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July 20, 2005

Dear Attorney General Lockyer:

Pursuant to Elections Code Section 9005, we have reviewed the statutory initiative relating to state taxation (File No. SA2005RF0086, Amdt. #1-S).


The state levies a personal income tax (PIT) on the income of individuals and noncorporate businesses, such as sole proprietors and partnerships, doing business in California. The rates of the tax range from 1 percent to 9.3 percent, depending upon the taxpayer’s income level (with an extra 1 percent levied on taxpayers’ incomes greater than $1 million). The state also levies a corporation tax (CT) on the net earnings of corporations operating within California at the rate of 8.84 percent. Both the PIT and CT allow various deductions from income and credits against any tax owed. The state also levies an estate tax payable upon death, equal to the amount of the available state tax credit allowed under the federal estate tax (this credit is currently zero). Finally, residential and commercial property is subject to a general-purpose local ad valorem property tax rate of up to 1 percent annually.

Provisions of the Initiative

This measure contains the following main provisions:

Establishes a Wealth Tax. The measure institutes a state wealth tax levied on those estates of living individuals with values in excess of $20 million as of January 1, 2006. The wealth tax would be based on the tax rates established by the federal estate tax, which in calendar year 2006 are scheduled to range from 18 percent to 46 percent. It appears that the wealth tax would be levied on taxpayers in the state on a one-time basis, with revenues to be received in 2007‑08 and 2008‑09.

Alters Income Tax Rates. The measure reduces the CT rate from 8.84 percent to 4 percent, reduces the CT minimum tax, and enacts various other changes to the CT. In addition, it imposes a 6 percent additional tax under the PIT for high-income taxpayers. It also eliminates the current alternative minimum tax for both the PIT and the CT.

Curtails Certain Tax Expenditures. The measure eliminates or restricts certain so-called tax expenditure programs (TEPs). These TEPs are various provisions of the tax code such as tax credits, income deductions, and income exclusions that reduce the amount of revenues the state collects. Among the most significant of the TEPs that would be eliminated or restricted are: (1) personal and dependent exemption credits, (2) enterprise zone deductions and credits, and (3) research and development activity credits.

Institutes New Tax Programs. The measure establishes several new tax programs including tax credits for: (1) certain taxpayers with a federal estate tax liability, (2) income earned by teachers, (3) higher education tuition and fees, (4) rents foregone by property owners due to rent control, (5) property tax payments, (6) the costs of purchasing health insurance for certain individuals, and (7) particular designated organizations. A number of these credits would be refundable.

Fiscal Effects of the Initiative

This measure would make major changes in the state’s tax system. Some of these proposals would generate significant behavioral and economic responses from taxpayers. For example, a wealth tax of the magnitude imposed by the measure would result in a significant decline in state wealth in the short term. Such a development would depress economic activity and revenues to the state and local governments. Given factors such as this, the fiscal estimates provided below are subject to considerable uncertainty.

State Revenues

One-Time Revenue Increases. The measure would result in a one-time increase in state revenues (realized in 2007-08 and 2008-09) as a result of the establishment of the wealth tax. The increase could be in excess of $100 billion.

Ongoing Revenue Impact. The increase in the top PIT rate, the elimination or restriction of various TEPs, and certain other changes to the state’s tax system would together result in additional combined revenues in the range of $10 billion to $20 billion dollars annually. Offsetting these additional revenues would be reductions associated with various TEP provisions and the CT rate reduction. The largest of these reductions involve the proposed teacher tax credit, health insurance tax credit, and CT rate reduction. These and other provisions would reduce state revenues (or result in increased expenditures in the case of refundable credits in excess of tax liabilities) in the low tens of billions of dollars annually. The net impact of all of the ongoing revenue provisions would be annual revenue decreases potentially in excess of $10 billion annually.

Impacts Related to Revenue Increases

The measure’s major one-time revenue effects would lead to significant interactions with other State Constitutional provisions, particularly regarding the state’s spending limit and school funding.

Spending Limit. While state spending is currently subject to an annual limit on appropriations of tax revenues, the state is currently far below—about $11 billion—its limit. As a result, the state could spend some portion of the large influx of new tax revenues estimated under the measure in 2007-08 and 2008-09. In addition, the state could spend some of the remaining funds on appropriations not subject to the limit (such as debt service on outstanding obligations and capital outlay). Still, the state would likely have remaining a large amount of “excess revenues,” which existing law requires to be allocated as follows:

These could each exceed $10 billion in 2007-08 and again in 2008-09.

Proposition 98. Proposition 98 consists of specific funding formulas for K-12 school districts and community colleges (K-14 education). The level of and changes to General Fund revenues are important factors in determining school funding under Proposition 98. The large one-time revenue increases generated by this initiative in 2007-08 and 2008-09 would result in additional school funding potentially in excess of $10 billion dollars annually for those two years. Thereafter, the net reduction in annual revenues would substantially lower the required funding level for K-14 education, potentially by billions of dollars. Actual school funding would be determined by future legislative decisions in dealing with the major reduction in ongoing revenues.

Summary of Fiscal Effects

The measure would have the following major fiscal effects:

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