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Prop 13: It’s Time To Stop Being Railroaded by the Third Rail


I was recently invited to Sacramento to testify in front of the California Assembly Revenue and Taxation Committee about tax reform in the state – specifically Prop 13, the limitation on property tax increases enjoyed by current property owners. While the session mainly focused on the reassessment process for commercial property, I also spoke more broadly about my views on the overall structure of California’s property taxes and my opinions about the revenue system as a whole.

While I presented slides as part of my talk (click here to view the PowerPoint), I also spoke off the cuff, and engaged in a vigorous Q&A with some of the legislators on the Committee. To give you a sense of where I stand on Prop 13 I can do no better than the quote that began appearing in press coverage and popping up on blogs almost immediately after my testimony: "I can't think of one reason in the world why Prop 13 should exist. I think it's an awful regressive tax.”

Yes, I touched the third rail of California politics, as I am well aware from the hate email I received from people who, to put it mildly, disagree with my view, and from the public bashing I received from various pundits who see this as just another attempt by the left (that’s me, Mr. Lefty) to destroy the state’s economy. I don’t begrudge these opinions; I know that most polls show there is support for Prop 13, at least on the residential side of the equation.

Sadly, the only reason Prop 13 is a third rail is because of the myths created by those who support it. In these fanciful tales we hear of a time in the mid 1970’s when government was running amuck, every senior citizen was being pushed from their homes onto the streets, and the state was in imminent danger of economic collapse. In this version of history, Howard Jarvis and his allies were heroes who led a taxpayer revolution—and saved California.

These stories are essentially silly despite their insidious climb into that realm we call ‘conventional wisdom’. In fact, there is little evidence that there was much of a problem in the first place, or that Prop 13 has done anything to stop the state’s public sector growth. Instead Prop 13 is exactly what I said it was – an unfair, regressive tax that has ultimately cost California’s economy far more than it ever gave. It is a system that has enriched some at the expense of others and it’s a large part of the reason that the state continues to grapple with staggering deficits and a bad business climate.

But there are enough people making broad claims. Instead let’s look at the issues one at a time.

What did Prop 13 do? The bill had many provisions, but the major ones include capping the property tax rate at slightly over 1%, capping the rate that current property owners would see their property taxes rise per year at 2% (this, of course, does not apply to newly purchased properties), centralizing the property tax system with the state, and requiring a two-thirds majority in both legislative houses to raise future taxes.

98% Regressive

Let’s focus first on the 2% rule for current owners. Basically this provision limits the annual increase in assessed valuation for existing property owners to 2% or the CPI, whichever is smaller (it has always been 2% with the exception of the last two years). This means that two neighbors who own homes with the exact same market value, who receive the same level of public benefits (roads, fire, police, etc,) may end up paying vastly different property tax bills.

To put this in perspective, if your neighbor bought his/her home 25 years ago, and you bought your house last year, your neighbor will be paying slightly less than half of the annual tax payments that you are obligated to pay. And, by the way, this calculation is only because of price declines in recent years. Near the peak of California’s housing bubble, your neighbor would have been paying less than one-third (yes, one-third) the rate that you, as a new owner, would have to pony up.

To understand why this is so regressive, lets add some numbers. Imagine that you bought your home for $600,000—roughly average for single-family residences in central Los Angeles. You would be paying $7,500 per year in property taxes. Also note that as a new buyer, you are liable to be younger and would have paid full price for your property—so you’d be carrying a very large mortgage payment on top of everything else.

Your neighbor, in contrast, paid roughly $200,000 for their house back in 1987 and is likely to have paid off a large portion of the mortgage—so their debt overhead is much smaller. They have also, by virtue of having bought early, enjoyed nearly $400,000 in capital gains on their property over the course of 25 years. Your neighbor, richer and with fewer financial obligations, will only have to pay approximately $3,700 year in property taxes. Quite a perk.

One of the most repeated “wisdoms” I hear from supporters of Prop 13 is that it has been a godsend for homeowners. Really? I guess that’s true for those homeowners who have been lucky to live in the state for a long time. But for newer buyers, young families who represent the future of this state, residents who have not been privy to hundreds of thousands of dollars in capital gains, would hardly characterize Prop 13 as something heaven sent. Quite the opposite, they are being saddled with the largest portion of California’s property tax bill.

In truth, it is difficult to find a tax in the United States much more regressive than this one: Tax those with the greatest wealth the least, and those with the least wealth the most. Californians who feel they are entitled to pay less than their neighbors for the same public services they receive are not brave, anti-tax warriors—they are legalized tax cheats.

And there is another underbelly to the 2% protection – residential vs. commercial property. Those involved with commercial property, particularly large investment properties that have many owners, have learned over the years how to shift ownership around in ways that avoid the tax reassessment attached to complete changes in ownership.

