Analysis of the 2004-05 Budget Bill Legislative Analyst's Office February 2004

Another Property Tax Shift?

Background

California—like most other states in this country—relies extensively on local governments to protect the public, help the needy, educate students, and respond to local concerns. For nearly a century, California's property tax has been reserved for the exclusive use of local governments and has served as the mainstay of local finance.

Before passage of Proposition 13, local governments and their residents controlled property tax rates and the distribution of property tax revenues to local agencies. Proposition 13, however, placed into the California Constitution a maximum rate for nondebt-related property taxes and specified that its revenues are to be allocated to local agencies "according to law."

As Figure 1 shows, immediately after Proposition 13's passage, the Legislature established a property tax allocation system that reduced the share of property tax revenues allocated to educational local agencies from a statewide average of 54 percent to 39 percent—and increased the share of property taxes allocated to cities, counties, and special districts. (The state replaced the shifted K-14 district property taxes with increased state funding.) Specific property tax allocation formulas then were assigned to every area of the state, designating the portion of the property tax to be allocated to each local agency serving the area. These property tax allocation shares were based on each agency's proportionate share of property taxes in the mid-1970s and are commonly referred to as "AB 8" shares, after the bill that created this property tax allocation system—Chapter 282, Statutes of 1979 (AB 8, L. Greene). With the exception of several relatively minor changes, the state did not alter these AB 8 shares until the early 1990s.

Faced with significant budgetary challenges in 1992 and 1993, the state twice enacted major changes to the state's AB 8 property tax allocation system to direct larger shares of property tax revenues to K-14 districts—and reduce state General Fund spending for education accordingly. These changes reduced noneducational local agencies' share of the property tax from a statewide average of 65 percent to 48 percent. The property taxes shifted to K-14 districts because of the 1990s property tax shift now total about $5 billion. (For context, total property tax revenues in the current year are estimated at $29 billion.) These property tax allocation changes commonly are referred to as "ERAF," after the name of the fund into which the shifted property taxes initially are deposited, the Educational Revenue Augmentation Fund. 

Administration's Proposal

In 2004-05, the administration proposes to redirect to K-14 districts $1.3 billion of property taxes that otherwise would be allocated to cities, counties, special districts, and redevelopment agencies. This shift, if enacted, would bring K-14's share of the property tax to an overall statewide average of 56 percent and would decrease state General Fund education spending by $1.3 billion. Similar to the ERAF shifts in the 1990s, this redirection of property taxes is expected to provide ongoing, growing state fiscal relief.

Figure 2 below summarizes the distribution of property tax losses to each group of local agencies under the administration's plan. The largest component of this property tax shift would be from counties.

LAO Assessment

The administration's proposal raises significant questions regarding the appropriate role of the state regarding local taxes. The State Constitution establishes the property tax as a local tax. While the state's voters gave the Legislature responsibility to allocate property tax revenues, nothing in the Constitution or the history of Proposition 13 suggests that the intent of this delegation of authority was for the state to benefit fiscally from its control of the property tax—or that the tax should serve as a de facto rainy day fund for state government.

The administration's proposal raises further questions regarding the future of the property tax. That is, if the state enacts a third major reduction in city, county, special district, and redevelopment agency property taxes within a dozen years, what would prevent the state from imposing additional reductions in the future—or eliminating noneducational agency property taxes over time?

In reviewing proposals to reallocate the property tax, we recommend the Legislature avoid viewing the local property tax as a "state" resource. Rather, we suggest the Legislature approach its authority over property tax allocation with the restraint of a fiduciary: enacting changes to the property tax allocation system only for the overall benefit of local governments and striving to avoid conflicts of interests in carrying out these responsibilities.

In addition to these policy concerns relating to the proposed property tax shift, the proposal presents significant practical and immediate problems for local agencies. Simply put, based on their projections of future property tax revenues, local governments made myriad program and financial commitments to their residents, employees, businesses, bondholders, and others. A sudden and major loss in general purpose revenues will disrupt local agency ability to meet these commitments. The administration's proposal is not, therefore, a budget "solution" in any real sense: it is simply a transfer of fiscal problems from one level of government to another.

Because of these significant policy and practical concerns, we recommend the Legislature reject the administration's proposal to use local taxes to remedy the state's fiscal problems.

