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July 2000

State Government

Exploring the Gann Limit: Then and Now
By Lisa Martin

As California's general fund swells with nearly $13 billion in excess tax revenues, many taxpayers want to know about the Gann spending limit and how it affects this monetary largess.

Historical Perspective: What is the Gann Limit?
Thanks to a group of spending-limit advocates in the late 1970s, the Gann limit prohibits the Legislature from freely spending excess stashes of cash. While the goal of Proposition 13 of 1978 was to cut local property taxes, this still left taxpayers vulnerable to increases in other types of taxes, and the initiative did not limit spending of state and local revenue growth.

Consequently, Paul Gann (the co-sponsor of Proposition 13), Cal-Tax and other spending-limit advocates formed a private group: "The Spirit of 13, Inc." The group drafted a spending-limit initiative to restrict growth of tax-funded programs and services, collected over 900,000 signatures, and placed the measure on the November 1979 ballot as Proposition 4, otherwise known as the Gann initiative. Proposition 13 had created Article XIIIA of the state Constitution in June 1978. The Gann initiative, creating Article XIIIB, passed with nearly 75 percent of the vote.

Proposition 4: The Gann Limit
The gist of Proposition 4:

  • What's the limit formula? The 1978-79 expenditure level serves as the base. It is adjusted annually for population growth, inflation (using the lower of the percentage growth of the U.S. Consumer Price Index or California's per capita personal income), and transfers of financial responsibility from one governmental entity to another.
  • What types of revenues are covered? Subject to the Gann limit are all tax revenues and investment earnings from these revenues; proceeds from regulatory licenses, user fees and charges that exceed costs to cover services, and tax funds used for "contingency, emergency, unemployment, reserve, retirement sinking fund, trusts or similar funds."
  • What spending is exempt? Certain appropriations are exempt from the Gann limit, such as debt service, appropriations for mandates ordered by the courts or the federal government, specified special districts, etc.
  • What happens to non-exempt revenues above the limit? They are to be "returned by a revision of tax rates or fee schedules" or a majority of voters can increase the limit.

Exceeding the Gann Limit
Eight years after passage of Proposition 4, California experienced a revenue flow of $1.1 billion over the Gann limit. While Governor George Deukmejian wanted to spend $400 million on schools and refund $700 million to taxpayers, the Legislature refused to pass a bill authorizing the education appropriation. Deviating from the constitutional requirement of tax or fee rate reductions, the final resolution was to refund taxpayers all the $1.1 billion excess in the form of personal income tax rebates. They ranged from a minimum of $32 single/$64 joint for lower income earners to a maximum rebate of $136 single/$272 joint for those in the top income tax brackets.

Sending 11 million checks to California taxpayers was not only costly, but administratively problematical. It cost up to $200 million to issue the checks, including $167 million in additional federal taxes paid on rebate-enhanced income; $69 million to send the rebates in 1987 (before Christmas) versus 1988 (when federal tax rates would have been lower); $30 million in lost interest (because the state borrowed funds at the end of 1987 during a "General Fund dry period" to pay for the rebates), and over $7 million in administrative costs (which could have been mitigated without the pre-Christmas deadline). Another administrative problem was locating taxpayers. About 150,000 checks were returned by the Post Office as undeliverable.

Lisa Martin is a Cal-Tax policy analyst

This was not the first time California experienced a direct tax rebate and administrative difficulties. The first rebate, one-time payments of $70 to 2.5 million homeowners, occurred between June and December of 1969. Just five days after the first checks were issued, over 2,600 mail inquiries and 751 telephone calls were received, relating to incorrect addresses and check endorsements due to deaths or divorces.

Locally, in 1985 - two years before the 1987 state rebate - Kern County refunded excess property tax revenues by sending 300,000 checks, totaling $94 million. Approximately 15,000 checks were undeliverable. Generally, local governments that exceed their spending limits opt to return excess revenues by reducing property tax rates or holding elections to increase their spending thresholds.

Amending the Gann Limit
Shortly after the 1987 state tax rebates were issued, two initiatives were respectively placed on future ballots to fine-tune the Gann limit. Proposition 98 of 1988 allowed schools to receive Gann limit refund revenues up to 4 percent of schools' minimum funding base. Proposition 111 of 1990 made several noteworthy changes:

  • Altered how the Gann limit is calculated, adding K-14 public school enrollment rates in the population formula to correct a school-funding inequity. Locals were provided the option of using California per capita personal income growth or the percentage of local assessed value attributable to non-residential new construction.
  • Based cost-of living adjustments solely on per capita personal income growth to recognize state economic growth.
  • Dedicated half of the excess revenues to taxpayers and the other half to schools.
  • Made further appropriations exempt from the Gann limit, including "qualified" capital outlay (as defined by the Legislature), natural disasters, and projects funded from gas tax revenues and truck-weight fees.
  • Declared that the Gann limit would be triggered only if tax proceeds are in excess in two consecutive fiscal years.

Current Perspective: How the Gann Limit Affects California's Monetary Largess?
Currently, it appears history is repeating itself. In 1986-87, the state exceeded the Gann spending limit by about $1.1 billion, and consequently issued rebates in the form of checks to taxpayers. In 1999-00, California is expecting a Gann limit overflow of roughly $1.1 billion, and policymakers' primary solution for the overage is, again, to issue rebates to taxpayers.

The difference between then and now is that refunds are only required when the Gann limit is exceeded in two consecutive years. Several rebate proposals were considered to prevent the Gann limit from officially exceeding its peak next year, including "tax and fee rate reductions" as shown in the chart on page 22. Various types of other "exempt" appropriations have also been contemplated, such as tax incentives, use of gas tax revenues to fund transportation, increased discretionary funding to schools and local government, etc., to further draw down windfall revenues.

