Is the sun setting on the California Dream?
Thinking about Starting a Business in Orange County? The first question you need to answer is: Should I move to a more Business Friendly State?
Editor’s Note: This article is a little old, but the infor is still relevant. California won the lottery when many Silicon Valley companies went public, and founders paid huge one-time tax bills to the state. We are currently projected to have a surplus in the state budget, but the underlying factors remain the same. We try to keep the main pages non-political, but it’s hard to ignore California’s regulations, litigation costs, high taxes, and prospects for the future have been in the news.
Orange County Entrepreneurs can no longer ignore these problems. Carl’s Jr. CEO Andy Puzder seems to have summed up what people are feeling when he said “in California it’s How Can We Stop You?” (see 1:15 on video below)
Okay, some might argue that’s not a big deal. These are minimum wage hamburger-flipping jobs that we don’t really need in the state. The state’s government is targeting high wage jobs for tomorrow’s information economy. Well, others would argue that if you drive up the costs of doing business, that affects all businesses. And they would point out that some people still believe that its better to have a “hamburger flipping” job than be unemployed; and that the franchise owners and managers of these businesses do make a decent living. They would also point out that after 57 years, Toyota has decided to move its headquarters to Texas. The mayor of Torrance attributed this in part to the high burden that businesses must pay to be in california for costs such as workers compensation insurance. Nissan also had its headquarters in Southern California for years has also decided to move those jobs out of state. These jobs California is losing at these headquarters running multi-billion dollar operations and designing cars are what we are losing along with the “hamburger flipping” jobs because of California’s anti-business attitude.
There has been a lot of talk recently that California is no longer a good place to set up a business. In more prosperous times, well-educated people were moving to California for employment and to start businesses. Now it seems like educated and professionals are moving out for a better life, better job prospects, and avoiding the high costs of doing business. It’s hard to discern why people are making this choice because are no exit interview conducted. But there is a lot of anecdotal evidence entrepreneurs and the professional class have been leaving the state for a while.
People are moving to tax friendly states. According to a 2011 LA Times Article, ” trend toward out-migration is looking less like a blip than a long-term condition…since 2005 more people have left California than have arrived from other states.” The concern is that the people who are moving away for better opportunities tend to be those who have the ability to contribute the most to the stat’s economic future and tax base–people who are unemployable and people who start/run businesses. A September 2012 report by the Manhattan Institute used census and IRS data to confirm what we have all been observing. Since 1990 California has a net loss of 3.4 Million people to other states. A Bloomberg News article put this in illustrated this fact by pointing out that from 2006-2011, ” The equivalent of the entire city of San Francisco packed up and left California…” The top states they are moving to are business friendly Texas, Nevada and Arizona. Californians are moving for employment opportunities and to take advantage of lower tax burdens. (Note that this report focuses on migration among states, immigration from foreign countries has mitigated this impact as California is the place foreigners choose to live in first for a variety of reasons. But the foreign migration rate seems to be slowing down.)
Technological Leaders are Transitioning out of state. Larger businesses have done the math. They are bound to California because this is where the talent lives; but the question is for how long? Quintessential high-tech California business have already made the move. Apple will bring 7,100 new jobs to Texas when the new support/engineering center in Texas is completed (wired article), and it is officially headquartered in Nevada. While the first Apple computers were assembled in California, this company has spent 100 million dollars to set up a new facility to assemble Macs–in Texas. This article attributes apple’s big move from its California Roots to Texas’s low business taxes relative to California’s rates. (See Computer World Article) Intel set up its research campus in Colorado, and has a big chip production plant in Chandler, Arizona. And in 2014 the only company to assemble cars in California, Tesla, decided to set up its gigafactory just across state line in Nevada. While Governor Brown and legislative leaders worked hard to have Tesla locate in the golden state, experts feel that California’s environmental and regulatory climate pushed them into the Silver State. Tesla and their Japanese partner Panasonic needed to get the factory built fast, and that just wouldn’t happen if they had to go through all the environmental reviews and associated lawsuits that California requires to build big projects. (SacBee Article) Additionally you have to wonder if all the talk about the business community needing to pay their fair share also pushed the factory out of the sate.
California’s iconic movie/TV business is doing more production out-of-state. Production peaked in 1997 and has been declining since then. Producers have been driven to more business friendly states by lower costs of production. The States response has been to label this as “run-away-production” and offer industry specific subsidies to help offset the high costs and keep production in the state.
