Prop 13 as Original Sin

Give credit to David Crane. Unlike the pundits and would-be tax reformers who moan about California state government's boom-and-bust revenues, Crane, who was economic advisor to former Gov. Schwarzenegger, is brave enough to state the obvious: Prop 13 is the original sin.

Why are state revenues volatile? Because over the last 35 years California voters and policymakers cut the taxes that vary least with economic conditions, leaving governments increasingly dependent on the ones that vary the most.

The first and biggest whack, as Crane notes, was the 1978 Jarvis-Gann Prop 13, which cut and capped the property tax, a revenue source that declines only in the most dire economic moments, such as the Great Depression and the bursting of the housing bubble in the Great Recession. It was followed by the 1982 initiative eliminating state gift and inheritance tax and Schwarzenegger's 2003 cut in the vehicle license fee (which, perhaps not surprisingly, Crane fails to mention). Even more than the property tax, these were stable revenue sources, death and driving being inevitable features of the California scene.

But when they cut taxes, Californians didn't mean they wanted fewer public services. They have filled the void, partly by raising sales tax rates (since Prop 13 the combined uniform state-local rate has gone from 6% to 7.5% plus locally approved add-on levies for transportation or general city services); and partly from the rising yield of the personal income tax, which delivered more and more dollars because of the enormous shift of income to the wealthy that has taken place over the past several decades. Now, with the higher rates on the rich enacted last year in Prop 30, the yield will be even greater.

But it will also be episodic. Income tax collections swing with capital gains in the markets, and taxable sales swing with the economy (they fell 18 percent from 2007 to 2010).

As Crane argues, the right cure for this volatility would also be good for the state's economy. I think he exaggerates the risk that California's current taxes will cause the rich to flee, but he's right that our current tax balance—high taxes on work and investment, low or no taxes on property and oil—is "crazy." From an economic perspective, property taxes are, in the words of conservative economist Milton Friedman, "the least bad tax there is." If you tax land, you don't have to worry that you will cause people to produce less of it. If California imposes an oil severance tax, as every other oil-producing jurisdiction in the world does, you don't have to worry about the oil disappearing or oil prices rising, because oil prices are set by a global market, in which California tax policy is but a blip. Shifting taxes toward land, oil, and carbon and reducing them on work and investment would strengthen the economy while providing a more stable base for public services.

Crane cautions that, before changing Prop 13, "governments would first need to reduce pension and health-care liabilities." But here he has it backward. As we show in California Crackup, it was Prop 13 and the governing system it created that made the out-sized pay and pensions of local government workers possible and perhaps inevitable. Getting rid of them is the necessary condition for creating a local taxpayer counterweight to public employee power in city and county politics.

The Facebook Effect?

Over at The Reality-Based Community Matthew Kahn has a post suggesting that the Facebook IPO and the minting of a thousand new millionaires will make property tax revenues “soar” in Silicon Valley and help local schools. Matthew Yglesias picks up the theme on his blog. They both seem to forget that, in California, public finance is, well, different.

Even if the demand created by Facebook employees were to raise housing prices in the Bay Area, the effect on property tax revenues would be small. Under Prop 13, increases in the assessed value of existing homes are limited to 2 percent a year. The Facebook effect would be limited to houses at the margin—either those newly built (which Kahn sees as unlikely under the Bay Area’s restrictive housing policies) or those existing homes whose sale would not have happened in the absence of the Facebook IPO and whose new and higher value would result in a higher tax on the property.

How big would that marginal effect be?

Let’s assume all thousand Facebook millionaires buy a house and each sale (both new construction and upward assessment of an existing house) results in an increase in assessed valuation of $500,000. The resulting annual increase in property tax paid would be 1 percent of $500 million, or $5 million. (There would be some extra in jurisdictions that have passed bonds that add an increment over the basic 1 percent rate.) Even if we assume that all the Facebook millionaires buy their houses in Santa Clara and San Mateo counties, the increased property tax revenue amounts to only one-tenth of 1 percent of the roughly $5 billion a year in property tax collected by those two counties, of which about 60 percent goes to schools.

But because this in California, not even that $3 million necessarily helps the local schools. Under its Prop 13 and Prop 98 school financing system, California imposes revenue limits on school districts. Changes in local property tax revenue collections for schools are offset by increasing or lowering general state aid to districts to maintain the revenue limit. In the typical district, the increase in property tax revenue from a Facebook millionaire will flow to back to the state budget, not the local school.