Guidelines to Consider

Given the severity of the state's budget constraints and the difficult choices it faces, we recognize that the Legislature may decide to explore elements of the administration's proposal, despite its evident shortcomings. We also note that the administration has indicated a willingness to consider alternative local government proposals, provided they offer ongoing state fiscal relief.

Accordingly, Figure 3 outlines several guidelines for the Legislature to consider as it reviews budget proposals involving local governments revenues. We discuss these guidelines in more detail below. In the following section of this analysis, we outline an alternative local government budget proposal that is more reflective of these guidelines.

Minimize Reductions to General Purpose Revenues  

General-purpose revenues, such as the property tax, allow local governments to respond to their community's perceptions of their greatest local needs, a function integral to local governance. State actions to reduce local general-purpose revenues limit local governments' ability to fulfill their commitments and responsibilities to local residents. Accordingly, we suggest that any reduction to local property taxes or other general-purpose revenues be imposed at an amount that is as modest as possible.

Leave Past Formulas in the Past

Instead of offering a policy rationale regarding how these major local revenue reductions should be imposed across local governments, the administration simply proposes to extend the property tax shift formulas used in the 1990s. (These 1990s methodologies, in turn, were based on property tax formulas dating from the 1970s.)

Given the magnitude of this proposal, we believe it would be inadvisable for the Legislature to rubber stamp dated formulas. This is particularly true because, as we explained in our 1999 publication Shifting Gears: Rethinking Property Tax Shift Relief, the 1990s shift had disparate fiscal effects on local governments, often without any obvious policy rationale.

Finally, we note for clarification purposes that the formulas provided by the administration to estimate proposed local agency 2004-05 property tax losses differ notably from the state's intent and decision making in the 1990s. Figure 4 outlines major differences between the administration's formulas and state actions in the 1990s.

Allow Local Control

In a state as large and diverse as California, it is impossible to reflect each community's needs and interests when making centralized fiscal decisions regarding thousands of local governments. Instead of seeking to design another statewide formula to redirect local taxes, we suggest the Legislature permit at least some degree of local decision making. Allowing local decision making would increase the likelihood that property taxes are allocated to local governments in a manner that best promotes community needs and objectives.

Be Mindful of Effects on Land Use Incentives

Under our governance system, cities and counties have considerable authority over new land developments. These local governments establish general plans for their communities, determine the intensity and purpose by which areas may be developed, and approve permits for individual projects. While cities and counties review many factors when making these decisions, the impact of land development on the fiscal health of the local government is among the higher considerations.

Under the state's local finance system, cities and counties typically report that they receive the highest net revenues from retail developments—and that housing and manufacturing developments frequently yield more costs to the local government than tax revenues. These fiscal evaluations of developments have resulted in many cities and counties orienting their land use policies to promote retail over other land uses.

While an individual city or county may be "better off" by promoting retail development in their community, this undue focus on retail is undesirable from a state standpoint. We note, for example, that the cost of new manufacturing or housing developments may be increased if a community zones disproportionate amounts of ready-to-develop land for future retail development—and leaves less desirable land for other development purposes. Similarly, developers of manufacturing plants or housing may face higher costs if local agencies require them to pay impact fees, build infrastructure improvements, or modify their plans to alter their development's fiscal effect on local government.

From the perspective of overall state economic development, the administration's proposal reduces the local tax that probably has the best local government land use incentives. Specifically, the property tax gives local governments incentives to encourage a broad range of high value development in their community: retail, industrial, office, hotel, or residential.

Consider Impact of Revenue Reductions

In addition to K-14 districts, California has five other groups of local agencies: counties, cities, "nonenterprise" special districts (districts organized and financed like governmental agencies), "enterprise" special districts (districts organized like a business, usually with the ability to charge fees for services), and redevelopment agencies. Because these local agencies have different responsibilities, authority, and revenue bases, reducing their property taxes would yield very different effects. We urge the Legislature to consider these effects in reviewing any proposal for shifting local government property taxes.

