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In One Image, Everything You Need to Know about California’s Fiscal Troubles
Two days ago, I shared some California humor. Today, we’re going to look at some California tragedy.
I’ve often explained that the most important variable in fiscal policy is the the growth of government, More specifically, good fiscal policy occurs when the burden of government spending over time grows slower than the private sector.
As you can see from this chart (based on data from the National Association of State Budget Officers), California has the opposite of good fiscal policy.
At the risk of understatement, it’s not good when government grows more than twice as fast as inflation.
I was motivated to create this chart after reading this article in National Review.
Written by Will Swaim, it discusses how California got in trouble. It starts by looking at how red ink forecasts have dramatically worsened ins a very short period of time.
In the summer of 2022, California governor Gavin Newsom, apparently high on the smell of cash, announced that California had just smashed through the state-budget equivalent of the first four-minute mile: a one-year surplus of $100 billion.…Just one year later, Newsom announced — this time without the trumpet blasts, chest-thumping and press tour — that California was $32 billion in the red. Today, the governor is staring into the business end of a $78 billion deficit. You didn’t have to be a prophet to see the financial chaos coming. In this state’s notoriously mercurial tax system, which depends largely on revenue from just 150,000 wealthy Californians and massive, occasional paydays to investors in the state’s tech sector, what went up in 2022 was certain to fall hard, fast, and soon.
But volatile tax revenues are not the problem.
California is in trouble because of too much spending. Governor Newsom and other politicians in Sacramento can’t resist buying votes in every possible way.
…back in 2022, when Newsom was still feeling like the casino’s biggest whale, he spent as if there’d be money forever, boosting spending to $308 billion, more than double Jerry Brown’s last, 2019 budget of $140 billion. In the Year of the Historic Surplus, there were gifts for almost everyone and a soundtrack of Vegas slots paying off. …He announced that the state will pay $5 billion to cover health-care insurance for illegal immigrants. And though he has already spent a remarkable $20 billion to reduce homelessness — while the number of people on the street continues to grow — Newsom asked voters on March 5 to approve a $6.4 billion bond program that would feed California’s voracious homelessness–industrial complex but almost no one else.
I did a poll back in 2018 about which state will be the first to go bankrupt. Illinois has a big lead, for understandable reasons. But you won’t be surprised to see that California is in second place, ahead of even the basket case of New Jersey.
P.S. The NR article discussed the volatility of tax revenues. Because of its class warfare-based tax system, California is especially vulnerable to big swings in tax revenue (and big revenue losses because of successful people fleeing the state). But this is also a nationwide challenge, which helps to explain why a spending cap (like Colorado’s TABOR) is a much better policy than a balanced budget rule.
The Laffer Curve’s Latest Victim: California
The Laffer Curve is the common-sense notion that people respond to incentives.
And even Paul Krugman admits this has implications for tax revenue.
For instance, if tax rates increase, people may decide to earn and/or report less taxable income. When that happens, revenue won’t increase by as much as politicians hope.
And the reverse is true (in some cases, dramatically true) if tax rates decrease.
For today’s column, let’s look at a real-world example of the Laffer Curve.
Joshua Rauh of Stanford and Ryan Shyu of Amazon have new research that looks at what happened after California voters approved a big class-warfare tax increase in 2012.
Here are some excerpts from their study.
In this paper we study the question of the elasticity of the tax base with respect to taxation…on the universe of California taxpayers around the implementation of major 2012 ballot initiative, Proposition 30. …The Proposition 30 ballot initiative increased marginal income tax rates…by 3 percentage points for singles with over $500,000 in taxable income (married couples with over $1 million)…, the highest state-level marginal tax rate in the nation.…We…document a substantial onetime outflow of high-earning taxpayers from California in response to Proposition 30. …For those earning over $5 million, the rate of departures spiked from 1.5% after the 2011 tax year to 2.125% after the 2012 tax year, with a similar effect among taxpayers earning $2-5 million in 2012. …California top-earners on average report $522,000 less in taxable income in 2012, $357,000 less in 2013, and $599,000 less in 2014; this is relative to a baseline mean income of $4.15 million amongst our defined group of California top-earners in 2011. Compared to counterfactuals in similarly high-tax states, California top-earners on average report $352,000 less in taxable income in 2012, $373,000 less in 2013, and $481,000 less in 2014.
