Tax Reform: Good Ideas but Plenty of Political Risk : Policy: Experts say state’s revenue system is outdated. November vote on sales tax hike could force an overhaul.

States tend to embark on tax reform under one of three conditions: When the federal government has changed its tax system, when a governor is starting a fresh term and when there is fiscal crisis.

All of those conditions will be present in California within the next 16 months. But will the state’s leaders seize the opportunity to streamline and modernize what they concede is a creaky, outmoded tax system?

In part, the answer may turn on the Nov. 2 election, when California voters will decide whether to make permanent a half-cent sales tax increase enacted temporarily in 1991.

The money would go to cities and counties, which have been forced by the state to turn over nearly $4 billion in property tax funds to pay for state financing of public schools. If the proposition fails, Sacramento will have to forge an alternative fiscal bailout--or watch cities and counties make devastating cuts in local services.

Yet the need for tax reform goes far beyond local government finance.

During a five-month study, experts told The Times that much of California’s tax system is substantially the same as it was in the 1930s, that it has failed to keep pace with a changing California economy. The relationship between state and local governments has become virtually dysfunctional in the aftermath of Proposition 13, the 1978 property tax revolt ballot measure.

An opportunity for reform may be provided next year by the creation of a 23-member California Constitution Revision Commission to study the budget process. The commission may study the state tax system as well.

Here are some of the major proposals for fixing the state tax system--some from the political right, some from the left and most from academic public policy experts:

* SALES AND USE TAX

Proposal: Expand the sales tax base by taxing services and such items as sports and amusement park tickets, candy and legal work in order to reduce the overall sales tax rate from as high as 8.5% to less than 6%.

Almost universally, state officials and tax experts say the sales tax is one of the most antiquated of California’s levies.

Just as when it was adopted in 1933, the sales tax primarily applies to tangible consumer goods, such as clothing, autos and furniture. The tax does not apply to prescription drugs and most groceries. Also excluded are a variety of items, from candy bars to farm fertilizer, under exemptions gained by industry lobbyists over the years.

The sales levy has borne the brunt of statewide tax increases in recent years, to the point that California now has one of the nation’s highest rates, ranging up to 8.5%. But there are so many exemptions that the base is narrow. The net result: In 1991, California ranked 24th in sales tax collected relative to personal income.

Tax experts say this outcome violates the most fundamental hallmark of a good tax system--having the broadest possible base and the lowest possible rate.

A UC Davis study completed this year concluded that California--by expanding the sales tax base so that more items are taxed--could generate enough new revenue to lower the high rate by nearly 3 cents on the dollar, down to 5.75%.

Many industrial states tax a wider range of services and entertainment activities. A recent survey by the Federation of Tax Administrators shows that California taxes only 19 out of a possible 160 services--fewer than all but six states. If the state imposed just a 1% gross receipts tax on all but medical and educational services, it could collect an extra $1.2 billion a year, an Assembly committee estimated this year.

Such wholesale change is tough, as officials in Massachusetts and Florida will attest. Efforts in those two states to tax a wide range of services were beaten back by public outcry.

Still, most experts recommend a gradual push to tax such services as haircuts, pest control, shoe repair, linen cleaning and legal fees--as well as professional sporting events and amusements--in order to widen the tax base.

A tax reform advisory commission appointed by then-Gov. George Deukmejian in the mid-1980s made a similar proposal, as well as recommending further study of the tax system. The proposals were largely ignored.

* PERSONAL INCOME TAX

Proposals: Make permanent the temporary 10% and 11% top income tax brackets for the most wealthy Californians and reduce deductions available to the rich. Alternatively, cut the top rates to encourage investment.

California has one of the nation’s most progressive state income taxes. There is little or no tax on the income of lower-income Californians, only a modest take on those in the middle and a heavy bite on the most affluent Californians. The top tax rates on the wealthiest were reduced in 1986 from 11% to 9.3%. The higher rates were restored temporarily in 1991 to help offset the state’s budget crisis but are set to expire at the end of 1995.

Some Democrats and liberal tax reformers believe those higher top brackets should be made permanent. Conservative tax organizations such as the Center for the California Taxpayer argue that rates should be reduced further to encourage the wealthy to put more income into job-generating investments.

Some conservative economists have proposed going to a single-rate flat tax in California, but the proposal has not received much serious attention.

