California’s ‘fair tax’ hike spurred taxpayer exodus, hurt middle class and went mostly to pensions

New academic research on a progressive income tax hike in California should be a warning to Illinois voters deciding on Gov. J.B. Pritzker’s progressive income tax hike in November 2020.

California now has proof that taxing the rich caused the rich to leave, leaving the rest of the state’s taxpayers to pick up the tab.

A new paper by Stanford University researchers shows wealthy residents were about 40% more likely to leave after Californians in 2012 passed a progressive income tax hike. Those departures and other responses to higher taxes also eliminated 45.2% of the revenue the state expected to get from high earners.

California voters were persuaded to pass the Temporary Taxes to Fund Education, Proposition 30. It turned out the taxes were neither temporary nor did they fund education in the way voters expected. The rates are still in place and a Stanford University public policy expert determined all the education funding went to pensions rather than classrooms.

Illinois Gov. J.B. Pritzker finds himself in the same place as then-California Gov. Jerry Brown was in back in 2012 – trying to convince voters that a progressive state income tax hike will fix state finances in crisis. Brown claimed the burden of those tax hikes would only harm those earning $250,000 or more – the top 3% of earners. That’s exactly what Pritzker promises with his “fair tax” proposal.

Brown was wrong. By depressing aggregate economic activity, the California tax hike depressed improvements in living standards for everyone and the state collected less tax revenue than expected.

Here are the main findings of the new study:

• The negative economic effects of the tax hike wiped out nearly half of the expected additional tax revenue. Among top-bracket California taxpayers, outward migration and behavioral responses by stayers together eroded 45% of the additional tax revenues from the tax hike.
• The “temporary” income tax hike, which has now been extended through 2030, made it about 40% more likely wealthy residents would move out of California, primarily to states without income taxes.

The new research validates fears surrounding Pritzker’s push for the same in Illinois, which voters will decide in November 2020. Illinois is the only state experiencing five consecutive years of worsening population decline driven by outmigration. And high-income earners are the most likely to leave.

When taxpayers respond to tax hikes by reducing their contribution to the state’s economy or by leaving the state altogether, they slam the brakes on economic growth. Everyone suffers, not just the rich.

Illinois is headed down a similar path.

In November 2020, Illinoisans will get a rare opportunity to have their voices heard on a statewide policy question. They will face a ballot question about adopting a progressive state income tax, where tax rates rise with income.

Should voters approve the referendum, Pritzker has already signed into law the new rate structure that would take effect. It is a $3.4 billion tax hike on individual taxpayers and businesses in Illinois.

Californians faced multi-billion dollar budget deficits when they were convinced to approve Prop. 30 in November 2012 as a way to fix the state and fund education. The new taxes included a 3.45% sales tax increase as well as $42 billion “temporary” increase in the state’s progressive income tax rates of:

• 1 percentage point tax increase for singles with $250,000-$300,000 in taxable income (married couples with $500,000-$600,000)
• 2 percentage points tax increase for singles with $300,000-$500,000 in taxable income (married couples with $600,000-$1 million)
• 3 percentage points tax increase for singles with over $500,000 in taxable income (married couples with over $1 million).

Despite netting a 42% increase in the state general fund revenues after Prop. 30, California estimated it would face a $4 billion deficit if the “temporary” tax increase were to expire, prompting politicians to go back to taxpayers for more. Meanwhile, many services are actually receiving a smaller share of the budget than in the past despite record revenues. Even schools, which were supposed to be the main beneficiaries of the tax increase, have little to show for it, as all the money that went to education from Prop. 30 went to cover rising pension costs instead of going to classrooms.

It is a story that Illinoisans should be familiar with.

In 1989, state lawmakers passed a two-year temporary income tax hike, bringing the personal income tax rate up to 3% from 2.5%. Transcripts from the Illinois General Assembly show lawmakers framed the debate around providing school funding and property tax relief. In 1991, they made the education portion of the tax hike permanent, with the rest extended for another two years. In 1993, they made the entire tax permanent.