City and County Program Reductions Likely. Most city and county programs currently financed with property taxes are not amenable to user fee financing. In addition, the Constitution requires voter or property owner approval before a local agency may impose or increase a local tax or assessment. Thus, reductions in city and county property taxes likely will trigger program reductions. Because some local agency programs (particularly county programs) are subject to statutory and other spending requirements, the programs likely to be reduced most due to a property tax shift include: parks and recreation, libraries, public safety and, in some counties, local health programs. The level of program reduction would vary considerably across the state. Because counties and some older cities are heavily reliant upon the property tax, these agencies are likely to impose the deepest reductions. More recently incorporated cities, in contrast, tend to be more reliant upon the sales tax. Similar to the 1990s shift, these cities are less likely to sustain major losses from the proposed property tax shift.

Effect on Nonenterprise Special Districts Not Clear. While almost half of these districts rely entirely on other revenue sources (fees, assessments, and payments from other governments) to finance their operations, some districts depend on property taxes for most of their budgets. Under the 1990s shifts, various categories of nonenterprise special districts were partially or fully exempt from the shift (including fire districts, multicounty districts, and cemetery districts), placing the burden of the shift on a narrow group of districts—mostly flood control, library, and park and recreation districts. In addition to these fiscal differences, local perceptions of the efficiency and importance of these districts appears to differ greatly. Because of these factors, it is difficult to project how a property tax shift would affect these agencies. If the shift were structured similarly to 1990s, we assume that there would be significant cuts to flood control, library, and park and recreation programs, possibly offset to some extent through new fees and assessments. On the other hand, if the property tax shift were imposed selectively—on districts with the greatest capacity to raise revenues from alternative sources or districts that had potential for efficiency improvements—a tax shift might have less pronounced effect on governmental services.

Enterprise Special Districts Likely to Raise User Charges. Most of the state's approximately 1,700 enterprise special districts provide water or waste disposal services. Enterprise special districts have considerable authority to levy user fees to pay for services. As Figure 5 indicates, based on the most recent data available, more than half of these districts do not receive property tax revenues and those that do rely on property taxes for only 7 percent of their revenues. Given the significant fee authority of enterprise special districts and the nature of the services they provide, we assume that increased user fees would offset a significant portion of a property tax shift. The Constitution does not require local voter approval for increases in water, sewer, and refuse collection service user fees.

Redevelopment Agencies May Offset Tax Losses Through Project Expansions. Unlike other local agencies, redevelopment agencies do not receive a share of the property tax under the AB 8 system. Rather, after a redevelopment agency identifies a "project area" in the community needing redevelopment to eradicate "urban blight," the agency receives most of the annual growth in property taxes from that area. (That is, the existing AB 8 formulas for sharing the property tax are modified for the life of the project. K-14 districts and other local agencies do not receive their usual shares of property tax revenue growth. The state backfills K-14 districts, however, for their property tax losses.) Redevelopment agencies use property taxes—often in conjunction with private developer funds or other governmental resources—to finance capital improvements, land and real estate acquisitions, affordable housing, and planning and marketing programs. In the short term, decreasing redevelopment property taxes likely would result in decreases to all redevelopment activities, with the possible exception of affordable housing (because statutes specify a level of spending on housing). Over the longer term, however, it is likely that redevelopment agencies would increase their efforts to establish or expand redevelopment areas. This is because under current law, cities and counties gain control over a greater amount of property tax revenues when their subordinate redevelopment agencies create redevelopment projects—and this fiscal advantage would increase significantly if city and county property tax shares were reduced as part of a 2004 property tax shift. Over the long term, therefore, a redevelopment property tax shift might be offset by an expansion of redevelopment activity.

An Alternative Approach

In this section, we outline an alternative budget option involving local finances that reflects the guidelines discussed above. While we acknowledge that this alternative represents an undesirable intrusion into local finance, we think it would have fewer negative effects on local governments and their residents than the administration's proposal.

In order to "compare apples with apples," we scaled our alternative so that it would provide $1.3 billion in ongoing state fiscal relief. We note, however, that each element in our alternative, summarized in Figure 6, could be reduced or eliminated, to reduce its particular negative effects on local governments.

Reduce Restricted Purpose Subventions First

To mitigate the impact of the early 1990s property tax shifts and increase funding for local programs, the state established or augmented several restricted-purpose subventions to local governments. While some of these subvention programs were eliminated last year or are scheduled for elimination in the proposed budget, the administration proposes $216 million in 2004-05 for:

• Citizens' Option for Public Safety (COPS)—$100 million subventions to all cities and counties for local law enforcement.
• Juvenile Justice Challenge Grants—$100 million in grants to counties to improve juvenile justice programs.
• Public Library Foundation—$16 million to support local libraries.