Like much of California’s tax system, the income tax base is significantly narrowed by exemptions, credits and loopholes. The largest is the home mortgage interest deduction, which costs the state about $2.5 billion a year. There has been no serious proposal that this popular deduction be eliminated, though some argue that it should be capped at mortgages under $500,000 and eliminated on second homes.

Other suggestions have been to tax Social Security and unemployment benefits as the federal government does, giving the state an additional $300 million; to suspend indexing of the income tax now that inflation is at lower levels ($400 million), and to repeal a provision that allows certain corporate losses to be deducted from personal income ($500 million).

A constant goal of many reformers is to tailor the state tax return to the federal return, thereby making the state paperwork as painless as possible. California made considerable progress in that direction after the federal tax reforms of the 1980s.

The ultimate goal, advocated by groups such as the Center for the California Taxpayer, would be to simply pay the state a specified fraction of federal tax. That would save the state some costs of administering its income tax. But legislative tax writers oppose a one-step state return because it would prevent them from adopting special deductions or credits unique to California.

* BUSINESS TAXES

Proposal: Raise some corporate taxes or close loopholes, based on the argument by some that businesses should pay a larger share of taxes in California.

Liberal tax reformers argue that businesses should bear a greater share of the California tax burden. Yet a voter initiative to boost the corporate tax rate to 10.3% and to raise other taxes on businesses and the wealthy was defeated in 1992. Opponents said the measure would drive businesses out of state and hurt all California workers and consumers.

Officials have expressed concern that the state corporate income tax, a 9.3% levy on net profits, has failed to keep pace with economic growth since the mid-1980s.

Revenue collected from the major business tax--the bank and corporation tax--”is the most volatile and difficult” to predict because the tax base can fluctuate dramatically in response to economic conditions, said Legislative Analyst Elizabeth G. Hill. This makes it difficult to budget prudently, she said.

A national expert on state taxes, Stephen D. Gold of the Rockefeller Institute of Government, has said California should consider replacing the corporate income tax with a value-added tax. Under the value-added plan, products are taxed at each stage of production. Such a system makes the revenue stream more stable and predictable, Gold said. But this proposal has gathered little support among state leaders.

There is periodic pressure to impose a severance tax on oil and gas extracted within the state. California is the only major petroleum-producing state without such a severance tax. Levies in other big oil and gas states range up to 12.5% of market value, as in Louisiana. The California petroleum industry has argued, successfully so far, that such a tax would make its products less competitive. The state does collect an extraction fee of about 2 1/2 cents a barrel--or about two-tenths of 1% of the value of the oil.

As for business leaders, they are more inclined to support lower tax rates than they are to back special incentives or tax credits of the sort adopted by the 1993 Legislature, according to a nationwide survey of executives by the accounting firm Coopers & Lybrand.

Of 375 executives polled, 45% preferred lower rates. Only 21% mentioned particular credits or incentives. Another 25% said they would like to see more uniformity in tax laws of the states.

* PROPERTY TAX

Proposal: Return the bulk of property tax revenues to city and county governments.

For city and county officials, the most urgent task facing government in California is to straighten out the problems created by the passage of Proposition 13 in June, 1978. They say it is critical that local governments receive a stable and reliable long-term source of revenue.

As the state budget sank into the red over the past three years, Gov. Pete Wilson and the Legislature pulled back state aid that local governments had been getting since 1978 to compensate for vanished property tax revenues. The 1993 budget completed the transfer of $3.9 billion in remaining property tax revenue from cities and counties, using the money to fund state education.

In exchange, the state gave the cities and counties the proceeds from a temporary half-cent sales tax through the end of this year. At a special election Nov. 2, California voters will decide whether to make the half-penny tax permanent, with the proceeds earmarked for local law enforcement.

Reformers decry the growing reliance of local governments on sales taxes. It has prompted cities and counties to compete fiercely for high-volume retail outlets such as shopping centers and auto malls at the expense of housing, manufacturing and sound land use planning.

Several influential figures have proposed that the bulk of the property tax--the traditional tax base of local government--be given back to cities and counties. Under one plan, by Legislative Analyst Hill, local government’s current sales tax revenues would be turned over to the state to help finance public education.

* PROPERTY TAX SPLIT ROLL

Proposal: Tax all business property on the basis of its current market value.

