Capitol Alert: Why budget deficit would increase under federal tax change

We've noted a couple times before that the federal estate tax change loomed as a $2.7 billion budget deficit bomb, and today Gov.-elect Jerry Brown included that calculation in his budget presentation, pushing the projected 18-month deficit total to $28.1 billion.

California has collected hardly any estate tax revenue for several years in the wake of the 2001 Bush tax law changes. Come 2011, absent any action on the federal level, the estate tax law would revert to 2001 law, in which case the state would gain $2.7 billion in revenues.

But the tax framework negotiated between President Barack Obama and Republicans appears to eliminate the mechanism that once provided estate tax revenues for states like California, according to the Tax Policy Center of the Brookings Institution and Urban Institute (hat tip to the Legislative Analyst's Office for sending the link). That mechanism was phased out over the past few years, so the fact that it has again been eliminated was not entirely a surprise.

Even if the federal government were to keep the mechanism, the reported rate and exemption level would lead to lower revenues. In 2001, the first $675,000 was exempted from taxation and the rate thereafter was 55 percent. The new proposal for 2011 calls for a $5 million exemption and a 35 percent rate.

There are some caveats: The federal tax package is far from a done deal, and the final language may change.

One more note: The absence of estate tax revenues would cause the state's spending guarantee for K-12 and community colleges to drop even further, according to LAO state finance director Jason Sisney. The LAO's November projection already assumed school spending would drop from $49.6 billion in 2010-11 to $47.5 billion in 2011-12. It's unclear how much further the guarantee would fall.

Because of the way state budget formulas work, Sisney said the absence of estate tax revenues would likely not have a dollar-for-dollar impact on the deficit, so the actual deficit growth would be less than $2.7 billion.