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February 2000

Taxes: Cal-Tax Q & A

Senator Peace: Cure Prop. 13 'Sickness' by Reassessing Commercial Property, Boosting the Homeowners' Exemption and Cutting the Sales Tax

Senator Steve Peace has decided to lock horns with Proposition 13, the 1978 property tax-slashing initiative that he believes is no longer immune from change.

The Democrat from San Diego County says he has been speaking out against Prop. 13 for quite some time now, touching this "third rail" of California politics, and he's still alive - and kicking. He's more determined than ever to take whatever political risk there may be, while eyeing statewide office in the months ahead.

Mr. Peace, chair of the Senate Budget and Fiscal Review Committee, will have completed 20 years in the Legislature in 2002 when his current term expires and he cannot seek re-election. He said he is raising money to run for California secretary of state.

Besides his legislative career, he has owned and operated a film production firm, Four Square Productions.

He explains why, how and when he intends to attack Proposition 13. He will leave the tax rates alone, and win the hearts of homeowners by increasing the homeowners' exemption. A one-time reassessment of commercial property would increase property taxes on businesses, but he says businesses would prefer to pay that if sales taxes are reduced.

Following are the senator's views as set forth in a Q-and-A session January 4 with Cal-Tax Digest:

Q: Are you considering leading a push to change Proposition 13? What do you have in mind?

Senator Peace: The authors of Proposition 13 would be the first to say that not all that has come in the aftermath of 13 are things that were contemplated or intended. The core motivation of 13 was to keep people from being taxed out of their homes, and that was an important goal. It was clearly a circumstance, which local government and the Legislature at the time failed to respond to, and the people ultimately cured by way of initiative.

Initiatives sometimes have collateral damage. Because Proposition 13 was so powerful politically, there was never the opportunity to go in and fine tune and ensure that it dealt with the disease that motivated the initiative in the first place without creating all kinds of other illnesses. We are still dealing with those collateral illnesses today.

Q: What are some of these side effects?

Senator Peace: Lack of local control and local decision-making capacity too much power in Sacramento. That has its roots in 13. Cities, counties and school districts are ultimately more dependent upon the state as a financier. Whether you're sending your kids to college or starting a business, he who pays the piper calls the tune. And you wouldn't want a system in which you had one entity over here responsible for financing things and somebody else in control, because you have no accountability for the money. But, that's what we've got.

Second, it has been called many things year in and year out. The current term is "fiscalization" of land use. As cities have become dependent on the sales tax, it clearly has driven very poor land use decisions. That has a consequence, not only in terms of the "big box" super store phenomena, but the kinds of jobs driven out of retail in turn reduce the disposable income, in essence, of our citizens. And it impedes growth by moving away from a job mix that otherwise would have a much higher manufacturing component. The irony is local government has the incentive, in the short term, to chase sales tax. In the long run, they actually are diminishing their revenue stream.

Steve Peace, first elected to the Legislature in 1982, represents the 40th District in the state Senate.

The most unhealthy aspect is the perception that city councils, members of boards of supervisors or state legislators have pitted themselves against each other in this war over the dollar. The real world is we are all in the same pot. We all represent the same citizens. We all have the same kids we are trying to serve in terms of having them grow into adults who are healthy physically as well as economically. If we make the pot big enough for everybody, we'll do that. The big problem now is Prop. 13 and all the actions the Legislature took over the ensuing years to try and backfill local government have us in a constant battle over these various mystical formulas.

Q: Isn't it politically dangerous to criticize Prop. 13, much less be out front trying to change it? As you know, it has been called the third rail of California politics - touch it and die.

Senator Peace: Almost every initiative that has anything to do with money since 1978 is really a subset of Prop. 13. Every year we talk about the funding guarantee for schools (Proposition 98 of 1988), which is really the son of Prop. 13. Without Prop. 13, you don't have the political environment to drive Prop. 98. You have the cities talking about running an initiative to have some similar kind of guarantee for the cities. So all of these are out there.

