Fix California’s Tax Structure To Help Solve Its Housing Shortage

For years, Proposition 13 (Prop 13) has been viewed as the third rail of California politics. While Prop 13 is responsible for capping annual property tax assessment increases at 2%, it also required that future tax increases face a two-thirds vote for passage, making it very difficult for elected officials to tinker with the tax code.

In 2012, voters approved Prop 30 which both increased the statewide sales tax rate (by one-quarter of a percent) and increased marginal tax rates on high-income tax payers. The revenues generated in the aftermath enabled the State of California to overcome a dire budget situation resulting from the ‘Great Recession’.  More recently, the changes to the personal income tax code from Prop 30 were extended through 2030 with the passage of Prop 55 in November 2016, the idea being to chart a more sustainable course for the revenue stream of the state budget.

Today, in mid-2017, the California economy has achieved “cruise speed” and the labor market has essentially achieved full-employment. Wages are also on the rise – maybe not as fast as some would like – but they have been steady.

All is well, right? Wrong.

State lawmakers passed a budget in June that shows a surplus of over $2 billion, with total reserves of nearly $10 billion for Fiscal Year 2017-18. State revenues are projected to rise by 6%, or $7.3 billion, mostly due to a $5.7 billion increase in personal income tax revenues, with a modest bump from Corporate Income Tax revenues and a decrease in sales tax revenues.

As a rule, most of the revenues that go into the state’s general fund come from the personal income tax (PIT). Given the current budget numbers, PIT will account for 78% of the state’s budget for the current fiscal year. As Los Angeles Times columnist, George Skelton, reported in April 2017, based on data from the Franchise Tax Board for Fiscal Year 2015, the top ‘one percent’ paid 47% of those revenues.

Here is the problem. Even if you think the top 1% can afford to pay the taxes they incur, there is no escaping the volatility of their income stream, which is largely tied to capital gains. If you have paid any attention to the state budget in recent years, you know that this feature of our tax structure transforms the state general fund into a roller coaster.

Admittedly, Governor Jerry Brown sought, and achieved, approval to build a reserve fund to smooth out the peaks and valleys, but it does not eliminate them.  The main point is, it’s hard to believe that the fiscal well-being of the 6th largest economy in the world depends on the financial success or failure of the top 1% of its taxpayers.

While the state budget looks to be sound for the current fiscal year, budget problems plague local jurisdictions across California, despite the fact that residents and businesses are doing fine, if not better than fine. Instead of being flush with general fund and other revenues, there is talk of budget shortfalls. Part of this is due to pension liabilities that must be addressed one way or another. That’s on the outlays side, but the bigger problem is on the revenue side.

The effect of Prop 13 is that it limits property tax growth and limits the benefits to local general funds, no matter what the rate of inflation or the actual cost of providing services to a jurisdiction’s residents. So, local officials have looked elsewhere for sources of revenue, especially those that fill the general fund over which they have control. A big source of local revenues is taxable sales. It may be difficult to raise tax rates, but a local jurisdiction can increase tax revenues if its businesses generate more taxable sales. Ultimately, because of the opportunity to increase sales tax revenues by attracting businesses that generate taxable sales, there is a fiscal incentive for cities to favor retail and other sources of taxable sales over housing.  The key here is that local officials have control over these sales tax revenues and can use them to provide services and programs to their constituents.

For decades, local officials have seen the same opportunity with building fees. Known as fiscalization of land use, this is when local officials increase permitting and other development fees beyond recovering direct permitting and oversight costs to the point where they actually become a revenue source in their own right. They do this to generate another revenue stream over which they have control, but it makes construction more expensive in the process.

So, connecting the dots between the last two points, one source of revenues is sales taxes which only come from retail and similar establishments, that is, NOT housing, so there is no fiscal incentive to build housing. Meanwhile, when they do allow new home construction to take place, they impose fees to generate revenues. The rationale is clear, but so are the consequences. Local governments have little reason to seek more housing… and that makes California’s housing shortage all the more problematic.

This only begins to lay out some of the problems with the state’s tax structure, and it connects the dots between problems with the tax code and the housing challenge we face. Like it or not, if the state wants to enable sustainable revenues streams for both state and local governments, and if it wants to enable the construction of much needed housing, the solution to both of these challenges begins with a hard look at Prop. 13.

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