So some upper-income taxpayers moved and others (unsurprisingly) earned/reported less taxable income.
Did that have an impact on tax revenue?
The answer is yes.
…we assess the implications of our estimates for tax revenue in the context of California Proposition 30. A back of the envelope calculation based on our econometric estimates finds that the intensive and extensive margin responses to taxation combined to undo 45.2% of the revenue gains from taxation that otherwise would have accrued to California in the absence of behavioral responses within the first year and 60.9% within the first two years.
Wow, more than 60 percent of projected revenue evaporated within two years.
By the way, these estimates are based on data only through the middle of last decade. And something significant happened after that: The state and local tax deduction was curtailed as part of the Trump tax package.
The authors speculate that this will have very important implications.
…the “Tax Cuts and Jobs Act” (TCJA). Under this law, the top rate is 37% for single and head-of-household filers earning over $500,000, and for married filers earning over $600,000. Despite this nominal cut to top rates, the legislation on net increased rates on top earners because it capped state and local deductions at $10,000 total. … we use our top line intensive margin elasticity estimate to provide a ballpark quantification of the federal tax revenue implications of TCJA for the particular set of California high earners in our treatment group. …Consider a married California taxpayer earning $4.15 million of wage income. In 2017, this taxpayer pays a federal tax bill of $1,431,305. In 2018, incorporating the 8.6% income decrease, this taxpayer pays a federal tax bill of $1,333,946. This amounts to a 6.8% decrease in tax revenue, putting the TCJA on the wrong side of the Laffer Curve for high-earning individuals in California. … the TCJA increased incentives (in terms of the level of the average tax rate gap) to leave California for zero-tax states by 2.15 times the amount of Proposition 30 for those earning over $5 million, and by a factor of 2.43 for those earning from $2-5 million. Based on these scaling factors, we would predict an out-migration effect of 1.46% of those earning $2-5 million, and 1.51% of those earning $5 million.
None of this should be a surprise.
Indeed, I wrote back in 2012 that bad things would happen when Proposition 30 was approved.
I feel safe in stating that this measure is going to accelerate California’s economic decline. Some successful taxpayers are going to tunnel under the proverbial Berlin Wall and escape to states with better (or less worse) fiscal policy. …It goes without saying, of course, that California’s politicians…will act surprised when revenues fall short of projections because of the Laffer Curve.
To be fair, I don’t know if California politicians are genuinely surprised. I suspect many of them privately understand the adverse consequences of class-warfare tax policy. But they nonetheless support bad policy because they are motivated by a selfish desire to maximize votes.
Lessons from Reaganomics for the 21st Century, Part II
In Part I of this series, I looked at Ronald Reagan’s reasonably successful track record on government spending (which could be characterized as fantastically successful when compared to other Republican presidents) and explained why we need Reaganomics 2.0 to deal with today’s federal leviathan that is far too big and projected to get even bigger.
In Part II, let’s look at Reagan’s track record on tax policy and ask whether we need another dose of “supply-side economics.”
When he took office, one of Reagan’s main goals was to lower marginal tax rates on American households. This was necessary for two reasons.
- First, tax rates were too high, including a staggering 70-percent top rate for the personal income tax.
- Second, more and more Americans were being hit by punitive tax rates because of “bracket creep.”
Since I’ve already written a lot about the problem of high tax rates, let’s address the second point.
During the 1970s, when inflation was high, there was understandable pressure to increase wages and salaries so that workers did not fall behind.
But when employees got pay raises to keep pace with inflation, that often meant they had to pay higher tax rates even though their inflation-adjusted incomes stayed constant.
This was not a trivial problem. Here’s a table from the study I recently wrote for the Club for Growth Foundation. As you can see, middle class households wound up paying much higher marginal tax rates as the 1970s came to a close.
President Reagan recognized this problem and he did two things to help American families.
- First, he lowered tax rates across board as part of his 1981 tax cut and his 1986 tax reform, with the top tax rate dropping from 70 percent in 1980 to 28 percent in 1988.
