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December 1999

Guest Commentary
A "SMART" Proposal for the Future of California
By Kathleen Connell

Over the last four years, California's working families have watched their incomes soar, but they still cannot find affordable homes. This is because California is building new housing at only half the rate needed to meet future demand. As a result, the rate of home ownership in California is a dismal third from the bottom among states nationwide.

California's research, manufacturing and service industries have experienced unprecedented growth in profits, but cannot expand their facilities. Cities have zoned the largest available land parcels for retail uses only. Many local governments in California have watched their roads, libraries, parks and other community services deteriorate due to lack of revenues - all while state government and a handful of cities have celebrated unprecedented financial surpluses. As the state's chief financial officer, I realized that the cause of these anomalies is a defective statewide system of government finance.

Kathleen Connell is controller of the state of California. A former businesswoman, Dr. Connell was first elected in 1994. She was re-elected in 1998.

 In February, I convened a task force of governmental financing experts from throughout California to study shortcomings of our current approach to government financing and propose remedial alternatives. After six months of meetings and discussions, the State Municipal Resource Team (SMART) task force recently released a 50-page report that recommends a phased overhaul of the current formula for sales and property tax distribution.

Since 1992, the state has used approximately $21.4 billion in local property taxes to fund state obligations. Without these diversions, that property tax revenue would have been available to local governments. Control over that tax revenue translated into political power for Sacramento, and state elected officials have been reluctant to permanently return any portion of those revenues to local governments, even when they could easily afford to do so. Despite a $4.3 billion surplus in the 1999-2000 state budget, only $300 million was appropriated for discretionary spending by local governments.

The SMART tax plan proposes to "cap" these diversions of property taxes by state government, increasing annual local revenues by $450 million. By adding another $150 million to the state's existing local government financial package and distributing the entire $450 million in accordance with the SMART plan, local governments will receive a much greater share of the property taxes generated within their jurisdictions.

The SMART proposal uses this property tax dividend as an equalizing tool so that local sales tax can be gradually shifted from distribution based on point-of-sale to distribution based on population. During this transition, some of the cities' sales tax receipts are "swapped" with their respective counties so that cities and counties would have a more balanced revenue stream. Cities will have a more predictable revenue flow and a true financial incentive for increasing property values within their jurisdiction. Counties will benefit from the high growth potential of sales taxes. In this manner, the SMART plan can both encourage balanced growth and end the disturbing preoccupation of local governments with retail businesses.

The battle over local sales taxes has become a municipal blood sport.

For the last 20 years, some California cities have been increasingly engaged in war-like competitions to attract businesses that generate retail sales taxes. Since the local portion of the sales tax has been distributed to the city in which the sale occurs, city officials have used their residents' tax dollars to underwrite expensive subsidies to attract giant retail stores and auto dealers. As the regional retail feeding frenzy escalates, businesses pit one locality against another by demanding more and more expensive taxpayer-financed "incentives." This phenomenon is called "retail fiscalization."

The result is that traditional downtown business districts, residential housing, and high-income employment opportunities are sacrificed in exchanged for miles of car lots and "big box" discount warehouses that pay relatively low wages but generate high retail sales taxes. The financial managers of these "car lot" cities justify this distortion by protesting that their city cannot afford the demands of additional residents.

For example, in the 1997-98 tax year, the City of Industry generated approximately $34,000 in sales taxes for each of its 690 residents. A few miles away, Lynwood, with 68,500 residents, earned less than $27 per resident in sales taxes. The combined population of Cerritos and Santa Fe Springs is approximately 16 percent that of Long Beach. Yet by focusing on retail businesses, particularly auto malls, in 1998-99 those two cities generated one and a half times the sales tax income of Long Beach.

These so-called "successful" cities generate disproportionate retail sales taxes by using "corporate welfare" to financially underwrite car dealerships and warehouse discount stores. This enables those businesses to undercut regional competition and lure residents and revenue from neighboring cities. This financing approach by local government more accurately resembles a "fiscal food chain" in which each local government aggressively attempts to seize tax revenues at the expense of its neighbors. The battle over local sales taxes has become a municipal blood sport.

By ultimately distributing sales tax revenues according to population, without regard to where the sale occurred, these predatory tactics will end. Cities will be compensated in proportion to the actual demand for government services and be rewarded for encouraging balanced growth. Residential, commercial, industrial and retail development will regain equal footing under the tax system. The pursuit of residential housing and high quality employment opportunities will once again become a positive fiscal investment strategy for California cities.

The SMART report provides the vast majority of California residents with a creative response to a challenging problem, an innovative blueprint for financing and building commercial and residential development within California's local communities.

By ultimately distributing sales tax revenues according to population, without regard to where the sale occurred, these predatory tactics will end.