The exception is for what are called “basic aid districts,” those whose local property tax revenues for schools exceed the statewide revenue limit, permitting them to spend over the limit. Because many of the school districts in Silicon Valley are basic aid districts, they would receive some of that $3 million in new revenue. Their new revenue would be dwarfed, however, by the money they have lost from the state’s new policy of reducing categorical funding for basic aid districts.

If the Facebook IPO will make for “a neat event study,” it will not be for the reasons Kahn suggests. The more interesting story here is how, under California’s strange and radical system of public finance and governance, an event so large in economic terms can have so little effect on the public finances of the local communities in which it is happening.

The fly—and the elephant—in the realignment soup

Joel Fox, editor over at Fox & Hounds Daily and godfather of the professional defenders of Prop 13, is warning about “The Fly in the Realignment Soup” of Gov. Jerry Brown’s budget. Yes, voters tend to be more friendly to local than to state government, he writes. “But given the outbreak of scandal and questionable judgment exhibited by local officials and reported across the state, the governor may face an unexpected hurdle in selling his realignment plan,” which would transfer more authority from Sacramento to local government.

The fly in the soup is real. The least justifiable public spending in California happens at the local level. Strange, though, that Fox fails to notice the elephant it rode in on: the unintended and unworkable operating system created by Prop 13.

Local governments everywhere have their share of scandal and wasteful spending. But as we show in California Crackup, Prop 13 makes California even more vulnerable to those things. Shorn of their taxing power, local governments ceased to be of much concern to business and taxpayer advocates. That has left local politics to those more interested in grabbing a piece of the spending. And because local elected officials are spending tax revenue they don’t have any political or legal responsibility for raising, they are less careful about how it is used. It’s always easier to waste somebody else’s money.

The scandals that Fox cites, from the City of Bell to Vallejo, have their roots in a system he helped create and now ardently defends. There will be flies in the soup until the elephant is taken away.

The road to budget hell

California has spent many years in budget hell. Deficit has followed deficit, alarm has followed alarm. The temptation is strong to greet this year’s news of budget crisis with a shrug of the shoulders and a yawn: What else is new?

But this year looks different. The two-year budget gap is over $28 billion, the state has piled up debts of more than $85 billion, the gimmicks have been used up, and Washington is turning its back on the fiscal plight of the states. California, a victim of the bizarre and radical governing system it has imposed upon itself, piece by piece, over a century, has seemingly reached a moment of reckoning. It will not get out of budget hell until it makes itself governable.

To understand what’s required to escape budget hell, it helps to know how we got here. There are four big pieces that paved the road to budget damnation:

The Prop 13 operating system. The first of these, you will not be surprised to learn, is Proposition 13. But not in the way you probably think.

Yes, Prop 13 cut property taxes. But its more important long-run effect was to transform how California governs itself. As we show in California Crackup, “By slashing local property tax revenues, putting up higher barriers for local passage of taxes and bonds, and giving the Legislature the authority to divvy up remaining property tax dollars, Prop 13 was the Great Centralizer.”

In the wake of Prop 13, California’s leaders had a choice. They could let local governments readjust to the new fiscal reality of the 1978 Jarvis-Gann measure, which cut local property taxes by the equivalent of 22 percent of local spending by schools, cities, and counties. Or the state could step in and use its own revenue to soften the blow. Then-and-now-again Gov. Jerry Brown and the Legislature chose to bail out local governments.

California’s new Prop 13 operating system, and the state’s willingness to bail them out, have largely turned local governments into spending agencies. Those elected to run local governments have little control over, or political responsibility for, raising the money they spend. As Bruce Cain and Roger Noll have pointed out, this arrangement “creates perverse incentives…. Because so much of local services are paid for by the state, local officials are in a position to reap the benefits of expanding local services, but state officials bear the political costs of either raising revenues or sacrificing other programs in order to finance expanded local services.”

And that is just what has happened. Compared to other states, California local governments spend more than average, despite local revenues much lower than average. The state has made up the difference, deepening its own budget problems and, as we’ll see in a moment, skewing priorities.

Budget bondage. The second stone on the road to budget hell is made up of all the fiscal provisions, many of them requiring supermajority votes in the Legislature, that litter the state constitution. There is the familiar two-thirds majority vote requirement for passing budgets, which was finally repealed last November. And the state spending limit. And the balanced budget rule. And the rainy day fund in which money must be set aside in good times. And the limits on borrowing, both in the financial markets and from transportation accounts and local government. And the Prop 98 funding guarantee for schools and community colleges. And all the initiatives mandating spending.

But the most critical has been Proposition 13’s two-thirds requirement for raising taxes. Last November voters extended this requirement to fees and to any bill that has the effect of raising any taxpayer’s obligation. There is no similar two-thirds requirement for cutting taxes.

