Asking the Right Questions About Prop. 55: Are the Revenues Needed? Would the Measure Raise Them Fairly?

Four years ago at this time, California was deep in the midst of a period of fiscal and political angst. The state was still reeling from the Great Recession and the resulting loss of tens of billions in state revenues, along with deep spending cuts across California’s education systems and social safety net.

Also in fall 2012, California voters were being asked to decide on Proposition 30, a ballot measure backed by Governor Brown, which would increase personal income tax (PIT) rates on the wealthiest Californians through 2018 and the state sales tax rate through 2016. If voters rejected Prop. 30, the state would confront $6 billion in retroactive cuts to K-12 schools, community colleges, and other essential public services.

In November 2012, California voters approved Prop. 30 by nearly a 10-point margin.

Fast-forward four years: The passage of Prop. 30, in combination with a sustained economic recovery, has provided critical revenues to California. Funding for K-12 schools and community colleges has increased from $47.2 billion in 2011-12 to $71.9 billion in 2016-17. By significantly lifting state revenues, Prop. 30 has helped boost rainy day fund deposits and pay down budgetary debt as required by Prop. 2 of 2014. The additional revenues also have provided space in the state budget to take the first steps in restoring funding for other vital state services, such as higher education (CSU and UC) and early childhood education (preschool and child care), and expand health care for low-income households as envisioned by federal health care reform.

The state’s fiscal health is in better shape than four years ago, thanks in large part to Prop. 30, and California voters are now being asked — via Prop. 55 on the November ballot — whether the state should extend a central component of Prop. 30 and the revenue boost it has provided. Prop. 55 would:

  • Extend Prop. 30’s higher PIT rates for the wealthiest Californians for 12 years, through 2030;
  • Generate a projected $4 billion to $9 billion per year from 2019 through 2030, according to the Legislative Analyst’s Office; and
  • Allocate these revenues to K-12 public schools, community colleges, health care for low-income Californians, the state’s rainy day fund, state debt payments, and other state services.

Prop. 30 played a critical role in stabilizing public investment, increasing revenues by $7 billion to $8 billion annually. If voters reject Prop. 55, the state budget would lose roughly this level of revenues, a situation that would threaten to destabilize the state’s budget situation. Yet despite this, a number of arguments have been made against Prop. 55 that misplace emphasis on lesser effects of the measure — drawing attention away from the measure’s larger and more significant impacts — or that in some cases simply lack underlying evidence.

Would Prop. 55 Make the State Budget Overly Reliant on “Volatile” Revenues?

One critique of Prop. 55 is that it would “tie California’s fate to Wall Street volatility” through an overreliance on taxes on the wealthiest Californians that “amplify the peaks and valleys of the economy.

The crux of this argument is that California’s system is too susceptible to revenue volatility — that volatile taxes, particularly personal income taxes, should be avoided in favor of more predictable revenue sources. The volatility of California’s revenue system cannot be addressed solely through the state’s tax structure; trends in the economy and in income and wealth distribution also have a huge impact. Although the personal income tax may be more volatile than other tax sources, all of California’s tax sources are volatile because income and wealth are increasingly concentrated in fewer and fewer hands. High-wealth individuals and households make significantly more in income and capital gains (reflected in the personal income tax), spend far more in absolute dollars (reflected in the sales tax), and own significantly higher-value properties (reflected in local property taxes) — a situation that makes all of the state’s tax sources subject to greater fluctuation than in the past. Managing volatility is less about changing the state’s tax code to make it less reliant on the highest incomes — an approach that would primarily serve to make the system both less fair and less adequate — and more about using the higher revenues that accompany periods of economic growth to invest in broadening economic opportunity and supporting a stronger overall state economy.

The best way to address the inevitable up-and-down cycle in state revenues is smart management of the state’s revenue stream. This means using a portion of the available revenue growth during the good times to both save for a rainy day and pay down budgetary debt. Thanks to voter approval of Prop. 2 two years ago, passage of Prop. 55 would increase the amount of funds the state is required to set aside in reserves and for paying down budgetary debt.

Would Prop. 55 make California’s revenues more likely to rise and fall along with the strength of the state economy? Yes, but only at the margin. But a crucial point is that state revenues will be susceptible to the economic cycle regardless of whether Prop. 55 is approved or rejected, and passage of Prop. 55 would help increase state reserves and reduce state debts.

Would Prop. 55 Make Broader Tax Reform Less Likely?

Another critique of Prop. 55 claims that it is the wrong approach because “California needs a significant overhaul of its antiquated tax structure to reflect a modern economy” and, relatedly, that if Prop. 55 passes state leaders will be unwilling to “get serious about tax and budget reform.”

We wholeheartedly agree about the need for more comprehensive tax reform. But what would that mean? It would have to mean taking on a number of the so-called “third rails” of California politics, especially the limitations imposed by Prop. 13 (1978) that leave California state and local governments under-reliant upon more stable property tax revenues (and more reliant upon income and sales tax revenues) and that leave many of the most valuable commercial and residential properties on the tax rolls at dramatically below-market levels. Comprehensive tax reform would also mean taking on the many costly tax breaks in the state’s corporate and personal income tax systems — tax breaks that largely go to households and businesses that don’t really need the help, while the state constrains the amount of aid provided to individuals and families who do need the help. It would also mean extending state and local sales taxes to a broad mix of services that are currently exempt or considering other consumption-tax alternatives.

