Our annual review of local tax rates in California points out the wide disparities in locally controlled taxes: some cities charge, and make do with, far less than their neighbors. The 1998 Kosmont Cost of Doing Business Survey also reveals some interesting characteristics of California compared to neighboring states.

Now in its fourth year for Southern California and its second year for Central and Northern California, the Survey has two goals: to collect local tax, fee and incentive data in a standardized format that allows easy comparison; and to provide a relative ranking of tax rates among the communities.

The Survey covers nearly 190 "business destination" city and county areas in California (i.e., large communities and smaller ones with large inventories of office and industrial facilities). To some extent, coverage of taxes and incentives is ultimately subjective, but we believe our approach is reasonably thorough. We also include eight key cities in Arizona, Nevada, Oregon and Washington.

On the tax side, coverage includes local business, utility user, hotel, property and sales taxes. Business taxes include business license and payroll taxes for six primary business sectors. On the fee side, the Survey includes selected planning fees and development impact/exaction fees. We also determine what types of incentives city staff say they will consider, and allow local officials to comment directly on their current economic development policies in our "quotes" section.

The Kosmont Cost Ratings, new this year, are believed to be the first comprehensive rankings of local tax rates in California. This feature is a relative ranking of tax rates, taking account of a community's average business tax rate, electric tax rate, telephone tax rate, and typical property tax rate. The ratings focus on the taxes that most impact businesses; other locally imposed taxes that have far less impact on businesses are excluded, including sales and hotel taxes. Based upon survey data, we assigned each community one of four possible ratings: Very Low Cost, Low Cost, Medium Cost, and High Cost.

We should note that business susceptibility to local taxes does vary by industry. Office tenants with gross-rate leases, for example, are less likely to pay directly for property taxes than retail tenants with net leases. Similarly, a manufacturing plant filled with machine tools will likely care more about electric bills and taxes than a customer call center, which will be more concerned with the local telephone tax. However, our ratings provide an overall view of tax liability among communities, and identify the expensive places where businesses should be wary of high costs.

The Kosmont Cost Ratings Results
The ratings yielded an unexpected result: most of the High Cost cites are located outside California. Five of the eight High Cost cities are in Arizona, Oregon and Washington. The reason? Property taxes tend to be substantially higher outside California. Proposition 13 has had its intended long-term effect: property tax rates have increased much more slowly in California than in many nearby locales. Voters in Oregon, apparently concerned about increasing taxes, recently placed controls on property taxes similar to Proposition 13. Among the four other states included in the Survey, only Nevada has property tax rates that are competitive with California. In earning High Cost ratings, some out-of-state cities are also hurt by their own high business taxes.

A great majority of communities fall into the Very Low Cost and Low Cost ratings: 91 percent don't have rates high enough by themselves to impede business development. The remaining 17 cities have rates that some businesses will find onerous:

Medium Cost Cities	High Cost Cities
Bell Berkeley Compton Culver City Industry Inglewood Modesto* Oakland San Bernardino	Los Angeles San Francisco Santa Monica Phoenix, Arizona Portland, Oregon Seattle, Washington Tacoma, Washington Tucson, Arizona
* Modesto has a utility tax cap that would make it a Low Cost city for larger companies.

Highs and Lows: Where are They?
Within California, some patterns are apparent between the north and south. For example, average and median business taxes tend to be higher in northern and central California than in the south (see chart). The highest business tax rate in the state is charged in San Francisco, where the average among non-property categories is 0.628 percent of gross receipts. (This figure is based upon payroll assumptions by industry; actual tax rates may vary depending upon payroll.) Los Angeles is second with an average of 0.330 percent.

Larry J. Kosmont, CRE, is president of Kosmont & Associates, Inc., a full-service real estate consulting firm specializing in economic development, finance and entitlement services to both public agencies and private corporations. He has served as a former city manager and director of various departments and agencies including redevelopment, planning, housing and transportation for several Southern California cities. He currently serves on the board of the Metropolitan Water District of Southern California.

