A Chance to Improve on Tax Reform : Opportunities Exist, if Big Interests Don’t Grab Them

The federal Tax Reform Act of 1986 was marked by the closing--or at least the partial closing--of a variety of tax loopholes and deductions. It shifted some tax burdens from individuals to business, and it reduced or eliminated taxes for people at the lower end of the income spectrum.

As the California Legislature now debates state tax reform, its challenge is to equal, if not improve on, the federal tax reforms.

Opportunities and pitfalls abound. Undoubtedly, whatever is done will be done in the names of “fairness” and “simplicity.” But those goals could, depending on one’s point of view, mean anything from eliminating to expanding the current special-interest tax privileges. Tax rates could also be adjusted, in the name of simplicity, in such a way that the wealthy pay less and the middle class more.

As the Legislature works on its package, a few key issues stand out. How each of these, and certain others, is resolved will largely determine the nature of the tax reform that California will have.

Capital gains : These are taxes that are paid on income earned from investments, as opposed to income earned from work. The federal government, in an important reform, determined to tax all income in the same way, and eliminated the preferential treatment that was given to capital gains. California should do the same. But some interests are fighting hard to maintain special tax privileges for small-business capital gains. Such a break may sound positive, but the definition of “small business” is so broad as to include Ewing Oil of television’s “Dallas” fame. Those most likely to benefit are venture capitalists, not ma-and-pa operations.

Depreciation : Here again the issue is whether to conform or not with the federal system. Conformity would be simpler, but federal depreciation rules--despite some tightening--are more advantageous to business than California’s rules are. Thus conformity would improve the tax position of equipment-intensive industries like oil companies and automobile manufacturers. By enabling those industries to take advantage of more generous depreciation schedules, California would also suffer a significant loss in tax income --up to $300 million--which would have to be made up elsewhere. In the absence of compelling evidence to the contrary, non-conformity may be the wiser choice in this case.

Mortgage-interest deduction: Under both federal and state laws, Californians can deduct the mortgage interest that they pay on two homes. A good case can be made that the “second home” deduction is too generous a break for wealthy individuals and, ultimately, for the real-estate and development industries. But that fight was lost in Washington, and will be lost in California. The issue now is whether or not luxury yachts and motor homes should qualify as second homes. Builders of those “dwellings” will be fighting hard for such qualification.

Deductions for business meals and entertainment: The federal tax law took a modest step toward reducing this so-called three-martini-lunch subsidy. Under the new law only 80%, not 100%, of such expenses are deductible. California should consider greater reductions in this subsidy; at a minimum, we should follow suit.

Tax brackets--personal credits and deductions: This is the arena in which conflicts between “simplicity” and “equity” are most apparent. Those who advocate a less-progressive tax system often couch their argument in terms of simplicity; they propose a tax-rate schedule with fewer tax brackets. Conveniently, most simplicity proposals end up by lowering the rates for the high-income taxpayers and raising the rates for the middle-income taxpayers.

In fact, the number of brackets employed has little relationship to simplicity. Whether there are three brackets or 10, a person still has to determine taxable income and look at a tax table to determine the tax that is imposed on that income. Where the state sets its standard deduction and personal credits will provide one indicator of its readiness to ease tax burdens on lower-income Californians and on the working poor. Higher personal credits and standard deductions will leave more low-income individuals paying lower taxes, or none at all.

The tax-reform battle has not reached far beyond the Capitol. While the amounts of money at stake are huge, the issues are complex and largely inaccessible to the general public. The unfortunate result of such political circumstances is usually disproportionate influence for Sacramento lobbyists representing those with the most at stake--in this case, real-estate interests, equipment-intensive industries, venture capitalists and some others.

Thus far the major bills, while reflecting some influence of business lobbying forces, have maintained a certain progressive integrity. But the final product is not yet on the governor’s desk. The real battle will take place over the next few weeks in a legislative conference committee. In that committee almost everything will be on the table. The opportunities and the pitfalls remain.