Two UC Davis studies published this year have proposed that all commercial and industrial property in California be periodically reassessed at full market value, creating what is known as a split roll. Residential property would continue to be reassessed only when it changes ownership or undergoes substantial remodeling, as stipulated by Proposition 13 in the California Constitution.

The studies recommend a split roll because it would put all companies on an equal property tax footing. As it is now, older firms pay relatively lower property taxes than new companies trying to gain a foothold.

One study recommended phasing in the split roll over four years, a plan that would yield an additional $10 billion annually when fully in effect. The study proposed that some of the new money be used to eliminate many of the fees that local governments have imposed on development projects since 1978 to make up for revenue lost to Proposition 13.

* MAJORITY VOTE

Proposal: Allow voters and legislative bodies to raise taxes by majority vote.

Another controversial proposal is to eliminate provisions of Proposition 13 that require a two-thirds vote in both houses of the Legislature to pass any statewide tax increase and the same margin among local voters to approve any city or county special tax.

These mandates--along with a two-thirds requirement to pass the annual state budget that predates Proposition 13--are largely responsible for the gridlock that has characterized Sacramento, according to many tax experts and students of state government.

The plan authored by Hill would allow local government to exceed the Proposition 13-established property tax rate of 1% if a simple majority of local voters approve. Whether such a reform is politically possible may depend on how severe the problems of local government become.

Democrats tend to favor eliminating the two-thirds rules, but most Republicans oppose the idea.

State Treasurer Kathleen Brown said: “I want home rule. I want accountability. I want the ability to build and invest in this state based on what a majority of the people of this state want. It’s more fiscally responsible. It’s more democratic.”

Joel Fox of the Howard Jarvis Taxpayers Assn. counters that the two-thirds vote requirement is justified in some instances.

Fox cited recent Los Angeles city proposals to raise property taxes to pay for additional police. Because those who would be forced to pay the bill--homeowners--are a minority, he argued, that minority should have the power to block such a proposal. Both city proposals failed when they got more than a majority vote but less than the two-thirds needed.

California is one of the few states requiring a two-thirds vote in its Legislature to pass a budget or raise any tax. Assemblyman Johan M. Klehs (D-Castro Valley), chairman of the Assembly Revenue and Taxation Committee, said the provision is especially frustrating because it takes only a majority vote to grant a tax break to an industry with an effective lobby.

Lawmakers in other states “often ask how we even survive in California,” Klehs said. “We say we don’t.”

* CONSOLIDATION

Proposal: Consolidate the State Board of Equalization and the Franchise Tax Board into a single state Department of Revenue.

Most tax experts agree that California should combine its two major tax collection and administration agencies--the State Board of Equalization, responsible for sales and property taxes, and the Franchise Tax Board, which oversees the personal and corporate income taxes. California is the only state that does not have a single department of revenue to administer all taxes.

The Franchise Tax Board has about 4,000 employees and an annual budget of $200 million. The Board of Equalization has 3,000 employees and a budget of $232 million.

Board of Equalization Chairman Ernest J. Dronenburg Jr. of San Diego says consolidation of administrative functions could save money. But he said there could be no wholesale job eliminations because the staff members’ “ability to manage the workload will probably be the same whether there’s one agency or two agencies.”

And there might be some additional cost in buying a new computer system that would be compatible with all operations of the new agency, he added.

The benefit, Dronenburg said, is eliminating public confusion over two agencies with side by side responsibilities for different taxes.

Consolidation efforts have been stymied by political turf fights; both boards are run by elected officials or their appointees. A consolidation bill has gotten through the Assembly for the first time this year. It would retain the elected Board of Equalization as the governing tax body.

About This Series

“California Taxes,” a six-part series that ends today, is the result of a five-month analysis of the state tax system by reporters Bill Stall and Ralph Frammolino.

At a glance, here are the series’ six parts:

* Sunday: Myths have obscured public debate over taxes and blocked serious efforts toward reform.

* Monday: Are state taxes fair? The Times examines who bears the burden and talks with Southland taxpayers about their views.

* Tuesday: Businesses have gotten their way for decades with special pleas to the Legislature.

* Wednesday: The California tax system is riddled with loopholes.

* Thursday: Proposition 13 did what it said it would do--lower property taxes--but it also did a lot more, much of it unintended.

* TODAY: How should the state tax system be changed?