David R. Doerr, principal contributor
Ronald W. Roach, editor

1997 OUTLOOK: NOT THE BEST OF TIMES?

As 1996 goes down in the history books as one of the best years for taxpayers, 1997 could be one of the worst. While the crystal ball is still a bit cloudy, as many freshmen legislators are still unknown quantities, it is clear enough to see that this year could be a defensive struggle for taxpayers to keep from losing ground.

It is doubtful that taxpayers will see meaningful state tax relief this year. On the contrary, 1997 may see significant pressures for tax increases. At the state level, it will likely be a year of budgetary expansion and more spending that, without structural budgetary reforms, could pave the way for future deficits. The year could also see renewed attacks on taxpayer protections in Proposition 13 and Proposition 218.

Even before the election, Capitol observers agreed that if Democrats regained control of the Assembly (which they did), the odds that the Legislature would approve a significant tax reduction measure would be only slightly better than the odds that the Sacramento Kings would win the National Basketball Association championship.

What has caught many Capitol observers by surprise, however, are the well-orchestrated efforts after the election by significant constituencies to promote tax increases. State Superintendent of Public Instruction Delaine Eastin is seeking to establish a consensus for a multi-billion dollar tax increase to fund a high-technology program in the schools. High-level meetings have been held in Sacramento during the past 45 days to gain and solidify support for such a plan. Also on the school front, the California Teachers Association (CTA) is beating the drums for a one percent increase in the sales tax, which could be used to enhance teachers' salaries and benefits. However, the CTA may be more focused on a ballot initiative, rather than legislative enactment that would require a two-thirds vote and the governor's approval.

Transportation interests, who want more funding, are exploring the feasibility of a tax increase. Some of Sacramento's top lobbying firms are involved in this effort.

Meanwhile, health interests are eying another hike in the state's cigarette tax to raise more money for health services to uninsured people. It is also expected that local government interests will be seeking authority to impose up to $1 billion in additional ad valorem property taxes, without voter approval, by removing legislatively imposed limits on higher property taxes to fund public pension programs.

The positions of many legislative Democrats on tax issues could appear to be in stark contrast with the actions of the party's leader, President Bill Clinton. Mr. Clinton is expected to propose up to $130 billion in tax relief when he unveils his new budget on February 3.

It is unknown whether Governor Wilson will renew his call for a 15 percent tax cut. During a visit in December to an Elk Grove school, he said he "would like to see some tax reduction." Because last year's proposal was only marginally adopted (corporate tax rates were cut 5 percent) with Republicans controlling the Assembly, it is even less likely that the proposal can fly this year with Democrats dominating both houses.

SPENDING OUTLOOK

In its 1997 forecast issue, the respected Economist magazine notes that "almost every serious government is following the same agenda: a rigorous cutting of expenditures, especially of borrowing, and constraints on any growth to the welfare state. The era of big government will be in welcome retreat in 1997."

Well, California, despite the best efforts of Governor Wilson to the contrary, is poised to march off in the opposite direction. This year's budget, which probably will not be passed on time, as usual, will be bigger, contain new spending initiatives and probably will not contain any significant reforms promoting more efficiency and economy. In addition, the Legislature is likely to approve scores of bills proposing more spending programs and will be seeking to make public employee pension benefits more lucrative.

Look for the governor to put plenty of wear and tear on his veto-writing word processor. He has enough allies in the Legislature to ward off override efforts on major issues.

Based on what happened in 1996, the substantial windfall of additional revenues, resulting from the state's improved economy, will be gobbled up by the spending lobby. This will leave virtually none of the money to be shared by taxpayers who produced it in the first place. In 1996, an estimated $1.5 billion windfall in revenues developed between the time the budget was introduced in January and the May revision. (In January, general fund revenue for 1996-97 was projected at $45.57 billion; by May, the forecast was $47.06 billion.) Virtually all of this money was spent. Because the corporate tax cut was made effective in 1997, it reduced revenue by only $85 million in 1996-97. In the targeted tax relief bill (SB 38, Lockyer), after including the revenue-raising conformity items, the net tax reduction was only $8 million for the current fiscal year ending next June 30.

In 1997, there appears to be a consensus in Washington, D.C. on both sides of the aisle to shrink the federal deficit and eliminate it by 2002. (At the federal level, this means current revenues will balance expenditures for operations and capital outlay.)

