On June 6, 1998, Proposition 13 will turn 20 years old. This landmark ballot measure dramatically reduced and changed the taxation of property and has influenced changes in the entire public finance system for state and local government in California.

It is not surprising that the government spending lobby takes every opportunity to blame Proposition 13 for problems facing government, and the occasion of this 20th anniversary has spawned such commentary in the media.

To provide the taxpayers' perspective on this anniversary and to re-emphasize the benefits that have come to Californians because of Proposition 13, Cal-Tax has updated this article on Proposition 13, which originally ran in the November 1993 Cal-Tax News under the title "Proposition 13: Love it or Hate it, its Roots Go Deep." This article examines California's property tax system. It highlights the strengths of acquisition-value assessments and projects the ramifications of possible changes to the taxation system established by Proposition 13.

Taxpayer Revolt
In 1966, after an assessors' scandal, the Legislature enacted a reform bill (AB 80) to keep assessments at a uniform percentage of market value. As a result, during the 1970s, when real estate values escalated rapidly, so did home assessments.

By 1978, with home ownership threatened by escalating property tax bills, the fate of Proposition 13 was sealed. The tax revolt was born, aided in part by the release of new assessments just prior to the election showing large increases in assessed value for many taxpayers.

On June 6, 1978, voters selected Proposition 13 over Proposition 8, an alternative proposal to lower and stabilize tax rates. The latter, placed on the ballot by the Legislature, had no control on rising assessments. It garnered 47 percent of the vote; Proposition 13 was approved by 65 percent.

Acquisition Value Provisions of Proposition 13
Section 2 of Article XIIIA of the California Constitution (enacted by Proposition 13) establishes an acquisition-value assessment system. It provides that property is to be assessed at its value when acquired through a change of ownership or by new construction. Thereafter, the taxable value of property may increase annually by no more than the rate of inflation or 2 percent, whichever is less.

There are certain exceptions: (A) market value, if lower than acquisition value, establishes value for tax purposes; (B) property transferred to a spouse, between parents and children, etc., is not reassessed; (C) certain other changes of ownership, added to Article XIIIA by voter approval in the years since 1978, do not trigger reassessment, and (D) property assessed by the State Board of Equalization, such as property of state-regulated utilities, is not subject to the acquisition-value limitation. (See ITT World Communications v. City and County of San Francisco, 1985.)

Constitutional Validation
Almost immediately after passage, the California Supreme Court sustained Proposition 13's constitutionality in the Amador case (Amador Valley Joint Union High School District v. State Board of Equalization. September 22, 1978). After a series of legal challenges in the 1980s, the issue of acquisition-value assessments reached the U.S. Supreme Court in Nordlinger v. Hahn. In a stunning 8-1 decision, the court in 1992 upheld California's acquisition-value system.

The court ruled that an acquisition-value system does not violate the Equal Protection Clause of the U.S. Constitution because it rationally furthers a legitimate state interest. The court said, "The state legitimately can conclude that a new owner, at the point of purchasing his property, does not have the same reliance interest warranting protection against higher taxes as does an existing owner who is already saddled with his purchase and does not have the option of deciding not to buy his home if taxes become prohibitively high."

The court also opined that a state has a rational interest in neighborhood preservation, continuity and stability, and that Proposition 13's system of "locking in" lower tax assessments contributed to such preservation.

Acquisition Value Versus Assessed Value
Many other property tax systems link tax liability to market value. Property is often equated to wealth and the ability to pay. Thus property taxes predicated on market value, the theory goes, should be equitable and affordable.

Inequity by market-value standards is the chief argument used by critics against Proposition 13. They point to inequities between side-by-side properties that receive similar government services but pay differing property taxes.

A 1993 study by the California Policy Seminar (CPS), a joint program of the University of California and the State of California, focused on the inequity argument. It found on average in Los Angeles County that properties with a 1975 base year were assessed at 19 percent of market value, while 1991 base-year properties were assessed at 100 percent, a five-to-one ratio of disparity. This was a key argument presented by those challenging Proposition 13 to the U.S. Supreme Court in the Nordlinger case.

Disparities in property tax systems are nothing new. In a 1966 report entitled "Problems of Property Tax Administration in California," the Assembly Committee on Revenue and Taxation reported that equalization of assessments was "more a myth than a reality."

At the time of the study, California had a traditional ad valorem property tax system. County assessors periodically reassessed properties to market value, and aimed for a reasonably uniform assessment roll. The results, however, showed dramatic variances.

