Monday, January 26, 2004


Something is amiss in the world of California journalism. Inquisitive energy should distinguish real reporters from the hacks who collect press releases and paste them together, but so many of our state’s news writers have apparently never learned how to ask questions.

Daniel Weintraub’s recent foray into tax policy is a case in point. His January 18 column in the Sacramento Bee uses a peek at preliminary statistics from the Franchise Tax Board to argue that “when the rich aren't getting richer the state is in the poorhouse.” Weintraub bemoans the recent decline in the number of California tax returns showing incomes over $1 million: there were 44,000 income millionaires in year 2000, but only 25,000 of them two years later. While admitting that “normally, an unequal distribution of income is considered bad for society”, the column maintains that “California's skewed income distribution, combined with progressive tax rates, means that the people at the very top of the income heap pay a very high percentage of the personal income tax collected in this state.” Weintraub seems to believe that the super-rich should be pampered and cultivated like rare, fragile orchids, for “When they do well, their wealth is shared with the rest of us. When they do less well, we also pay the price.”

Now, it is true that California tax return data shows a very unequal distribution of income. In 2001 (the most recent year with final data, because the filing date can be extended until the next October, and verification takes time) only one out of every 500 taxpayers was an income millionaire, but these folks had 12.6% of the income and paid 25.5% of the total tax. Indeed, the tax on returns with income over $5 million came to over $3.9 billion. These top 3,347 taxpayers paid over a million dollars apiece but with average incomes over $14 million, it appears they could afford it. These folks at the top had the same total income as the five million taxpayers with income under $22,000.

It is also true that a dramatic increase in high income returns, and in state income tax receipts in years 1999 and 2000 was followed by an unprecedented collapse in 2001. The same FTB Report shows income tax receipts were:

1998 $26BB, 1999 $33 BB, 2000 $40 BB, 2001 $31BB

(Incidentally, this suggests that Governor Schwarzenegger's budget propaganda turns history upside down. The initial cause of California's current budget woes was not reckless spending but was instead the instability and unpredictability of the state income tax system.)

But Weintraub fails to ask three important questions. First, how much of the decline in high income returns is real, and how much is due to the spread of tax shelters? Sophisticated high income tax shelters create paper losses that offset real income, so it won't show up on tax returns in the first place.

The second key question is: how much of the result is due to progressive rates and how much is caused by the skewed distribution of income? How progressive is California's income tax in reality? The answer is: very progressive for low and middle incomes, but not at all progressive for high incomes. The tax as a percentage of income starts at 1% on the first $6K ($12K for a married couple) and rises rapidly to a maximum 9.3% on income above $39K ($78K for a couple). Above that the rates don’t change at all. California collects the same amount of tax on an additional $100 of income whether it is received by a single person making $40K, a couple making $80K, an income millionaire, or one of the 3,347 folks at the very top.

Suppose one million middle class taxpayers with incomes just above the 9.3% bracket point were to earn $1,000 more each. This $1 billion addition to middle class incomes would produce the same increase in State revenues as would an additional $1 billion spread among the income millionaires ($40,000 each) or an additional $300,000 each for those in the exclusive zone above $5 million. Because the marginal tax rate is the same 9.3%, there is no gain from a budget perspective from cherishing and coddling the super-rich at the expense of middle-income taxpayers. Indeed, something may be lost – the work ethic. Weintraub’s use of the phrase “high income earners” to describe the super-rich shows that he hasn’t looked at the tables from which his statistics are plucked. The data show that folks in the $80K to $100K range get more than 80% of their income as wages and salaries from work. However, the income millionaires get only 37% from salaries, with a third of their total coming from capital gains on asset sales and another 21% or so from partnerships and closely held corporations. Above $5 million in income, the return to capital dominates: total salaries are less than a third of total income, and even in a down market about 40% of the income in this range took the form of capital gains that averaged $6 million each.

The final unasked question: has it always been this way? No. Back in 1973, during Ronald Reagan's second term as governor, California added two additional income tax brackets at the top: 10% and 11%. These rates were in effect through 1986. From 1987 through 1990 the top rate was reduced to 9.3%, but the 10% and 11% rates were reinstated in 1991 in response to that year’s budget crisis and remained in effect through 1995. The current rate structure dates from 1996. As recently as 1995 a married couple paid 10%, not 9.3%, on income over $220,000 and 11%, not 9.3%, on income over $440,000. (FTB Report, App. A Table 1-A.)

