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California Supplemental Report

Tax Environment

California’s tax system has received nationwide attention in recent months, as lawmakers attempted to find a way to close a $38 billion budget hole and pass a budget for 2004. The Golden State’s taxes are complicated by the sheer amount of revenue the state collects and distributes, and increasingly, by voter initiatives and referenda.

Residents pay the three typical taxes: income, sales and property. But the state has steadily become more reliant on the individual income tax to provide for its general fund. In the early 1980s, the income tax made up about 35 percent of the general fund’s revenue; by 2001 that figure had grown to 58 percent. The recent volatility of the state’s income tax, however, has proven that shift to be unfortunate.

California’s tax system also made national headlines 25 years ago, when voters passed Proposition 13. The initiative, which spawned similar ballot questions throughout the country, made local governments increasingly dependent on the state for their revenue. This law fixed the property tax rate at 1 percent and limited increases in property value to no more than 2 percent per year (though the value is adjusted to market rate when the property is sold). Local option sales taxes are limited too, and so cities, towns and counties must rely on cash from Sacramento.

The sales tax rate increases or decreases based on an economic trigger, imposed by a 1991 law. The sales tax rate is automatically reduced if the general fund surplus exceeds 4 percent for two consecutive years. This cut, which materialized in 2001, was allowed to lapse in 2002 after revenues began to decrease.

A two-thirds majority is required to pass the budget or any tax increase.

Recent Tax Developments

• Gov. Gray Davis in June signed an administrative order that returned the vehicle license fee, an annual 2 percent levy, to its pre-1998 levels. Between 1998 and 2002, the state slashed the fee by two-thirds; Davis’ order raised $4 billion for 2004.

• The effort to reinstate two higher tax brackets (10 and 11 percent, respectively) failed by one vote in the state Senate in 2002. The plan would have raised about $2.7 billion. A $2.13 per pack hike in the cigarette tax was also voted down during that session.

Budget Information

Legislators finally passed a 2004 budget in the early morning hours of July 30, after a 29-hour Assembly session. The $38 billion budget hole was closed without raising taxes, but instead relies on heavy borrowing, cuts in health services, increases in college tuition and fees and the restoration of the vehicle license fee. Funding for K-12 education was left largely intact. Lawmakers rejected a Democratic proposal to temporarily raise the state sales tax rate by 1/2 percent.

The budget bill also gives the governor authority for one year to cut programs if spending outpaces projections.

The budget compromise, however, is far from a solution to the state’s financial woes: this budget leaves an $8 billion gap in the 2005 budget, and credit rating agencies have lowered the state’s bond rating considerably in recent months. California now has the lowest bond rating of any state, and in July, Standard and Poor’s lowered the bond rating a full three notches, leaving it perilously close to junk-bond status. The moves will cost the state millions in extra interest costs.

The 2003 budget hole of $23 billion was closed using a number of budget-balancing maneuvers, including the suspension of the teacher’s tax credit—a savings of about $170 million—and a suspension of the deduction corporations can take on their losses, which saved about $1.2 billion for the year.

Ballot measures have built in increasing budget demands. Proposition 98, which sets a minimum amount that must be provided for primary, secondary and community college education, was scheduled to force at least $48 billion in spending in 2004. Spending relative to Prop 98 is projected to grow about 5 percent a year. Last year’s Proposition 49 may force school-related spending even higher: the state Legislative Analyst’s Office estimated the after-school program could add as much as $428 million to the annual budget. No monies, however, have been allocated to the program as yet.

Adequacy

Currently, California’s tax system is woefully inadequate to meet the state’s needs. The volatility of the state’s individual income tax—and the state’s over-reliance on the tax—led to much of the past years’ budget disaster. Several factors contribute to the steep decline in income tax receipts. The state’s individual income tax is the most progressive in the nation. The typical family of four doesn’t begin paying income tax until it earns more than $35,000, and rates range from 1 percent to a high of 9.3 percent. When taxpayers earn less or lose their jobs—a frequent occurrence in high tech heavy Silicon Valley—they drop down to lower tax brackets or fail to hit the income tax threshold altogether.

But capital gains caused an even larger part of California’s drop in income tax receipts in recent years. Unlike some other states, California taxes capital gains as regular income. In 2000, taxes on capital gains and stock options—again, frequent pieces of compensation packages in Silicon Valley—generated $18 billion. In 2001, as dot-com companies collapsed and capital gains and stock options disappeared, the state generated only $8 billion from the same source of taxes.

