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Modest Tax Cuts in New State Budget Proposal
By The Cal-Tax Staff

Unveiling his "responsive and responsible" $104.7 billion state budget for 2001-02, Governor Gray Davis said California's super economic boom times are over, but there's still plenty of money to pour into government spending, particularly education.

"It's responsive because it makes critical investments in the challenges facing our state, especially education and energy," the governor said. "It's responsible because it emphasizes one-time investments instead of long-term commitments and builds up our reserve."

Governor Davis' third annual budget proposal is typically cautious, keeping with his past fiscal behavior that is predicated on a desire not to be caught in a squeeze that would pressure him to support higher taxes. Complicating matters, besides the slowdown in the economy, are shortages of electricity and natural gas that have contributed to spiraling energy costs.

There will be no recession, the governor and his economists stated with confidence. However, the energy crisis clouds the state's economic future and could prompt major changes in spending priorities between now and July 1, when the new fiscal year begins.

The budget he outlined on January 10, as required by law, included several new or increased targeted tax incentives ranging from a boost in the manufacturers investment credit to a three-day sales tax "holiday." These modest proposals are intended to boost productivity, the governor said.

Of the state's revenue growth, he proposed splitting it 46 percent for one-time spending priorities and 54 percent for on-going programs. "We are investing in our future, but we are doing so without saddling future generations with unsustainable costs."

As has been the case since the early 1990s, there are no tax hikes in a California governor's proposed budget.
  

The budget he outlined on January 10, as required by law, included several new or increased targeted tax incentives ranging from a boost in the manufacturers investment credit to a three-day sales tax "holiday."

If adopted by the Legislature for the fiscal year starting July 1, the governor's tax proposals would amount to $108 million (2 percent of the estimated windfall in revenue) in budget-year relief, mostly for businesses. Based on reactions from Republicans and Democrats, there will be considerable debate and probable compromise on amounts and types of tax relief before the Legislature is finished. Also, Governor Davis will issue a revised budget plan in May, when he gets fresh economic forecasts.

Here are the governor's tax proposals:

• Manufacturers Investment Credit (MIC). The governor would increase the credit from 6 percent to 7 percent for the costs of equipment. The governor said the MIC is designed to offset some of the sales tax paid on equipment. The increase would save taxpayers $71 million in 2001-02 and $91 million in 2002-03. The budget would extend the MIC employment test sunset date until January 1, 2008. It also would extend the manufacturers' sales tax exemption to include software developers.
• Sales Tax Holiday. The governor called for a three-day state and local sales tax holiday for the fourth weekend in August for up to $200 in purchases of clothing and footwear and up to $1,000 for computers or related equipment. It is intended for back-to-school shoppers but would be open to anyone making such a purchase. This exemption from the state's 5.75 percent sales tax would save shoppers $27 million. Cities and counties, which levy their own sales taxes, would have the option of joining in on the holiday. If they all opted in, the impact would be an additional savings of $12 million to $15 million. It would amount to 8.25 percent in San Francisco but most Californians would realize a 7.5 percent break if their local governments opt in.
• Space Flights. The governor suggested expanding the current sales tax exemption for qualified property used for commercial space launches to include property used in the assembly, launch, or transport of flights, as well as in spaceport operations. Impact: $6 million. The governor said the Vandenberg Air Force Base space launch facilities are a tremendous state asset and he supported legislation last year to provide such an exemption, but SB 1582 (O'Connell) didn't reach his desk.
• Small Business Capital Gains. The governor would increase the current exclusion from 50 percent to 100 percent. Impact: Beginning in 2006-07, $30 million a year.
• Transit Passes. The budget would provide a graduated credit of 20 percent to 80 percent for employers who purchase subsidized transit passes or other commuter-fare media for their employees. Impact: $3 million.
• Math and Science Teachers. Employers who loan employees to schools to teach math and science would qualify for 50 percent credits that would have a total worth of $1 million. The credit also would be given to employers who open their in-house training courses to local educators.

