Sunne McPeak's Business Climate Testimony Befors Commission On Tax Policy In The New Economy

On behalf of the California Economic Strategy Panel, thank you for inviting input on the important issues being deliberated by the Commission on Tax Policy in the New Economy. It is significant and timely that the Commission on Tax Policy in the New Economy seeks information on the economic implications of tax policy. All too often economic impact is not considered when tax policies are debated, or considered only as an afterthought, usually framed in terms of short-term consequences (such as who will pay more or less taxes as a result of the policy reform). The Commission is to be commended for studying and considering the long-term economic strategy implications of tax policy option.

It is the role and responsibility of the California Economic Strategy Panel to bring the "voice of the economy" to state policy deliberations, and to support the thoughtful integration of economic impact into critical policy choices. Too often, other issues drive state policy in the absence of this analysis. Today, there must be a focus on how creating a strong economy will impact all public policies, whether it be policies about education, the environment, transportation, telecommunications, water infrastructure, public safety, or taxes. Thus, the Panel applauds your decision to factor this into your deliberations.

The California Economic Strategy Panel recently released its second report, titled: Creating a Shared California Economic Strategy: A Call to Action. That report is attached to this memorandum and forms the basis of this presentation. A simple analytic procedure for the Commission when considering a single tax policy reform or a package of reforms is to evaluate whether or not the reforms aligns with the principles and strategies of a successful economy. If the answer is either neutral or positive, then there is a solid economic argument for adoption, although clearly other factors of adequacy, fairness, ease of collection and political viability, among others, should be applied. If the answer is negative, then from the perspective of economic strategy, the burden of proof for going forward, based on these other factors, should increase. Therefore, tax policy options should be addressed using both standard tax principles and pro-economy principles.

This presentation addresses two principle questions:

What are the characteristics of the 21st Century California Economy? What are the implications of this 21st Century Economy for tax policy?

The Economic Strategy Call to Action identifies the four foundational elements of a long-term successful economy:

1. Understand the industry and workforce characteristics of regional economies, with a special focus on leading industries for which California has comparative advantage in the global economy.

2. Apply this information to education and workforce investment strategies that will enable California's workers to participate in the successful economy, with career progression opportunities so that all workers can earn a decent living to support their families.

3. Plan and invest in essential infrastructure (housing, water systems, transportation, open space and so forth) to ensure that communities are attractive places to site businesses and for workers to live.

4. Assure vital and effective economic leadership through policy-governance bodies (such as the Economic Strategy Panel and the Commission on Tax Policy in the New Economy) and strategic public-private partnerships.

As important as are short-term "business climate" concerns that drive up the costs of doing business in California, these may be more than offset by quality factors that attract employers and workers who provide the talent necessary for an innovative economy, and who can live wherever the quality of life suits them. The long-term issue for employers is whether or not there is an appropriate "return on investment" for the taxes being paid to support and promote public benefit.

The following responds to the two primary questions posted above.

What are the characteristics of the 21st Century California Economy?

Four major issues should be considered when thinking about the 21st Century Economy. (The appendix to the memo elaborates on each of these issues.)

This is not the first time that California's economy has changed significantly.

The California economy is constantly changing. It has been one of the most innovative economies since gold was first discovered in 1849 and the industry structure of the state has been transformed over many decades. In many ways, each transformation in the economic structure of the state has created a "New Economy" – referred herein as the 21st Century Economy.

What has really changed is the "way things are done" in the economy today, not just the products and services made and sold.

The Economic Strategy Panel found that the transformed, evolved 21st Century Economy has several key characteristics.

• Fast to market with mass customization.

• Flexible production with new ways of organizing work.

• Global orientation with local supply chains.

• Skilled workers, who have become the key competitive advantage.

Firms and regions must compete on innovation (not low cost) across a wide range of industries (not just "high tech" manufacturing).

California's 21st Century Economy is a composite of diverse regional economies which must compete on the basis of innovation across a range of industries including agriculture, manufacturing, and services, not just a narrow band of so-called "high tech" industries such as semiconductors, computers or software.

The definition of a competitive business climate in a 21st Century Economy has changed.

Rather than focusing only on low taxes and regulations, the essential requirements today are for tax and regulatory policies that encourage the private and public investments essential for the skills and infrastructure to compete.

The Economic Strategy Panel recognized that the cost of doing business is a major factor in the location, retention and expansion of business in California and recommended the assessment of business climate concerns, particularly in regards to the impact on the competitiveness of California.

What are the implications of the 21st Century Economy for tax policy?

As the California economy continues to change, so must California's tax policies and structures. The Commission on Tax Policy in the New Economy was established initially to examine one aspect of this change – the issue of internet taxation – but its mandate has changed by request of the Governor to include a broader review of California's overall tax structure and recommendations for fundamental tax reforms.

The timing is right for this assessment. Not only has the internet "bubble" of the 1990s broken, reducing state revenues, but the state faces a major budget deficit which requires creative thinking about both revenue and expenditure reforms if the magnitude of the challenge is to met without major negative long-term impacts on the California economy.

The 21st Century Economy warrants consideration of appropriate tax principles rooted in three basic premises:

One, California's current tax structure is inadequate for moving the state forward in the 21st Century.

While addressing immediate revenue shortfalls, one or two short-term tax changes will not "solve" the long-term problems from an "economic" perspective. The real issue involves fundamental reform of the tax structure.

Two, California has become an innovative economy across all of its industries not just high tech.

Accordingly, California needs a tax structure that rewards innovation and investment in both the private and public sectors.

Three, California suffers from "boom/bust" revenue cycle that is disruptive of state and local investments in skills and infrastructure essential for a strong economy.

While, the "surge" nature of an innovative economy creates this problem, the overall tax structure could help moderate this problem if the tax base is broadened and made less dependent on single tax sources that are tied to the "boom/bust" economy cycle (e.g. broaden the sales tax base, changing the schedule of income tax rates, realign state and local tax sources)

The following are is a list of "standard tax principles" and "pro-economy tax principles" to consider in evaluating tax reform alternatives.

Standard Principles

Equity: Ability to pay: Is the tax fair for different income groups? Benefits received: Is the tax related to benefits received?

Stability: Is the revenue stable or sensitive to economic cycles?

Administration: Is the administration of the tax cost effective?

Compliance: Is compliance simple and inexpensive?

Pro-Economy Principles

Efficiency: Does the tax system distort economic decision-making?

Growth: Does revenue grow in proportion to the economy over time?

Diversity: Is the tax base broad, so tax rates can be low?

Neutrality: Does the tax system foster a ‘level playing field?'

Pro-Investment: Does the tax system encourage private and public investment in plant, equipment, people, and/or technology that will promote innovation and a rising standard of living for all?

Finally, tax policy options must align with the four foundational elements of a successful economy:

• Do the policies advance industries which are important for California's economic competitiveness?

• Do the policies advance the ability to support education and workforce investment strategies necessary for a long-term, competitive workforce?

• Do the policies advance the ability to support infrastructure planning and investment, and on-going infrastructure operations and maintenance?

• Do the policies advance the perception that California is able to provide sustained and stable economic leadership, involving business, labor, community and local government sectors?

In summary, these suggestions are intended to help inform the deliberations of the Commission with the "voice of the economy." Please know that the Economic Strategy Panel stands ready to assist you in your deliberations in the short-term and over the next several months. The Panel would be pleased to review proposed recommendations and provide specific input on potential impact on long-term economic strategy. Further, given that tax policy reform is so important for California's long-term economic success, we also hope that you are given whatever time and support is necessary to ensure that your mission is fulfilled with all the thought and care that these very complex issues deserve.