Texas: ‘The Better Choice’

Last week we started a series comparing California and Texas. Rather than get in the name calling and yelling match that the two states’ governors have engaged in, we wanted to look at economic factors of both states. The take away from our last issue was that both Texas and California were growing at the same pace till 2006. 2006 was the beginning of the end of the housing bubble that hurt California, but had relatively little effect on the Texas economy. Since then there has been almost a 2 to 1 exodus of individuals from California to Texas. This week we will continue to explore reasons for the shift towards to Texas.

The public policy contrast between California and Texas tends to make things clearer. Take the issue of taxes, for example.

In California, as we discussed last week, voters approved Proposition 30 to take effect January 1, 2013. Proposition 30 is a tax hike that pushed the state’s sales tax up by a quarter cent for four years and increased the income tax on those earning $250,000 or more a year for seven years, as well as collecting some retroactive taxes. Even before Prop. 30 was approved, California already had the second highest personal income tax rate and the highest state sales tax rate in the nation.

Then there is Texas. While the next legislative session has just begun, there is already plenty of talk about cutting taxes and a number of bills have been pre-filed to do just that. One of the more promising bills, Senate Bill 113, would do away with the state’s revised franchise tax entirely, making Texas the only state in the nation without a personal income tax or a business tax if enacted. But even if the legislative session passes and no changes were made to lighten the load on taxpayers, Texans would still enjoy one of the lowest state and local tax burdens of anywhere around (45th in the nation).

Spending

Let’s look at each state’s budgets and how the money is spent. In recent years, California has become the poster child of the big spending state while Texas has come to represent the polar opposite. This difference has really only gained attention as of late, but the data shows that this contrast has been ongoing for quite some time. From 1978 through 2009, using 2009 inflation-adjusted dollars, California state and local governments spent a total of $7.69 trillion dollars providing generous goods and services to its residents, according to the Tax Foundation. By comparison, Texas’s more frugal state and local governments spent only a total of $3.42 trillion over the same period, or about half of what California spent.

California’s population is bigger than Texas’s, but even when looking at the data on a per capita basis, the comparison is just as compelling. Consider that from fiscal 1978 to 2009, again using inflation-adjusted dollars, California’s state and local government per capita spending grew from $6,232 to over $11,200. In contrast, Texas’s state and local government per capita spending rose from $4,046 to $7,736 over the same period, still far below that of California’s budget.

State debt

California again shows its largesse in this category, while Texas takes the opposite approach. According to the Texas Comptroller’s report on state and local debt, ‘Your Money and Local Debt’ (issued 9/12), California state government’s per capita debt for 2009 totaled $3,641, while Texas state government’s per capita debt in the same time period came out to be $1,228. Even accounting for the local component, Texas’s debt levels are well below the Golden State’s. There are two ways to look at this. There could be the embarrassment that Texas does not take care of their less fortunate. This analyst looks at the difference in cost of living (35 – 40+% difference in favor of Texas) as well as fiscal responsibility and responsiveness to each state’s voters.

In matters of fiscal budget and policy, it seems that Texas and California are on two radically different paths with the former having clearly embraced low taxes, conservative spending and borrowing, while the latter continues to tax-and-spend at an accelerated rate. At this point, one can only speculate on the endgame, but if history is our guide, then California faces a difficult road ahead as it tries to maintain its ever-growing style of government.

According to the Tax Foundation, California’s state and local government consumed 11.8 percent of personal income in 2009, compared to the national average of 9.8 percent. By stark contrast, Texans pay 7.9 percent of income to support state and local government — making the Lone Star State the 45th-most-frugal state in the nation. Put another way, the cost of government in California is 49 percent greater than in Texas. This cost increase difference has happened over the last decade. Those opposed to the increase are voting with their feet and moving vans.

Poverty, jobs, and migration

On paper, California’s official poverty rate is a couple of points lower than Texas’s. However, the Lone Star state has a cost of living 42% cheaper than California’s and a lower unemployment rate. After considering the lower cost-of-living, Texas’s adjusted poverty rate is actually 7 percent lower than California’s (paying less for food, rent, and transportation matters a lot when you’re struggling to make ends meet).

Texas works with the same monetary policy as the other 49 states do. Texans pay the same interest rates on mortgages and on commercial and industrial and consumer loans; Texans work under the same federal regulatory regime governing banks and financial institutions and operate within the same financial parameters as the rest of the nation. The difference is not in the conditions, but how they are handled on a legislative basis. In the interest of full disclosure, we have some natural advantages: we produce more oil than Norway and more natural gas than Canada, but California is a close third to our output.

But here is a little economic secret: Like the United States, Texas has a more diversified economy than many states, including the ‘Golden State’. Over the last ten years we have seen Texas relying not just on energy and tech but a much broader base. There is no such thing as recession proof, but Texas through it policies as well as luck has become a much broader based economy, helping to insulate us from recessions. As this chart of where jobs were created in 2011 demonstrates, Texas is diversified pretty much along the same lines as the United States. The oil and gas and mining sector accounts for only 2.3 percent of our employment. The sector created over 37,000 jobs in 2011, but the trade, transportation and utilities, professional and business services, and educational and health services sectors created more.

Working under the same federal fiscal and monetary policy as the rest of the United States, Texas has created over 50 percent more jobs than it had in 1990, whereas other states not (just California) have not expanded as quickly. New York has expanded its nonfarm employment by a paltry 6 percent, Illinois by 8 percent, and California by 14 percent.