The data for assessment roll year 1965 demonstrated there were serious departures from the goal of uniform assessments. In San Francisco, for example, where the average countywide assessment ratio (assessed value to full value) was 18.6 percent, one industrial property from a sample of 42 properties was assessed at 4.6 percent of full value, while another was valued at 114 percent.

Sparsely populated Trinity County showed even wider disparities. In a sample compiled from records of the State Board of Equalization, one vacant residential lot was assessed at 3.8 percent of full value, while certain timber land was valued at 212 percent. Countywide, the average assessment ratio was 19.9 percent.

The county with the best record for uniform assessment, Contra Costa, had only 24.4 percent of the properties sampled fall within a 15 percent tolerance zone. The worst performance was turned in by San Francisco County, where 89.2 percent of sampled properties fell outside a 15 percent tolerance range. Indeed, in that county, almost 42 percent of sampled properties were more than 50 percent above or below the county average assessment ratio.

Even after enactment of the reforms in AB 80, uniform assessment remained elusive. According to a State Board of Equalization study, Sierra County in 1977 had five times more variance in assessments than did Marin, the most uniform of all the counties.

From these data it is obvious that pre-Proposition 13 property tax disparities were at least as flagrant as in the examples in the arguments on behalf of Stephanie Nordlinger, a Baldwin Hills resident whose 1988 suit against the Los Angeles County assessor reached the U.S. Supreme Court. Indeed, the 1965 San Francisco sample showed wider divergences than have occurred in Los Angeles County assessments since 1975. According to the CPS report, fully 18 percent of all Los Angeles County properties had disparity ratios (market value to assessed value) of less than 1.27, and another 43 percent (those with a 1975 base year) had the exact same tax rate.

In Defense of Acquisition Value
Proposition 13 supporters point out other reasons for defending the acquisition-value approach. Wallace F. Smith, a professor of business administration at the University of California at Berkeley, has concluded that there really is no higher tax burden on new home buyers compared to those holding a home for a longer time. His work showed that the increased tax assessments on a new buyer were completely capitalized into a home's price, meaning the higher tax is offset by a lower home price which compensates the buyer for the increased assessed value.

Others argue that as real estate values gradually drop or grow slowly, the disparities between 1975 base-year properties and newer properties lessen. For instance, a high percentage of properties purchased after 1989 received reduced assessments in the early to mid-1990s, reflecting a declining real estate market. Thus, the disparity between those more recently purchased properties and properties held since the late 70s and early 80s declined accordingly.

Progressivity of Proposition 13
One measure of tax equity is ability to pay. Taxes are deemed more equitable, by this measure, if those who can afford more pay more. Under this standard, acquisition-value assessments appear to provide property tax equity. According to the CPS study, the acquisition-value system has a progressive impact on the tax structure. Low- and middle-income taxpayers, on average, pay less than they would under a market-value system and higher-income taxpayers pay more, according to CPS findings.

The CPS report concludes: "A revenue-neutral reform of Proposition 13 would have unwelcome distributional effects. Using a match of property tax rolls and income tax returns, we were able to analyze the effects of alternative changes in the property tax system on homeowners. Consider the following experiment for Los Angeles County. Raise all assessments to true market value but lower the property tax rate to raise the identical amount of total revenue. We estimate that this policy would adversely affect elderly and low-income households. In fact, according to our calculations, 92 percent of the elderly would lose under this revenue-neutral reform.

"Under the hypothetical revenue-neutral tax change described for Los Angeles County, the 43 percent of households with 1975 base years would find their property tax bills increasing by over 160 percent!"

Table 1, developed from the CPS study, illustrates the progressivity of acquisition-value assessments.

Average Change in Tax Liability for Different Income Groups  Table 1 (Assumes asessments are raised to market value and tax rate is reduced so the net change is revenue neutral.)     Average Change in Tax Liability Personal Income  Alameda  Los Angeles  San Bernardino  San Mateo  0 - $10,000 $268   $179  $65 $335  $10,000 - $20,000   304  206  79 386  $20,000 - $30,000   213  138  38 294  $30,000 - $40,000   95  57  -3 164  $40,000 - $50,000  5  0  -25 62  $50,000 - $60,000  -47  -22  -35  6 $60,000 - $70,000  -105  -49  -47  -50 $70,000 - $80,000  -162  -69  -60  -105 $80,000 - $100,000  -233  -109  -56  -202 More than $100,000  -366  -335  -61  -530 Source: "The Future of Proposition 13 in California," California Policy Seminar, March 1993, University of California.

Stability in Revenue Flows
High volatility in tax systems leads to a lack of predictability and certainty of revenue for governmental agencies for planning, budgeting and management purposes. Acquisition-value assessments provide greater stability and predictability of revenue flow to local agencies than any other major tax.

