyst, the sales tax brought in $22.3 billion for the fiscal year 2002-2003, accounting for roughly one-third of all general fund revenues. Projections show that percentage holding through fiscal year 2008-2009. Over the next six years, California will collect an average of roughly $27 billion per year in sales taxes. If that revenue stream were converted from the sales tax to a deductible tax, the tax savings to Californians would be significant -- perhaps as much as $5 billion a year.
Alternatively, the state itself could capture that saving by raising more than $27 billion in deductible taxes. For example, $32 billion raised through deductible taxes would increase state revenues by $5 billion, but because of the federal deduction it would keep the net tax burden on Californians the same.
That means the state could increase annual K-12 spending by roughly $800 per pupil; it could boost annual Medi-Cal spending for the low-income insured population from $10 billion to more than $15 billion; it could use the saving to slash the current operating deficit by half.
How exactly should the state change its tax structure to take advantage of the saving possibilities? Because the federal income tax deduction is most valuable to individuals in the highest federal income tax brackets, the most effective strategy would be to replace the sales tax with an income tax on high-income individuals. Or if Proposition 13 were on the table, as Schwarzenegger's advisor Warren Buffett once suggested, then increased property taxes could be used to replace sales taxes. That sort of fiscal reshuffling would be highly controversial. Because the distributional effects of these taxes are so different, some people would pay more in taxes while others would pay less.
In effect, there is $5 billion per year of federal money available to help California, but only if we can craft a tax system that takes maximum advantage of federal tax law. That's a challenge the governor should want to embrace. Schwarzenegger's "Collectinator" comment shows that he can talk the talk, but if he is serious about getting the state's fiscal house in order, he also needs to walk the walk.