High Cost of Living/Quality of Life Issues People have been moving out for a while to avoid the high housing costs. For instance we know a couple that sold their house and bought a better house in Arizona. The cost of living was just lower, and with the extra money they had from selling their California house, they could have a nice retirement. And they felt like they were in a much safer area. But now, people who are employed in California decided to start a business in another state. They have set up businesses with less of a hassle in Nevada or Arizona. One professional explained that he would be taking a “pay-cut” to move to Arizona, but he could afford to buy a house in a low crime area and the schools would be good for his kids. And it would be easier to hire people when his business grew. Another small business owner moved to Colorado because he couldn’t afford to rent in “nice area” and wanted to get his kids out of a “gang area.”
California’s K-12 school system seems to be a driving force pushing people out of the state. Unless you can afford to live in a really nice area or send your kids to private school the perception is that the schools that serve middle and lower-income families are not effective. But the math does not seem to add up. Even though California has one of the highest tax rates, per-pupal funding has dropped to 35th in the nation. And as the state’s pension obligation and employment costs increase over time, money more money will be diverted from public safety (FN7). Recently, thousands of state prisoners have been released from overcrowded detention facilities. As with education, unless you can afford to live in an expensive area, the prescription is that you will have to suffer higher crime rates in areas controlled by street gangs.
Counterpoint: California Schools Underfunded? According to this edsource article, Governor Brown is credited with increasing per-pupal funding by 45% in the past few years! According to the state’s Legislative Analysis Office that means that per-pupal funding from the state government alone comes to $9,978. So for a typical class of 30 students, state tax money pays a public school district 30 x $9,978 = $299,340/school year. If we assume that a school year is only nine months, but many small business people work all year round. So to compare apples to apples we have to annualize that figure. That means we can kids are only in school 9 of 12 months = 3/4 of a year. So if we annualize the spending to reflect the time kids are actually in school, this comes to $299,340.00 ÷ (3/4) = $399,120.00/year/class
If we wanted to have more fun with math, we would consider that the state is effectively buying educational services from the districts, so in a fair world they would have to pay an additional sales tax of $33,925/year/class. And school districts are exempt from income taxes. So if you make the conservative estimate that such an service business would make a 10% net margin on gross sales, and be taxed at a federal rate of 28% and state rate of 10% that means that a school district run as a tax-paying business would have to pay an additional $22,750 in income taxes. And to be fair, if a public school was like a business they would have to pay property taxes. How much that would be is anyone’s guess, but school buildings and facilities would cost a lot to build today and so under the split rolls they would have to pay current value. We could ballpark that by assuming that each classroom and proportionate share of school grounds, sports facilities, libraries, office space, maintenance facilities … etc. costs about $200,000 so at 1% that comes to $2,000 if for no other reason than it’ a round number. But wait there are more subsidies. School bonds receive special no-tax status and are backed by the taxing power of the government. So they have much lower rates than any business could hope to get. People think this is free, but think about it: if a wealthy person buys a state bond she avoids paying federal and state income tax. That’s why she is willing to accept a lower interest rate. So school bonds actually exchange tax revenue for lower interest payments on the bonds. So for the sake of simplicity assume the school would have been financed by a rate lower than a non-subsidised rate of say 2%. So that’s $4,000 per year in lower tax payments. Summing up, annualized cost of one class in state funding and tax subsidies would be about $399,120 + $33,925 + $22,750 +$ 2,000 + $4,000 = $461,795.
Where the money actually goes and why are so many families dissatisfied with California schools is another story for another website.
High Income Business Owners. And with the recent passage of Prop 30 in Nov 2012, higher income people have a greater incentive to move or set up their businesses in other states. This raised the marginal state income tax rate another 1% to 10.3% for those making over $250,000, and imposed millionaires tax by raising the states top tax rated from 10.3% to 13.3%. Arizona (4.5% top tax rate) and Nevada (0% income taxes) are nearby states that California’s wealthy could relocate their businesses and establish residency in. For instance Phil Mickelson recently decided to pull out of his investment in the San Diego Padres and is looking for a new more tax-friendly state. USA Today Article But these numbers don’t tell the entire story as wealthy residents are uncertain how high taxes could go. The proposition was passed because voters bought into the backers get even with the rich justification for higher taxes.
Even Higher Taxes? The November 2012 elections allowed the state’s Democrats have established a supermajority in the state house, so they can now pass tax increases without any negotiations with Republicans. The legislator has passed budgets which put off any meaningful pension reform or downsizing for years; and state spending has been growing faster than economic growth. For a long time, they have found ways to move things around such as not including the state’s pension liabilities in the budget and borrowing money meant for one thing to be used for another. But now the bills are coming due. Business owners just don’t know how much taxes will go up. There is already talk of a split property tax system whereby business property would be re-assessed every year and keep up with property values. Nearly every business lease passes property taxes along to the tenants–so the businesses would end up paying. And there are plans to raise the payroll tax to help pay back an almost $9 billion loan from the federal government that was used to pay for benefits in California (FN4). And nobody can seem to agree on how big California’s unfunded pension liability (FN3) (They amount the state has promised in pension benefits less the amount saved to pay for these benefits.) A Stanford University found that if we assume the state can make 4.4%–much higher than you can get on a CD–this liability amounts to $500 billion. And Moody’s–the well known bond rating company–estimates it at around $291 Billion if California can earn a 6.2%.