All government revenues are affected by economic conditions, resulting in slow tax growth or even reductions in collections when the economy enters a recession. The early 1990s brought a severe recession to California, causing sales tax, personal income tax and corporate income tax revenues to decline. The reduction in revenues led the Legislature and governor to increase the rates of sales and personal income taxes. But even while the recession produced 30 percent reductions in property values in many parts of the state, property tax revenues never stopped growing.

Growth in property tax revenue did slow down in the mid-1990s (it had averaged over 10 percent in the 1980s), but it continued to produce modest revenue increases without a tax rate increase (see Figure 1). By comparison, if lawmakers had not increased sales and income tax rates in 1991, state sales tax collections would have fallen off some 3 percent in 1991-92, and personal income tax revenues would have been down about 6 percent that same year.

Acquisition-value assessments have worked in the nature of a reservoir by keeping a reserve of value that will accrue to local entities each year. Stable revenue flows are ensured by the unrealized market value that is taxed when properties change hands and by the many properties that can be assessed upwards by 2 percent each year because their assessed values remain well below market value. Even with falling real estate values, property tax growth held up because of this reserve value. If California had used a market-value property tax system during this time of reduced property values, the results would have been drastic reductions in revenues to local jurisdictions.

An August 4, 1994 article in the Los Angeles Daily News highlighted this reserve feature of Proposition 13 when it noted that Los Angeles County's tax rolls increased even while property values were falling because of the recession and lingering damage from earthquake, floods, riots, and fires. "Thank goodness for Proposition 13," said Gil Parisi, special assistant to the county assessor's office.

Objective Standard of Measurement
Proposition 13 introduced an objective standard upon which property is taxed. For most properties, the purchase price is the value placed on the roll, and this value is changed by no more than 2 percent per year until there is a change in ownership and another purchase price.

Under a market-value system, the assessor's opinion of value is the basis of assessment. The State Board of Equalization admitted prior to Proposition 13 that "no assessor, even one given unlimited resources, could produce an assessment roll in which the appraisal of property was strictly current and precisely accurate in all respects."

The subjective standard of the market-value system led to assessment abuses in the 1960s and 1970s as assessors had enormous latitude to determine values for taxation. Several assessors were sent to prison during this period.

Acquisition value removes subjective judgment and discretion, and reduces the chances of corruption.

Predictability for Taxpayers
One of the major arguments used by the campaign in support of Proposition 13 in 1978 was that it would give taxpayers predictable property taxes. This argument was also well received by the court in Nordlinger v. Hahn and in earlier cases dealing with the issue of acquisition-value assessment.

Taxpayers are protected under an acquisition-value assessment system with the certainty that the property tax burden will grow no faster than 2 percent per year. Thus property owners can know precisely how much the property tax liability will be at the time of purchase and at any time in the future.

This contrasts dramatically to a market-value ad valorem system where taxpayers can be taxed on the paper gain in the value of property. Prior to Proposition 13, this had the impact of doubling and quadrupling the property tax burden of homeowners very quickly due to unrealized appreciation in the value of their property.

The 1990s brought a huge drop in real estate values after the overheated 1980s market produced unrealistic property value gains. The temporary run-up in housing prices in the late 1980s illustrated how the market value of property would not have been a good indicator of wealth or ability to pay and would have been an entirely inappropriate base for taxation. Fortunately for taxpayers, Proposition 13 protected homeowners from being taxed on those illusory gains in property value.

Pressures to Change
The advantages of Proposition 13's acquisition-value approach notwithstanding, there exists pressure to change the system. Longtime opponents of Proposition 13 - including advocates of bigger government - have claimed that government has suffered from insufficient funding and that owners of business property have benefitted too much from Proposition 13.

Looking to the 1998 ballot, public employee unions worked on an initiative that would have included a repeal of Proposition 13's acquisition-value assessment procedures for corporations. This would have been a partial repeat of the failed Proposition 167 (1992). An initiative for 1998 was not pursued, but its backers stated their intentions to try to qualify it if other political events did not go their way. These kinds of proposals also surface in the Legislature from time to time.

Common to many of the policy discussions about changing Proposition 13 are four proposals. These are:

Equalize up
Equalizing up would bring all properties to market-value ad valorem assessments. This would have the effect of raising taxes substantially for many homeowners with 1975 base-year values and those who have transferred property or constructed properties since that time and who benefitted from inflation protection provided in Proposition 13. Equalizing up would provide several billion dollars of additional revenue to local agencies.