We as a Legislature - not just the Legislature, but local politicians - have been unwilling to utter the words "It is time to change Proposition 13," not because privately there wasn't the recognition this whole time that it was irrational, and it was hurting citizens under any objective criteria, but because it was part of the political lore. It was the death penalty for even saying it. And somebody had to say the words, so I spent last year saying the words. And I'm still standing.

I've been up and down the state holding budget committee hearings and I've made a point of raising the question and asking people if they agree, that Prop. 13 must be changed. The response throughout the state, from local government officials who in past years would have been afraid, even if they agreed, who were politically fearful of stepping forward and joining in and saying, "Yes, you're right." They've said it. A strong majority of local government officials agrees that having that conversation is politically survivable. People may disagree about what that means, what it is that ought to be done about it, but it is a critical juncture politically to have gotten to the point where we can talk about it. And I think there is an opportunity.

Q: Why change the tax structure? It is producing plenty of revenue.

Senator Peace: California's tax structure is burdensome, we need tax cuts, we have this fiscalization of land use, and we have problems with respect to the independence of local government. We have problems with respect to a reliable income source for our school systems. There really is a convergence here. They really are all the same issue. Our current tax structure doesn't make sense. Prop. 13 Is at the heart of it because every other tax that we have, our income tax and our sales tax levels, are all driven with the assumption the property tax mechanism is going to stay exactly as it is. That doesn't make sense.

The reason that's hurting us in so many ways may be best exemplified by the overlaying issues. It is rather ironic that in every community of the state there are discussions now about extending sales taxes, either laying on a new sales tax or extending an existing sales tax.

Senate President pro Tempore John Burton also has a major sales tax proposal in terms of roads (SCA 3, which would allow local sales taxes for roads to be approved by majority votes instead of two-thirds). People recognize the problems of gridlock and the need to be more aggressive. But at the same time there's a separate conversation going on throughout the country among those who fear what relying on sales taxes may mean, because of the emergence of the Internet. Governors from all over the country are concerned, looking ahead to the diminishing reliability of sales taxes as a revenue source.

Similarly you have a third rail in terms of the sales tax problem. And that is, in 1986, Congress changed federal laws to make sales taxes nondeductible.

It was the death penalty for even saying it. And somebody had to say the words, so I spent last year saying the words. And I'm still standing.

 Now, if I put all those things together: the perception that taxes are too high, and the fact cities and counties are rushing to find some other way because they have fear in terms of sales tax reliance. They know they've got themselves in trouble with respect to their sales tax reliance, even to the point of now having a proposal that would in essence have the state swap other tax revenues for the sales tax. They want to give the state the sales tax. They've got this general angst about relying on sales tax. And most fundamentally, the fact the sales tax is not deductible. And to me that is the heart of where the conversation needs to start.

Q: So what do you propose? Change the deductibility of the sales tax?

Senator Peace: We can't do that. It is a federal law. What we need to do, if we are going to make responsible tax policy for our citizens in California, is figure out how we have the lowest possible tax generate the highest possible yield. And when we look at Californians' tax obligations, we should be looking at their ultimate net tax obligation, because every penny we send to Washington is money lost. So, if I collect a dollar in income and property tax to spend on schools, on roads, on libraries and parks, I can spend a dollar on roads, libraries, parks and schools. If, on the other hand, I collect a dollar in sales tax, I only get to spend 65 cents because 35 cents goes to the federal government. Put more accurately, I've got to charge $1.35 in sales tax in order to get a dollar. So I am overtaxing my citizens when I rely on sales taxes.

And if we look at our tax structure and compare it to other states, you can bring us back to the property taxes discussion, and you say, "Gosh, OK, simple, Steve, then lets just drop the sales tax." Our income tax is already pretty high. So you naturally are going to be looking at the property tax.

Now, start with the premise that we don't want to raise property taxes for homeowners, and we don't want to get rid of the Prop. 13 core intent of protecting homeowners. Everybody knows there's no news to what the periodic complaints are of the Prop. 13 formula: no periodic reassessment. Only reassessment on sale, and that creates tremendous inequity within the property tax structure, particularly in the business equation. I own business property. I can be right next door to a competitor who happens to have been there selling the same goods. I can have 10 times the property tax burden simply because I'm a new business that came in and bought the property. More interestingly, if you are a more sophisticated and larger enterprise, you can avoid, through legal and accounting mechanisms, changes in ownership that keep a reassessment from occurring. That's an option a less sophisticated or smaller property owner doesn't have.