A few thousand here, a few more there -- it all adds up. Our 29,000 or so income millionaires and the 50,000 wannabes in the $500,000+ range have a strong interest -- about $1.2 billion for each 1% change in the top rate – in having the public forget the past. Certain questions, it seems, should not be asked. Weintraub’s obliging failure to ask them forces an update to Humbert Wolfe’s cynical couplets.

“You cannot hope to bribe or twist
A California journalist.
But seeing what the press will do
Unbribed, there is no reason to.”

Thursday, January 22, 2004

Do Androids Blog with Eclectic Script?

No updates last week. Professor Tax has been researching the recent history of California state budgets and issues in the design of benefit eligibility tests.

Web writing is easy. Any fool can blog. But writing something that is worth the time and attention of an intelligent reader is not easy at all. The Professor has great admiration and respect for folks like Pacific John of Gropinator, Brad DeLong, Billmon and Steve Gilliard who are capable of cranking out intelligent essays on current events on a daily or even hourly basis. Where do they get those extra 25 hours in the day?

So many interesting frauds, from Ponzi schemes to Parmalat, are in the news these days that one almost regrets having to give renewed attention to California’s celebrity Governor. Yet the collision between the synthetic charisma of the Hollywood star and the rational administration of state finances is a continuing drama. Credible reports quote Todd Harris, the spokesman for the Gröpenleader’s $15 billion bailout bond campaign, as saying they will promote "Arnold Schwarzenegger's image as a truth-teller, as someone they trust".

Let’s play that back. “Image as a truth-teller” – what a wonderfully surreal phrase. To seem – to appear - to tell the truth. Lights! Action! Stuntman! In Gov. Gröpenegger’s California, politics is just another special effects camera trick. Here, appearance and reality fuse together into an indistinguishable blur. If only Philip K. Dick were still alive – there should be a great SciFi tale somewhere in all this.

Wednesday, January 14, 2004

Another Budget Detail: Tax Cuts for Rich Heirs

Governor Schwarzenegger’s new budget contains a hidden $1 billion tax cut for the wealthiest Californians -- those who inherit money from multimillionaires. Here's how it works:

The Federal tax law changes enacted back in 2001 phased out the existing Federal credit for state-level taxes paid on estates and inheritances. California defined its estate tax in terms of the maximum amounts that were allowed as Federal law credits: about $390,000 on a $5 million estate and $3.4 million on a $25 million estate. The Federal law change reduced the credit in four yearly steps, down to zero in 2005, but California law didn’t change.

The result: state receipts from this tax that affects only the richest 2 percent of the population decreased from $647 million in 2002-03 to $135 million in 2004-05 – a $1 billion decline from what they would have been otherwise. That's about twice the amount that Gov. Gropinator plans to cut from the budgets for all of California's universities. See the Governor’s Budget Summary, pp. 35-36.

Sunday, January 11, 2004

The Devils in the Details:
A Closer Look at the Governor’s Budget
Plan for the California State Universities

It looks bad enough on the surface. According to the press release from system headquarters: “Governor Arnold Schwarzenegger proposed cutting $240 million or 9 percent from the California State University system for the 2004-05 fiscal year, potentially limiting student access by approximately 20,000 students if the cuts are implemented as proposed.”

But a careful reading of the budget documents shows that this cut is only the first step in a multi-year plan to trash the nation’s largest university system. The 23 campuses of the CSU make up the second tier of California’s uniquely fragmented Master Plan for public higher education: the more prestigious University of California draws the top one-eighth of the state’s high school graduates, while the CSU admits students who are in the top one-third. The numbers are colossal: 23,000 faculty (11,700 full-time professors, and almost as many part-time instructors) teach more than 400,000 students (335,000 “full time equivalents”, if part-time students are counted as fractions), supported by a staff of 20,000 and 1,400 administrators. The CSU campuses award more than 75,000 diplomas every year, including 14,000 masters’ degrees, and prepares over half of California’s teachers, 40% of its engineers and almost half of its business graduates.