While these subventions support valuable local activities, we note that local agencies cannot use restricted purpose subventions to meet community needs as flexibly and efficiently as general-purpose revenues. We also note that local communities are acutely aware of their public safety and library needs and historically have used general-purpose revenues to support these programs. Thus, if local government general-purpose revenues are preserved, public safety and library programs likely would receive high consideration for local support.

LAO Alternative. Our first guideline recommends the Legislature minimize any reduction to local general-purpose revenues. Accordingly, before acting to shift local property taxes, we recommend the Legislature consider eliminating these restricted purpose subventions. In our alternative, we use all funding from these subvention programs to reduce by $216 million the amount of the property tax shift. (We note that in the "Judiciary and Criminal Justice" chapter of the Analysis of the 2004-05 Budget Bill, we suggest alternate uses for two of these subventions in lieu of the Governor's proposal on juvenile justice probation programs.)

Give Local Flexibility Over Special District Shift

In the 1990s property tax shift, the Legislature enacted statewide formulas that directed county auditors to reduce special district property taxes. Because the state did not allow communities to revise these shift formulas (or change underlying special district AB 8 shares) to reflect local interests, the formulas resulted in greater reductions to valued local government services than otherwise would have been the case.

We note, for example, that the 1990s shifts did not allow communities to reconsider the shares of property taxes allocated to enterprise special districts. Because enterprise districts can finance most of their activities through user fees, local communities might have preferred to reduce or eliminate enterprise special district property taxes in order to preserve property tax resources for other local agencies. (Government Code Section 16270, dating from 1978, declares the Legislature's intent that these districts transition to user fee financing.)

The 1990s shift formulas also did not give communities an opportunity to reallocate property tax shift amounts, or AB 8 shares, of nonenterprise special districts. This authority would have allowed local communities to preserve funding for their highest priority programs and caused other districts to improve efficiency, consolidate, reduce programs, and/or shift to other forms of financing.

LAO Alternative. Our alternative includes a $400 million special district shift. This amount is equivalent to almost an 80 percent reduction to enterprise special district 2004-05 property taxes, or about a 15 percent reduction to all special district property taxes. Consistent with our guidelines, the allocation of this property tax shift would not reflect dated formulas, but would be locally determined. Communities would have full flexibility in the implementation of this reduction. Specifically, the Legislature would establish a special district property tax shift amount for each county. Every county Board of Supervisors, after public hearing and debate, would revise the share of property taxes received by special districts in their county to implement the shift and reallocate property tax resources in a manner that best meets the needs of their county residents.

Transition Period. Because local communities have had no authority over property tax allocation in more than a quarter century, we are mindful that such an approach would engender both concerns by special districts and significant public debate. In general, we believe that this result would be a sign of a healthy local democratic process, appropriately debating the allocation of local revenues. Should the Legislature wish to moderate the rate of change resulting from this alternative, it could impose certain limitations on this authority for a defined period. For example, the Legislature could specify that county boards of supervisors may not (1) reduce a nonenterprise special district's property taxes by more than 20 percent in any single year or (2) reallocate property taxes so that county-dependent special districts receive increased property tax revenues.

Focus the Redevelopment Shift

Over the years, the Legislature and administration frequently have voiced concerns regarding local agency overextension or misuse of redevelopment powers and the resulting increased state education costs. In an effort to address these long-standing concerns, the Legislature enacted in 1993 Chapter 942 (AB 1290, Isenberg), clarifying that local agencies may establish redevelopment projects only in areas that meet specific "urban blight" definitions and that redevelopment expenditures must be limited to projects needed to eradicate blight and create affordable housing. Chapter 942 also sought to reduce redevelopment agency subsidies to auto dealerships, large volume retailers, and other sales tax generators.

Since enactment of Chapter 942, many concerns regarding local agency use of redevelopment powers have persisted. Cities and counties have expanded redevelopment project areas so much that 15 percent of all assessed valuation in the state is contained within a redevelopment project. In three counties, more than one in five property tax dollars is allocated to redevelopment agencies, instead of K-14 and other local agencies. Redevelopment agencies continue to find ways to subsidize retail developers and auto dealerships. Finally, the Department of Housing and Community Development (HCD) reports that redevelopment agencies frequently spend more than 50 percent of their housing funds on planning and administration, not housing development—and that some agencies undercount funding that should be deposited to housing funds or use the monies for nonhousing purposes. For example, HCD auditors found that Santa Ana redevelopment officials spent three-quarters of their housing funds over a seven-year period on planning and administration and off-site street and sidewalk improvements.