Some of these tax reforms would broaden the underlying tax base, thereby allowing for lower rates. But, all types of tax reform would require state leaders to take on powerful constituencies that would push back against the changes to the tax system. Further, expecting comprehensive tax reform to happen through the legislative process could be politically unwise given that most of the necessary reforms would require a two-thirds vote in both houses of the Legislature.

So in light of the many barriers to broader tax reform, Prop. 55 represents “good tax policy”: It would raise revenues efficiently by tying the tax system more closely to growing parts of the California economy, and it would do so fairly, based on people’s ability to pay.

Furthermore, there is nothing in Prop. 55 that would preclude state leaders from pursuing comprehensive tax reform. The structural and political impediments described above would need to be overcome, but no more or less so depending on the outcome of Prop. 55.

Would Prop. 55 Cause Wealthy Californians to Leave the State?

The most perplexing — and least evidence-based — assertion made against Prop. 55 points to “the very real concern that if California increasingly relies on only its wealthiest people, they will take their money elsewhere.” This is the same bogeyman that gets carelessly bandied about every time California voters and policymakers attempt to deliberate tax issues (and is another barrier to comprehensive tax reform). This “if you tax them, they will leave” claim has never been grounded in rigorous research and in fact, when researched correctly, appears to be nothing more than urban legend. The promulgators of this argument, unfortunately, often rely on anecdotes or numbers that track net domestic migration — the flow of people to and from California — and whether those numbers are positive or negative.

Since California actually has more wealthy households today than it did prior to the passage of Prop. 30, if we used the same approach we could conclude that raising taxes on wealthy households leads to the state having a greater number of wealthy households.

Fortunately, beyond what we know since the passage of Prop. 30, we have even better information available. Research that tracked individual tax record data over an 18-year period, pre- and post-passage of Prop. 63 (2004) — which put in place an additional tax on those with taxable incomes over $1 million — showed the exact opposite of what critics argued would happen: outmigration of wealthy taxpayers actually declined after the Prop. 63 tax took effect. What’s more, the effects were marginal, underscoring the fact that tax increases targeting high-income earners have little or no impact on relocation decisions.

The reality is that various other factors play a much larger role in decisions households make about location. These include whether or not the household is faring well economically in a particular place, access to economic opportunities in “like” industries (what economists call “agglomeration economies”), and personal considerations unrelated to the tax code (being near family, divorce, retirement, etc.).

The argument that increasing taxes on the wealthy will lead to “tax flight” is based more on ideology and rhetoric than on research and analysis, and yet this same issue continues to be offered up as an argument against Prop. 55.

Does the State Need the Revenues? And Would Prop. 55 Raise Them in a Fair Way?

Ultimately, the right questions to be raising about Prop. 55 are: (1) Does the state need the revenues the measure would provide? and (2) Would the measure raise these revenues in a fair way? The claims made against Prop. 55 tend to entirely sidestep the question of need, perhaps because the list of essential public services in which the state has underinvested is so long. For a sense of scale, consider this: Based on Department of Finance data, we estimate that the state would lose $7.7 billion in revenues in 2019-20, the first full year after Prop. 30 expires. This amount is nearly equal to combined state General Fund spending for the CSU system, UC system, and student aid. To argue that the state does not need the revenues from Prop. 55 would mean:

  • Leaving the state’s child care and preschool system operating with 70,000 fewer slots and 20 percent less funding (adjusted for inflation) than before the recession and with up to 1 million children awaiting access to the system;
  • Leaving funding per student in the CSU system more than $2,000 below, and funding per student in the UC system more than $4,000 below, funding levels prior to the recession;
  • Leaving Californians in need of additional public support through the CalWORKs welfare-to-work program and SSI/SSP cash assistance for seniors and people with disabilities, living with grant levels below the federal poverty line and unable to keep pace with rents in California.

These are just a few examples of state needs — a list that also includes a lack of investment in affordable housing, deferred maintenance on infrastructure, and  the need to continue making progress in paying down state debts strengthening state reserves.

Since it’s clear that there are a number of areas where public investment is critically needed, the question then becomes whether Prop. 55 raises revenues in a fair manner. Some critics complain that the measure would continue to make California’s revenue system unfairly reliant on a small number of wealthy households. They are right that Prop. 55 would only impact a small number of households. The top 1 percent of households pay 98.6 percent of the total dollar increase in income taxes brought in by Prop. 30, and Prop. 55 would likely have a similar effect. But, the critics are wrong to claim that this is unfair to these households. If Prop. 55 is rejected, the top 1 percent of households would pay less than 8 percent of their family income in state and local taxes on average, while the lowest-earning one-fifth of households pay more — over 10 percent of their family income in state and local taxes. Even if Prop. 55 is approved, the top 1 percent would still pay less than 9 percent of their family income in state and local taxes, a portion smaller than that for the lowest earners. Furthermore, the top 1 percent of California households have seen their average income more than double since the 1980s, after adjusting for inflation, while the income of the entire bottom 80 percent of California households has declined.

The bottom line is that Prop. 55 provides the state with the revenues needed to continue investing in vital state services and increases the fairness of California’s revenue system. If they disagree, the critics of Prop. 55 should build a case for why Prop. 55’s revenues are not needed instead of distracting Californians with arguments that fail to focus on what the measure does, that misplace emphasis on lesser effects, or that are not based in fact.

— Chris Hoene