Loophole Heaven

Just as major league ballplayers were taking the field for the first spring training exhibitions on Feb. 28, Arnold Schwarzenegger was putting taxes in play in California's budget debate.

"I am a big believer that when we have a financial crisis like this, we all should chip in," California's governor said about his state's two-year, $16 billion budget shortfall. "This why I totally agree with the Legislative Analyst’s Office when she says we should look at tax loopholes.... We should go after those tax loopholes."

It won't be hard to find them. California is a big-league loophole-creating machine. It takes only a simple majority of California's Legislature to carve out a tax loophole, but it takes a two-thirds vote to close a loophole or pass a budget. That imbalance has created a ratchet effect in California's tax code.

Legislators disinclined to support the annual budget have found that they can trade their vote for a nice tax loophole for their favorite group or industry. And once in law, the two-thirds rule makes loopholes nearly immortal. For example, even as the Legislature struggled in February to begin attacking the budget crisis, it failed to muster the two-thirds vote needed to close one of the most egregious loopholes, which allows buyers of yachts and private jets to duck paying sales and use taxes on their toys.

The result is a Swiss-cheese of a tax code, with little grounding in either economic efficiency or logic.

The California sales tax, as Irvine Fellow Annette Nellen pointed out at the Feb. 27 tax reform workshop jointly sponsored by New America and the University of California Center Sacramento, piles some of the highest rates in the nation on one of the narrowest tax bases. It exempts diesel fuel in trucks that carry cotton to market but not in trucks that carry cotton shirts to stores. It taxes the magazine you buy at the newsstand but not the same magazine you buy by mail subscription. If you wash your own clothes or mow your own lawn, you pay sales tax on your washer and your lawn mower; if you can afford to send your laundry out and hire a gardner, you pay no tax.

The California income tax is just as holey. It incorporates most of the exclusions, exemptions, and deductions in the federal tax code, including the biggies like the mortgage interest deduction and the exclusion of employer-paid health insurance premiums, then adds more than two dozen of its own, both big (a total exemption for Social Security benefits, which costs $1.8 billion) and small (a rice straw credit and a credit for transporting donated farm products.)

My two favorite loopholes (because they are among the most perverse) are those that give privileged treatment to the lucky over the diligent, to chance over work.

The first, a California special, exempts state lottery winnings from the state income tax. If you work hard in California, you pay tax on your wages. If you save and invest well, you pay tax on your dividends and gains. But if you pick the right six numbers in the state lottery, you're home free.

The second, which conforms to the federal code, awards a tax exemption to capital gains on inherited property (at an annual state revenue loss of $3.1 billion). This provision adjusts upward the tax basis on inherited property to its value on the day the giver dies, wiping out the receiver's for any gains previous to inheriting the windfall.

In other words, if you are shrewd enough, say, to have bought 100,000 shares of Cisco System at 8 cents a share in 1990, you would be looking at paying income tax on a $2.4 million gain if you sell. But if you are lucky enough to have had a parent shrewd enough to make that same trade (and generous enough to will the stock to you), you'd have the $2.4 million gain and no tax liability (and depending on when the parent died, perhaps a big paper loss to offset other gains.)

Favoring luck over work and saving may be bad tax policy. But then maybe that's what to expect in a state that got its big start when James Marshall came across gold in his sawmill. Eureka, indeed.