Would further tax relief be part of the May budget revise, based on updated revenue estimates? "I wouldn't rule it out. I wouldn't rule it in," the governor told reporters. There was no mention in the budget documents of income tax conformity as a component of the proposed tax package. He stressed that his biggest priorities are dealing with the energy crisis and making progress in education. "Tax cuts, health care and others would compete for additional money" only after the "first two challenges" are completely satisfied, he said.

The governor refused to speculate whether the economy will produce enough revenue to trigger another one-year, 0.25 percent sales tax reduction. The formula, a high level of surplus revenues in back-to-back years, was adopted in the early 1990s and caused such a cutback this year for the first time. A decision about next year will be made next fall.

The governor's budget is based on $3.8 billion in additional revenue during the current and past budget years that was not expected last summer when a $99.4 billion budget was signed into law, plus $2.5 billion in revenue growth for fiscal 2001-02.

The governor called for a three-day state and local sales tax holiday for the fourth weekend in August for up to $200 in purchases of clothing and footwear and up to $1,000 for computers or related equipment.

Legislative Analyst Elizabeth Hill forecast a budget surplus of $10.3 billion last November, counting revenues through June 2002. The governor's new budget proposal has $5.5 million in increased spending and $108 million in tax cuts, the analyst reported, plus $1.9 billion held in reserve. The analyst said the governor's budget contains $8 billion in "uncommitted resources," including the reserve, or $2.3 billion less than the November projection. The lower revenue projection is justified because of the national economic slowdown, Ms. Hill said.

California's astounding economic growth - 11.7 percent in personal income in 2000 - will moderate to less than 6 percent in 2001, with a rally expected late this year and nearly 7 percent growth in 2002, according to the budget forecast. It also pegged wages and salaries to grow 5.5 percent on the heels of last year's 14 percent surge. Much of this is a result of a cooling economy, particularly in stock options from the dot.com companies.

Governor Davis, in his 2001 State of the State address, said, "California's economy remains fundamentally strong. It continues to create new jobs and opportunity for our citizens. But our economy is also re-stabilizing, expanding at a more sustainable rate of growth." He said the "short-term stock market windfalls" through capital gains and stock options can no longer be expected, and there will be no $10 billion budget surplus as was the case in each of his first two years in office.

As the economy moderates, the Davis administration expects a "soft landing." The governor said he is confident there will be no recession in 2001-02. A recession would be defined by back-to-back quarters of negative growth, the governor said, adding that he doubts the state would experience even one three-month period of negative growth.

General fund spending is expected to grow 3.9 percent, far less than the first two years of Gray Davis' administration, when spending soared 37 percent.

The proposal for a sales tax holiday, which would be in effect for just the one three-day period in 2001, came as a surprise. The governor said he had studied such programs in other states, particularly New York and Texas, and was convinced it would work in California. (While seven states had sales tax holidays in 2000 and an eighth state approved one for this year, California has not had such a law since enactment of the sales and use tax in 1933. Bills to establish sales tax holidays failed in the last session of the California Legislature, although the Assembly unanimously approved one bill that died in the Senate Revenue and Taxation Committee.)

Energy Crisis
The governor set aside $1 billion to respond to California's energy crisis, including $250 million for incentives for Californians to meet a goal of a 7 percent reduction in consumption. He said he would work with the Legislature to determine how the rest of the money is allocated, calling the situation a "moving target." The budget has $50 million for state departments to meet expected increases in their energy bills.

The governor listed a number of potential responses to the shortage of electricity and natural gas and pledged that he would not allow energy utilities to go bankrupt. "Our fate is tied to their fate," he said in his State of the State address. "Bankruptcy would mean that millions of Californians would be subject to electricity blackouts. Public safety would be jeopardized. Businesses would close. Jobs would be lost. Investment would flee the state. And our economy would suffer a devastating blow."

Would further tax relief be part of the May budget revise, based on updated revenue estimates? "I wouldn't rule it out. I wouldn't rule it in," the governor told reporters.

