Existing law authorizes and directs the Governor to execute a compact on behalf of the state with each or all of the 11 western states and the States of Alaska and Hawaii for the purpose of cooperating with those states in the formation of a Western Interstate Commission for Higher Education. Existing law requires that notice of intention to withdraw from the compact be executed and transmitted by the Governor.

This bill would make nonsubstantive changes to those provisions.

Date of Hearing: April 16, 2018

ASSEMBLY COMMITTEE ON REVENUE AND TAXATION

Autumn R. Burke, Chairwoman

ABPCA Bill Id:AB 2351 (

Author:Eggman) – As Amended Ver:March 19, 2018

2/3 vote. Fiscal committee.

SUBJECT: Higher Education Assistance Fund: personal income taxes: additional tax

SUMMARY: Imposes, under the Personal Income Tax (PIT) Law, an additional 1% tax on taxable personal income in excess of $1 million, and deposits the additional tax revenue into the Higher Education Assistance Fund (HEAF) to expand the availability of student financial assistance for students attending the University of California (UC), the California State University (CSU), and the California Community Colleges (CCC). Specifically, this bill:

1. Imposes, on or after January 1, 2020, an additional tax of 1% on taxable personal income in excess of $1 million.
2. Prevents this tax from being reduced by a tax credit.
3. Provides that the $1 million tax bracket will not be subject to indexing for inflation, and provides that the tax applies regardless of filing status.
4. Establishes the HEAF in the State Treasury. Moneys in the fund are continuously appropriated, as specified, to the Student Aid Commission for the funding of student financial assistance for in-state undergraduate students, not subject to nonresident tuition and fees, enrolled at a UC, CSU, or CCC.
5. Provides that the additional tax revenue shall be utilized to expand the availability of student financial assistance to eligible students attending public postsecondary educational institutions in the state. The funds shall supplement, and not supplant, existing state, federal, or private funds currently utilized to provide student financial assistance.
6. Provides that the additional tax revenue shall not be construed to modify the obligation of public postsecondary institutions to provide student financial assistance, or be construed to modify or reduce the existing authority or responsibility of the Office of the Chancellor of the CCC or the Student Aid Commission.
7. Provides a transfer schedule and funding mechanism substantially similar to the Mental Health Tax (MHT) provisions under Revenue & Taxation Code (R&TC) Section 19602.5. No later than March 1, 2022, and each March 1 thereafter, the Department of Finance, in consultation with the Franchise Tax Board (FTB) would determine the "annual adjustment amount" for the following fiscal year (FY).
8. Leaves the "estimated tax liability increase from the additional tax" for tax years 2021 through 2024, and the "estimated revenue from the additional tax" for FYs 2020-21 through 2023-24, unspecified.
9. Provides that the provisions of this bill are contingent upon voter approval of Assembly Constitutional Amendment (ACA) 13, which excludes the revenue generated by this tax from the General Fund and excludes the appropriations from constitutional limitations.

EXISTING LAW:

1. Imposes seven different PIT brackets, at the federal level, on individuals ranging from 10% to 37%. Each tax bracket applies to a different range of income.
2. Imposes six permanent and three temporary rates ranging from 1% to 12.3%, at the state level. Each tax bracket applies to a different range of income, and the FTB is required to adjust the tax brackets each year based on the change in the California Consumer Price Index.
3. Imposes an additional 1% tax on the portion of a taxpayer's taxable income that exceeds $1 million, known as the MHT.

FISCAL EFFECT: The FTB estimates that this bill will result in revenue gains of $0 in FY 2018-19, $1.3 billion in FY 2019-20, and $2.1 billion in FY 2020-21.

COMMENTS:

1. The author has provided the following statement in support of this bill:

In 1960, the Master Plan for Higher Education was developed to increase access to and improve the quality of higher education in California. For decades, students benefitted from the state's robust education system, often graduating with little to no debt. This is no longer the case. Increasing access and opportunity is not only an investment in students, but in the future of California's economy and workforce. Over the last 50 years our students and the state as a whole have been shortchanged by a system that is moving further and further from its original mission. This bill provides a chance to right the course, and to forcefully declare that higher education is a right that should be afforded to all of California's students.