A lot of people say that California should have a balanced budget law to keep spending in check; we have one and it’s part of our state constitution. The only problem is that Sacramento seems to find ways around it. Eventually our growing unfunded liabilities will cost everyone who earns an income a lot of money. The numbers above are a bit hard to comprehend, so to put it in perspective, the state has a total number of people working legally of 15,961,000 (10/29/12 estimate from caljobs). So if we were to give everybody working a bill–who else will ultimately pay this?– for this unfunded liability, just like MasterCard sends you a bill of your personal unfunded liability, that number would be between $31,415 and $18,213. Just like paying off the MasterCard bill, if we pay this off we will have nothing new to show for it. It wouldn’t correct Sacramento’s overspending problem. And there are more off the books liabilities. (FN5)
But all we seem to hear Sacramento are a discussion of who should pay more.
This Bloomberg article aims to show their readership of financial investors that their are systemic problems with the Golden State’s spending and that bond investors should be cautious. California Employees are among the highest paid in the nation, and that the passage of SB400 of 1999 increased pension costs dramatically. It’s clear from the article that it’s politically impossible to reduce these costs. Another recent study calculated that California’s total debt including unfunded liabilities for state and local governments could be around $1.1 Trillion. That comes to about $80,000/household (FN 9)
Meredith Whitney, renowned Wall Street for predicting the collapse of the housing market and banks, analysed all the state budgets for her best selling book The Fate of the States, and came to this conclusion about California’s spending problem: The state of california has been the worst transgressor when it comes to foolish government spending…during the good years public sector unions negotiated some astoundingly rich contracts. (P.59)
Already, investors have shied away from commercial property because a 2/3 majority gives the powers that be an ability to raise property taxes, and plans to raise payroll taxes are already in the works. (See WSJ article)
High Insurance Costs California’s 1913 system Workers Compensation System was initially instituted as a way to hold litigation costs down and make sure injured workers received a minimal level of support. But bureaucracy, litigation and fraud have failed to keep costs down. In some areas of Orange County, attorneys advertise openly by putting flyers on cars, telephone poles and sending out agents to let people know they could be taking home $2,900/month if they say they have been injured on the job. Flyers are distributed in some parking lots on a daily basis. This is another factor that is encouraging businesses in labor intensive industries (i.e. have to hire a lot of people.) to move our expand outside of California. Only Alaska and Connecticut have higher workers comp rates. California’s about 55% higher than the national median. (See SF Business Times Article) And unlike states like Illinois which have recently reformed workers comp, rates in the Golden State are trending higher (See Sacramento Business Journal Article.)
And litigation costs are driving up business liability insurance costs. Only four states have a worse legal climate than California. According to the US Chamber of Commerce’s Institute for legal Reform “California’s lawsuit climate was ranked 46th due to its treatment of class action lawsuits, tort or personal injury lawsuits, damages and contract litigation.”(website) And it isn’t just the direct cots reflected in insurance rates that’s the problem, business owners and managers have to spend a great deal of time dealing with theses law suites. As with taxes the rich should pay their fair share attitude seems to be prevalent among those who serve on juries that award large sums to send a message, redistribute wealth from big business, or remedy some social in-justice or unfairness.
One of the latest fads is the Prop 65 Lawsuits. Businesses are sued if they did not give adequate warning about chemicals that could be dangerous whether or not they knew about the damages. And according to analysis done by Forbes, 74% of the settlements go to legal fees. That’s why Disneyland and Starbucks are putting up Prop 65 Warning signs.
High Operating Costs Irrespective of tax issues, all of these other costs add up. An organization that helps businesses relocate to Arizona (a right-to-work state) claims that large firms can save 40% on operating costs. FN6 They point out that it only takes 90 days to get permitted because they don’t have to deal with California’s Environmental Quality Act (CEQA) or which every business which wants to build something new or change the existing use of land or buildings.
California’s Downward Spiral
Some might argue that we are in a downward spiral. As our tax base moves away, those remaining will have to carry a higher portion of the load or state funded services like education will have to be cut. Tax rates will have to increase for existing residents and businesses. But higher taxes will only encourage more business to make the move making it necessary to increase taxes to maintain the government’s spending level.
For instance, a 2008 study shows that the proposed changes in property tax would decrease employment by 86,000-152,000; increase costs to consumers, reduce the amount of investment being made in the state, and increase California’s unfunded pension liabilities as the value of assets owned by pension funds (i.e. real estate) decrease.
