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California Democrats Propose Raising Income Taxes to Plug $19 Billion Gap

California’s Democratic leaders plan to unveil a budget proposal to erase a $19.1 billion deficit as early as next week that may include a 1 percentage-point rise in the personal income-tax rate.

The increase would affect all taxpayers except those in the highest tax bracket, according to Senate President Darrell Steinberg, a Democrat. To make it more palatable to voters, California’s highest-in-the-nation sales tax would be cut simultaneously by 2.5 percentage points. Unlike sales levies, state income taxes are deductible from federal returns. The swap would add as much as $3 billion to the general fund.

“The idea is to increase some taxes that are already federally deductible and to allow taxpayers to take advantage of that while lowering some taxes that are not federally deductible, while the state general fund can gain $2 billion to $3 billion for education and other vital services,” Steinberg said in an interview yesterday.

California’s legislative leaders have been meeting for the past three weeks to discuss ways to close the deficit for the fiscal year that began July 1. Controller John Chiang said he may issue IOUs to creditors in August if a budget isn’t passed soon. Steinberg said the proposals will be vetted during a joint budget committee of state Senate and Assembly members next week.

Republican Governor Arnold Schwarzenegger, who this week ordered more than 150,000 public workers to take three days of unpaid time off to conserve cash, probably wouldn’t support an income tax increase, said his spokesman Aaron McLear.

‘Volatile Income Tax’

“Relying even more on the volatile income tax is not the way to go,” McLear said in an interview yesterday. “Our tax system is mostly based on capital-gains taxes on rich folks, so when those rich folks have a good year we have more revenue coming in. But when California taxpayers have a bad year we end up having less revenue coming in.”

Schwarzenegger in May proposed $12.4 billion in cuts, including the elimination of some health-care and welfare payments to the poor. Steinberg said the Democrats may support half of those cuts, if the balance could be satisfied by tax increases.

California’s top individual income tax rate is 9.55 percent, although there is an additional 1 percent tax for mental-health services on incomes in excess of $1 million. The state has the highest sales tax in the U.S. at 8.25 percent, according to the Washington-based Tax Foundation, a non-partisan research group.

Republican lawmakers, who first brought the idea of the tax swap to the negotiating table, said they can’t support the plan as the Democrats are suggesting.

“It was intriguing but when we looked at it we realized there was no way to accomplish it without a massive tax increase on the middle class,” said Senate Republican Leader Dennis Hollingsworth in an interview yesterday.

To contact the reporters on this story: Michael B. Marois in Sacramento, California, at mmarois@bloomberg.net; Christopher Palmeri in Los Angeles at cpalmeri1@bloomberg.net.

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