1. Proponents state that "AB 2351 would establish the Higher Education Assistance Fund with the goal of providing tuition‐free higher education to all qualified California students. It funds itself through a 1 percent tax on incomes exceeding one million dollars." Proponents argue that "[t]here is a strong economic case for a free public higher education. The Public Policy Institute of California (PPIC) estimates that California will be over 1 million college graduates short to meet the demands of California's economy by 2030. Yet the CSU turned away 31,000 qualified students this past year due to funding. This trend will only get worse without action as more California high school students meet CSU qualifications and need access." Finally, proponents argue that "[e]ducation is the driving force of California's economy and is one of the strongest solutions to poverty. Every dollar the state invests in the CSU generates more than five dollars for California's economy. Research has continually confirmed that having a bachelor's degree increases long‐term earnings. This translates into increased income tax revenue and a reduced reliance on other state services."
2. Opponents state "[w]hile we agree that funding higher education is an important policy issue, we disagree with the proposed revenue source set forth in AB 2351. AB 2351 proposes to add another 1% tax on top of what is already the highest personal income tax rate in the country by far – raising the existing 13.3% tax rate on individuals who have taxable income of $1,000,000 or more to a 14.3% tax rate. As recently reported by the Legislative Analyst's Office (LAO), the top one percent of income earners is largely from capital gains, and therefore, the revenue received is volatile and difficult to predict."
3. Committee Staff Comments:
   1. Background: Throughout California's history, governors, the Legislature, and the voters have imposed progressive tax brackets on the highest income earners. Beginning with Governor Ronald Reagan, a 10% tax bracket was enacted in 1967 and later raised to 11% in 1971. In the early 1990s, California faced a severe recession, which resulted in significant shortfalls in the state budget. In response, the State acted to increase revenues and reduce expenditures. The Legislature and Governor Pete Wilson, in addressing the issue, increased the PIT rates by adding a 10% and an 11% tax bracket for the State's highest income earners and increasing the AMT rate from 7% to 8.5% [SB 169 (Alquist), Chapter 117, Statutes of 1991]. In 1991, the 10% rate was imposed on filers with incomes over $100,000 (single) and $200,000 (married filing jointly). The 11% rate was imposed on filers with taxable incomes over $200,000 (single) and $400,000 (joint filing). These income thresholds were increased for inflation each year; by 1995, the 10% rate was imposed on filers with taxable incomes over $109,936 (single) and $219,872 (joint filing), and the 11% rate was imposed on filers with taxable incomes over $219,872 (single) and $439,744 (joint filing). In 1995, supporters of a permanent extension of the tax bracket rates placed Proposition 217 on the ballot. The measure would have continued the 10% and 11% tax rates permanently and allocated revenue to schools and local governments. Proposition 217 failed narrowly by 2/10ths of one percentage point.
      
      In February 2009, in an effort to deal with a $20 billion budget deficit, the California Legislature voted to add 0.25%, or twenty-five basis points, to the tax rate for all brackets for the 2009 and 2010 tax years. [ABx3 3 (Evans), Chapter 18, Statutes of 2009.] The Legislature also proposed to the voters to extend this 0.25% increase to the 2011 and 2012 tax years, but the voters did not approve Proposition 1A (2009) in the May 19, 2009 special election.

In 2012, voters approved Proposition 30, which, among other things, required high-income taxpayers to pay an extra 1%, 2%, or 3% tax on part of their incomes. Specifically, the marginal tax rate on taxable incomes above $250,000 (single) and $500,000 (joint filing) was increased to 10.3%; the marginal tax rate on taxable incomes above $300,000 (single) and $600,000 (joint filing) was increased to 11.3%; and the marginal tax rate on taxable income over $500,000 (single) and $1 million (joint filing) was increased to 12.3%. The voters extended the income provisions of Proposition 30 through 2030 with the passage of Proposition 55. In additional to these high-income rates, a 1% marginal tax rate for mental health services applies to taxable income in excess of $1 million. As a result, the marginal tax rate on taxable income in excess of $1 million is currently 13.3%. If the provisions of this bill were to be enacted, the highest marginal tax rate would increase to 14.3%.

• 1. Progressive Taxation: Currently, California has a progressive taxation system. A progressive tax is one where the tax rate increases as the taxable base amount increases. As explained earlier, California has various tax rates, each increasing as the base increases. There are several schools of thought addressing this issue. Generally speaking, there are those who believe in a progressive system of taxation, and those who do not, preferring other methods of taxation, such as a flat tax.

The argument against a progressive tax system is similar to the one espoused by Austrian economist and author, Eugen Von Bohm-Bawerk. Addressing the concept in his work, Karl Marx and the Close of his System, Von Bohm-Bawerk focuses his argument on the consumption of goods versus the consumption of capital. Applying the concept of diminishing returns, as income rises, a smaller portion of that income will be used for consumption of goods. By default, a larger portion will be used for capital investments, which will generate more income for more capital investments. By purchasing more and more capital goods, the cost of production begins to fall and begins to elevate the standard of living. A progressive system of taxation would increase the tax rate on higher income individuals, reducing the amount of income available for capital investments and thereby reducing improvements to the standard of living.

This argument against a progressive system of taxation, however, fails to address the issue of a growing gap between those who have capital investments generating an exceedingly greater amount of income and those who are just able to pay for life's necessities. Because low-income earners spend a larger share of their income on necessities, they have a much smaller portion of income left over to make their own capital investments. The argument also fails to address the elimination of jobs from increased capital improvements. For example, a company employing 10 workers may decide to purchase large capital equipment, eliminating the need for those workers. The machine can perform the same amount of work, but the business will become more efficient by reducing its labor costs in subsequent years.

