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The open secret about California taxes

By | May 8, 2018

California’s tax system, which relies heavily on the wealthy for state income, is prone to boom-and-bust cycles. While it delivers big returns from the rich whenever Wall Street goes on a bull run, it forces state and local governments to cut services, raise taxes or borrow money in a downturn. During the Great Recession, the capital-gains taxes that sustained the state in good times plummeted. School districts handed out 30,000 pink slips to teachers, and the state was so cash-strapped it gave out IOUs when it couldn’t pay some of its bills.

California is now enjoying one of the longest economic expansions in state history, but the good times can’t last forever. With an “inevitable recession lurking in our future,” Gov. Jerry Brown has warned, state and local governments are more vulnerable than ever to teacher and police layoffs, park and library closures and cuts in health and welfare services for the poor.

Past bipartisan efforts to reduce volatility without raising taxes on the poor and working class have had limited success. The overall tax structure hasn’t been updated, leaving parts of the economy taxed at some of the nation’s highest rates while other sectors, such as services—which many other states do tax—aren’t taxed in California. Politicians like to talk about the problem, explaining how Proposition 13, the famous 1978 measure that limited property taxes, has created unequal tax burdens. Yet few have been willing to initiate change.

Let’s take a deeper look at California’s tax structure, examine the tradeoffs we live with as a result and explore what changes might be afoot. We’ll walk you through what we live with today, the problems we encounter and the proposals to fix them.

(This reporting project was produced in partnership with the Ravitch Fiscal Reporting Program at the CUNY Graduate School of Journalism.)

HOW IT WORKS NOW


  1. How much we pay
  2. Where the money goes
  3. What other states do

THE TRADEOFFS WE'RE MAKING


  1. There's instability
  2. The Silicon Valley factor
  3. Unintended consequences
  4. Housing's more expensive now
  5. The system is outdated
  6. The poor get hurt

GOING FORWARD: PREPARING FOR THE NEXT DOWNTURN


  1. Fewer choices
  2. The bull run will end
  3. What's In the works
  4. Questions

HOW IT WORKS NOW

How much we pay

California state and local governments received $419 billion from taxes, fees and federal funding in 2015, the most recent data available from the U.S. Census Bureau.

California taxes

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Of that, $93.3 billion came from Washington, while state and local governments raised $325.7 billion from a combination of taxes and fees. This included not only common taxes that residents pay on property, sales and individual and corporate income, but also other charges and fees that governments have tacked on over the years for hospitals, highways and schools.

The differences between taxes and fees can be obscure and often provoke politically charged debate, but in the end they’re both a way to raise revenue for state and local governments.

If we were to isolate common taxes, the amount would be $228.7 billion. The Legislative Analyst’s Office, a nonpartisan adviser to lawmakers on financial matters, breaks down the distribution of revenue sources.

California’s major revenue sources have shifted over time. Until 1995, the biggest was property taxes Today, it’s personal income taxes.

Where the money goes

As the fifth-largest economy in the world, California has big demands—a wide variety of public needs from roads and highways to parks and prisons. But by and large, the state’s two biggest services are education and health care.

The state is projected to spend $78.3 billion* in 2018, from its own revenue sources, on six million students in K-12 public schools. That amounts to $11,614 per pupil from state and local sources and reflects recent years of improved funding due to the improved economy and voter-approved tax increases.

Taxpayers also subsidize a higher-education network made up of community colleges and the California State University and University of California systems.

On health care, California was early to embrace the federal Affordable Care Act, which established an individual health-insurance market and expanded Medicaid, known here as Medi-Cal, which covers the poor. Today, California’s Medi-Cal program tops $100 billion each year and covers 13.5 million, or one in three, residents.

The bulk of that cost has been borne by the federal government, but there’s much uncertainty about ongoing federal aid as Republicans in Congress propose to scale back spending. The question of how to sustain this coverage has triggered a public debate about a single-payer health care system for California.

On top of all these costs are some long-term debts that have flown under the radar, such as retirement obligations for public workers. California state and local governments now spend $25 billion a year on pension payments and retiree health care for public employees—a threefold increase since 2003, with payments projected to grow.

*Updated to clarify revenue sources

What other states do

California ranks fairly high in overall taxation: 10th highest both per capita and as a percentage of personal income, based on the latest available data from the U.S. Census.

There’s a variety of ways to measure taxes. The most common is percentage of personal income. This is the measure we applied.