In California, 1997 will likely see an expansion of state debt through more new state general obligation bonds for public works and continued use of non-voter-approved revenue bonds (such as being used to fund the Franchise Tax Board's new building). With approval of the bonds on last March's ballot, the Legislative Analyst's Office estimated that debt service as a percent of general fund revenue will grow to 5.3 percent in 1998-99. When debt service exceeds 5 percent, there is concern that the drain on the general fund is reaching the danger zone.

There will be strong pressure this year for another huge state general obligation bond for schools. Assembly Education Committee Chair Kerry Mazzoni has already proposed a $5 billion school bond (AB 40).

With the pressure for the bonds, there will also be pressure for a special statewide election this year for voter approval or rejection, rather than wait until June 1998. If a special election is held, two controversial initiatives filed too late for last November's ballot will also be voted on. One severely limits what schools can spend outside the classroom (sponsored by a teacher union) and one restricts the state's ability to contract out (sponsored by a state employee union).

The critical difference between local G.O. bonds and state bonds is that local bonds are funded by a specific new revenue stream (ad valorem property taxes in excess of the one percent limit established by Proposition 13) and state bonds are not funded by any future new revenue stream, but are simply payable out of general fund revenues in the future. This makes them analogous to deficit spending by Congress.

PROPOSITION 13 AND PROPOSITION 218

The spending lobby has been grumpy about Proposition 13 taxpayer protections for a long time. With passage of Proposition 218 last fall, designed to end the practice of local governments imposing non-voter-approved tax increases, they and their legislative allies are expected to launch a frontal attack in 1997. They seek modifications making it easier to raise taxes.

These changes could come through a "constitutional revision" proposal, or could be sought directly through legislation similar to SCA 36 (O'Connell) of 1996, which sought to relax the voting requirement for special taxes for schools and transportation. The bill died on the Senate floor.

According to information released by Cal State University-Sacramento, a so-called "Consensus Project" has been meeting for some time to try to put together a package of revisions to Propositions 13 and 218. The group, which has hired a facilitator from the university, is dominated by spending lobby representatives. The main sponsor of the two initiatives, the Howard Jarvis Taxpayers Association, is not represented.

Among proposals being discussed by the group are a reduction of the two-thirds legislative vote requirement to impose new taxes, elimination of the two-thirds vote requirement for "special taxes," a reduction of the voter-approval requirements for local property tax-backed general obligation bonds, and a score of others.

Any change to Propositions 13 or 218 will require a two-thirds vote of both houses of the Legislature and statewide voter approval. Observers believe this will be difficult to achieve. To get two-thirds support in the Assembly, 11 Republicans would have to vote for the change, along with all Democrats. However, pressures will be substantial.

ECONOMIC OUTLOOK

The final months of 1996 were good ones for California's economy and 1997 also promises to be a good year. In Santa Clara County, including the Silicon Valley, the jobless rate for November dropped to a fantastic 3.3 percent. It was even lower in San Mateo County at 2.9 percent. California's unemployment rate has dropped to 6.9 percent, the lowest since 1990.

UCLA economists see job growth in California continuing to outpace the nation through the rest of the decade. The latest report from the university's Business Economic Forecasting Unit predicts non-farm payroll will grow by 3.1 percent in 1997, up from 2.8 percent last year. The forecast also sees the state's unemployment rate will not be as high above the national average as in the past.

OTHER MAJOR TAX ISSUES IN 1997:

• Proposition 218 Implementation. Implementing this initiative, the taxpayers' "Right to Vote Act," will be a major task for the Legislature this year. Whether the effort will be contentious is still unclear. There are a number of features that need clarification, such as the impact on bonds, procedures for voting on assessment protests, how governmental entities will be assessed, pay and vote on proposed assessments, etc. The Legislative Analyst's Office is coordinating discussions to find common ground for proposed legislation.
• Conformity. State franchise and income tax laws have been drifting further and further out of conformity with federal law. To remedy this situation, Senate Revenue and Taxation Committee staff has initiated meetings with interested parties. The goal: a bill that can pass with bipartisan support.

Taxpayers are stressing the urgency to conform to federal Subchapter S changes immediately. They also have indicated there is a very high priority for quick passage of provisions relating to financial institutions, such as allowing conversion of common trust funds to mutual funds and conforming to provisions to secure consumer receivables (FASIT).

This collegial process was used successfully in the early and mid-1980s to develop conformity bills that were enacted into law.

• Taxation of Electronic Commerce. Taxation of electronic commerce will be the "in" issue for the year. In the words of the late Jimmy Durante, "Everybody wants to get into the act." More symposia on this issue are being organized than people have time to attend. Articles on the subject by practitioners and tax officials have been published recently.