Rebates v. Tax/Fee Rate Reductions
Although the Gann limit specifically states that tax proceeds exceeding the limit "shall be returned by a revision of tax rates or fee schedules," a popular legislative means to return excess revenues - with tangible benefit to taxpayers - has been to issue tax rebates. There are some benefits and disadvantages to both of these payments.

Tax Rebates
Pro:
Income tax rebates are more closely associated with the source of the surplus revenues. Since personal income tax collections tend to comprise the source of the state's windfall revenues, personal income tax rebates more accurately reflect a return of actual surplus revenues received than sales tax rebates.

Con: Most tax rebates are subject to federal taxation. As experienced with the 1987 personal income tax rebate, approximately $167 million of California revenues were funneled to the federal government from federal income taxes on rebates. Under Governor Gray Davis' personal income tax rebate proposal, it is estimated that approximately 20 percent or more of the rebate would flow to the federal government as tax owed on the amount of the rebate received. California already receives far less in federal services than is paid by Californians in federal tax dollars, and it is appropriate to minimize any additional flow of tax dollars to federal tax collectors.

Currently, it appears history is repeating itself. In 1986-87, the state exceeded the Gann spending limit by about $1.1 billion, and consequently issued rebates in the form of checks to taxpayers.

Rebates and Tax and Fee Rate Reduction Proposals to Refund Excess Revenues
Source Type of Refund Description
Governor Gray Davis: PIT Tax Rebate Up to $150 single/$300 joint
Senate Democrats: Sales Tax Rebate $50 single/$100 joint; $25 per dependent
Senate Democrats: Sales Tax Rebate $30-$80; $25 per dependent
Budget Conference Committee: Sales Tax Rebate $50 for AGI less than $20,000
$100 for AGI from $20,000 to $150,000
$125 for AGI above $150,000
Senate: PIT rate reduction PIT tax bracket reduction of 0.55%
Governor Gray Davis: Park fee rate reduction Park fee reduction of 50%
Senate Republicans: College fee rate reduction College fee reduction of 50%
Senate Republicans: VLF rate reduction Accelerate VLF reduction to 46.5%
Abbreviations: PIT (personal income tax), AGI (adjusted gross income), VLF (vehicle license fee)

Although the Senate-proposed sales tax rebate is intended to avoid federal taxability, this strategy could be flawed, because it appears to be more of a transfer payment than a tax refund. One of its major flaws is that the rebate checks would not be related to the amount of sales tax paid by a recipient. This is a direct violation of the original drafters' intent, which clearly states their desire for the Gann limit not to redistribute wealth (i.e., allow those who paid less taxes to receive a greater share of the refund). Yet, this is exactly what occurred when rebates were granted in 1987: those taxpayers with AGIs under $20,000 paid only 4.3 percent of the income tax, but they received 25.6 percent of the refund. However, taxpayers with AGIs over $100,000, who paid 34 percent of the income tax, received only 5 percent of the excess.

With tax rebates, more taxpayers are excluded from the refund, including nonresidents and businesses. Moreover, lost checks, changes in mailing addresses, and simple inability to find a great number of taxpayers are unavoidable, making rebates difficult to administer and costly.

Rate Reduction
Pro:
An income tax rate reduction would also return the source of the state's excess revenues to those who were largely responsible for it, while a sales tax rate reduction would achieve the goal of broad-based tax relief for all California taxpayers. Either is more efficient and less costly than a rebate program and does not transfer California tax dollars to the federal government. Rate reduction does not require applications to be processed and reviewed, costly state-generated checks to be mailed to taxpayers, or auditing by tax agencies. There is a greater assurance that a rate reduction would be felt by every Californian.

Con: Since many taxpayers do not pay close attention to tax rates, the benefit of a rate reduction would not be as tangible as an actual check in hand. With the benefit being less obvious, this also diminishes the ability of elected representatives to take credit for their efforts to achieve this particular tax refund. Yet, another problem with rate reduction relates to the task of rate adjustment. Adjusting accounting systems to reflect the lower rate could be onerous to those responsible for altering rates.

Although the Senate-proposed sales tax rebate is intended to avoid federal taxability, this strategy could be flawed, because it appears to be more of a transfer payment than a tax refund.
Brief History of the Gann Limit
Year       Measure Description
1978 Proposition 13: Precursor to the Gann Limit Major property tax reduction initiative approved.
1979 Proposition 4: The Gann Limit Major spending limit initiative approved, targeting concerns not addressed in Prop. 13.
1987 Proposition 4: The Gann Limit In Effect Gann limit overage of $1.1 billion. Income tax rebates issued.
1988 Proposition 98: Amendment to the Gann Limit Major education initiative, funneling portion of Gann limit excess revenues to schools.
1990 Proposition 111: Amendments to the Gann Limit Alters calculation of limit, grants schools 50% of excess revenues, increases exclusions, and declares the Gann limit triggered in 2-year period.
2000 Proposition 111: 
In Effect
Due to Prop. 111 amendment, refund of excess $1.1 billion not required this year. Forced policymakers to enact several proposals to prevent the Gann limit trigger next year.

Today's Decision, Tomorrow's Impact
In 1987, an in-depth Cal-Tax study of the Gann limit, entitled "Up to the Limit," (which served as primary reference for this article), concluded, "Today's spending decisions will have an enormous impact on tomorrow's spending discretion."

Ironically, a year later, California exceeded its Gann limit and chose to fix it by issuing personal income tax rebates. Unfortunately, this myopic tax relief was followed by one of the worst recessions in California history, causing a budget deficit of roughly $14 billion.

Let's hope that Gann limit-related measures adopted today result from lessons learned yesterday, and will sustain our robust economy tomorrow and beyond.