Politics & Policy

In Arnold’s Ear

What are Warren Buffet and Pete Wilson telling the Terminator?

Arnold Schwarzenegger, a poster child for the American dream, may very well be the next governor of California — a state which is crying out for some economic leadership. Yet not much is known about Schwarzenegger’s economic views. So far, some conservatives are encouraged by the fact that he is Austrian. The implicit assumption many people are making is that he is a Friedmanite devotee and a follower of Austrian economic thought. My answer to that is that while I am from San Pedro de Macoris, I can’t play shortstop nor hit a 90 mile-per-hour fastball.

Since little is known about his economic views, it’s hard to infer what Schwarzenegger is likely to do as governor by the political and economic company he keeps. But so far, his campaign allegiances are cause for concern. First, he appointed ex-governor Pete Wilson as his co-chairman and hired the Wilson political team to run his campaign. He also selected super-investor Warren Buffett as his campaign’s financial advisor. Unless Wilson or Buffett repudiate their past economic views, it’s unlikely that either one will recommend a pro-growth agenda.

Prior to 1991, when Wilson’s governorship began, California had benefited from a large surge in capital-gains tax revenues. Back then, the surge was largely due to a change in the federal law that raised the capital-gains tax to 28 percent from 20 percent. In order to avoid the higher tax rate, people realized their gains, which led to an unexpected increase in tax revenues. Viewed this way, it is obvious that the surge in revenues was a “one time gain.” However, the state made a fatal mistake: It projected the revenues to continue into the future. As a result, state spending rose to meet the now “permanently” higher revenues.

Once the “one time” surge in capital-gains realizations subsided and the state tax revenues fell back to their normal trend, the state budget deficit grew. The proper solution was to reduce spending to meet the lower revenues. Instead, the governor pushed through a Solomonic concoction of spending cuts and tax increases. When California went into a recession, the governor attributed the state’s woes to the national recession and to the reduction in defense spending. This argument did not hold water.

Other states experienced a similar reduction in defense spending per capita and did not fall off the cliff like California. Also, workers and businesses were leaving the state in droves while the neighboring states enjoyed economic recoveries. In fact, some of Fife Symington’s advisors argued that Pete Wilson was the secret weapon in Symington’s re-election as Arizona’s governor. California’s tax increase did the state’s economy in.

People may also forget that Wilson was the one who set up California’s energy “deregulation” policy, which was a time bomb for the state’s energy and economic situation. The Wilson energy policy gave his successor Gray Davis the opportunity to further compound the mistakes of the past and make the state much worse off.

Will Arnold Schwarzenegger make the same mistakes his “sensible” co-chairman made when he was governor? Hopefully not. However, the comments made by Schwarzenegger’s financial advisor only reinforce the concern.

In a recent interview in the Wall Street Journal, Warren Buffett hinted that state property taxes need to be higher in California. He pointed out that his property tax is $14,401 on his $500,000 Omaha home, while he only pays $2,264 on his $4 million California home. He also pointed out that his property taxes have gone up $1,920 in Omaha while only $23 in California. He attributed the small increase to California’s Proposition 13, which limits the increase in property taxes to 2 percent a year. But he neglected to say that if he were to sell his home today, the new property tax would rocket up to $40,000, or 1 percent of the purchase price. From that point on, tax increases would be limited to a maximum increase of 2 percent a year until the property again changes hands.

Here’s another way to view it: At 1 percent of property value, the Buffett California house was purchased, at most, for $200,000. Imagine a middle-class family who bought a comparable house for that amount, say 30 years ago. Imagine also that the family is now retired and living on a fixed income. If the property tax were adjusted every year to 1 percent of the market value, the retired family would now have to cough up $40,000 in property value every year. Obviously, in these conditions, many retirees would be forced to move. That is what Howard Jarvis, one of the crusaders behind Prop. 13, was trying to prevent. When people move to a retirement home or die and their homes are sold, the tax base will adjust and the new owners will pay the higher property taxes.

Upon reading the interview in the Journal, one gets the impression that this is not what the sage of Omaha was after. Buffett hinted that California’s property taxes were lower than those in his state (i.e., were below average), and that they should be brought to his state levels. But this is also a dangerous train of thought: He seems to suggest that California should increase every tax rate that is lower than other states, despite the fact that it is very hard for anyone to argue that California is under-taxed.

Comparing California’s tax collections with the average of all the states, California ranks near the top of the charts. During fiscal year 2001, the per capita revenues for California ranked 6th in the nation. Per $1,000 of personal income California ranks a little lower — 8th.

California also has a much more progressive tax structure (i.e., the tax rate rises faster as income increases) than most of the remaining states. At the same time it also has a narrower base (i.e., it excludes lower-income people from the tax rolls). This means that the average is being brought down by the inclusion of “non-taxpayers” (those with income low enough to fall off the tax rolls) in the tax-burden calculation. Therefore, those who pay taxes in California face a much steeper tax structure and a higher tax burden than in most other states.

The annual growth of tax revenues and personal income from 1991-2001 provides additional evidence of the progressiveness of the California tax code — and that the state’s problem is not a lack of tax revenue. The resurgence in the national economy was indeed a rising tide that lifted all boats. Given the absence of major tax increases at the state level, the excess of tax-revenue growth over personal-income growth experienced by California is only possible under a progressive tax structure that pushes people into higher tax brackets as income rises.

All state tax revenues have grown faster than income in the last decade. California, having a more progressive tax structure, experienced even faster revenue growth. The data suggest that California’s problems are not due to a lack of revenues. In fact, they can be blamed on a lack of prudence. The state forgot to set aside some of the revenues in excess of income growth for a rainy day. Progressivity works both ways — during times of rising income, revenues grow faster than income. However, during recessions, revenues fall faster than income. That is exactly what happened to California.

During the boom, capital-gains tax revenues surged. This accounted for a large percentage of the state revenues, but rather than treating these revenues as one-time additions, the state treated them as recurring revenues. The reason for this is obvious: A recurrent revenue allows a state to increase spending, dollar for dollar, while a one-time revenue allows a state to increase permanent spending only by the income generated by the one-time collection (i.e., the equivalent of the interest earned on the one-time revenues). It was excess spending, not a lack of revenue, that did California in.

The solution to the problem in California today is to reduce spending without raising taxes.

Looking at their résumés, it’s hard to believe that Pete Wilson and Warren Buffett are going to recommend that Gov. Arnold Schwarzenegger pursue this course of action and not raise taxes. Wilson did not do this when he was governor and Buffett is clearly suggesting a tax increase. Perhaps the only hope is that Democratic challenger Cruz Bustamante forces Schwarzenegger to try to capture the followers of conservative candidates Bill Simon and Tom McClintock. This will require him to focus on a non-new-tax, pro-growth agenda.

Otherwise, California is in for a repeat of the Wilson-era meltdown.

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