The same thing happened in 2011 when lawmakers promised that another temporary income tax hike would fix Illinois’ ailing public finances. By 2017, lawmakers had broken another promise by making the tax hike permanent.

Despite shouldering the largest permanent income tax hike in state history, within a single year Illinoisans saw their state’s net financial position worsen by a staggering 35%, or $47.4 billion. The hike lowered Illinois jobs growth for the rest of the year.

The similarities between California and Illinois don’t end there.

What can Illinoisans expect?

Evidence shows Prop. 30 had serious negative consequences for economic activity and aggregate income. The tax increases also fueled an exodus of those affected by the tax hike.

Prop. 30 exacerbated the outmigration and in the first year alone, the state lost an additional 0.8% of households that would have been directly affected by the passage of this new tax hike.

This finding is consistent with a large body of research that has shown that certain segments of the labor market, especially high-income workers and professions with little location-specific human capital, may be quite responsive to taxes in their location decisions.

Prop. 30 also caused a decrease in non-investment pre-tax income by $1.5 million on average for top earners between 2012 and 2014, indicating either a change in tax filing behavior or a reduction in labor market activity for these workers.

Proposition 30 harmed the middle class 

Research suggests that Prop. 30 may have reduced California’s contribution to U.S. personal income. A 1% increase in the top marginal personal income tax rate reduces the state share of U.S. personal income by 0.27% one year immediately afterward. That decline continues by up to 0.6% five years after impact.  Prop. 30 may have hindered California’s growth and reduced the state’s status in the national economy. This decline can be expected to continue, as the tax has been extended, and will have persistent negative implications for the state economy.

Evidence from all 50 states also shows that higher taxes kill innovation. By punishing innovation, tax hikes cause economic activity to decrease, thus reducing the rate of economic growth. When the economy grows more slowly, tax hikes harm everyone, not just the rich. Furthermore, the reward for innovation is higher income, so tax hikes on the rich raise the cost of innovating. By slowing the creation of ideas that drive economic growth as well as improve standards of living, top income taxation reduces everyone’s income.

More progressive income tax rates also discourage risk taking. When the marginal tax rate rises with income, then entrepreneurs save little in taxes on losses but can wind up owing substantial taxes on any profits. Entrepreneurs receive more severe punishments for failure, and diminished rewards for success. As such, more progressive tax schedules lower the expected after-tax return from entrepreneurial activity.

Other research also finds that entrepreneurs – job creators – are very responsive to changes in their tax burden. Entrepreneurial activity in the U.S. is heavily concentrated among the top earners in the population. Wealthy individuals who choose to be entrepreneurs are able to decide the fraction of their wealth that they will invest in risky projects. Entrepreneurs respond to higher taxes by creating fewer jobs and paying workers less.

This happened in Connecticut – the last state to adopt a progressive income tax. In the ’90s the state scrapped taxpayers’ flat income tax for a “tax on the rich” that was sold as magic pill for “middle-class tax relief.”  Instead, job creation fell, the state’s labor force shrank, and the state’s poverty rate increased.

Illinois already lags the nation in employment growth and income growth. Another income tax hike in Illinois will translate to more of the same: even fewer opportunities for everyone, as well as a decline in real wages for hard-working Illinoisans.

Learning from others’ mistakes

Similar to California, an Illinois progressive income tax will fail to fix state finances and likely see most of the money devoted to the state’s massive unfunded pension obligations. Instead of opting for a progressive income tax hike that is likely to worsen Illinois’ record exodus and opens the door even farther to income tax hikes on the middle class, lawmakers should realize that Illinois’ woes stem from the expenditure side of the ledger. And that ledger is becoming increasingly unbalanced as pension costs continue to rise, currently eating up 26% of the state budget and expected to rise dramatically.

Just like in California, further tax hikes on Illinois’ already overburdened taxpayers are not going to solve the state’s financial problems. Illinoisans would be wise to learn from California’s and Connecticut’s mistakes.