LAO Analysis of the 1997-98 Budget Bill
Perspectives and Issues Part VI A, Property Tax Shift
Property Tax Shift
|What Should the Legislature Consider As It Reviews
Proposals to Reduce the Amount of the Property Tax
Again this year, local government officials are asking the Legislature to reduce the property tax shifts of 1992-93 and 1993-94. Combined, these property tax shifts permanently redirect one-sixth of all
property taxes from counties, cities and special districts to K-14
schools. These property tax shifts caused local governments to
reduce many programs, and continue to strain local budgets.
Proposals to modify the property tax shift pose two difficult
choices for the Legislature. Specifically, in order to provide any
significant local relief, the Legislature would need to:
- Reduce state program expenditures or increase state revenues.
- Choose which local governments would receive the property
This write-up examines two approaches to reducing the property
tax shift, and discusses alternative ways to allocate relief among
In 1992-93 and 1993-94, in response to severe budget deficits, the
Legislature and administration permanently redirected about
17 percent of California property tax revenues from counties, cities, and
special districts to schools. These increased school property taxes, in
turn, decreased the state's ongoing General Fund obligation for funding schools. California's overall level of K-14 school financing was not
affected by this shift of tax dollars.
While these property tax shifts continue to relieve fiscal pressures
on the state, the loss of property tax revenues has:
- Caused cities, counties, and special districts to reduce a wide
variety of programs.
- Strained the fiscal conditions of many local governments.
Although data summarizing the impact of the property tax shift are
not available, park and recreation, library services, and programs for
the indigent (including general assistance) are among the programs
most adversely affected. In addition, while all local governments experienced fiscal disruption from the tax shift, many counties, some large
cities, and some special districts continue to experience significant
fiscal strain from the property tax losses. This strain impedes their
ability to plan, respond to emergencies, and implement improvements
that impose short-term costs.
Economic Development and Property Tax Administration Incentives
The shifts also exacerbated two pre-existing local government disincentives. Specifically, because cities and counties now get a smaller
share of property tax revenues, they have less of an incentive to promote new business and residential land developments in their communities. For example, the average county now receives only about
$370 dollars per year in property taxes when a $200,000 home is built,
down $660 from before the property tax shift. Some counties find this
revenue level to be insufficient to pay the county's costs to provide
services to new dwellings. To offset these net costs, a city or county
may increase developer fees, require assessments, fail to approve a
rezoning request needed to build new homes, or take other actions
with the direct or indirect effect of discouraging development.
The property tax shifts also reduced counties' incentives to manage
the property tax collection system in a manner that ensures all property
owners pay their fair share. This is because counties now receive about
20 cents of every dollar of property taxes, yet pay more than 70 percent
of the cost of property tax administration. (As we discuss more fully in
a separate write-up in this part, this disincentive regarding property tax
administration was evident before the property tax shift, and merits
Legislature's Actions in 1996 and 1997
Concerned about these consequences of the property tax shifts, last
year the Legislature passed without a dissenting vote AB 2797 (Aguiar).
This measure would have "frozen" the amount of property taxes local
governments transfer to schools at the 1996-97 level, allowing local
governments to keep any property tax growth over this amount. Under
the state's school funding laws, schools would not be affected by this
freeze. The state would have backfilled the schools' revenue losses
with increased state general fund revenues.
Citing concerns about the state cost of this measure, the Governor
vetoed AB 2797. In his veto message, the Governor stated that any
property tax relief should come as part of a comprehensive state-local
restructuring. The Governor's budget, however, does not propose any
Early this legislative session, Members of the Legislature introduced
two bills and one constitutional measure to provide partial relief from
the property tax shifts: AB 1 and ACR 4 (Aguiar) and AB 96 (Sweeney).
Local governments have also indicated that a reduction to the property
tax shift is among their highest priorities.
Options for Reversing the Property Tax Shift
There are two commonly discussed approaches to reducing the
property tax shift:
- Freeze Shift--placing a cap on local property tax shift amounts.
- Baseline Reduction--reducing the property tax shift by a fixed
Below, we explain how much each approach would benefit local
government (and cost the state),which local governments would benefit, and how the approach addresses the economic development and tax
administration disincentives discussed above. In reviewing the two
approaches, it is important to note that they are not exclusive--various
combinations of the approaches are possible.
To accomplish the property tax shift, state law requires every county
auditor to deposit a portion of county, city, and special district property
taxes into a countywide Educational Revenue Augmentation Fund
(ERAF). The amount of property taxes diverted from any specific local
government in 1992-93 and 1993-94 was set forth in statutory formulas.
While the formulas are complex, a local government's property tax
obligation generally reflected two factors:
- The benefit the local government received from the state after
Proposition 13, its so-called "AB 8" benefit.
- In the case of counties, the county's receipt of Proposition 172
sales tax revenues.
(For information regarding the property tax shift amounts, please see
our April 1996 policy brief, Reversing the Property Tax Shifts.)
