IntroductionThe California Tax Reform Association has authored Proposition 217 to permanently reimpose tax rates that expired at the end of 1995. Some local government agencies support the measure, because it would distribute some of the revenue to local governments. The local share of this tax revenue is intended to compensate for property tax shifts imposed by the state, beginning four years ago.
Cal-Tax's analysis of Proposition 217 has discovered serious flaws that could undermine the very nature of property taxes in California. This bulletin, prepared by Cal-Tax Director of Research Stephen Kroes, examines Proposition 217 and its potential impacts, including the property tax error that could have a dramatic negative effect on California public finance and economic growth.
Major ProvisionsThis statutory initiative would permanently raise taxes by retroactively reimposing 10 percent and 11 percent tax brackets that were temporarily in effect from January 1, 1991 through December 31, 1995. Revenue generated from this tax increase would be allocated to schools according to Proposition 98 formulas and the remainder would replace a portion of property tax revenue shifted by the Legislature in 1992 and 1993 from cities, counties and special districts to schools. Specifically, Proposition 217 would:
Highest State Income Tax RatesIf Proposition 217 passes, California would have the highest effective tax rates in the nation. Table 2 shows each state's highest and lowest tax rates. If Proposition 217 were approved, California's 11% top rate would be more burdensome than any other state, considering that Massachusetts' 12% rate only applies to investment income, and the other two high states allow a deduction for federal taxes paid, which California tax law does not allow.
Tax Increases on Small BusinessEighty-four percent of California business taxpayers file under the personal income tax law, not the bank and corporation tax law. Fifty-four percent of all business income taxes are paid through the personal income tax (see Figure 2). The vast majority of California's small businesses have 10 or fewer employees. This initiative would substantially increase tax liability for some small businesses paying personal income taxes, and small business are creating 60 percent of new jobs in California.
Retroactive Tax PenaltiesIf approved by voters in November, this initiative would retroactively apply higher tax rates to income earned since January 1, 1996. Businesses and taxpayers that are complying with current law and making quarterly payment and withholding based on 1996 tax rates could be subject to underwitholding penalties as a result of Proposition 217.
Most Progressive Income TaxHigh progressivity means that disproportionately high taxes are paid by taxpayers with high incomes. California's income tax is very progressive, as shown in Figure 1. Ten percent of the taxpayers are paying two-thirds of all the income tax collected in California. This is a disincentive for upper-income individuals to move to California or to locate or expand a business here. Evidence from the 1991 tax increase on upper income Californians and the federal tax increase in 1993 shows that this kind of tax increase diminishes economic activity and results in slower economic growth.
A number of studies have shown that high rates reduce incentives to invest, shift money into non-taxable investments and result in a drag on the economy. Leading economists state high tax rates
reduce the incentive to work, save and invest by reducing after-tax rates of return. With reduced
incentives for work and investment, there is a smaller economic pie for all citizens.|
High progressivity also increases the volatility of income taxes. During recessionary periods, California's income tax drops dramatically because so much of the revenue depends on so few people. The 1996-97 Governor's Budget Summary states: "The difficulty of forecasting personal income tax receipts is enhanced by the progressive nature of the tax.... In addition, very high-income taxpayers usually have a great deal of discretion over the realization of income and the
timing of deductions. Thus substantial changes in the portfolios or tax planning of relatively few
taxpayers can have a dramatic impact on state revenues."|
How Will Funds be Spent?The initiative states its intent to fund local public safety, libraries and recreation programs. However, there are no requirements in the initiative specifying how the funds are to be spent. If cities and counties were to spend the money as they now allocate their budgets, half of the money would fund health and welfare programs, and only about 10 percent of their new revenue from this proposition would be used for the programs mentioned.
Complicates Tax ReformThe proposition would freeze the amount and the proportionate share of income taxes paid by taxpayers in the 10 percent and 11 percent brackets, with respect to any future proposals to reform the state income tax. This would create monumental difficulties in future attempts to conform California law to federal law. It would also preclude any future across-the-board tax reduction or consideration of a "flat" tax by the Legislature. (Since the proposition only allows amendment by the Legislature to further its intent, voters would have to modify the proposition with a subsequent ballot proposition.)
Causes More Shifting of Property Tax RevenuesProposition 217 contains language that could prevent any city, county or special district from ever increasing its share of all property taxes collected in its county. This would force faster-growing jurisdictions to transfer some of their property tax to slower-growing jurisdictions. These property tax shifts would harm development of projects important to growing communities by limiting the payback local agencies could rely upon from approving new projects. That payback is necessary to fund public safety and other services required by new housing and commercial development. It would also limit the ability of local agencies and their citizens to restructure local governments, change boundaries, annex territory, or lower property tax rates.