Frank F. Taplin is senior vice president of Kosmont & Associates, Inc., and participates in projects involving economic development, real estate economics and fiscal impact analysis. Mr. Taplin has served as the project manager for the Kosmont Cost of Doing Business Survey since the first edition was published in 1995. He has been retained by public sector clients to assess fee structure competitiveness and opportunities for economic development and other incentives.

The authors may be reached at (213) 623-8484.

Different north-south patterns are apparent with utility user taxes. The highest tax rates are found in Southern California, but more communities in Central and Northern California (47 percent versus 40 percent) charge utility taxes. The following chart shows the differences:

Typical property tax rates range from 1.0 percent in Redwood City and San Rafael to over 1.8 percent in the resident-scarce City of Industry. No significant differences were found between north and south.

What Do These Costs Mean for Cities and Businesses?
Local taxes are but one of the many factors that influence business location decisions. They are not the most important: real estate lease and purchase costs are a bigger influence. Also important are an array of labor, customer, transportation and quality-of-life considerations, as well as statewide tax policies. Where available, local financial incentives can also lure companies. While incentives can make a difference by reducing initial occupancy costs, incentive packages are rarely large enough to substantially impact long-term costs of a new location.

These costs become a significant factor in the Medium Cost and especially the High Cost cities. There aren't many such cities in California, but usually they are next to less-costly cities where real estate and labor costs are similar.

Some of the High Cost cities can overcome their relative disadvantages in the short run. San Francisco and Santa Monica both benefit from their favored status among firms that care more about location than occupancy costs (financial and multimedia firms in the case of San Francisco, and entertainment and multimedia firms in the case of Santa Monica). But these cities are betting they can out-race the cyclical nature of business. Their high costs may not attract attention in the current strong economy, but an economic downturn will make them vulnerable to their "bargain priced" neighbors. And the impact of high taxes is magnified by their high real estate costs.

Accordingly, High Cost cities must better position themselves for future economic challenges. Like any downsizing corporation in a competitive global economy, more High Cost cities need to cut fixed expenses. Infrastructure burdens are one contributing factor - some larger, older cities like Los Angeles are providing a disproportionate level of infrastructure for their neighbors.

Cities' bureaucracy-swelling labor practices also contribute to high business costs. The Cost of Doing Business Survey includes data on number of city employees per 1,000 residents. While the average statewide is 6.9 employees per 1,000 residents, San Francisco has an estimated 30 per 1,000. Santa Monica is also exceptionally high at over 16 per 1,000. Los Angeles has the much lower ratio of 9.0, but in comparison to the statewide average, which includes hundreds of smaller cities, this figure doesn't seem to reflect the economies of scale one would expect for a city of 3.7 million residents.

Los Angeles is actually making the most progress in this regard (see following article), since it is tackling both charter reform and tax change, although the city's disjointed political structure makes radical reform unlikely.

Such High Cost cities need to focus on cost cutting that will allow them to lower taxes, and thus better compete with more nimble competitors. Unfortunately, all California cities are handcuffed by Proposition 218, which doesn't allow for tax increases without voter approval. So the High Cost cities, like Los Angeles, have been caught charging the most at a time when Low Cost cities won't be able to easily raise taxes. And, of course, how likely is Los Angeles to reduce business taxes when other tax increases require a nod from the voters?

L.A.'s Tax Equity Study: What Next?

The antiquated business tax structure of the city of Los Angeles has for many years left taxpayers annoyed, accountants confused, and - ironically - city coffers underfilled.

In an effort to address this problem, the city commissioned a consultant team consisting of UT Strategies, Inc., Landmark Partners, Arthur Andersen LLP and the Milken Institute for Jobs and Capital Formation to study issues of tax equity and competitiveness arising from the current Los Angeles tax ordinance. The team's interim findings were summarized nicely by Dave Naney of Arthur Andersen in the April 1997 Cal-Tax Digest.

The consultant team delivered its final report last fall, and the city accepted it without much comment. The consultant team stands ready with its elaborate financial models to study the fiscal and economic impacts of alternative approaches to revising the tax code, but so far the city has presented no specific proposals.