As a result, commercial property has enjoyed much greater protection under the 2% rule than has residential property, where turnover is more common. It used to be that commercial properties paid a much larger share of the state’s property tax, but over time, the commercial share of California’s tax receipts have become smaller and smaller. Moreover, large properties have been protected more than small properties—again, a regressive tax that favors large investors over small business owners and businesses over residents.

Does it really surprise anyone that it turns out that Howard Jarvis was a commercial real estate investor? He was personally one of the lucky ones – those who would gain the most from Prop 13 while shifting the burden of supporting the state to others. Hero? Absolutely not. Howard Jarvis was a special interest fighting to increase his own personal wealth at the expense of others and, worst of all, doing so under the guise of helping the greater good.

The 1% mess

Another major provision of Prop 13 is that it caps property taxes even for newly purchased units at 1% (the rate is often slightly higher, but typically runs about 1.25%). The Howard Jarvis Taxpayers Association views this as one of their crowning achievements, bragging that this limitation has saved California taxpayers close to one-half of one trillion dollars in taxes since Prop 13’s inception.

What rubbish.

Governments need to raise funds to run public services – and/or to waste on special interests (depending on your political bent). If one source of revenue is capped or eliminated, that government will simply go to other places to raise money. In this case, the reduction of property tax rates to levels that are far below average rates across the United States has simply meant that Californians now pay higher income and sales taxes. Howard Jarvis and his ilk haven’t saved state taxpayers a dime—they have only shifted the source of the state government’s funding. To claim otherwise is something between spin and total fantasy.

Moreover, it is those very changes in funding sources that are largely responsible for California’s business unfriendly reputation. When looking at the state’s tax receipts as a share of the economy, they aren’t particularly high. California typically falls right into the middle of the other U.S. states in terms of taxes paid as a share of the state’s total economy. But Prop 13’s limitation has given us what are now considered to be ‘friendly’ property taxes in California and shifted the burden to business unfriendly corporate and income taxes.

Texas is often cited as a business friendly location, particularly because they don’t have a personal income tax at all. But, as it turns out, if we took Texas’ revenue system and applied it to California, taxes paid would fall by less than $2 billion (that’s about 2% of our overall general fund revenues, and slightly over 1% of overall state and local revenues – big whoop). This is because Texas relies far more heavily on property taxes – the average property tax rate paid in Texas is well over twice what is paid in California.

Not only is California’s over-reliance on personal income taxes business unfriendly, it also leads to hyper cyclical revenue conditions – when times are good, the cash flow is ample, but when the economy slows, the deficits are devastating. And along the way, the state over-commits to expanding various public programs and hands out ever more generous perks to employees. When the economy turns sour, it creates terrible conditions as programs are dismantled and funding for anything even remotely discretionary gets pushed to the back burner.

We have watched this cycle run its course twice over the past 15 years, and the state’s educational system and infrastructure have both suffered enormously because of it. Want to know why the University of Texas at Austin is prospering while the world famous University of California campuses continue to diminish in quality? Thank Howard Jarvis and his proposition.

Centralization Crisis

Another highly regrettable legacy of Prop 13 is the over-centralization of funding in the state—where too much public money flows directly though Sacramento, preventing local government from setting local priorities. Blame for this shift away from local government can be placed directly on the shoulders of Prop 13.

The centralizing of funds has had another subtle but pervasive effect. Because property taxes are limited and diminish over time, cities have taken on a distinct anti-housing slant in their development strategies. They promote industrial and retail development, because it generates far more generous local revenues in the long term. Residential cities, where there is little commerce or industry, and who bear the burden of educating children, find themselves starved for cash, while specialty cities like Vernon, Santa Monica, or Industry have so much excess cash, they don’t know what to do with it.

California has developed a serious housing shortage over the past 20 years – one of the reasons for the state’s low housing affordability. Not all, but much of the problem can be traced back to Prop 13’s perversion of local incentives. Want to reduce property taxes? The easiest way would be to incentivize the construction of new homes, driving property prices down. This would lower everyone’s tax rate.

What About Grandma?

By this point, if you are a defender of Prop 13, you’re likely already lining me up as a hater of senior citizens, someone who wants to return to the time when fixed income elderly residents were being thrown out of their homes because of the crushing tax burden they were under. After all, this is why Prop 13 was passed in the first place, right?

Wrong. This story is historically untrue, logically incorrect, and has nothing to do with most of what Prop 13 does anyway.

First, thinking logically, when people’s property taxes go up, it’s because the value of their property has increased. In other words, they are being asked to contribute more because they have more. Using current tax rates, your taxes would go up by $2,500 per year, if the value of the property you own and live in increased by $200,000. Fixed income? Your household just earned $200,000 because you happened to own a house at the right time. Financially speaking, this is a great deal—that $200,000 would cost a lot more annually if borrowed from a bank.

