Closing tax loopholes could help California’s budget gap

A couple decades ago, when Silicon Valley was beginning to flex its political muscle, a local Democratic lawmaker carried legislation to exempt custom computer software from California sales taxes.

The rationale — one so illogically thin as to be transparent — was that the creative-design work that went into such programs was essentially an intangible service, and services are not taxable.

Almost every taxable product has a major component of intangible design and labor. Much of a car’s retail value, for instance, consists of labor, marketing, transportation and other “services,” but we tax its complete sales price.

Moreover, exempting custom software programs — many of which sell for millions of dollars — left off-the-shelf programs used by the public on the tax rolls.

That exemption costs state and local governments about $120 million a year in sales tax revenue. Officially it is called a “tax expenditure,” but the more common term is “loophole” — a special break from taxation to benefit a particular class of taxpayers.

Collectively, tax expenditures cost state and local governments around $60 billion a year, about three times as much as the state’s annual budget deficit. They have grown steadily over the years as advocates contend — often without objective evidence — that they will improve the state’s economy.

Also, there is a legal quirk: Punching a new loophole takes just a simple majority vote of the Legislature, but closing one is legally a tax increase and requires a two-thirds vote.

The software loophole is by no means the largest one. The real biggies — those over $1 billion — are mostly time-honored exemptions that enjoy broad support, such as the income tax deductions for home mortgage interest, gains on sale of personal residences, and employer-provided health benefits and pension contributions, or sales tax exemptions for food and drugs.

In fact, two-thirds of the tax expenditure revenue losses are in personal income tax provisions, most of which benefit individuals.

Corporate tax breaks are just 10 percent of personal income tax loopholes, with the credit for research and development expenses the largest at $1.3 billion.

As Gov.-elect Jerry Brown and the Legislature struggle with a seemingly perpetual, multibillion-dollar gap between income and outgo, closing tax loopholes should be on the table.

The Legislature’s budget analyst, Mac Taylor, said they “often have not been shown to be cost-effective” and closing them “raises revenues without having to increase marginal tax rates.” Logically, closing unjustified loopholes with narrow benefits would be the first step toward balancing the budget without reducing vital services or imposing broad new taxes.

However, when it comes to public finance, logic is usually the last consideration.

 

Dan Walters’ Sacramento Bee columns on state politics are syndicated by the Scripps Howard News Service.

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