In 2015, state and local governments collected $228.7 billion in taxes, including property, sales, personal and corporate income levies and a few others, according to the census. That’s in a state with more than 39 million residents and personal income worth nearly $2 trillion that year.

California’s taxes have risen in ranking partly because of voter-approved increases. In November 2012, the state passed a temporary hike in sales taxes of 0.25 percent and raised personal income taxes on the rich. Four years later, voters extended the income tax increase for 12 more years.

Gov. Brown and lawmakers also approved a 12-cent gas-tax hike in 2017 to help raise $5 billion a year for aging infrastructure. The measure includes increasing the annual vehicle fee between $25 and $175, depending on the vehicle’s value.

Of course, there’s some variation:

  • California has the highest statewide sales tax rate, at 7.25 percent, and is ranked ninth by the Tax Foundation in combined state and local sales tax rates.
  • The state has the highest personal income tax rate for its wealthiest. It’s 9.3 percent for those making $53,000 to $269,000 and 13.3 percent for those making $1 million or more.
  • California has below-average property taxes due to Proposition 13, the famous 1978 measure that capped increases to no more than 2 percent a year. The Tax Foundation ranked California 35th in the nation in taxing owner-occupied housing.

THE TRADEOFFS WE'RE MAKING

There's instability

In its willingness to tax the rich, the state has become more reliant than ever on personal income taxes.

Individual wages and business income as a measure of the overall economy aren’t terribly volatile. But California’s income taxes are over five times more volatile than personal income because they also include investment gains, according to the Legislative Analyst’s Office. The state taxes capital gains, partnership income and dividends, interest and rent—areas where the highest-income taxpayers derive most of their money.

The result? Millionaires and billionaires contribute a disproportionate share of tax revenue—so much so that the top 1 percent of taxpayers now generate half of personal income tax receipts.

According to the Legislative Analyst’s Office, half of the state’s personal income tax revenue comes from those making $500,000 or more. Conversely, households making $50,000 or less make up nearly 60 percent of tax filings but make up just 2 percent of revenue.

This volatility can mean huge cash infusions in good times. For example, when Facebook went public in 2012, top employees such as company founder and chief executive Mark Zuckerberg, along with early investors, plumped state coffers with an estimated $2.5 billion, which arguably prevented some school funding cuts amid a $16 billion budget deficit.

The opposite is true in bad times.

During the Great Recession, the state faced multiple years of multibillion-dollar deficits, including a shortfall of $39.5 billion in 2009, as fallout from the housing and economic crisis.

The California Teachers Association estimates 30,000 teachers were laid off during the recession. When the state ran low on cash in 2009, it issued IOUs, mostly to taxpayers waiting for their tax refunds. The state cut benefits for the poor, such as dental coverage for those on Medi-Cal. And state workers, along with many local government  employees, were forced to take furloughs, hitting working-class families.

 

The Silicon Valley factor

The tech sector has an outsized influence on California’s tax volatility. According to the legislative analyst, the nine counties that make up the San Francisco Bay Area contribute 40 percent of personal income taxes but are home to only 20 percent of the state’s population.

That marks Silicon Valley’s largest share since 2000.

It’s why California budget watchers pay attention to stock-market gyrations. When the Dow experienced two 1,000-point plunges in one week in February, it triggered anxiety over state revenue. There’s a saying that when Wall Street catches a cold, California gets the flu.

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What stock market swings mean for California’s budget, and how that could affect you https://t.co/BauMFCDStG

Unintended consequences

Perhaps no other measure has defined California taxes like Proposition 13, the property-tax cap driven by a taxpayer revolt. Instead of taxing properties at market value, Prop. 13 is based on a property’s purchase price. For each year after that, a property’s tax can increase by only 2 percent or the rate of inflation, whichever is lower.

While Prop. 13 helps people on fixed incomes stay in their homes, it has created significant disparities among neighbors, depending on when they purchased a home, condo or some other building or land.

There are two ways Prop. 13 has driven inequality. First, the tax benefits have disproportionately gone to the wealthy. Second, because local governments are increasingly using development fees and assessments in lieu of property tax, Prop. 13 is helping to drive up the cost of new housing.

For homeowners, the amount of tax relief is proportional to the value of their homes. And since high-income households tend to own homes with higher values, they receive the majority of tax relief.

“About two–thirds of tax relief goes to those with incomes higher than $80,000, with the bulk of that relief going to homeowners with incomes in excess of $120,000,” according to the Legislative Analyst’s Office.