Local government's property tax shift obligations did not stay constant at these 1992-93 and 1993-94 amounts, however. Rather, every year
each local government's ERAF obligation grows as assessed value in
the community grows. Growth in assessed value generally occurs due
to construction of new homes or businesses, the annual two-percent
increase in assessed value permitted by Proposition 13, and the recognition of higher assessed values when properties change ownership.
One approach to providing property tax shift relief is to "freeze" the
amount of property taxes any local government must contribute to
ERAF. For example, in AB 2797, the Legislature specified that local
governments need not place into ERAF in 1997-98 or future years an
amount greater than that which was deposited in 1996-97.
How Much Would the Freeze Shift Approach Benefit Local Government and Cost the State?
The level of local relief provided under the freeze shift approach
(and the commensurate increased state education costs) turns on the
growth rate for assessed value. For 1997-98, we estimate assessed value
will grow by 3.5 to 4 percent statewide. (The Department of Finance's
estimate is about the same.) Thus, if ERAF contributions were frozen
at 1996-97 levels (approximately $3.4 billion), local governments would
benefit by keeping about $130 million of property tax growth in
1997-98. As Figure 1 shows, the amount of relief under this option
grows very rapidly--exceeding $1 billion by 2002-03. This is because
local governments benefit by keeping all the growth on a $3.4 billion
share of property taxes--and this growth compounds annually.
Which Communities Benefit?
The amount of fiscal relief provided to any local government under
this approach depends on two factors: the local government's required
shift amount, and the future assessed value growth rate in the community. The greatest relief would go to fast-growing communities with
comparatively large ERAF obligations; the least to slow growing communities with small property tax shift requirements.
Figure 2 displays information about the local government entities
that bore the largest portion of the property tax shift and thus stand to
gain the most from a freeze--counties. Specifically, if the Legislature
were to implement a freeze in the budget year, counties on average
would realize fiscal relief of about $3 per constituent. Individual counties, however,
|Freeze Shift: Relief Depends on
Shift Amount and Growth Rate
1997-98 Growth Rate
||Initial Fiscal Relief
would realize different levels of fiscal relief, depending on the magnitude of their property tax shift obligations and their rate of assessed
For example, Alameda is likely to benefit more on a per capita basis
than Los Angeles in the first year, because its ERAF obligations are
higher and its growth rate is expected to be higher. Counties with
lower ERAF obligations (such as Butte) would tend to receive lower
benefits from a freeze shift approach, unless they have a high growth
rate. Finally, while Figure 2 focuses on counties, the range of benefit
from a property tax shift freeze for cities is even greater, because city
ERAF obligations are even more varied.
Are Economic Development and Tax Administration Incentives Improved?
A property tax shift freeze would mitigate the fiscal disincentives local
governments face to approve new developments and to finance improvements to the property tax administration system. For example,
under the freeze shift approach, a local government would receive
significantly more property taxes from the construction of a new office
building than it would under current law. (The local government,
however, would continue to receive its current low share of property
taxes from all existing developments.) While the incentives local governments face regarding land developments and tax administration still
would be less than optimal, local governments' incentives would be
restored to their levels prior to the property tax shift.
A second approach to providing property tax shift relief is to reduce
the "base" amount of local government property tax shift obligations
by a fixed amount or percentage. Local government property tax shift
obligations would continue to grow under this approach. However, the
shift obligations would grow from a lower base.
How Much Would a Baseline Reduction Benefit Local Governments
and Cost the State?
The Legislature could use a baseline reduction approach to provide
large or very modest fiscal relief to local governments. Figure 3 shows
the local benefit and state costs for a $130 million baseline reduction in
the budget year. (This is about the same amount of local fiscal relief as
the freeze shift approach provides in its first year.) In contrast to the
freeze approach, the costs and benefits of the baseline reduction approach do not escalate rapidly. After six years, local relief and state
costs are less than $170 million, whereas the freeze shift's relief/costs
are over $1 billion.
Which Communities Benefit?
Under the baseline reduction approach, the Legislature would determine which local governments would receive fiscal relief. The Legislature could reduce the property tax shift requirement for specific local
governments, or to all local governments on a proportionate basis.
Are Economic Development and Tax Administration Incentives Improved?
Modest reduction to baseline ERAF obligations would not measurably improve the incentives for local governments to promote new land
developments or to invest in property tax administration. Only very
large and permanent baseline reductions to local government ERAF
obligations would achieve that result.
What Should the Legislature Do?
Our analysis indicates that the property tax shifts have:
- Reduced local government's ability to respond to constituent
needs and preferences.
- Strained the fiscal condition of some local governments.
- Decreased local government incentives to approve new land
developments and invest in property tax administration.
As a result, we believe the concept of reducing the amount of the
property tax shifts merits serious consideration by the Legislature.
