September
1996

Proposition 217
Retroactive Tax Increases and Harmful Property Tax Changes

Highlights

If passed, Proposition 217 would:

Retroactively reimpose 10% and 11% personal income tax brackets that expired at the end of 1995. The new brackets would be permanent tax increases.
Give California the highest effective income tax rates in the country.
Increase taxes on small businesses, which are now creating most of California's new jobs.
Impede future income tax reforms, including conformity with federal tax changes, capital gains tax reduction, or across-the-board tax rate reductions.
Freeze each local agency's share of countywide property tax collections at its 1995-96 level.
Force fast-growing cities to give up some of their share of property tax to other jurisdictions in their county.
Impair the ability to incorporate, annex, detach or otherwise change a city's or district's boundaries.
Prevent local agencies from lowering their property tax rate.
Prohibit new redevelopment projects, if those projects would increase the redevelopment agency's proportionate share of countywide property tax collections.

Introduction

The 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 Provisions

This 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:

Retroactively impose a 10 percent personal income tax rate for California taxpayers with taxable income over $111,695, and an 11 percent rate for taxable income over $223,390, effective January 1, 1996. (Joint filers would pay at incomes over $223.390 and $446,780, respectively.)

Allocate approximately half of the increased revenue to schools through the Proposition 98 guarantee; the remainder would be allocated to local governments based on their proportionate share of property tax revenue transferred to local schools and community colleges since 1992 and 1993 law changes. There are no requirements on how the money would actually be spent.

Prohibit any reduction in a local agency's proportionate share of property tax, without respect to future growth patterns. It would prevent growing communities from receiving their full share of future property tax revenues.

Lock in place the dollar amount and proportion of income tax paid by taxpayers in the new 10 percent and 11 percent brackets as the minimum with regard to future changes in the state personal income tax.

Current California Income Tax Rates
Table 1

Single Taxpayers

Taxable Income

Over But not over Tax Rate

$0 $4,908* 1%

4,908 11,632* 2%

11,632 18,357 4%

18,357 25,484 6%

25,484 32,207 8%

32,207 and over 9.3%

Joint Taxpayers

Taxable income

Over But not over Tax Rate

$0 $9,816* 1%

9,816 23,264* 2%

23,264 36,714 4%

36,714 50,968 6%

50,968 64,414 8%

64,414 and over 9.3%

*Note: Personal exemption credits elminate all state income tax for single individuals earning $5,766 or less,
or for a couple with two children earning $18,231 or less.
Source: Franchise Tax Board

Personal Income Tax Rates States Ranked by Highest Rate Table 2
				Deduction
		Lowest	Highest	For Federal
Rank	State	Rate	Rate	Tax?

1	Massachusetts	5.95	12.00
2	North Dakota	2.67	12.00	Yes
3	Montana	2.00	11.00	Yes
4	Hawaii	2.00	10.00
5	Oklahoma	0.50	10.00	Yes
6	Iowa	0.40	9.98	Yes
7	D.C.	6.00	9.50
8	California	1.00	9.30
9	Oregon	5.00	9.00	Yes
10	Maine	2.00	8.50
12	New Mexico	2.20	8.50
11	Minnesota	6.00	8.50
13	Idaho	2.00	8.20
14	North Carolina	6.00	7.75
15	Kansas	4.40	7.75
16	Delaware	3.20	7.70
17	New York	4.55	7.59
18	Ohio	0.74	7.50
19	Utah	2.55	7.20	Yes
21	Arkansas	1.00	7.00
20	South Carolina	2.50	7.00
22	Nebraska	2.62	6.99
23	Wisconsin	4.90	6.93
24	New Jersey	1.70	6.58
25	West Virginia	3.00	6.50
29	Kentucky	2.00	6.00
30	Georgia	1.00	6.00
28	Missouri	1.50	6.00	Yes
26	Tennessee	0.00	6.00
27	Louisiana	2.00	6.00	Yes
31	Virginia	2.00	5.75
32	Arizona	3.00	5.60
33	Colorado	5.00	5.00
34	Alabama	2.00	5.00	Yes
37	Mississippi	3.00	5.00
36	New Hampshire	5.00	5.00
35	Maryland	2.00	5.00
38	Connecticut	4.50	4.50
39	Michigan	4.40	4.40
40	Indiana	3.40	3.40
41	Illinois	3.00	3.00
42	Pennsylvania	2.80	2.80
--	Vermont	25% of Federal Tax
--	Rhode Island	27.5% of Federal Tax
	Alaska	0.00	0.00
	Florida	0.00	0.00
	Nevada	0.00	0.00
	South Dakota	0.00	0.00
	Texas	0.00	0.00
	Washington	0.00	0.00
	Wyoming	0.00	0.00