Similarly, for homeowners, we have reached the situation where the burden of that tax of the (acquisition value) assessment methodology actually hurts more people that it helps. Just because of the march of time, for most people, the properties have turned over and are assessed closer to true market value.

You can lower tax burden for a variety of people in terms of how you assess. As I look at tax burden, as a businessman, who does own commercial property, and pays sales tax as well, I'd rather swap. I'd rather have lower sales tax and have a higher property tax because the property tax is deductible. I'd rather have that money stay here and go to the benefit of increasing the potential of growing my business, rather than have it go back to Washington and have them do with it whatever it is they do with it.

It also means I can get a tax cut in the process because I swap a sales tax dollar for a property tax dollar. For simplicity sake, say I split the difference in terms of the federal tax rate, I can get a 15 percent tax cut and improve the yield to the state by 15 percent, just in the swap.

Q: Are you saying you want a "split roll" to increase taxes only on business property?

Senator Peace: No, you don't have to go to a split roll. What you can do is simply expand the homeowners' exemption and you keep a unified tax rate. You can also turn the homeowners' exemption from a fixed rate that graduates so you have a dollar-for-dollar tradeoff. You assure no increase in homeowners' taxes.

And you can also look at the reassessment process, which may be as simple as a one-time reassessment of all commercial property. But if you get the base up, and the reason why that's fair, and it's very consistent with Prop. 13 and the Prop. 13 effort, is that homeowners are currently paying an unfair share of property taxes. That's because what has happened over time, because of turnover in residential property is much faster than commercial property. Thus the percentage of property taxes paid by the commercial sector is dramatically reduced as a portion of the overall property tax burden. So now , particularly after you factor in add-on fees and assessments, you have homeowners being overtaxed. And, ironically, that is the mathematical out-year result of Prop 13. I don't think that was the intent of the authors.

It also means I can get a tax cut in the process because I swap a sales tax dollar for a property tax dollar.

 Q: Why would businesses support an increase in their property taxes?

Senator Peace: There's no chance of being successful unless the California business community not only supports, but takes a leading role in promoting this tax structure change. And the reason why they should is because it is in their economic interest. The California Business Roundtable and others recognize the gross deficiency in infrastructure investment, and they are pushing legislation to attempt to capture revenue streams to attempt to cure that.

Q: Aren't you the author of the legislation?

Senator Peace: Yes, of the Business Roundtable-sponsored measure. The original notion was to capture an increment of sales tax to do that. I'm attempting to persuade them that it is in their economic interest and the citizens' economic interest not to capture an increment of sales tax but to capture an increment of property tax. It makes infinite sense for those of us who own commercial property to be the source of revenue to build infrastructure, because that is what infrastructure accommodates. It accommodates the opportunity for the expansion of business opportunities. And by shifting away from the sales tax, cities will be more accommodating to manufacturing and industrial development. That is what business needs to occur. Because cities will no longer be driven by the sales tax, you will get a rationalization of land use policy.

Q: How much would you cut the sales tax?

Senator Peace: Certainly something in excess of $1 billion. In an ideal world you would get rid of sales taxes altogether. But the yield from sales taxes is too high (sales and property taxes both produce revenues in excess of $20 billion a year) to be replaced from other sources. What we're working on is how far can we drive that sales tax down? And my goal is to make the sales tax as low as I possibly can. My goal here is to have a net tax cut for California and at the same time increase the amount of money the state has to invest in schools, roads and highways.

Q: Are you looking at expanding the base for the sales tax?

Senator Peace: I haven't looked at that, although it is something I can see people bringing to the table. It is not something I consider doing, because, remember, my goal is to get away from the sales tax.