Arthur Andersen LLP published a white paper on the subject, noting complex issues are involved in state taxation of electronic commerce. A white paper by the U.S. Treasury Department, released in November, stated concerns that inconsistent tax policies will leave taxpayers subject to "Quixotic taxation." The paper suggests the need for rules that provide certainty and prevent double taxation. Rules should be guided by the principle that no new or additional taxes on electronic commerce should be imposed.

A task force of the Interactive Services Association (ISA) issued a paper in November that recommends "policy makers take time to consider the unique nature of the emerging industry before imposing taxes that would be difficult to implement and collect."

Bruce Reid of Microsoft, chair of the ISA's Online State Tax Committee, said: "There are many states that are taking a deliberate approach to examining these issues. However, many states have already demonstrated that they are prepared to tax Internet and online services. While no one welcomes the prospect of additional taxes, we want to ensure that if they are imposed, that they don't impede the growth of the industry."

Cal-Tax has also organized a "roundtable" of its interested members. The group has scheduled additional meetings to develop policy on this important topic.

Despite this flurry of activity, it is unlikely that anything will be ripe for final action in this first year of the two-year legislative session.

• Property Tax Allocation. The "sleeper" issue for the year may well be the issue of property tax allocation. Cities and counties are organized and have introduced legislation (AB 1, Aguiar) to take back the growth in the property tax base that was shifted to schools in 1992 and 1993. As similar legislation (AB 2797, Aguiar) developed in the closing hours of the last legislative session was vetoed by Governor Wilson, proponents have also introduced a constitutional amendment (ACA 4, Aguiar) to bypass the governor and put the issue on the ballot.

Because of Proposition 98 formulas, the proposal would have the effect of increasing the growth rate for the largest expenditure in the state budget -- that for K-12 education. Because of the leveraging aspect, the state would be required to pick up the costs that normally would be funded by property tax growth. This could cause future state budget problems. It could increase pressures for state tax increases and may make it more difficult for the state to find money for school improvements, such as Governor Wilson's class-size reduction program.

Interesting to note is the fact that almost the total amount of the property tax shift has been replaced by a one-half percent sales tax adopted by voters in November 1993 and locally imposed new taxes and assessments. Revenues from the one-half percent sales tax, although restricted in use, have been growing faster than property tax revenues.

• Elective Combination. Taxpayers have been trying to extend to franchise tax law a procedure similar to the federal elective combination provisions. Due to differences in the structure of state law, the California counterpart would be elective combined reporting. Last year, bills on the subject were approved by the Assembly and were approved by the Senate Revenue and Taxation Committee. Another push is expected this year. The concept would eliminate endless non-productive hours of conflict between taxpayers and the FTB over whether an affiliate is "unitary" or not. Whether the proposal will have a better chance this year is unknown.
• Research and Development (R&D) Credit. Taxpayers are looking for two improvements this year in the ever-popular R&D tax credit. They would like to see the credit at 12 percent, rather than 11 percent. They also want to conform the static base period provisions to federal law. If the Legislature is to approve any pro-taxpayer proposal this year, this is a likely candidate.
• Minimum Franchise Tax. There will be bipartisan efforts to reduce the hated $800 minimum franchise tax. Bills have already been introduced by Democrats and Republicans to limit the reach of the tax (see AB 8, Brewer, and AB 27, Strom-Martin). Yet, fiscal considerations may intrude as they have in past years when major reductions of the minimum tax have faltered.

On the alternative minimum tax front, the Legislature directed the Department of Finance and FTB to make recommendations by next June on how to simplify the levy. Even Lenny Goldberg, who opposes virtually all tax relief proposals, has testified in committee that the tax is too complex and should be simplified. Hopefully, the recommendations forthcoming in June will provide a framework for the Legislature to make statutory changes.