The consultant team presented three alternative tax structures:

• A gross receipts tax with only five business categories (down from over 60) taxes at rates ranging from $1.30 to $4.90 per $1,000 of gross receipts.
• Consolidate all current business categories into only one, with a rate of $2.65 per $1,000 of gross receipts.
• Eliminate all gross receipts tax and instead establish a payroll tax of 1.1 percent of payroll.

In addition to verifying that taxes in Los Angeles are quadruple the amount in surrounding communities, the report found that the city overtaxes professionals, gives special treatment to the movie business and other select industries, relies on a de facto honor system for tax enforcement, and surprises new investors with huge development fees.

Quick, decisive action is needed to remedy these problems, because the process of tax reform is painfully long, requiring economic analysis, business community support, and voter approval. Leadership of iron fortitude is required to balance often conflicting policy goals, to protect a reform effort from lobbyists seeking special exemptions, and to sell the new package to the voting public, who thanks to Proposition 218 are likely to have veto power over any significant change in tax policy.

There is almost universal agreement on the need for fewer business categories. Formulating the best way to collapse the existing categories will trigger major disagreements, as many businesses and industries may find themselves paying more. While political reality makes it inevitable that certain industries and businesses will receive favorable treatment, the playing field ought to be leveled among business categories for the first time in decades. This would include an elimination of tax caps such as those enjoyed by movie studios.

Fewer categories do not necessarily make for better tax policy, however. The new categories must be clearly defined using very basic criteria to minimize confusion and to allow for the accommodation of future business types. One of the reasons the current tax ordinance is so complicated is that whenever a new type of business was developed - multimedia production firms, for example - the city simply created a new, narrow category specific to that type of business.

Simplified apportionment rules are also badly needed. Current apportionment rules vary depending upon business category, and favor certain industries - professionals and retailers pay much more than movie studios and manufacturers; banking, insurance and utility companies are all exempt. The city must devise simple apportionment rules, which apply to all business categories. The city should not switch to the complicated four-factor apportionment formula recommended in the study, as this would force businesses to track inside-city and outside-city sales, payroll and property values annually. This would create even greater complexity for what should be a simple and relatively small tax.

An even greater change, but one which should be carefully weighed by city government, is switching to a flat tax on gross receipts, or eliminating gross receipts as a tax base entirely, instead taxing a percentage of total payroll. Changing the base of the business tax, however, would greatly impact city revenues, which conflicts with a stated city goal: that whatever changes are made to the tax ordinance, its net effect on the city's revenue stream is zero.

Revenue neutrality is an unrealistic policy goal. The "revenue neutral" assumption of the city (and the tax equity consultant team) is both unrealistic and short-sighted. It is manifest that any business restructuring will affect tax revenues one way or the other. Further monkeying with the tax ordinance in order to produce a zero sum will only complicate, rather than simplify, the business tax structure. A far more worthy policy goal is to cut overall business taxes, thereby making the city more benign for small business and attractive to larger businesses needing to relocate.

Auditing and collections must be improved. This is one simple step that would pay for itself through higher revenues. Compliance with the current tax ordinance is so poor that revenues would rise as much as 33 percent if the city collected all the taxes it was due. A system is needed to cross-check what all taxpayers report (not just retailers), to avoid penalizing honesty. By improving collections, the city could afford to lower tax rates to be more competitive with nearby cities.

The complexity and enormity of L.A.'s business taxes adversely impact businesses large and small. Small and start-up businesses are taxed on gross receipts, not profits, creating a hostile environment for such important sources of new jobs. Larger businesses are faced with the highest overall taxes in the region, which costs the city jobs through both out-migration and a failure to attract relocating firms.

High development fees also discourage investment in Los Angeles. These fees are typically two to four times higher in Los Angeles than in such neighboring cities as Burbank, where the motion picture industry has been burgeoning at the expense of Hollywood. Further, the fees are unpredictable, and are often tallied only after a project has broken ground. Thus, development fees are often a "wild card" that increases developer risk and lowers return, thereby hurting real estate investment and job creation in Los Angeles.

- By Larry J. Kosmont and Frank F. Taplin