I’m not saying the elderly should pay more. I am only arguing that they can afford to pay as much as anyone else in the neighborhood.

When I pointed this out to one supporter, their reply was: “So what? Its paper money.” Really? I invest in some hedge funds. Annually, I receive a K-1 from the funds that I turn over to my accountant. And guess what? I have to pay taxes on my ‘paper money’ gains. That’s the way it works. No one likes to pay taxes, but we have to pitch in fairly. And even if on a fixed income, in today’s liquid mortgage market, reverse mortgages and home equity lines of credit are more than available and allow people to access that cash. Californians were more than willing to use this ‘paper money’ to fund all sorts of purchases over the last bubble.

The reply to this is always that senior citizens don’t want to go into debt. True. Nor do I. Nor does the young family down the street, or the new small retail center owners struggling to turn their first profit. No one likes to go into debt, particularly to pay taxes. But sometimes, we have to.

Perhaps the most honest comment I’ve heard in regard to the ‘elderly effect’ was from a gentleman in Orange County who became very heated over my views on Prop 13. He saw them as an attempt to kick his mother out of the house she had lived in for 30 years. Now mind you, his mother lived in a $1 million plus property with no mortgage in ritzy Newport Beach. Clearly this was someone who could afford to pay as much in property taxes as her younger and less equity enabled neighbors. After pointing out that her equity was very real wealth and could be accessed, his reply was, “Well she wants something to give to her children when she passes away.”  The candid acknowledgement of his selfish motivation was actually refreshing. It’s always better to have someone else pay the check. But it is in no way a valid argument. I too would rather have other people pay more so my inheritance will be larger. But government should be in the business of making sure we all pay our fair share, not creating protected classes based on years of residence.

Moreover, this debate misses a fundamental point. Prop 13 doesn’t just apply to seniors—it applies to everyone. If we are so worried about the elderly, why isn’t Prop 13 limited to those past retirement age? Other states do worry about fixed income seniors. Rightly or wrongly, in those states the tax rate drops sharply once the property owner reaches a certain age. California is the only state with a law like Prop 13. No one else has needed it. That alone is indicative of the emptiness of the various defenses for this awful tax system.

Equivalently, if Prop 13 is about protecting seniors, why is commercial property included at all? Commercial property is a cash flow business and these cash flows are tied directly to the market value of the property. In other words, property taxes increase only when the value of the property goes up, which is typically (although not exclusively) when the operating profits on the property increase – making taxes easier to pay.

And of course, empirically, there is no evidence that there ever was a massive wave of foreclosures – on the elderly or anyone else. Prop 13 came into effect in 1979. That year, the foreclosure rate was less than 4/10ths of 1%—for the next 25 years it was never lower. Far from preventing foreclosures, it seemed to coincide with an increase in them. As an economist, I don’t think there is any causality, but it certainly blows a hole in that theory that Prop 13 was about stopping a wave of defaults.

Tax and Spend Liberal

Last but not least is the common refrain among Prop 13 supporters that getting rid of the law would be unfriendly or damaging to business in the state. California certainly has its share of strikes against it in trying to attract new businesses – and Prop 13 is one of those strikes. New investors in any economy face an uphill battle. They must learn local rules and regulations, develop new networks of clients and vendors, and of course build their local labor force. In California, they are also handed the burden of paying higher property taxes than the other businesses around them, perhaps businesses they compete with.

And one thing that clearly makes California business unfriendly is its exceedingly volatile and cyclical tax system. I have never argued that Prop 13 should be tossed out on its own. I would prefer to see it dismantled in the context of overall tax reform, including lowering and flattening the income tax, lowering the corporate tax, and lowering the sales tax while extending it to some or all of the service sector. This allows for small, even taxes spread across a large base.

I am not arguing for higher taxes – I am arguing for their fair distribution.

A Waste of Breath?

When I rail against Prop 13, I often get this friendly piece of advice: You’re wasting your breath kid. It’ll never change. Forget it. It’s a third rail.

Well, maybe. Consider this: 7 out of 10 self-made wealthy people in California made their fortunes in real estate. These are powerful and connected families – and they, more than anyone in the state, benefit from Prop 13. Their long-term holdings are taxed at some of the lowest rates. And they wield tremendous political clout. They want Prop 13 to continue to be a political third rail.

But if we can debunk the myths, and help people see through the frayed and broken logic peddled by proponents of Prop 13, perhaps we can begin the long process of finally overhauling California’s badly broken revenue system. Yes, we need expenditure reform. And pension reform. All of these represent significant status quo-breaking challenges. Dumping Prop 13 is a necessary step in the process of fixing these larger problems.

The good news? We still get to live in paradise!

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