Has California Hit the Limit on Tax Rates?

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The share of people in the top income bracket who moved out of state climbed from 1.5% to 2.12% annually after California’s tax hike. | iStock/eyecrave

In 2012, after a remarkable campaign by Gov. Jerry Brown, California voters approved a ballot initiative that substantially raised state tax rates on top earners — especially those earning more than $1 million a year.

The Proposition 30 tax increase did generate more revenue, though it got huge help from the state’s booming economy. California’s budget swung from a $27 million deficit in 2011 to a $21 billion surplus in 2019.

But a new study led by Joshua D. Rauh, a professor of finance at Stanford Graduate School of Business and a senior fellow at the Hoover Institution, finds that revenue gains were barely half what they would have been if all the state’s top earners had actually paid the higher rates.

Why? Because many of those people escaped the increase by either moving out of state or finding ways to reduce their taxable incomes.

What’s more, says Rauh, the erosion has probably increased even more since then, because Congress largely eliminated the federal tax deduction for state and local taxes in the $1.5 trillion tax cut of 2017. In effect, that amounted to a second tax hike for Californians.

The Laffer Curve

The result, Rauh says, is that California may now be on the “wrong side of the Laffer curve” — a reference to the famous proposition by Arthur Laffer that, at some point, higher tax rates will lead to lower tax revenues.

“The good news, for people who don’t believe in the Laffer curve, is that California did take in more money — even if it was only 50 cents on the dollar,” Rauh says. “But that’s cold comfort when you recognize that in 2018 you effectively had a second Prop. 30. It seems quite likely that California is now on the wrong side of the Laffer curve.”

Rauh, who collaborated with Stanford GSB doctoral candidate Ryan Shyu, essentially measured two separate potential responses to the tax increase.

The first was to see how many additional top earners moved out of California after the tax increase took effect. Critics of higher state taxes have long argued that many people will respond to a tax increase by moving to a state with lower taxes or no income taxes at all.

The researchers found that Prop. 30 did seem to prompt an increase in departures. The share of people in the very top bracket who annually moved out of state climbed from 1.5% in the years before 2012 to 2.12% in the years afterward. Not surprisingly, states with no state income tax — notably Nevada and Texas — were among the most popular destinations.

The much bigger erosion, however, was triggered by declines in the taxable state incomes that Californians in the very top bracket were reporting. Those people, with incomes above $1 million, saw their top rate jump from 9.3% to 12.3%.

To measure the income-reduction effects, the researchers focused on taxpayers who had consistently been in the top tax brackets in the years before and after Prop. 30. The average income of that group was $4.15 million, and they paid about half of California’s income taxes.

Moving Away vs. Tax Avoidance

To figure out how much those taxpayers were modifying their taxable incomes, the researchers took advantage of a peculiarity of California: Even if a person lives out of state, the state taxes income from California sources, which means that many non-residents are still required to file returns with California.

Because of that rule, the researchers were able to compare the returns of residents and non-residents in the very top bracket to see what happened to each group after Prop. 30. The short answer: California’s in-state top earners suddenly found more ways to reduce their taxable incomes. On average, the in-state filers reported $522,000 less income than the out-of-state filers in 2012 and almost $600,000 less by 2014.

Rauh says it’s not clear how much of that decline resulted from people actually earning less or from people who made heavier use of tax-avoidance strategies. Whatever the cause, the bottom line is that the combined effect of out-migration and the reductions in taxable income eroded about 45.2% of the Prop. 30 tax increase in its first year. The erosion increased to 60% by 2014.

Rauh says it’s not entirely surprising that only a small part of the lost revenues stemmed from wealthy people who moved out of state.

“If you’re a tech executive who earns $750,000, it’s not so easy to just move out of state,’’ he says. “But top-income people are the ones most likely to have the resources at their disposal to engage in tax avoidance.”