This imbalance creates what I’ve called The Ratchet. This ratchet turns one way only: revenue lost by majority vote can only be restored by supermajorities, which have seldom materialized.

The Ratchet was cranked most furiously during the dot-com bubble of the late 1990s. As the hot money from IPOs and stock options flooded in, the Legislature cut the corporate tax, income tax, and, most precipitously, the vehicle license fee, a property tax on vehicles, dubbed the “car tax” by its opponents. When the stock market collapsed in 2001 and the IPO and stock option revenue disappeared, California’s ratcheted-down tax base could no longer support the base of public services. Rather than restore the revenue cut in the good years, Gov. Arnold Schwarzenegger and lawmakers patched over the gap for most of the last decade with gimmicks and massive borrowing. But when the second bubble, in housing, burst in 2008, the economy and tax revenues plunged and the permanent hole in California’s budget was again exposed. Closing the hole would have been difficult under any circumstances. But the task was made immeasurably harder by all the supermajority vote requirements.

Something for nothing. Lawmakers are required, in theory at least, to balance the budget. The voters operate under no such discipline. A large part of California’s budget crisis arises out of the bad habit of California voters of enacting what I call “something for nothing” ballot measures. In the two decades beginning with Prop 98’s passage in the spring of 1988, California voters considered 259 ballot measures. Of these, 127—nearly half—proposed to have something for nothing: that is, they increased spending or reduced taxes, or both, without offsetting funds. Of the 127 measures, 80, or about two-thirds of them, passed. Many of these measures were initiatives, and they came from all points on the political spectrum. There was the Three Strikes sentencing measure and Jessica’s Law and the stem cell agency and the children’s hospital bonds and the park bonds and the water bonds. Even Arnold Schwarzenegger got in on the act with his initiative for afterschool programs in 2002, the prequel for his gubernatorial campaign.

We want, therefore we borrow. These something-for-nothing measures contributed to the fourth big source of budget hell, the growing overhang of debt. Over the last decade California voters have approved more debt than in any time in the state’s history. In the traditional fashion, some of these bond measures financed construction of long-term capital projects that benefit the general public, such as school and college buildings. But others were entirely new. The 2004 stem cell bonds are debt taken out to fund an ongoing program. The $15 billion in deficit bonds approved in 2004 papered over the state’s inability to deal with post-recall budget crisis. The infrastructure bonds approved in 2006 broke with the state’s traditional policy of having users and beneficiaries pay for investments in roads and flood control. They instead transferred the cost to the general fund, soaking up dollars formerly available to pay for education, healthcare, and public safety. The percentage of the general fund used for debt service has tripled over the last two decades, to over 6 percent, on its way to a projected 9 percent by 2014.

Where have these pieces left us? With a unworkable fiscal system and badly skewed priorities.

  • State general fund spending, measured as a percentage of California personal income, is lower than at any time since Ronald Reagan was governor. California now spends less than the national average on state functions (but is at the top in transferring state dollars to local governments.) Yet because of past tax cuts and the effects of the Great Recession, state revenue, also at a 30-year low as a share of the economy, isn’t sufficient to cover the combination of spending on state functions, even at its reduced level, and transfers to local government.
  • Without the discipline of having to raise their own tax revenues under the Prop 13 operating system, local governments have let the pay and benefits of their employees soar. As Cain and Noll show, California has only 11.8 percent of local government workers in the country, less than its share, but pays them 15.2 percent of the national payroll for local employees.
  • California’s broken system of government has produced a major shift in spending priorities. Over the last 25 years, the share of the state general fund spent on criminal justice, mostly prisons and courts, has gone from 5 percent to 13 percent. Likewise, the share of the state’s output spent on local public safety has soared; state and local government in California is today spending about $10 billion a year more on public safety than if its share were at the same level as in 1989. This extra spending does not buy more public safety services. California cities generally have far fewer police per 100,000 population than elsewhere in the country, and the state has less than its proportionate share of prisoners. No, this $10 billion consists almost entirely of higher compensation for correctional officers, police, and firefighters, whose pay and pensions dwarf the compensation public safety employees receive in other states. The gold-plated pay in public safety has come at the expense of higher education, social services, and the fiscal stability of the state.

California’a politics is awash in calls for different budget results: more taxes, less taxes, less prison spending, less debt, lower pensions. But it has not awakened to the fundamental challenge. California doesn’t need just to change budget priorities. It needs to fix the broken system that generates these bad results—and that will keep delivering bad results until it is overhauled.