Changing Proposition 13 by raising taxes dramatically on older taxpayers who are high-propensity voters would be politically difficult. Such a plan would threaten homeowner voters with the prospect of tremendous increases in property taxes that could push them out of their homes. It would also tend to reduce resale values.

Equalize down
A change in the opposite direction would involve equalizing all properties downward to achieve equity. Most often this is discussed in terms of establishing 1975 base-year values for properties existing then, and indexing values for properties constructed since that time.

Equalizing down would substantially reduce revenue to local agencies. This would amount to several billion dollars per year in revenue reduction. While this could initially sound enticing to some, the predicted impacts on public services could convince many voters to reject the proposal, even though property values would increase.

Equalize up and reduce the rate
A third approach would combine equalization upward - bringing properties up to market value - with a rate reduction to ensure revenue neutrality and avoid revenue windfalls to local agencies.

This third approach has received a good deal of attention and focus in recent years. The objective of equalizing property assessments without producing substantial additional revenue for local agencies sounds reasonable. However, the problem with this approach is that it would result in major tax increases for low-income and elderly property owners, despite a rate reduction.

As an example, from the CPS study noted earlier, in Los Angeles County, 92 percent of the elderly would pay more property tax under such a plan, and 43 percent of households would pay 160 percent higher property taxes.

The major drawback in each of these three approaches is that taxpayers would again be placed at risk for large tax increases if property values increased. Further, the purchase price would no longer serve as an objective standard of assessment. Once again, a subjective standard - the assessor's opinion - would be used to determine property assessments. Finally, the change-of-ownership cushion that keeps the assessment roll and property tax revenues growing during economic downturns would be lost.

Split Roll
A fourth alternative is to impose a split-roll property tax in which business would pay property taxes at a rate higher than that imposed on residential properties. Essentially, higher business taxes would allow equalization downward for homeowner property taxes.

At least three prominent studies have recommended a split roll, including the California Policy Seminar (CPS) study mentioned earlier. In 1991, the Senate Resolution 42 Study Commission and the California Tax Reform Association recommended a split roll. A 1985 preliminary report from Governor George Deukmejian's Tax Reform Advisory Commission referenced the split-roll approach, although this recommendation was not incorporated in the commission's final report.

Several split-roll proposals have surfaced since Proposition 13; none has been successful. The most recent effort to be rejected - by a 2-to-1 vote - was contained in Proposition 167 in November 1992.

Arguments Against the Split Roll
A split-roll property tax would be bad economic policy for California, because business already pays its fair share of property taxes, and California needs to become more competitive to attract and retain job-producing businesses.

There is no evidence that business is not paying a "fair share" of property tax. Indeed, evidence abounds that the opposite is true. According to a 1997 calculation by the State Board of Equalization, business properties are assessed at 86.69 percent of market value. The ratio of assessed value to market value for other property was much lower when measured in the CPS study. (The statewide average, including business properties, was 55 percent.) The ratio of business assessed value to market value has been increasing steadily, as shown in Figure 2. This ratio is an estimate calculated by the State Board of Equalization based on the average reassessment of business properties when sales occur.

The massive tax increase on business from a split roll would either be passed on to consumers (in a regressive fashion) or make California business less competitive, resulting in job losses as some businesses move to other states. In 1992, a somewhat limited split-roll measure contained in Proposition 167 was estimated as a potential $1 billion to $2 billion property tax increase on California businesses. More far-reaching proposals, which would increase all business property assessments to market value, would increase taxes many times that amount. Small businesses, including many that are struggling to survive, would be particularly hard hit.

Conclusion
Difficult political realities surround any proposal to change the acquisition-based assessment system. Problems with equalizing up, equalizing down, and equalizing up with a rate reduction have been evident for some time.

Even though a split roll has been recommended by some studies, it too would be inequitable and very difficult to achieve politically. Public opinion surveys associated with 1992 statewide ballot measures showed voter attitude against a split roll.

If California did not have an acquisition-value standard for assessing property, it would have to consider creating one. An acquisition-value standard has advantages for taxpayers and for government. This system is more equitable as it links tax liability to ability to pay more directly than a market-value system. It is also more predictable for taxpayers, removes much of the problem of subjective assessments, and protects homeowners against prohibitive property tax increases during periods of rising values.

For businesses, most find the predictability of Proposition 13 one of the few bright spots in California's often-burdensome climate of taxation and regulation. For government, acquisition value has created a stable and fast-growing revenue source, with a reserve of value to cushion revenue downturns in economic bad times.

This report was prepared by Cal-Tax Research Director Stephen Kroes, Chief Tax Consultant David R. Doerr, and Communications Director Ronald W. Roach.