• Dynamic Revenue Forecasting. Will 1997 finally be the year in which the Department of Finance makes a dynamic revenue estimate? As required by 1994 legislation, the Department of Finance in 1996 developed a dynamic forecasting model. The department indicates that 1997 will be the year it is used.
• Taxpayers' Bill of Rights. In 1996, Congress enhanced federal Taxpayer Bill of Rights provisions. It would appear that legislators could score points with taxpayers, with little downside revenue risk, by adapting California's Taxpayers Bill of Rights to conform. Yet the outlook for such a change is questionable, based on discreet inquiries on the subject last fall.
• Software MIC. Last year, AB 2661 (Alpert) to extend the manufacturers' income tax credit and sales tax exemption to software manufacturing did not get far. It was killed in the Assembly Appropriations Committee, due to the FTB's estimate of a $30 million revenue loss in the first year, with $55 million in unused credit carryforward. This year's measure may have a better chance because the author will have more clout as chair of the Senate Revenue and Taxation Committee.
• Tax Agencies. There will be a new face in the chair at the State Board of Equalization, as long-time Member Ernie Dronenburg takes over the post from Johan Klehs, who will become vice-chair. This change also means that the composition of the FTB will change, with Mr. Dronenburg joining Controller Kathleen Connell and Teresa Parker of the Department of Finance.

At the BOE, there will also be a slot to fill with the departure of Brad Sherman to Congress. It was unknown whether Governor Wilson will nominate someone to complete Mr. Sherman's term (through 1998) and, if so, who will be named. Because of the difficulty of getting Democratic legislators to confirm a nominee, speculation centers on a nonpartisan caretaker. If the governor leaves the post vacant, the question arises to what extent John Chaing, Mr. Sherman's top aide, will be able to participate in place of Mr. Sherman (Government Code Section 1775 allows a departing constitutional officer to name a temporary successor until a nominee is confirmed or an election is held).

Issues before the BOE this year will include enforcement of the property tax exemption for computer software, revision of several assessor handbooks, and additional regulatory projects.

ASSESSORS SUE BOE OVER CABLE-TV ASSESSMENTS, RULE 152

Assessors welcomed 1997 with two lawsuits against the State Board of Equalization that seek to impose higher values on cable-television property and computer software.

San Francisco County Assessor Doris Ward's suit seeks to have a state law (Revenue and Taxation Code Section 107.7), establishing a procedure for assessing cable-TV possessory interests, declared unconstitutional.

Meanwhile, eight counties sued the board over the adoption of Rule 152, which limits assessors' authority to impose property taxes on computer software. Last year, the BOE adopted changes in the rule limiting taxes to basic operational software bundled with the sale of the computer. Proponents said this was consistent with original legislative intent. The Los Angeles County Superior Court suit was filed by counties of Los Angeles, Orange, San Diego, San Francisco, Santa Clara, Alameda, Napa and Solano.

The cable-TV possessory interest law, which has been on the books since 1988, provides that the "preferred method" of valuing cable possessory interests is to capitalize the annual rent paid for use of the government property. Annual rent is defined to be the franchise fee paid for the remaining term of the franchise.

Ms. Ward, whose office was roundly criticized for sloppy assessment practices in a BOE report last year (see Caltaxletter of March 25, 1996), argues that the statute is unconstitutional because it treats cable-TV property differently than other property. Additionally, the county contends that to the extent it results in undervaluation, it creates an unconstitutional partial exemption.

It should be pointed out, however, that Section 107.7 permits an assessor to place the value he or she thinks is the correct one on the property. The assessor only loses the presumption of correctness on an appeal if the prescribed procedure is not followed.

In the 1993 County of Orange v. Orange County Assessment Appeals Board No. 1 cable-TV case, the appellate court noted the appeals board used the income capitalization method "which is presumptively correct under Revenue and Taxation Code Section 107.7."

In the Rule 152 legal action, the fight is over which software is not exempt by statute. Santa Clara County Deputy Counsel James Rees said the suit will determine whether the state's interpretation on software is correct. He estimated that IBM could be liable for as much as $2 million in back taxes in Santa Clara County alone if the suit is successful. IBM spokesman Fred McNeese was quoted by the San Jose Mercury News as saying, "It's IBM's position -- and it's consistent throughout the U.S. -- that software should not be taxed as personal property because it's intellectual property."

TRANSFER OF PROPOSITION 99 FUNDS UPHELD

In a major victory for Governor Pete Wilson, the Third District Court of Appeal upheld a shift of Proposition 99 tobacco tax funds in 1995 (Americans for Nonsmokers' Rights v. State of California).

In SB 493 (Solis) of 1995, the Legislature and governor increased the amount of Proposition 99 funds directed to physicians' services and reduced the amount allocated to education and research.

The court said, "The four-fifths vote requirement was met in SB 493 and is not at issue here. The principal issue is whether these percentage changes in the Act's accounts are legally consistent with the Act. Our standard of review on this issue was recently formulated in Amwest Surety Ins. Co. v. Wilson (1995) 11cal.4th 1243 (Amwest), a decision that was not available for the trial court to use. Under that standard, we conclude SB 493 is valid because SB 493 reasonably can be construed as being consistent with the purposes of the Act. Accordingly, we reverse."