The idea of a progressive tax system has gained acceptance from a wide range of individuals. Writing in The Wealth of Nations, Adam Smith outlined the hardship and burden that lower income individuals have in society. Specifically, Smith focused on the necessities of life, on which low-income individuals spend a much larger percentage of their income. In recognizing the disproportionate impact on the poor, Smith stated "it is not very unreasonable that the rich should contribute to the public expense, not only in proportion to their revenue, but something more than in that proportion." Other arguments also encourage the use of a progressive taxation system because individuals with greater capital are also more likely to take advantage of societal benefits supported by taxation, such as defense, infrastructure, and the protection of property rights. Individuals who control larger sums of capital are also able to take advantage of economies of scale, a wider range of investment opportunities, and are able to more directly participate in shaping government. By providing a progressive tax system, democracies are better able to enhance economic opportunity for the lower and middle classes.

• 1. Revenue Volatility: Revenue volatility is related to both California's economic cycle and its tax structure. As noted in Revenue Volatility in California by the Legislative Analyst's Office (LAO), California's economic cycle has historically been more volatile than the nation's economic cycle due to the presence of high-paying, cyclical technology-related industries and the housing sector. In addition to the historic volatility of California's economic cycle, revenue volatility has also been an issue because of California's increased dependency on the PIT. According to the LAO's report, Volatility of California's Personal Income Tax Structure, the graduated rates structure on higher income filers makes the PIT revenue more volatile because aggregate income reported by high-income filers has been much more volatile than incomes reported by low-income filers. According to the LAO, taxing higher income filers at higher rates amplifies the volatility. In fact, the LAO found that about 40% of the California's PIT volatility is due to the rate structure, which currently taxes higher incomes at higher rates. Increasing the marginal tax rate on taxable income in excess of $1 million, as this bill proposes, will likely further increase volatility.
     
     The LAO's report mentioned several ways in which California could reduce the volatility of its revenues. One of the proposed approaches was reducing the progressivity of the basic PIT structure, which would involve flattening the PIT structure by increasing the tax rates on lower and moderate-income earners and reducing the tax rates on high-income earners. Other suggestions included increasing the State's reliance on alternative tax revenues. Specifically, the State may be able to reduce its dependence on the PIT by extending taxes to services, which tend to be relatively stable during a business cycle, or by increasing property taxes.
     
     With regard to property tax, revenues generated from the levying of taxes on property tend to be the most stable of the major state and local sources. According to the Commission on the 21^st Century Economy, property taxes are more stable because property tends not to fluctuate as much as other tax bases in response to the business cycle, most notably the PIT. Prior to 1978, property tax was assessed at the market value. However, in 1978, voters passed Proposition 13, which limited assessments to the property's acquisition value, plus an annual increase capped at the lesser of 2% or the rate of inflation. Proposition 13 also added a two-thirds vote requirement for raising taxes. After the passage of Proposition 13, there was a dramatic drop in property taxes relative to personal income. Property tax as a share of personal income dropped from 5% in FYs 1977-78 to 2.4% in FYs 2005-06. In terms of preventing volatility in the state's revenue, Proposition 13 made it incredibly difficult to raise revenue from one of the most stable sources.
  2. Budgeting: It is also important to note that volatility is not inherently undesirable; it is only a problem if state government operates with an expectation of stability. If the Legislature properly addresses the issue of volatility within the budget, state-funded programs and other costs could be properly managed without having to restructure California's tax system. In 2014, the Legislature and voters took steps to address their budgetary issues by approving Proposition 2, which sets aside revenues during good budget years in order to help stabilize the budget during bad budget years. Proposition 2 does not change the tax base or the rate structure. As such, Proposition 2 does not change the PITs volatility.
  3. Implementation Concerns: According to the FTB, "[a]bsent specified amounts for the "estimated tax liability increase from the additional tax" and "estimated revenue from the additional tax," it is unclear how the transfer would be implemented."
  4. ACA 13: This bill may only become operative if ACA 13 is approved by the voters. ACA 13 provides that the funds generated by this tax will not be subject to the Gann limit and will not be deemed to be General Fund revenue. ACA 13 is pending referral by the Assembly Rules Committee.
  5. Double-Referral: This bill is double-referred to the Assembly Committee on Higher Education.

REGISTERED SUPPORT / OPPOSITION:

Support

California Faculty Association (Sponsor)

National Association of Social Workers

Opposition

California Apartment Association

California Beer and Beverage Distributors

California Business Properties Association

California Chamber of Commerce

California Taxpayers Association

California Restaurant Association

Family Business Association of California

National Federation of Independent Business

Analysis Prepared by: Carlos Anguiano / REV. & TAX. / (916) 319-2098