Brutal Honesty Over Hype Since 2008
The standard political response to criticism of California’s high tax burden is that businesses should simply accept taxation as the cost of operating in a prosperous market. This response fundamentally misunderstands how business taxation works in a competitive economy. Taxes on business are not absorbed by an abstract corporate entity — they are passed through to the humans who interact with that entity: consumers pay higher prices, employees receive lower wages, and shareholders receive lower returns. California’s tax burden is not a levy on capital — it is a levy on the people that capital serves.
The Hoover Institution’s analysis of California’s business tax climate, drawing on Tax Foundation data, makes this transmission mechanism explicit: if taxes take a larger portion of profits, that cost is passed along through some combination of higher prices to consumers, lower wages to employees, fewer jobs created, and lower dividends and share value to shareholders. The question is not whether these costs are real — they are — but how they are distributed across these groups in California’s specific economic context.
The Consumer Tax Pass-Through
When a California business faces higher operating costs than its competitors in lower-tax states, it has two options: absorb the cost differential in lower margins, or pass it through to consumers as higher prices. In competitive markets where consumers can source from out-of-state or online competitors, absorbing the cost differential is often the only viable option — which means the California tax burden translates directly into margin compression. In markets where California businesses face less direct competition — local services, healthcare, construction — the cost is passed through to consumers, who pay more in California for comparable services than they would in lower-cost states.
This is one reason why California’s cost of living is structurally high beyond just housing. The operating cost environment of California businesses is baked into the prices those businesses charge. The $800 franchise tax, the compliance costs associated with 518 regulatory agencies, the workers’ compensation premium rates, the payroll tax obligations — all of these flow through to the price of goods and services in the state.
The Employee Tax Pass-Through
The employee dimension of tax pass-through is less visible but equally real. When a California employer’s total cost of employment — wages plus benefits plus payroll taxes plus compliance costs plus workers’ compensation — is materially higher than in competing states, the employer faces pressure to reduce the wages component. This is not a straightforward mechanism, because California’s minimum wage and various employment regulations establish floors below which wages cannot fall. But at the margin, and particularly for above-minimum-wage positions, the high-cost operating environment does constrain the compensation employers can offer relative to their productivity expectations.
The counterargument — that California’s high wages are evidence of economic health — is partially correct but incomplete. California’s high wages reflect both genuine labor market productivity and the cost of living premium that forces workers to demand higher nominal wages simply to maintain comparable real purchasing power. A $75,000 salary in Sacramento buys less than a $65,000 salary in Phoenix, once cost of living is accounted for. The nominal wage comparison flatters California; the real wage comparison is much less impressive.
The Shareholder and Capital Allocation Effect
For businesses with external investors — whether public shareholders or private equity — California’s tax and regulatory burden is a direct drag on returns. A business generating identical revenues and gross margins in California versus Texas will generate lower net income in California due to higher tax and compliance costs. Lower net income means lower distributions, lower valuations on earnings multiples, and lower investment returns. Over time, this return differential steers capital allocation away from California — a rational response to risk-adjusted return differentials.
This is not a theoretical concern. The pattern of corporate relocations and new investment decisions visible across the California economy reflects, in part, capital allocation decisions made by investors and boards evaluating returns across geographic alternatives. When the same invested capital generates better returns in Texas, capital flows toward Texas. This is the market working as designed — it is also, for California, a long-term competitiveness problem.
The Politician’s Fallacy
California politicians frequently argue that the state’s economic size and prosperity refute the argument that its tax and regulatory environment is harmful to business. California’s GDP is the fifth largest in the world. Its technology sector is unrivaled. Its agricultural output is enormous. These facts are cited as evidence that the tax and regulatory environment is not actually a problem.
This argument commits a basic analytical error: it measures California’s absolute performance rather than its counterfactual performance. The question is not whether California has a large economy — it clearly does, partly as a function of its population, geography, and historical advantages. The question is whether California’s economy would be larger, more dynamic, and more broadly prosperous under a less burdensome tax and regulatory regime. The answer, from every economic study that has examined the question, is yes. California’s advantages are real. Its tax and regulatory burden costs it growth relative to what it would otherwise achieve. Both things are simultaneously true.
— The Hedge | Brutal Honesty Over Hype Since 2008
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