Ultimately, however, the decision regarding modifying the property
tax shift will turn on the Legislature's perception of the relative need
for state and local programs and the appropriate level of taxation. As
we discuss in Part I, although the state's economy continues to grow
moderately, state revenues cannot fund all the requirements of current
law. Reducing the property tax shift, therefore, would require the
Legislature to reduce state programs, or raise revenues.
Should the Legislature decide to provide some relief from the property tax shift, it must choose the manner in which to provide the relief
and which local governments would benefit. To assist the Legislature
in this regard, we offer the following observations.
The Freeze Approach Only Makes Sense on a Permanent Basis
Although the freeze shift approach imposes significant future costs
to the state, this approach has the advantage of correcting some of the
counter-productive economic development and tax administration
incentives local governments face.
Our analysis indicates, however, that this advantage does not materialize unless the freeze is implemented on a permanent basis. Specifically, placing a sunset provision on the freeze (which was suggested as
an option in last session's debate on this issue) greatly reduces its
positive benefits regarding economic development and tax collection
incentives. This is because it usually takes a while for local governments to realize benefits from a change in land development policies
or enhanced tax collection efforts. By the time a local government
would receive additional tax revenues from these activities, the freeze
on ERAF growth may have ended. In addition, implementing a freeze
shift approach for a limited time period would be extremely difficult
from an administrative standpoint.
Baseline Reduction Is a Better Way to Deliver Modest Relief
If containment of costs is an important objective, the easiest way to
provide property tax shift relief is through a baseline reduction. As
discussed earlier, the state costs of this approach increase modestly
over time. The Legislature could implement additional baseline reductions to the property tax shift in subsequent years, depending on the
state's fiscal condition.
Deciding Which Local Governments Should Benefit Is Complex
Ideally, all property taxes in California would be allocated among
local governments in a manner that best facilitates local governments'
ability to meet the needs and preferences of their residents. In considering ways to provide more property taxes to cities, counties and special districts, therefore, the Legislature is faced with the task of determining how to allocate property taxes among the many overlapping
local jurisdictions serving California residents. The Legislature has
three options for addressing this issue.
Allocate the Relief Proportionally. The Legislature could allocate any
property tax shift relief in proportion to the amount of a local government's property tax shift. Such an allocation is perceived as "fair" by
many because it provides relief in a manner that is commensurate with
the impact of the property tax shift. On the other hand, this methodology reaffirms the property tax sharing formulas in existence before the
property tax shift. As we discuss in a separate write-up in this part of
the Perspectives and Issues, those tax sharing formulas have not been
updated for nearly two decades and may not reflect the priorities or
needs of the present day. Some California residents may prefer, for
example, to have more property taxes allocated to their city or library
special district, than a simple proportional reversal of the property tax
shift would provide.
Allocate Relief Based on Other State Formula. Alternatively, the
Legislature could allocate property tax shift relief to local governments
based on some state perception of local need. For example, the Legislature could provide baseline reductions to the property tax shift obligations of fiscally distressed communities, or to cities and counties that
receive particularly low shares of property taxes collected in their
community. From a practical standpoint, however, these alternative
methodologies are likely to be controversial and imperfect. The state
has no workable definition of local fiscal distress and low property tax
shares may be appropriate for some communities (such as those that
rely extensively on special districts to provide services).
Let Communities Determine Allocation. A third approach would be to
allow local residents to choose how to allocate the additional property
taxes among the many local governments serving their community.
While such an approach has not been undertaken before, the California
Constitution Revision Commission included such an option in its
recommendations. Specifically, the Legislature could state that local
residents have the authority to direct the allocation of a certain amount
or share of property taxes. The proportion of property taxes to be allocated to any specific local government would be determined by local
residents in a county-wide, or sub county-wide election. Local residents
could alter this property tax allocation methodology in the future with
a subsequent vote. The primary advantage of this approach is that it would represent
the first time in nearly two decades that local residents had a voice in
the allocation of property taxes among local governments. On the other
hand, this approach would be complicated in large urban counties and
is probably only practical if a significant amount of the property tax is
to be placed before the voters.
Local Control of the Property Tax Makes Sense
Our review indicates that local governments can best respond to
local needs and priorities when they have a reasonable degree of fiscal
autonomy. In addition, local residents would have a better ability to
obtain the public services they want if they had some authority to
reallocate property taxes among local governments. For these reasons,
we think that ultimately some mechanism for allowing local control of
the property tax should be developed.
Proposals to reduce the property tax shift pose very difficult choices
for the Legislature. Specifically, there is not likely to be "room" in the
state budget to provide significant local fiscal relief, unless the Legislature
reduces state program expenditures below the levels called for under
current law or increases taxation. Accordingly, the Legislature must
weigh the relative need for revenues and services by state government,
local government, and the private sector.
If the Legislature decides to take action to reverse part of the property
tax shift, the Legislature would need to determine how to allocate this
relief among the several thousand units of local government. Clearly, the
simplest way to provide relief is on a proportional basis. We note, however, that such a proportional allocation may not be consistent with local
residents' current needs or priorities.
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