Again, I think the smart place to be, and I'm thinking strategically, from California's perspective, is that states with low sales tax rates will have an advantage in the future. If it is true that the Internet sales world is emerging and it is also true that the governors and the federal representatives arrive at some sort of agreement to allow for state taxation, presumably, that's going to be at origin of sale. Now, don't we have the opportunity to keep a lot of these emerging industries here in California and attract new ones if, in fact, we are a very low sales tax state? If we keep those businesses here, we'll still do great because we'll expand our property tax base as well as our income tax base.

It's really an interesting convergence. You have this old Prop. 13 problem and this emerging new economy. They have the same solution. The smart things for California to do, to rectify the perceived inequities of past consequences, are the exact same solutions that are necessary for us to anticipate what the world is going to look like 20 years from now and put California ahead of the curve and be an attractive place to do business. And at the heart of it is accepting reality that sales taxes are not a smart way to get income.


There's no chance of being successful unless the California business community not only supports, but takes a leading role in promoting this tax structure change. 

And the interesting thing, the hard part of that, is politicians are initially going to have a hard time accepting that, because their pollsters and their political consultants are going to say, "Oh, the only tax that you can get away with expanding is the sales tax." It is the easiest one to sell. And the reason for that is people go out and buy something and they feel like they can control whether they pay the sales tax or not by not buying anything. But the reality is they are getting soaked. A too-high sales tax is soaking Californians. It is a rip-off. And if somebody will start telling the real story, public attitudes about preferences over taxes will change.

People were getting ripped off by their property taxes 30 years ago and they responded, and appropriately. Somebody told them there was a way to do it. Today people are being ripped off by sales taxes that are too high and are not in the economic interest of the citizens of the state on either side of the equation. Whether you are interested in yield or you are looking at it from the standpoint of what the burden is on the taxpayer, it is an inefficient tax that creates all kinds of distortions.

Q: When are you introducing the legislation, or can you simply amend the measure you're carrying for the Business Roundtable? How does Roundtable President Bill Hauck feel about it?

Senator Peace: I don't want to speak for Mr. Hauck. I have had a number of conversations, positive conversations, and the leadership of the business community certainly understands these relationships. They are going to have to make their own decisions about the politics. It's less about whether something makes sense but whether you can sell it, and because there is no current proposal on the table, it's premature to say, "Go and sell this to your members." Am I prepared to carry that? Absolutely. Making any material changes, of course, requires a constitutional amendment subject to a vote of the people, and what I would hope to do is to put that on the ballot by 2002. I suppose there's an outside possibility I could get it on the November ballot, and I'm certainly not adverse to that, but you've got an educational process first.

This is such an historical opportunity. It's not often you can identify five or six different big picture problems and one change solves or improves upon four or five of them.

Q: Proposition 26 on the March 7 ballot would amend Proposition 13 by allowing local school bonds to pass with majority votes, automatically increasing property taxes. It now takes a two-thirds vote. The California Teachers Association also is pushing an initiative for the November ballot that would require the Legislature to raise $5 billion to $6 billion in taxes - and without the two-thirds vote requirement that Proposition 13 now requires. Will the fates of these initiatives send a signal that you are correct, it is time to change 13, or you are wrong?

Senator Peace: No, and I don't have any problem with majority vote for school bonds. But the CTA initiative for November should be rejected until we resolve our tax structure problem. Otherwise, it perpetuates the same mentality to just go raise taxes and go raise the most burdensome taxes you can think of to raise. Let's be as inefficient as we can possibly make ourselves. So, without even getting to the issue of whether we ought to raise taxes by $5 billion; before we get there, under no circumstances should you propose raising the taxes. Instead, we should start with a blank piece of paper and say, "How can we make something that really makes sense, and then let's go sell what makes sense." I think there's an opportunity right now in this state to move beyond the politics of pandering and actually put together an adult business plan for this state that makes economic sense. When you do that, you can improve the yield to the state by billions of dollars, and that allows us to fund education at a higher level and to provide more independent decision-making for local government, and, just as importantly, provide a healthier tax base that will grow. And while you're doing that, deliver tax cuts.

Today people are being ripped off by sales taxes that are too high and are not in the economic interest of the citizens of the state on either side of the equation.