- Second, he “indexed” the personal income tax for inflation, meaning households no longer would be pushed into higher tax brackets because of bad monetary policy.
These reforms helped produce an economic boom.
Here’s some of what I wrote in the study.
In 1981, Reagan convinced Congress to enact the Economic Recovery Tax Act, which phased in lower income tax rates for all taxpayers. …Equally important, Reagan got Congress to adopt “indexing,” which meant that tax brackets were automatically adjusted for inflation. That reform ensured that government no longer profited from inflation. During his second term, Reagan then worked with Congress to approve the Tax Reform Act of 1986. That legislation further lowered tax rates for all taxpayers. …the Reagan tax cuts helped trigger an economic boom. The United States experienced a record economic expansion, with millions of jobs being created and family incomes rising to record levels after the malaise and stagnation of the Carter years. Households earned more money, and they got to keep a greater share of their earnings. Net worth also increased substantially, putting America’s middle class in a very strong position.
By the way, even though my left-leaning friends are viscerally opposed to lower tax rates for upper-income taxpayers, it’s worth noting that the IRS wound up collecting more money from the rich after Reagan slashed tax rates. A lot more money.
All things considered, the Reagan tax cuts were a smashing success (notwithstanding Paul Krugman’s protestations).
But is Reagan’s supply-side tax policy still relevant today?
Some people think tax policy is no longer a problem because individual income tax rates are lower than they were when Reagan took office and indexing is still protecting people from inflation (which has recently been a problem).
For what it’s worth, I think personal income tax rates are still far too high.
But the main reason that we need Reaganomics 2.0 is that the United States faces a major problem with double taxation. To be more specific, the IRS imposes very harsh tax rates on income that is saved and invested.
Here’s Figure 9 from the paper. You can see on the left that America’s personal income tax rate is only slightly higher than the average of other rich nations and the corporate tax rate is only somewhat higher.
But you can see on the right where America really lags, with significantly higher tax burdens on capital gainsand dividend income.
Incidentally, the chart also shows that the United States would be wildly uncompetitive if Biden’s tax proposals were enacted.
So the obvious takeaway is that Biden’s class-warfare plan should never be resuscitated and that lawmakers instead should lower (or ideally eliminate) the capital gains tax and to reduce (or hopefully eliminate) the double tax on dividends.
P.S. The capital gains tax is not indexed for inflation, so people often are hit by that tax even when they lose money on an investment. That’s obviously another area where we need Reaganomics 2.0.
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This past article below from Dan Mitchell tells the story of Ronald Reagan’s successful strategy against inflation. I had a front row seat since I got to read the book and see the film FREE TO CHOOSE by Milton Friedman in 1980 who Reagan agreed with on this issue and I have included below the episode on inflation!
Ronald Reagan’s Most Under-Appreciated Triumph
It’s no secret that I’m a huge fan of Ronald Reagan.
He’s definitely the greatest president of my lifetime and, with one possible rival, he was the greatest President of the 20th century.
If his only accomplishment was ending malaise and restoring American prosperity thanks to lower tax rates and other pro-market reforms, he would be a great President.
He also restored America’s national defenses and reoriented foreign policy, both of which led to the collapse of the Soviet Empire, a stupendous achievement that makes Reagan worthy of Mount Rushmore.
But he also has another great achievement, one that doesn’t receive nearly the level of appreciation that it deserves. President Reagan demolished the economic cancer of inflation.
Even Paul Krugman has acknowledged that reining in double-digit inflation was a major positive achievement. Because of his anti-Reagan bias, though, he wants to deny the Gipper any credit.
Robert Samuelson, in a column for the Washington Post, corrects the historical record.
Krugman recently wrote a column arguing that the decline of double-digit inflation in the 1980s was the decade’s big economic event, not the cuts in tax rates usually touted by conservatives. Actually, I agree with Krugman on this. But then he asserted that Ronald Reagan had almost nothing to do with it. That’s historically incorrect. Reagan was crucial. …Krugman’s error is so glaring.
Samuelson first provides the historical context.
