December 2001

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State Budget 

David R. Doerr is chief tax consultant for the California Taxpayers’ Association and author of “California’s Tax Machine – A History of Taxing and Spending in the Golden State.”

Taxpayer behavior during the current economic downturn suggests a merger of the disciplines of economics and psychology. With unemployment rising and income growth slowing, it is logical to assume that there would be a parallel drop in the estimates of earnings (as measured by taxable income) and consumption (as measured by taxable sales.)

However, recent data released by the Department of Finance suggest that such is not the case. The most recent report on revenue collections shows revenue from personal income tax at $698 million below estimates for the first four months of the fiscal year (July through October), while sales tax revenues are $11 million above estimates.

This same phenomenon occurred in 1991. After passage of Governor Pete Wilson’s $7 billion tax increase, it was estimated that the sales tax would generate $17.2 billion and the personal income tax would generate $19.6 billion. The sales tax came in $299 million higher than estimates and personal income revenues were down $2.4 billion below estimates.

Before we decide to tar and feather the state’s fiscal gurus as charlatans masquerading as experts, perhaps we should explore what might be the cause of this seeming inconsistency.

My theory is this: Just as government finds it difficult to reduce budgets, so do taxpayers. In fact, most people will fight like hell to maintain their current standard of living (generally a standard of consumption). Faced with a decline in earned income, it is likely that people will try to maintain close to current consumption, at least in the short run, by any combination or all of the following: use of savings, adding to credit card debt, and receipt of transfer payments (such as unemployment insurance) that are non-taxable.

This behavior would explain the strange phenomenon of sales tax exceeding fiscal estimates in sour economic times while personal income tax receipts plummet.

When Proposition 13 passed in 1978, many people were surprised that it had little effect on local spending (see Legislative Analyst’s Office 1979 report) despite the predictions of doom and gloom from reduced property tax revenue. In this instance, government acted in much the same way it is hypothesized that individuals act during hard times. Local governments used savings (many had large reserves at the time), borrowed (either with bonds or by use of “smoke and mirrors” to shift income and expenses), and relied on transfer payments (the state’s bailout).

Among lessons that can be learned from this analysis: The state should be wary of income tax fixes in times of economic downturns.