Because it artificially holds down property assessment values, Proposition 13 has hamstrung the local governments from raising adequate property tax revenue. That, in turn, has left the locals looking to the state, and the state looking to alternative revenue sources for funding to fill in the gaps. The primary source of this funding is the recently restored vehicle license fee.

Corporations in California, particularly high tech companies, have been hit hard by losses during the last two years, contributing to the state’s decline in tax receipts.

Fairness

California has built a tax system that is more fair than most. When all taxes are considered, the lowest income earners pay about 11.3 percent of their gross income to taxes; the highest 1 percent of income earners pay about 7.2 percent. While still a discrepancy, it is a smaller variation than in many states. This data is derived from the Institute on Taxation & Economic Policy study, “Who Pays? A Distributional Analysis of the Tax Systems in All 50 States”, http://www.itepnet.org/whopays.htm.

While the volatility of the graduated individual income tax has been a drag on state coffers, it does prevent additional regressivity from creeping into the state’s tax system. Unlike most states, California has built a strong corporate income tax. The state is tough on the creation of tax shelters, and corporate tax expenditures have been held in check. In addition, the state stands by the traditional three-factor apportionment formula to calculate corporate income tax, which considers a company’s property, assets and sales in tax liability. The rate is currently a flat levy of 8.84 percent.

An optimal sales tax system has a wide base with a low rate; California’s rate stands at 7.25 percent, plus an additional 1.25 percent local option tax. Food and prescription drugs are exempted from sales tax for all residents.

The major flaw with California’s tax equity appears in its taxation of services in its sales tax base. The state ranks among those taxing the fewest services, levying sales tax against fewer than 20 of 164 possible services, according to the Federation of Tax Administrators study of service taxation. http://www.taxadmin.org/fta/pub/services/rr147srv.pdf If California added amusement and recreation to its sales tax base, it would bring in an additional $2 billion during the 2004 fiscal year, according to the Legislative Analyst’s Office. Additional tax expenditures have been built into the budget in recent years to induce lawmakers to vote for unfavorable pieces of the budget. Tax subsidies amount to more than $30 billion a year.

Management

California’s tax administration is a unique system in which three agencies split the duties. The Franchise Tax Board collects personal and corporate income taxes, the Board of Equalization administers sales and excise taxes, local property tax oversight and the tax appeals process, and the Employment Development Department handles the state payroll tax. State officials acknowledge that consolidating the agencies would bring efficiencies, but political concerns make such a move highly unlikely.

The Franchise Tax Board does a somewhat better job in its role than the Board of Equalization. It is commonly cited throughout the state and by other officials around the country as a model program. The FTB strengthened its audit program in 1999 by adding a non-filer compliance system that better integrates the data collected by the state; officials estimated the system would generate an additional $36 million annually.

Electronic filing was the hot-button issue at the FTB in 2002. Taxpayers had been able to file their income taxes electronically since 1997, but only with the help of tax preparers and preparation software. After a years-long battle with lobbyists representing tax software companies over whether to allow free Internet filing for individual taxpayers, the state’s simplest return (used by about 30 percent of filers) now can be processed via the Web. Single taxpayers who earn less than $50,000 and married couples under the $100,000 threshold are eligible to use the free online form.

Politics have damaged the Board of Equalization’s reputation. The Board’s five elected members act as the state’s tax court; increasingly, that group has been comprised of term-limited state legislators. That they can accept campaign contributions—up to $250 from individual donors and additional cash from a political action committee—and the Board’s otherwise highly political atmosphere have led some to doubt the quality of its decisions in appeal cases. The Board has, however, cut a deep backlog of appeals cases. Several years ago, five- and six-year-old cases remained in queue; today, most cases are resolved within two years.

California does a pretty good job on tax policy accountability. The state prepares a tax expenditure report that itemizes the value of revenues foregone via tax breaks and makes the report available on the web. The state also has some capacity to determine the impact of state taxes or changes in the tax code on all taxpayers, but this capacity is still limited. State Assets Development Report Card, Oct., 2002

Local Issues

Proposition 13 drives the state-local tax relationship. Prop 13 centralized much of the revenue-raising authority at the state level, leaving limited ability for cities and counties to levy local-option taxes. The change also left the locals to rely on cash from Sacramento to balance their books.

Locals worry that in difficult budget times, the law makes it easier to cut local aid. In the mid 1990s, the state shifted about $4 billion in property tax revenues from the locals to its own school budget, and the cities and counties were left to make up the difference.

Debate continues about how the relationship between state and local taxes should be changed. The vehicle license fee, an annual 2 percent tax dedicated to local use, was sliced by two-thirds between 1998 and 2002. Gov. Gray Davis in June signed an administrative order that returned the fee to its pre-1998 levels.

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