Billionaire investor Warren Buffett used his own situation to discuss these aspects of Prop. 13. Back in 2003, he said there was a ten-fold difference in property tax on two of his multimillion-dollar properties in Laguna Beach simply because of when he purchased those homes. Both those property tax bills were less than the one on his Omaha home.

He added that a typical family buying a house for $300,000 in Chico would pay more in property taxes than he does. “This family, because of Proposition 13, has been selected to subsidize me,” Buffett wrote.

Local governments are also missing out on billions because of a homeowners exemption to the law that allows children and grandchildren to inherit up to $1 million in property without its having to be reassessed.

Over the past decade, the analyst found that around 650,000 properties, or 5 percent of properties in the state, have been passed down without triggering reassessment—and many of their beneficiaries have used those properties as rentals. That trend is expected to grow as baby boomers age.

 

Housing's more expensive now

The second unintended consequence of Prop. 13 is how it has added to the cost of building and owning new homes.

With property-tax revenue capped, local governments have imposed more sales, hotel and utility taxes. They have looked to home builders and land developers for impact fees, a charge for bringing public services to the new development. Impact fees have been easy to impose because they don’t require voter approval.

As a result, California has the highest average impact fees for construction of a single-family home, at $23,455—almost three times as high as in other states, according to a survey conducted by impact-fee consultants Duncan Associates.

Local governments have also increased the use of Mello-Roos assessments to pay for new infrastructure, a cost that’s often passed on to new homebuyers. Mello Roos is a special tax district approved by two-thirds of voters in the district, often in a new development. The money is used to finance everything from roads and street lights to water and sewer systems.

Many factors drive the cost of housing, but as CALmatters data reporter Matt Levin found, homeownership is becoming increasingly unattainable for Californians between 25 and 34 years old:

In 1969, the median sales price of a California house was about $166,000 in today’s dollars. That was about three times the average income ($55,400) of younger California families at the time who might be in the market for a starter home. Today, the average California home sells for over $500,000–seven times a younger family’s earnings.

Here’s the tradeoff on Prop. 13: It’s a great protection for homeowners, but young families are having a hard time getting in.

The system is outdated

California’s state and local sales-tax structure was built on a 20th-century economy of goods being sold—and not much has changed since.

The state doesn’t tax basic needs such as groceries, rent, utilities and prescription drugs. However, the sales tax is levied on cars, furniture, clothing and other tangible items, which generated about $50 billion in 2015.

While it’s still a major source of government funding, the sales tax is the slowest-growing revenue because it’s not capturing the growing volume of intangible goods and services being traded in a 21st-century economy.

For example, a consumer pays sales tax when buying a book (tangible) from a local bookstore but skips it when buying a digital copy of the same book (intangible) for an iPad or Kindle. According to the Board of Equalization, the “sale of electronic data products such as software, data, digital books (eBooks), mobile applications and digital images is generally not taxable.”

The growth of streaming entertainment in books, music and movies has weakened the sales tax base, but that’s not all: California does not tax most services.

While many states have started to tax services tied to personal property, such as the labor for car repair, California requires sales tax only on parts, such as brake pads and tires. Other examples: No tax is imposed on haircuts, yoga lessons or massages—or on the services of lawyers, accountants or doctors.

In 2009, a commission created to recommend updates for California’s tax system found the state charges tax on 21 services, while some other states tax up to 168 services. “Currently 41 states tax more services than California. Hawaii and New Mexico impose sales tax on virtually all services,” according to the report.

This means California is increasingly taxing a narrow set of goods and services at a high rate, as much as 10.25 percent in some jurisdictions, which treats consumption unevenly.

 

The poor get hurt

California’s state and local sales tax is high compared to those of other states, which can be viewed as regressive for the poor. The Washington, D.C.-based Institute on Taxation and Economic Policy found the bottom 20 percent of California families making $23,000 or less spend 6.8 percent of their family income on sales tax, the most of any group.

However, California began offering an earned income tax credit in 2016. So while the poor spend more of their income on sales tax, the state does offer some relief by putting as much as $2,775 back into their pockets.

GOING FORWARD: PREPARING FOR THE NEXT DOWNTURN

Fewer choices

There have been past efforts to add stability to the tax structure, but with little success.