* Massachusetts' top rate applies only to investment income. Reproduced with permission from CCH State Tax Handbook, published and copyrighted by CCH Incorporated, 2700 Lake Cook Road, Riverwoods, Illinois, 60015.

Highest State Income Tax Rates

If 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 Business

Eighty-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 Penalties

If 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 Tax

High 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.

California Personal Income Tax
Percent of total income earned and taxes paid, by income group
Figure 1

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

Business Income Taxes Paid by
Personal Income Tax Filers
Figure 2

"PIT"= Personal Income Tax; "B&C"= Bank & Corporation Tax.
Source: Franchise Tax Board, 1993 data.

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 Reform

The 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 Revenues

Proposition 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:

Fast-growing cities would lose their fair share of property taxes. Under current law, if a city's assessed value grows faster than other jurisdictions in its county (e.g., because of new residential or commercial development or simply from faster property appreciation), the fast-growing city naturally receives a greater percentage share of countywide property taxes. This is not to say that the slower-growing jurisdictions actually lose revenue - simply that their percentage of countywide property tax is smaller, because the countywide total increases by growth concentrated in other parts of the county.

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.

New incorporations of cities would not be allowed property tax. Similar to the situation outlined above, if a community incorporated as a new city, that city would not be allowed to receive any property tax revenue, because any allocation of property tax to the new city would reduce other jurisdictions' percentage share of that county's countywide property tax revenue.

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.

Annexations of new territory by existing cities would not provide additional property tax revenue. Also similar to the cases above, if a city annexed territory that had previously been unincorporated, the city would not be able to receive property tax from that annexation, because doing so would reduce the county's share of property tax collections.

Local agencies would be prevented from lowering their property tax rates. Shortly after passage of Proposition 13, the Legislature provided a mechanism for local agencies to lower their property tax rates below the one percent cap, if desired (Revenue and Taxation Code Section 96.8). This procedure requires the county auditor to reduce that agency's allocation of property tax and recompute the tax rate accordingly. Since Proposition 217 would prohibit an auditor from "reducing the proportionate share of total property tax" allocated to an agency, this kind of tax reduction would be impossible.

Special districts would also be affected. Any district that receives property tax revenues would be harmed if property within the district appreciates faster than other parts of the county or if new residential and commercial development is approved within the district boundaries. These districts provide services integral to a community's quality of life, including water, sanitation, libraries, recreation and parks.

Effects on Redevelopment

Redevelopment agencies would be harmed by this measure in two ways, potentially halting any new redevelopment project:

First, like any local agency, redevelopment agencies would not be allowed to increase their percentage of countywide property tax collections, because that would cause other local agencies' shares to diminish, which would be prohibited.

Second, by interaction with current law, redevelopment agencies are not included in the definition of "local agency" used by the initiative. This not only guarantees that redevelopment agencies cannot increase their share of property tax, upon which their projects are dependent, it also denies them the protection from property tax shifts which the measure attempts to provide for other local agencies.

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:

95. Definitions
For the purposes of this chapter:
(a) "Local agency" means a city, county, and special district.

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.

Fiscal Impact

Taxpayers: The Legislative Analyst estimates that this proposition would increase taxes approximately $700 million annually. This estimate is based on a static estimate that assumes no changes in taxpayer behavior to minimize the additional taxes the proposition would impose.

Schools: The Legislative Analyst estimates that approximately one-half of the increased revenue generated by the higher tax rates would go to schools. There are no provisions providing how the money is to be spent within the schools. If current spending trends continue, 85 percent would be spent for salaries of school administrators, teachers and classified employees of school districts.

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.

Cities, Counties and Special Districts: These local agencies would receive any remaining new tax revenues, allocated based on the property tax shift formula. There are no provisions as to how the money is to be spent.

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.

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