And according to some reports, there are more people living off checks they receive from he government than receive paychecks from private employers. The math gets kind-of tricky (FN8), but for every 100 people earning a private sector paycheck, there are 139 people receiving some sort of check from the government. And this is evident from the fact that businesses have started to market directly to the this growing demographic.. Recently, connivence stores like 7-11 became eligible to accept food stamp money, and they made it known by displaying flags and banners; and some apartment buildings have been putting “Section 8 Welcome” in their advertisements. The fact that these business are competing for the non-employed segment of the population indicates that it’s has a significant amount of spending power.
Media Stories About California’s Business Climate
Register Article 1, Register Article 2 These two articles by long time OC Register Business Writer Jan Norman give examples that illustrate the problems California is facing. Basically these articles list local companies that have move out of California. But if you were to add up all the lost jobs, lost taxes, and lost business incomes attributed to business that have moved out, you would underestimate the problem. Each business buys services from other businesses such as suppliers, security firms, computer consultants, utilities … and pay taxes. Now those business to business purchases are taking place in other states. Also, it’s not even possible to count the number of businesses that decided to open or expand outside of California we are perceived as a business hostile state.
This Article in CEO Magazine explains why businesses are moving to other states. “California’s enduring place of perpetual decline continues in this year’s ranking. Once the most attractive business environment, the Golden State appears to slip deeper into the ninth circle of business hell. The economy, which used to outperform the rest of the country, now substantially underperforms. “
And this article in the same publication explains why businesses are moving to Texas in particular and gives examples of big co’s. According to their 2012 Ranking, Texas is #! (best state), and California has moved to #50 (worst state).
We noticed a similar article in the Orange County Register based on the results of a survey taken by of Small Business Owners by the website Thumbtack. California Received an F along with only two other states. CNBC ranks also ranks states that are good to do business in. Article The good news is that California is not at the bottom of this list because of its number one on ranking for “technology and innovation” and “access to capital”–in other words the venture capital in Silicon Valley. But the state ranked 48th for cost of business and 43rd for business friendliness. The bad news is that the state has dropped from 32nd place in 2011 to 40 in 2012.
This is an interesting report from the CBC (Canadian Broadcasting Company) that explains how spending commitments of the past leave policy makers on the State and Local level with few options. Cutting back services does not make much of a difference, and as you can see from the reports above, high taxes along with California’s regulations are already driving businesses out of the state.
This video explains shows that jobs are moving out of the Golden State because of high costs.
Reader Comment “Toyota the world’s biggest car maker has designed cars in California and had their headquarters in California for 57 years. Looks like they are moving to Texas. And California’s best known carmaker has selected four possible locations to build it’s Giga Factory to make batteries for their cars. Wheat do all these locations have in common? They are all outside of california. And when will they relocate their car production to be next to their giga factory? Although this article looks like it’s a couple of years old, nothing has changed. The same factors are driving businesses out of the state.”
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For more information, we suggest the following:
This is a new book that contrasts high tax/regulation states with growing states in the South.
FN1. The photo provided via (cc) license. We chose it because it was a good shot. Photographer may or may not agree with the views expressed on this site.
FN2 We would like to thank the OCBusinessStartUp.com reader who told us about these Fox11 videos and CBC video.
FN3 For a discussion of these issues and other links see this OC Register Article.
FN4 Estimate of the loan value came from this website
FN5 For a comprehensive explanation of California’s unfunded pension problem, listen to this podcast from Stanford University Finance Professor Joshua Rush.
FN6 http://www.gpec.org/greaterphoenix We have asked for a reference to their 40% operating cost reduction.
FN7 See this Bloomberg article http://www.bloomberg.com/news/2012-12-11/-822-000-worker-shows-california-leads-u-s-pay-giveaway.html
FN8 Consider these numbers as an indication rather than an exact figure. There are a lot of people who are eligible to draw paycheck and also eligible for government benefits. We are not sure how the writer of this Forbes article came up with the numbers.
FN9 This is and estimate under the assumption of a 4.5% discount rate by the California Public Policy Center. (Link) Although it seems like it should be easy to know what the state owes, much of the debt is not reported. Accountants refer to it as “off balance sheet” or “unfunded liabilities.” An example of this might be the pension and health benefits that a government will have to pay a current employee for the rest of her life after she retires. updated info –>According to this October 2014 Sacramento Bee report, http://www.sacbee.com/news/politics-government/dan-walters/article3507521.html the amount of unfunded liabilities to State of CA employees alone has grown from 6.3 billion in 2003 to 198.3 billion in 2013. This is the estimate of California’s Controller.
LA Times story about Toyota and Nissan moving HQ out of CA (link)
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