Education
Governor Davis' education initiatives total $728 million, including voluntary longer school years for middle schools and additional math and reading training for teachers, plus extra money for schools to recruit algebra teachers. The budget's $32.1 billion commitment to K-12 education ($53 billion from all sources) increases Proposition 98 per-pupil spending to $7,174. This is $479 more than the current year, and the administration believes California will spend at or above the national average per pupil.

The governor set aside $1 billion to respond to California's energy crisis, including $250 million for incentives for Californians to meet a goal of a 7 percent reduction in consumption.

The governor's higher education initiatives include $33 million to launch a fourth University of California Institute for Science and Innovation. Three institutes, designed to speed innovation from the laboratory to daily life, were created last year and the governor proposes to spend $75 million on them in the budget year. These world-class research centers are to be funded by at least $2 in non-state money for each $1 in state funding.

The budget also includes $33 million to convert some campuses of the University of California and California State University to year-round operation, a move that has been advocated for years to make more efficient use of existing facilities and reduce the need to construct expensive new classrooms.

The governor's higher education initiatives include $33 million to launch a fourth University of California Institute for Science and Innovation.

Transportation
Transportation funding - last year's top-drawer issue other than education - drew scant mention in the governor's State of the State and budget messages. The state last year adopted a six-year funding plan that dedicates $8.2 billion from the general fund to support transportation programs, including $5 billion for 142 projects designed to relieve congestion. About $1.1 billion is expected to be spent on these projects in the current and budget years, according to the budget documents.

Local Government
In response to criticism of the shift of property taxes to schools in the 1990s, the budget continues a subvention of $250 million in one-time discretionary funding for local governments. These moneys will be allocated 50 percent on a per-capita basis and 50 percent on local governments' contribution to their counties' respective Educational Revenue Augmentation Fund.

Reaction
The Assembly Republicans' lead budget-writer, George Runner, criticized the governor's budget for lacking what he called real tax relief. Senate and Assembly Republicans have proposed a $3.5 billion package of tax cuts. The major GOP proposals would increase the manufacturers investment credit by 2 percent, increase the dependent exemption, suspend the sales tax on gasoline, eliminate the car tax and permanently cut the sales tax by 0.25 percent.

Mr. Runner argued that the budget could be perceived as raising taxes because proposed spending would reduce the budget reserve to 2.4 percent. According to statute passed in 1991, the 2.4 percent would be below the threshold (4 percent of general fund revenues) to continue the 0.25 percent sales tax reduction beyond this year. Expressing outrage, Mr. Runner was quoted by the Riverside Press Enterprise: "We just cannot imagine that when the taxpayers have that much extra money in the state coffers, that we would not give some of it back to them."

Senate Budget Committee Chair Steve Peace, a Democrat, said the governor's budget was responsible, but he told the Los Angeles Times that it shortchanged the commitment to solving the energy problem. Senator Peace, author of the electricity deregulation bill, wants the state to commit $2 billion to buy or build power plants. He also wants the governor to continue a $300 million-a-year program that provides tax relief to low-income homeowners and elderly or disabled renters.

Senate President Pro Tem John Burton was critical of the sales tax holiday proposal, complaining that rich people should not enjoy the same tax relief. His Assembly counterpart, Speaker Robert Hertzberg, said, "We will have the resources to keep our commitments to schools, housing and transportation."

Assembly Republican Leader Bill Campbell told The Times: "Unless there are more tax reductions, it will be very hard to find Republicans to vote for this budget." He said their minimum demand is to maintain the 0.25 percent sales tax reduction through 2002.

As expected, the sales tax "holiday" idea was praised by retailers, who said it would help families that have been hurt by recent economic setbacks. It was criticized by local government officials, particularly when they learned that any revenue they would lose by opting to participate would not be replaced by the state.

(This report was prepared by Ron Roach, Lisa Martin and David R. Doerr.)