For those too young to remember, here’s background. From 1960 to 1980, inflation — the general rise of retail prices — marched relentlessly upward. It went from 1.4 percent in 1960 to 5.9 percent in 1969 to 13.3 percent in 1979. The higher it rose, the more unpopular it became. …Worse, government seemed powerless to defeat it. Presidents deployed complex wage and price controls and guidelines. They didn’t work. The Federal Reserve — custodian of credit policies — veered between easy money and tight money, striving both to subdue inflation and to maintain “full employment” (taken as a 4 percent to 5 percent unemployment rate). It achieved neither. From the late 1960s to the early 1980s, there were four recessions. Inflation became a monster, destabilizing the economy.
The column then explains that there was a dramatic turnaround in the early 1980s, as Fed Chairman Paul Volcker adopted a tight-money policy and inflation was squeezed out of the system much faster than almost anybody thought was possible.
But Krugman wants his readers to think that Reagan played no role in this dramatic and positive development.
Samuelson says this is nonsense. Vanquishing inflation would have been impossible without Reagan’s involvement.
What Reagan provided was political protection. The Fed’s previous failures to stifle inflation reflected its unwillingness to maintain tight-money policies long enough… Successive presidents preferred a different approach: the wage-price policies built on the pleasing (but unrealistic) premise that these could quell inflation without jeopardizing full employment. Reagan rejected this futile path. As the gruesome social costs of Volcker’s policies mounted — the monthly unemployment rate would ultimately rise to a post-World War II high of 10.8 percent — Reagan’s approval ratings plunged. In May 1981, they were at 68 percent; by January 1983, 35 percent. Still, he supported the Fed. …It’s doubtful that any other plausible presidential candidate, Republican or Democrat, would have been so forbearing.
What’s the bottom line?
What Volcker and Reagan accomplished was an economic and political triumph. Economically, ending double-digit inflation set the stage for a quarter-century of near-automatic expansion… Politically, Reagan and Volcker showed that leaders can take actions that, though initially painful and unpopular, served the country’s long-term interests. …There was no explicit bargain between them. They had what I’ve called a “compact of conviction.”
By the way, Krugman then put forth a rather lame response to Samuelson, including the rather amazing claim that “[t]he 1980s were a triumph of Keynesian economics.”
Here’s what Samuelson wrote in a follow-up columndebunking Krugman.
As preached and practiced since the 1960s, Keynesian economics promised to stabilize the economy at levels of low inflation and high employment. By the early 1980s, this vision was in tatters, and many economists were fatalistic about controlling high inflation. Maybe it could be contained. It couldn’t be eliminated, because the social costs (high unemployment, lost output) would be too great. …This was a clever rationale for tolerating high inflation, and the Volcker-Reagan monetary onslaught demolished it. High inflation was not an intrinsic condition of wealthy democracies. It was the product of bad economic policies. This was the 1980s’ true lesson, not the contrived triumph of Keynesianism.
If anything, Samuelson is being too kind.
One of the key tenets of Keynesian economics is that there’s a tradeoff between inflation and unemployment (the so-called Phillips Curve).
Yet in the 1970s we had rising inflation and rising unemployment.
While in the 1980s, we had falling inflation and falling unemployment.
But if you’re Paul Krugman and you already have a very long list of mistakes (see here, here, here, here, here, here, here, here, and here for a few examples), then why not go for the gold and try to give Keynes credit for the supply-side boom of the 1980s
P.S. Since today’s topic is Reagan, it’s a good opportunity to share my favorite poll of the past five years.
P.P.S. Here are some great videos of Reagan in action. And here’s one more if you need another Reagan fix.
Milton Friedman’s FREE TO CHOOSE “How to cure inflation” Transcript and Video (60 Minutes)
In 1980 I read the book FREE TO CHOOSE by Milton Friedman and it really enlightened me a tremendous amount. I suggest checking out these episodes and transcripts of Milton Friedman’s film series FREE TO CHOOSE: “The Failure of Socialism” and “What is wrong with our schools?” and “Created Equal” and From Cradle to Grave, and – Power of the Market.“If we could just stop the printing presses, we would stop inflation,” Milton Friedman says in “How to Cure Inflation” from the Free To Choose series. Now as then, there is only one cause of inflation, and that is when governments print too much money. Milton explains why it is that politicians like inflation, and why wage and price controls are not solutions to the problem.
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