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Lessons learned 40 years after a monumental tax law

Lessons learned 40 years after a monumental tax law
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Forty years ago, California voters were sent a 63-page pamphlet explaining the 13 questions on the primary ballot that June.

At the end of the pamphlet was an analysis of a constitutional amendment that would become one of the nation’s most influential tax policies, known to both supporters and opponents simply by its spot on that ballot: Proposition 13.

The pamphlet explained that, if passed, Proposition 13 would set property tax rates at 1 percent, limit annual increases to 2 percent or inflation (whichever is lower) and only reassess a property’s taxable value after a sale. Additionally, it would establish supermajority requirements for state and local tax increases.

The pamphlet also included an argument for the amendment and a rebuttal. The pro argument clearly won in 1978, with Proposition 13 passing by nearly a two-to-one margin. But after 40 years as law, who was right on what Proposition 13 would mean for California? 

The amendment supporters were right that this was a big tax cut, but a little too Pollyannaish in their promise that simply cutting wasteful spending, such as “limousines for elected officials,” would make the cut affordable.

The opponents were right that Proposition 13 dramatically changed California’s tax system, but were a little too dire in their predictions of devastating cuts for schools and other services — in part because a large state surplus in 1978 mitigated the revenue loss. And both missed some large unintended consequences.  

Ultimately, state representative Paul Priolo, a Republican, quoted in the pro argument, got it mostly right: “[I]t’s a tough amendment but the state can live with it. It means public officials will have to go to work.” 

It is, and they did.

Proposition 13 dramatically changed California’s entire tax system. Before the amendment, property tax rates were well above 1 percent, so the new rate cap was an instant tax cut for many homeowners. California’s Legislative Analyst’s Office (LAO) reports property tax revenue immediately dropped 60 percent. 

Further, over time, the assessment restriction has reduced taxes for long-term owners whose homes are taxed at assessments well below their current market value.

The LAO recently found similar middle-income homeowners in the Bay Area had property tax payments ranging from $1,350 to $7,500, because owners of similar properties, with similar incomes and similar wealth, who purchased their homes at different times pay dramatically different taxes.

As a result of these tax restrictions, property taxes went from 27 percent of California’s combined state and local general revenue in 1978 (well above the national average) to just 14 percent in 2015 (below the national average).

However, that reflects both reduced property taxes and the other taxes California had to raise to replace that revenue. The Golden State now has the highest general sales tax rate and top individual income tax rate in the country. Of course, these rate increases were also approved by voters in ballot initiatives in 2012 and 2016.

Notably, income and sale taxes are state revenues, and left undiscussed in the pamphlet was how the state would distribute them to localities for local government’s major service: education. Much like Solomon splitting the baby, the state decided that each local government got the share they had in 1975.

Forty years later, as the state’s population has dramatically grown and become more diverse, these allocations still stand. Reliance on state revenue also increased revenue volatility and makes local revenue susceptible to state budget cuts during recessions.  

Also unforeseen was all the other budget propositions spawned by Proposition 13:

  • Proposition 4 limited state expenditures; 
  • Proposition 62 and Proposition 218 further limited local taxes, fees and charges; 
  • Proposition 98 mandated funding levels for kindergarten through community college spending; and 
  • Proposition 25 ended the state’s supermajority requirement for passing budgets. 

So how did the state learn to “live with” Proposition 13? It wasn’t always easy. An analysis of Proposition 13 might not have been so kind on its 25th or 30th birthday. For decades, California passed late budgets and governors were sunk by poor fiscal management.  

But today, the state’s biggest fiscal question is what to do with its $9 billion budget surplus. California got there through a combination of spending cuts and those voter-approved tax increases. The state also recently created a rainy day fund as a buffer against the next economic downturn.

And recent research has questioned whether ballot-box budgeting is really such a binding force on policymakers. In short, the people and politicians retain a lot of control, and California would probably have made similar budget decisions without these mandates.

Proposition 13 remains as popular and complicating as it was 40 years ago. As such, Californians, both in Sacramento and at the ballot box, must continue going to work on the state’s finances if it wants to keep its fiscal success story. 

Kim Rueben directs the Urban Institute’s State and Local Finance Initiative. Richard Auxier is a research associate at the Urban Institute's State and Local Finance Initiative.