The cost for all this? Setting aside self-supporting operations such as student housing, parking, bookstores, contract research and the like, the CSU cost California’s general fund $2.697 billion in budget year 2002-03, while a further $818 million came from student fees. The general fund money pays 75% of the cost, because the CSU schools lack capital endowments: investment earnings and alumni giving each cover less than 1% of the operating budget. The annual cost per student has recently averaged about $11,000, but the price charged to students has only been 20% of the cost. Indeed, half the students receive financial aid grants or loans, and the total amount of grants and loans exceeds the total fees paid. The real cost of being a student is not fees or room and board – it is the current income forgone when time is spent studying and learning for the future rather than working for pay in the present.

This pattern – where the cost to the college is greater than the price to the student, and the price to the student is less than the real cost to the student – is typical in US higher education. The economics of higher education are different from those of a soybean market. These subsidies are not a wasteful tampering with market mechanisms, but an investment in the general social benefit of an educated workforce and citizenry. Because an individual student does not capture all the economic benefit of college – a classic example of “market externalities” -- investment in higher education would be inefficiently low in the absence of subsidies.

Governor Schwarzenegger, it is safe to say, understands none of this. His benign ignorance lets his appointees push their own notions of policy in the belief they are "working towards the Governor." This has permitted Donna Arduin, the new Director of Finance imported from Jeb Bush’s Florida, to construct a budget plan based on an ideological distaste for public spending on higher education. In November, Arduin conducted an “audit” (any CPA would blanch at this misuse of the term) so as to appear to follow through on Arnold's campaign promise to solve California’s budget problems in a painless way by uncovering “fraud and abuse”. The ‘audit’ findings are included in the new Budget Summary, and guess what? There’s no finding of fraud or abuse at UC or the CSU. The findings are : “that university fees are generally low compared to their value to students and by comparison with other states” and that “subsidies for graduate and professional students are currently too high.” The ‘audit’ has uncovered the obvious: California subsidizes higher education, has done so for over a century, and has done so for good reasons of public policy. The claim that these subsidies are too high is a personal value judgment masquerading as an audit finding. “Too high” -- compared to what? What is it worth to California to have an educated workforce and citizenry in a competitive world? Ms. Arduin does not say.

This is the cynic’s approach to budgeting: measure all the prices and leave out all the values. The budget analysis never compares costs with results, but instead offers a laundry list of cuts aimed at making the CSU poorer, more crowded, more costly, more restrictive, more chaotic and permanently crummy. Or, in budget-speak, “applicable policy solutions that will help the state achieve significant cost reductions in these institutions.”

Big picture: the Budget cuts general fund support for the CSU by $212,000,000. That equals the amount it costs to run a university the size of San Jose State – with Sonoma State tossed in as small change. The Budget raises student fees by $101 million – or $150 million, depending on whether we believe page 70 or page 73 – and the state won’t increase financial aid to compensate. Next year’s freshman class will be 10% smaller, because 4,000 eligible students will be “diverted” into the community colleges. CSU will have to scratch on its own to find $40 million needed to cover an increase in the cost of health and liability insurance. Faculty and staff may have 1% of their pay nibbled away so the state can reduce its contribution to their pension plan. And get ready for more of the same for the next year, too.

Governor Schwarzenegger is a man of good intentions. It looks like his little helpers are paving the way for an interesting ride.

Marshmallows, anyone?

Saturday, January 10, 2004

The Kindergarten Governor Meets the New Math

“The governor's proposal does not contain any increase in sales or income taxes, but relies on fund shifts, borrowing and one-time accounting moves to cover more than half of the $14 billion shortfall between spending and projected revenue for the fiscal year beginning July 1. The plan anticipates $3 billion in proceeds from the $15 billion bond on the March ballot. The remainder of the bond proceeds will be used to cover deficits in the current fiscal year.” New York Times 1/10/04

There is an interesting article “Changing Red to Black: Deficit Closing Alchemy” by Professor John B. Petersen in the September issue of the National Tax Journal (56 NTJ #3 page 567). The article is a handy guide to the various tricks that are used to make State budgets appear better than they are. Standard budget magic includes:

1) overestimating revenues
2) booking one-shot asset sales
3) manipulation of transactions between the various “funds” (accounting categories)
4) accelerating revenue and delaying spending
5) capitalizing current costs and borrowing to cover them, and
6) relying on anticipated future savings that may or may not materialize.