True, we lag many other states as well as those shown on this chart in social services. Texas is the antithesis of the welfare state. And yet Texas has become the indisputable leader of job creation in the nation, outpacing the United States by 2.5 to 1 over two decades. Texas has drawn massive inflows of business investment, and we attract significant numbers of immigrants from within the United States and from abroad. (Samsung’s $3.5 billion dollar investment in Austin is the largest foreign monetary investment in physical property in the US.)
Look at these charts of immigrant flows for Texas, New York, Illinois, and California.

Yes, Texans have shown a low propensity for social services. But Texas has shown strength and pride at creating the single most important driver of human dignity and pride: jobs. If you believe people vote with their feet, the balance we have struck between job creation and social services seems appropriate enough to attract the migration domestically of the other mega states. Texas must be doing something right

Realize that the employment graph above covers legislatures that, under both liberal and conservative leadership, were committed to creating a pro-business, pro-growth environment. We would suggest that if you want to see an economy that has avoided the traps of an overburdened social structure, and if you want to consider a fiscal and regulatory regime that attracts rather than chases away business and jobs, you might look to Texas.

You might then compare it to California, which has the opposite approach and is paying the price for it.

Proposition 30

The biggest difference I see emerging between the states is the new tax on entrepreneurs. California and Texas have always been an entrepreneurial birth place for many national and international companies. One of the concerns for these start ups is Proposition 30. Prop 30 hits entrepreneurs the hardest. How?

Entrepreneurs have an idea or product that they believe in and invest their focus, often forgoing steady jobs, life savings, as well as borrowing from many that they are close to. Many times, ‘sweat equity’ is traded as they hire their first employees, who otherwise go for years with little to no salary. Often the main source of compensation is the chance of future wealth by offering stock options.

That said, many startups end up failing. It’s just the nature of the business. But in those rare cases when something of great value is created and a meaningful ‘value’ event (usually in the form of an acquisition or IPO), nearly all the money earned from the undertaking hits at one time. Instead of the income being spread evenly over the life of the company (the average time to exit for venture-backed startups is 7 or 8 years), a single once-in-a-lifetime event occurs. Pushing all those years of entrepreneurship and low wages into an income that shows up in one single year, making entrepreneurs highly vulnerable to the some of the top marginal tax rates in California.

In California, a great example in the last year is Facebook, which many speculate could have been the impetus for Prop 30 in the first place. Many of Facebook’s workers toiled long hours and worked for low pay (at least in the beginning) to build one of Silicon Valley’s multinational, potentially multi-generational companies. When their deferred reward hit years later in the form of a much publicized multi-billion IPO, it proved an attractive tax target for California’s legislative branch. The only problem was that the IPO occurred before the vote on the tax hike, therefore you had the need for the retroactivity in Prop 30. Yes, you read that right – a retroactive tax hike, meaning those who worked for so little, will be taxed on profits before this proposition was in place. California now has the ability to tax those entrepreneurs and their first employees on their previous and current success.

I am not a lawyer or a tax expert, but a precedent has been set with Prop 30. Could voters or legislators pass harsher top marginal rates extending back to 2010 or whenever? We can laugh, but the state has now set a precedent where it can legally reach into individual’s bank accounts and take money out for retroactive taxes. It may just be me, but this creates a feeling of fear (of your government), resentment (on many levels), and uncertainty of doing business in that state — the worst possible environment for an entrepreneur investment to take place. It discourages any investing from equity (whether it be friends and family, angel or venture funding) because it reduces the return on potential gains. It begs the question – do you want to penalize those who are responsible for success in your state?

Will it prevent intellectual capital from growing in the state? Entrepreneurship overall should not decrease — most startup founders do it for the love of the entrepreneurial journey, or because they have a passion for solving a particular issue that they feel will be profitable. In this analysts eyes, Proposition 30 definitely takes entrepreneurs enthusiasm for starting new businesses in California less desirable.

There are so many inherent risks entrepreneurs and their financial backers take just to start a new company. They now have to think about an additional tax and regulatory risk in their state of origin. Great startups can now be built almost anywhere. The information age levels the playing field. When a young CEO or group of investors sits down with their lawyers, now one of the discussions is the extra cost of doing business in each state. Realize that entrepreneurs are job creators, risk takers, and innovators who generate new wealth. We know that small businesses generate nearly two out of three new jobs in the U S. as well as representing 85+/-% of our national GDP. We have seen so many large international companies start from someone’s idea in a garage. So why would California go after this group? “Because that’s where the money is.”

We’ve all heard of the migration of U.S. population and jobs from the North and West to the South. Some are convinced it was because of the extra sunshine and warmth in the winter. However, many of us are convinced it is more of an economic decision.

Let’s face basic business economic facts. Employers come to Texas and other southern locations because they feel that they can make a higher profit. Taxes are a major consideration. Lower cost of labor is a consideration. So is the cost of living. Now part of the decision is the tax consequences within your state.

There are many great reasons to live in the state of your choice; weather, family, or job creation. It’s the last thing that Texans can continue to be proud of as other states push their companies to look at a ‘better choice’. Texas is blessed to be the recipient of that better choice discussion. May we continue to realize why jobs are created here, rather than the other 49 states.

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