Administration Proposal. Although redevelopment agencies receive about 20 percent of the property taxes allocated to local agencies other than K-14 districts, redevelopment property tax shift losses account for only 10 percent of the administration's plan, or $135 million. Because redevelopment's share of the property tax shift is relatively low, other local agencies' shares are commensurately greater. In addition, because the administration proposes that all redevelopment agencies contribute the same percentage of their property taxes to ERAF, cities and counties are likely to perceive increased fiscal incentives to create or enlarge redevelopment projects.

LAO Alternative. Our alternative sets the amount of the redevelopment shift at $320 million, approximately 11 percent of redevelopment 2004-05 property taxes. Setting the shift at a higher amount allows a larger share of the property tax shift to be borne by an agency that has greater ability to offset property tax losses with other revenues than do many cities, counties, and some special districts. In addition, we would replace the administration's single-percentage redevelopment property tax shift with a sliding scale approach that decreases—on an ongoing basis—city and county incentives to inappropriately expand redevelopment activities.

How Would the Sliding Scale Work? Under our alternative, agencies that show restraint in their use of redevelopment authority and place little land under redevelopment would sustain little property tax shift. An agency's ERAF obligation would be higher, however, in any year that it (1) had large amounts of developed land under redevelopment, (2) did not meet its affordable housing obligations, and/or (3) failed to comply with redevelopment requirements specified under the Health and Safety Code.

Shift Sales Taxes and Reallocate Vehicle License Fee (VLF) Instead

As discussed earlier in this document, the administration's proposal to shift property taxes from cities and counties would (1) worsen the fiscal incentives these agencies face when considering new land uses and (2) place significant burdens on the same property-tax dependent agencies that sustained the greatest losses from the 1990s shifts. In addition, the administration's proposal for counties to shoulder a large share of the property tax shift would result in deep reductions to county programs because counties have limited ability to offset property tax reductions with other revenues.

LAO Alternative. To mitigate the adverse land use incentives and program reductions that would result from the administration's proposal, our alternative (1) focuses on taxes other than the property tax and (2) minimizes county revenue losses. Specifically, our alternative imposes city and county reductions, totaling $200 million each, through the following reduction in the local sales tax and reallocation of VLF revenues:

• Sales Tax Reduction. The local agency sales tax rate (referred to as the "Bradley Burns" tax) is reduced from 1 percent to .92 percent, or $400 million annually. The state sales tax rate is increased by an equivalent percentage.
• VLF Reallocation. Because most taxable sales occur within incorporated areas, cities would bear a disproportionate share of the $400 million sales tax reduction. City sales tax losses exceeding $200 million would be offset through a statutory revision to the existing VLF allocation formula—shifting some county VLF revenues to cities.

Conclusion

By shifting to K-14 districts $1.3 billion of property taxes currently allocated to city, county, special districts, and redevelopment agencies, the administration's proposal places significant burdens on local agencies as a means of resolving the state's budget difficulties. We think it is inappropriate for the state to reallocate local taxes for the sole purpose of reducing state spending obligations. We also find that the shift would impose considerable fiscal disruptions to local governments and does not, in any real sense, represent a budget "solution." Accordingly, we recommend that the Legislature reject the administration's proposal.

If the state determines that, given its fiscal difficulties, local agency funding must play a role in resolving the state's budget crisis, we recommend the Legislature avoid relying upon the dated property tax shift formulas from the 1990s. Rather, we recommend the Legislature develop a new approach, consistent with the guidelines outlined in this analysis.

In our view, the alternative local government budget reduction outlined above—while still imposing undesirable fiscal effects on local governments—offers significant advantages over the administration's approach. Specifically, our alternative focuses a larger percentage of the property tax losses on those agencies that can offset revenue reductions through user fees or other revenues, if the community so desires. Our alternative also minimizes the loss of general-purpose revenues to cities and counties—and modestly improves the fiscal incentives local agencies face regarding land development and redevelopment.