State Budget Directors have their own strange lingo. Budgets are constructed out of “smoke and mirrors”. “Scooping” refers to a debt restructuring where all the saving occurs immediately and the costs are deferred to the future. Revenues can be magnified by means of a “spin-up” (accelerating tax collections into an earlier year) and the expenses can be held down by a “slow pay” (delaying payment of bills into the next fiscal year.) The problem, of course, is that reliance on such gimmicks eats away at the margin of safety in public finance to the point where, as Professor Petersen notes, the insulation has now worn very thin.

The extent of California's current desperation is suggested by two of the more convoluted gimmicks that former investment bank groupie and current Budget Director Donna Arduin has contrived in order to squeeze a few million dollars more from the numbers without admitting the necessity for a tax increase. We are told (Budget Summary, p. 103) that Medi-Cal check writes will be delayed one week “to allow additional time to investigate potential fraud”. The projected one-time savings of $143 million does not come from stopping fraud, but from the fact that only 51 weeks worth of checks get written in the year of the change. Similarly, $930 million of the budget shortfall is to be covered by issuing a “pension bond”, to be collateralized by anticipated future reductions in the net paychecks of state employees, who will be ordered to pay more so the State can reduce its contributions to their pension plan (p. 227). The “pension bond” debt service is further “scooped”, being interest-only for the first five years in order to make the cash flow appear positive. How ingenious – taking out a loan using potential future reductions in expenses as security. Our State Budget Director, it seems, has engaged in accounting practices that would subject her to criminal prosecution if used in the private sector. If the charismatic Governor wants to find “fraud and abuse”, he should look at his own budget document.

Arnold's budget is a fake. It is premised on false choice, on the assertion that California’s fiscal problem is due to excessive spending. The claim that taxes went up 25% while spending increased 43% is Kindergarten math. The history of state tax collections at page 45 of the Governor's own budget summary shows General Fund revenues are now 5.79% of total personal income, and as a percentage of income revenues are *lower* now than in 17 of the last 25 years. That table and the one on page 47 also show that the budget problem started with a revenue collapse in fiscal 2001-02, when income tax collections dropped 25% in one year, from $44 billion to $33 billion. Before that, the largest year-on-year decline was only 7% back in 1988.

All the charts in the budget summary compare actual expenditures with a dotted line called “population and inflation growth” over the past six years. (The charts seem designed to fool the news hacks who don’t know how to lie with statistics by selecting the base year.) Presumably this is because comparing expenses with State revenues would reveal that the problem is *tax* instability -- and taxes are the last thing that the big money supporters of Governor Gröper want discussed.

Friday, January 02, 2004


As Arnold Schwarzenegger starts a new year as California's governor, some of the more alert media hacks sense that something is wrong. Journalists allude to "his sudden and inexplicable flip-flops on major policy questions", and predict "In the coming year, the governor will have to make tough decisions that will earn him plenty of enemies." The popularity of a website that monitors the Gropinator, and the appearance of Doonesbury cartoons portraying the Governor as a giant groping hand are further indications that the post-election honeymoon is coming to an end.

It's time, it seems, to explain why the Schwarzenegger regime is going to be fundamentally different from those of the last 20 years -- much more amusing and more dangerous. In a word: "charisma": the divine gift of inspirational personality. Max Weber, the brilliantly unreadable founder of political sociology, saw charisma as one of the three basic sources of political authority, the others being tradition and reason. Arnold the candidate was a creature of Hollywood; his celebrity glowed with manufactured charisma. As a candidate, he was favor of kids and against bad stuff, and his election was a triumph of pure personality, divorced from any ideology.

In the "rational", modern California of the early 21st century, state government operates as a large, technically specialized bureaucracy. Governors Deukmejian, Wilson and Davis all wore the role of top bureaucrat like a glove. But charismatic authority is radically opposed to rational and particularly bureaucratic authority. The personality cult of the leader is inherently unstable. Actor Schwarzenegger’s role now is to play the Governor as Action-Hero, not the top state paper-pusher. Yet the machinery of California state government is, at its core, rational and bureaucratic. At present it is also under high stress, since the state’s tax structure and program budgeting have been repeatedly mangled by voter initiatives and fiscal gimmickry. Nothing in the special effects repertoire tells us what to expect when an Action-Hero confronts the budget dragon in the cave of structural deficits.

