A WA L L S T R E E T J O U R N A L O P - E D

Californias Greek Tragedy wall street journalopinion

by Michael J. Boskin and John F. Cogan

March 13, 2012 Long a harbinger of national trends and an incubator of innovation, cash-strapped California eagerly awaits a temporary revenue surge from Facebook IPO stock options and capital gains. Meanwhile, Stockton may soon become the states largest city to go bust. Call it the agony and ecstasy of contemporary California. Californias rising standards of living and outstanding public schools and universities once attracted millions seeking upward economic mobility. But then something went radically wrong as California legislatures and governors built a welfare state on high tax rates, liberal entitlement benefits, and excessive regulation. The results, though predictable, are nonetheless striking. From the mid-1980s to 2005, Californias population grew by 10 million, while Medicaid recipients soared by seven million; tax filers paying income taxes rose by just 150,000; and the prison population swelled by 115,000. Californias economy, which used to outperform the rest of the country, now substantially underperforms. The unemployment rate, at 10.9%, is higher than every other state except Nevada and Rhode Island. With 12% of Americas population, California has one third of the nations welfare recipients. Partly due to generous union wages and benefits, inflexible work rules and lobbying for more spending, many state programs and institutions spend too much and achieve too little. For example, annual spending on each California prison inmate is equal to an entire middle-income familys after-tax income. Many of Californias K-12 public schools rank poorly on standardized tests. The unfunded pension and retiree health-care liabilities of workers in the state-run Calpers system, which includes teachers and university personnel, totals around $250 billion. Meanwhile, the state lurches from fiscal tragedy to fiscal farce, running deficits in good times as well as bad. The general funds spending exceeded its tax revenues in nine of the last 10 years (the only exceptions being 2005 at the height of the housing bubble), abetted by creative accounting and temporary IOUs. Now, the bill is coming due. After running a $5 billion deficit last year and another likely deficit this year, Gov. Jerry Browns budget increases spending next year by $7 billion and finances the higher spending with income and sales-tax hikes. Specifically, hes proposing a November ballot initiative raising the states top income tax rate to 12.3%, making it the nations highest, and raising the basic state sales tax rate, already the nations highest, to 7.75% from 7.25%.

Michael J. Boskin and John F. Cogan

Californias Greek Tragedy

Hoover Institution

Stanford University

While Mr. Brown deserves credit for some earlier spending cuts to reduce a large inherited budget shortfall, the budget fails to address long-run structural problems, counting on a cyclical economic recovery and stock bubble for a bailout until the next self-inflicted crisis. Moreover, hes thus far failed to embrace a bold reform agenda to save money, improve services, and restore confidence among the states beleaguered taxpayers and bond holders. The ballot initiatives $31 billion, multiyear temporary tax increase is larger than the temporary hike it replaces and its income-tax hike is retroactive to Jan. 1, 2012. Worse, it doubles down on excessive reliance on high-income taxpayers, especially their stock options and capital gains, which are taxed as ordinary income. During economic good times, its not unusual for the state to collect one-half of all incometax revenue from the top 1%. This extreme progressivity leads to boom-bust cycles of rapidly rising revenue followed by complete collapse. Not surprisingly, the revenue is all spent on the upswing, forcing disruptive emergency cutbacks on the way down. The states progressive tax-and-spend experiment is broken, threatening basic services, from courts and parks to education and health care for its most vulnerable citizens. Mr. Browns tax initiative only exposes the state to an ever more dangerous roller-coaster ride. No wonder many Silicon Valley CEOs say they wont expand in California because of high taxes and burdensome regulation. And no wonder net migration has recently reversed, with hundreds of thousands of workers and their families leaving the state in search of better opportunities. California still ranks first in technology, agriculture and entertainment among the 50 states. But it is near the bottom in business and tax climate and state bond ratings. Its a complex picture, but at its core is the high-tax welfare state run amok. Many Americans fear the federal fiscal train wreck will turn us into Greece. But, barring major change, they need look no further than California to see what this future portends. Relying on ever-higher taxes to fund payments to an outsized population of benefit recipients is a recipe for exporting prosperity. That is one California trend that other states emulate at their peril. No one should write off California. It still has great strengths. And it can turn some of its short-term challenges, such as the pressures from ethnic and linguistic diversity (the state is now 37% Hispanic and 13% Asian), into long-term strengths in the global economy. But the political class must face up to the reality that services will have to be far more carefully targeted; the tax system overhauled with lower rates on a broader base of economic activity and people (almost half of all Californians pay no

Michael J. Boskin and John F. Cogan

Californias Greek Tragedy

Hoover Institution

Stanford University

state income tax); and inefficient state programs reformed to spend less and produce far better outcomes. Mr. Brown is a man of ideas, having run for president in 1992 on a bold flat-tax agenda. Instead of still more antigrowth tax hikes, he should break the grip on the state legislature of his partys special interestspublic employee unions, trial lawyers, teacher unions and extreme environmentalists. A California renaissancebuilding on the best reforms in budgeting and taxes, education and welfare, crime prevention and pensions by such leaders as Rudy Giuliani, Jeb Bush, Chris Christie and Andrew Cuomois still possible. What it requires is a governor with the vision, determination and political will to see it through. Messrs. Boskin and Cogan are, respectively, professors of economics and public policy at Stanford University, where they are both senior fellows at the Hoover Institution.
Reprinted by permission of the Wall Street Journal. 2011 Dow Jones & Co. All Rights Reserved

About the Authors

Michael J. Boskin is a senior fellow at the Hoover Institution and the T. M. Friedman Professor of Economics at Stanford University. He is also a research associate at the National Bureau of Economic Research, serves on several federal advisory panels, and advises heads of state, finance ministries, and central banks around the world. Among other posts, he served as chairman of the Presidents Council of Economic Advisers from 1989 to 1993.

John F. Cogan is the Leonard and Shirley Ely Senior Fellow at the Hoover Institution and a professor in the Public Policy Program at Stanford University, where he has had a continuing appointment since 1980. Cogan is an expert in domestic policy. His current research is focused on US budget and fiscal policy, social security, and health care. He has published widely in professional journals in both economics and political science. His most recent book, Healthy, Wealthy, and Wise: Five Steps to a Better Health Care System (Hoover Institution Press, 2011), coauthored with Glenn Hubbard and Daniel Kessler, recommends federal policy changes to improve US health-care markets.

Michael J. Boskin and John F. Cogan

Californias Greek Tragedy

Hoover Institution

Stanford University