Most notably, about 10 years ago under Gov. Arnold Schwarzenegger, a bipartisan commission led by Gerald Parsky* came out with a bold proposal to restructure the income tax. It recommended eliminating the corporate and sales taxes and replacing them with a Business Net Receipts Tax. The new formula would have taxed the value a business adds in its production of goods and services in California at a relatively low rate, around 4 percent, compared to the statewide tax rate of 7.25 percent today.

“This new tax system could retain some of its progressive aspects, while more stable tax revenues would greatly improve the state’s ability to provide goods and services to the most vulnerable in society without episodic, wrenching interruptions,” wrote the Commission on the 21st-Century Economy.

For a variety of reason, the recommendations didn’t go forward.

*A CALmatters donor.

The bull run will end

Today, even four-term Gov. Jerry Brown, who steered the state through its budget crisis, said he has no plans to tackle Prop. 13 before leaving office.

“It’s a little late for that now,” Brown said in unveiling his final budget proposal in January.

What Brown has done, however, was campaign for a tax hike, which voters passed in 2012, and he sought to cushion the next recession by building up the rainy-day fund. Since 2014, California has been setting money aside, and Brown is asking lawmakers to use the state’s current surplus to max out the fund at $13.5 billion and set aside even more in another fund.

Moody’s analyst Emily Raimes says while that number is big, it’s just a fraction of what California will need for the next recession.

“For a state [like California] that we see as volatile, 10 percent is not a very high amount of reserve,” Raimes said.

As California now reaches one of the longest economic expansions in state history, Brown is projecting “darkness” for the next governor, because the bull run can’t go on forever. His finance department warns that even a moderate recession could wipe out $84 billion in revenue over five years.

What's In the works

In the Legislature, Democratic state Sen. Bob Hertzberg has proposed expanding the sales tax to business services, such as those provided by lawyers, accountants and financial advisors, to better reflect today’s service economy.

Hertzberg said that, like a hotel tax, a service tax would ensure that out-of-state corporations that do business in California contribute their fair share to the economy. For example, a Colorado company would pay a small service tax when it uses a Los Angeles law firm, netting money for the state. He noted that Hawaii imposes a 4 percent tax on legal and accounting services while New Mexico has a 5 percent tax on large businesses that employ accountants.

“The key is, if you’re relying on service taxes, you’re going to get a lot less volatility than when you rely on income tax,” Hertzberg said.

He’s a member of the Think Long Committee for California, a bipartisan group of California dignitaries considering ways to improve California governance. The committee has been exploring ways to modernize and stabilize California’s tax structure.

In response to recent federal tax changes, Sen. Kevin de León, a Los Angeles Democrat, has a pair of bills, SB 227 and SB 581, to help Californians find a way to deduct most of their state and local taxes from their federal tax bill.

The California Association of Realtors is trying to qualify an initiative for the November ballot to let homeowners 55 and older carry their existing property tax rates over to new houses.

The Realtors say that could help with the housing shortage by encouraging more seniors to move to smaller homes or closer to their families. But opponents, including affordable housing advocates, say it would only widen the generational wealth gap and drain revenue for schools, local services and the poor.

The Legislative Analyst’s Office estimates that such a tax transfer would eventually cost schools $1 billion a year and at least $1 billion for cities and counties a year.

Local governments have already come out against an initiative effort funded by soda companies to block local taxes that pass on a simple majority. Instead, the “Tax Fairness, Transparency and Accountability Act” would raise the threshold to two-thirds for passing taxes.

Business groups trying to qualify the November initiative say a higher bar is needed to protect taxpayers. Union leaders say it’s a shameless attempt to block communities from imposing soda taxes aimed at improving public health. Soda is already taxed in San Francisco, Berkeley, Oakland and the Bay Area city of Albany.

Questions

Reader feedback is an important part of our reporting, and we welcome your feedback on this tax explainer. What questions do you have about California’s tax system that are not answered here? Let us know in the submission box below. Using your questions, we’ll periodically update this explainer and may consider some of your questions to pursue as stories.

HOW IT WORKS NOW


  1. How much we pay
  2. Where the money goes
  3. What other states do

THE TRADEOFFS WE'RE MAKING


  1. There's instability
  2. The Silicon Valley factor
  3. Unintended consequences
  4. Housing's more expensive now
  5. The system is outdated
  6. The poor get hurt

GOING FORWARD: PREPARING FOR THE NEXT DOWNTURN


  1. Fewer choices
  2. The bull run will end
  3. What's In the works
  4. Questions

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