Specifically, the proposition would not permit any local agency to be allocated a lower share of property tax than "the corresponding proportionate share for those Local agencies for the 1995-96 fiscal year." (Section 3 of the initiative, adding Revenue and Taxation Code Section 97.42). The initiative's author has said he merely intended to prevent future shifts of property taxes by the state; however, the measure's language is so sweeping that it could actually lock in, at the 1995-96 level, each agency's share of all property tax collected in the county.
Both the Attorney General's Office and a trial judge agreed that this language could freeze individual local agencies' shares of property taxes at the proportion of countywide property tax that each agency collected in 1995-96.
Consequences of the property tax freeze:
The payback from increased property taxes is necessary for local jurisdictions to approve new residential and commercial development. However, if Proposition 217 were approved, each local agency (except redevelopment agencies and school districts) would be guaranteed its share of property tax as received in 1995-96. Therefore, new property tax revenue could be taken away from the fast-growing city and given to other local agencies to keep those agencies at their 1995-96 share of the countywide total. If Proposition 217 would cause the agency to receive a diminished share of revenue from new development, it may not be able to pay for the added infrastructure and public services required by the newly developing area.
This becomes particularly alarming if a community wishes to detach from an existing city and form a new city, because residents of the new city would likely be required to continue paying all their property tax to their former city, since it would be protected from losing any property tax.
For example, if the San Fernando Valley were to detach from the City of Los Angeles and form a new city, those residents and businesses would continue paying property tax to the City of Los Angeles, and their new city would not be entitled to any of their property taxes.
Effects on RedevelopmentRedevelopment agencies would be harmed by this measure in two ways, potentially halting any new redevelopment project:
Proposition 217, among other things, would create Revenue and Taxation Code Section 97.42(a), which would read as follows:
97.42 (a) Notwithstanding any other provision of law, for each fiscal year commencing with the 1996-97 fiscal year, the auditor shall not reduce the proportionate share of total property tax revenues collected in the county that is allocated to Local agencies below the corresponding proportionate share for those Local agencies for the 1995-96 fiscal year.
This section would be part of existing Chapter 6 of the Revenue and Taxation Code, which begins with Section 95 and ends with Section 100. Section 95 sets forth the definitions to be used throughout the chapter. Nothing in Proposition 217 changes these definitions:
Redevelopment agencies are conspicuously absent from the definition of local agency used in Proposition 217. While proponents of Proposition 217 claim that the property tax freeze does not apply to each agency, only to the pooled share of all local non-school agencies, this definition makes it clear that redevelopment agencies are not included in that pool.
This means that even if the proponents' tenuous interpretation is correct, the initiative would deny redevelopment agencies any growth in their share of property taxes.
If a new redevelopment project's tax increment revenue were to increase that redevelopment agency's proportionate share of countywide property taxes, that naturally results in a corresponding decrease in the proportionate share of property tax allocated to all other local agencies in the county. Because the initiative would prohibit that corresponding decrease in other agencies' share of property taxes, it would appear that no new redevelopment projects could be undertaken.
In a briefing session with Legislative Analyst's staff, proponents and opponents of Proposition 217 debated this very point. The author of Proposition 217 admitted that it probably would prevent expansion of redevelopment and expressed no regrets about that conclusion, although he said it was unintended.
Redevelopment agencies are one of California's most potent tools for economic development. Redevelopment agencies have funded projects such as Third Street Promenade in Santa Monica, Old Town Pasadena, Old Sacramento, and Horton Plaza in San Diego, which have brought needed economic growth into formerly stagnant areas.
Redevelopment agency revenues also are utilized to preserve jobs. For example, the City of Emeryville recently used redevelopment agency funds to help expand a biotechnology facility. The company rejected out-of-state offers to relocate, saving 1,000 California jobs.
It is likely that not all school districts would receive new revenue under this proposition. There are about 50 "basic aid" school districts that do not receive more than a constitutionally fixed amount of state revenue due to a Supreme Court decision (in the Serrano case) requiring the state to equalize the spending of school districts. It should also be noted that local school districts, in the 1996-97 state budget, received $2.5 billion in additional state funds over the amount received from the 1995-96 budget.
Although a substantial amount of property tax revenues was shifted from cities, counties and special districts to schools, they have already backfilled the loss with other revenue sources. Voters in 1994 approved an added 0.5 percent sales tax increase to help fill the gap. Local governments have also increased local taxes, fees and assessments. The most recent report of the State Controller shows counties receiving more revenue in 1993-94 than they had before the property tax shift.