POTPOURRI: SYMPOSIUMS, SIGHTINGS, SALUTES & SNAFUS

The Senate's Martin Helmke and Anne Maitland are returning for another session as consultants to the Revenue and Taxation Committee, surviving the change in committee chairs from Lucy Killea to Dede Alpert. It was not yet known who would serve as top consultants to the Assembly Revenue and Taxation Committee under new Chair Louis Caldera. Majority Democrats chair all Assembly committees after regaining control of the lower House in November's elections ... Jim Lites, who was consultant to the Assembly Revenue and Taxation Committee when the Democrats were last in the majority, has taken a position as new Assembly Speaker Cruz Bustamante's advisor on tax issues.

Ex-Assembly Speaker Curt Pringle has been mentioned as a potential candidate for the State Board of Equalization. Los Angeles Times columnist George Skelton wrote that it would be premature to write the political obituary of the 37-year-old Pringle; that the Garden Grove Republican might also run for Congress in 1998 (in Bob Dornan's old seat) or possibly look at a seat on the Orange County Board of Supervisors. Mr. Pringle is currently barred by term limits from seeking re-election to the Assembly in 1998. The BOE seat that might interest him is that of Ernest J. Dronenburg Jr. of San Diego County, a Republican who cannot seek re-election in 1998 because of term limits.

In Orange County, former treasurer Robert L. Citron may not have to serve his one-year term behind bars. Sheriff Brad Gates announced just before Christmas that Mr. Citron probably will qualify for a work program for non-violent offenders, although a final determination had not been made, and Mr. Citron would have to apply. Mr. Citron, 72, was sentenced after pleading guilty to felony fraud charges in connection with the county's $1.64 billion investment loss and the largest municipal bankruptcy in U.S. history. He has been ordered to begin his jail sentence on January 10, but the sheriff says a work program can be requested any time after January 1.

COMING UP

Jan. 7: GOVERNOR PETE WILSON'S STATE-OF-THE-STATE ADDRESS
Location: Assembly Chamber at 5 p.m.

Jan. 8: BOE PROPERTY TAX COMMITTEE MEETING
Location: Room 121, 450 N Street, Sacramento, at 9 a.m.
Subjects: (1) Amendments to property tax change-of-ownership rules; (2) BOE rules of practice; (3) General aircraft value guide, and (4) Change-of-ownership consequences of subleasing a taxable possessory interest.

Jan. 8: BOE LEGISLATIVE COMMITTEE MEETING
Location: Room 122, 450 N Street, Sacramento, at 1:30 p.m.
Subjects: (1) BOE 1997 legislative program, (2) Positions on pending legislation.

Jan. 8: BOE BUSINESS TAX COMMITTEE MEETING
Location: Room 122, 450 N Street, Sacramento, at 2:30 p.m.
Subject: Stream of foreign commerce.

Jan. 8: BOE CUSTOMER SERVICES COMMITTEE MEETING
Location: Room 122, 450 N Street, Sacramento, at 3:30 p.m.
Subject: Taxpayer Bill of Rights' reimbursement claims procedure.

Jan. 9: STATE BOARD OF EQUALIZATION MEETING
Location: Room 121, 450 N Street, Sacramento, at 9:30 a.m.
Subject: (1) Administrative session: chief deputy to board member filling a vacancy; 2) Proposed amendments to conflict-of-interest Regulation 6001, reflecting organizational changes and classifications at the board, and (3) Business tax appeals.

Jan. 9: GOVERNOR'S 1997-98 BUDGET RELEASE
Location: Room 1190, State Capitol, at 11 a.m.

Jan. 10: STATE BOARD OF EQUALIZATION MEETING
Location: Room 121, 450 N Street, Sacramento, at 9:30 a.m.
Subject: (1) Administrative session: chief deputy to board member filling a vacancy; (2) Executive director's report; (3) Performance audit -- approval of notice of intent to award contract; (4) Timber Advisory Committee membership; (5) Authority to publish regulatory changes: Sales Tax Regulation 1587 (animal feel), Sales Tax Regulation 1610 (vehicle, vessels and aircraft), Sales Tax Regulation 1705 (relief from liability), and Emergency Telephone Users' Surcharge Regulations 2401 and 2406 (telephone billing agents), and (6) Franchise income tax appeals, and business, franchise, income and property tax non-appearance matters.