History, however, offers a clue. Ian Kershaw's recent biography of Adolf Hitler distills the essence of charismatic leadership in a quote from a minor party official "until now everyone has best worked in his place in the new Germany if, so to speak, he works towards the Führer." Kershaw elaborates: “Hitler's personalized form of rule invited radical initiatives from below and offered such initiatives backing so long as they were in line with his broadly defined goals. This promoted ferocious competition at all levels of the régime, among competing agencies, and among the individuals within those agencies.... Through working towards the Führer initiatives were taken, pressures created, legislation instigated -- all in ways which fell into line with what were taken to be Hitler's aims, and without the dictator necessarily having to dictate.... The disintegration of the formal machinery of government and the accompanying ideological radicalization resulted then directly and inexorably from the specific form of personalized rule under Hitler." (Kershaw: Hitler, Vol. 1 Hubris, pp. 529 – 531 (1998)) *

Arnold has no visible ideology beyond the well-meaning geniality of the self-made wealthy movie star. As a result, all of his friends, associates and appointees are free to push their own notions of policy in the belief they are "working towards the Governor." We can expect his political campaign staff to scrounge contributions in preparation for the next campaign – that’s what they know how to do, and that’s they how they can “work towards the Governor”. Arnold’s legislative contact folks will negotiate and play legislative games, even as the political operatives are denouncing the Legislature – all are, in their own way, “working towards the Governor”. Donna Arduin, Arnold’s spectacularly incompetent budget director, will slash and burn away at spending for Medicare, public universities and state regulatory agencies, while the Governor’s many political appointees will pursue their more-or-less conservative Republican agendas. All will act without coordination, since orders from the top require the bureaucratic style, not the inspirational. Arnold lacks the training, the experience and the instincts of a bureaucratic manager, and he knows it. The role of charismatic leader requires him to remain uninvolved, floating above the fray. Benign detachment allows him to claim credit for any successes, while disclaiming or even apologizing for any injuries done by followers who fail to correctly assess the political impact of their actions.

"Working towards the Governor" is the only sensible explanation of how the Schwarzenegger administration operates. Why else would there be an announcement of cuts in programs for the disabled (Arduin), followed by outcries and a promise of restoration (Maria Shriver/Kennedy)? Why else compound budget problems with a $4 billion tax cut (revoking the scheduled reversion of vehicle taxes to the pre-bubble level), followed after outcries by a promise to somehow restore funds to the shortchanged cities and counties, along with a declaration of a fake emergency so state university budgets could be cut midyear to backfill a few weeks of city and county money, topped off by firm insistence that it’s now up to the Legislature to unearth enough money to compensate for the Governor’s tax cut? Totally irresponsible but wonderful political theater.

The immediate problem for Schwarzenegger is the need to release the Governor’s proposed budget for fiscal 2004-05 on January 9. Even after allowing for the usual unrealistic assumptions about revenue and expense trends, this will be an ugly, painful document. No Action-Hero would want to be associated with the grab bag of college tuition increases, hospital waiting lists, early jail releases and other false economies that will likely emerge from Arduin’s Department of Finance. Charismatic leaders and civil service accountants are at the opposite end of the personality scale, and budget arithmetic is not part of the heroic skill set.

So what will Arnold do? What would you do? Given the intractable nature of the state’s budget problems, wouldn’t you govern by image? Perhaps media perception of fiscal reality can be distracted by offering a ballot proposition for strict budgetary virtue, starting real soon. (The New Year’s Resolution mentality: It’s OK to gorge today because the new diet starts tomorrow.) Perhaps a Hero needs enemies? Although, because Arnold is a Hollywood comic-book type of Hero, the enemies cannot be real people – that would be too divisive – but must instead be manga stereotypes. The Legislature is a stock cartoon villain, and the state employee labor unions can be caricatured as bureaucratic dinosaurs. (Even civil servants hate “bureaucracy”.) Arnold’s friends and appointees will predictably disorganize and weaken the rational operations of state government and fiscal policies in the course of “working towards the Governor”, but this can be interpreted as showing that rational government is failing, justifying additional grants of power to our charismatic ruler.

I hope I’m wrong.

* Do note: I am not implying in any way that Schwarzenegger is a Nazi. Nazis had an evil ideology, while Schwarzenegger appears to be a charming, slightly predatory egotist with no ideology at all. One could likely find among the followers of Franklin D. Roosevelt, Mahatma Gandhi, or Mao Zedong (to name three other charismatics) a similar desire to “work towards the leader” resulting in a similar tendency towards disintegration of rational bureaucratic structures of governance.

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