At the end of 2017, President Trump signed into law the Tax Cuts and Jobs Act (TCJA), passed with solely Republican support in Congress. As the Budget Center has previously noted, the TCJA — the most extensive revision of the tax code since 1986 — primarily cuts taxes for the wealthy and corporations while increasing the federal deficit by $1.9 trillion over 10 years, putting at risk funding for services that support low- and middle-income families.
Given the severe deficiencies of the TCJA, Californians may be surprised to learn that the new federal tax law has some potential benefits for our state — if our policymakers choose to act. There is much in the TCJA for advocates of tax fairness to dislike, including the large cut in the corporate tax rate (from 35% to 21%), the new deduction for income from “pass-through businesses,” and the reduction in the top personal income tax rate. All of these changes will lead to massive federal revenue losses. However, the new law also includes some reasonable changes that raise federal tax revenue in order to partially offset these losses, including limiting federal tax breaks that are costly, unfair, or economically inefficient. California now has the opportunity to increase state revenue by adopting (or “conforming to”) some of these provisions.
Unlike many other states, California does not automatically conform to changes in the federal tax code. Instead, it selectively conforms to the Internal Revenue Code as of a fixed date, which is currently January 1, 2015, meaning most of the changes made by the TCJA are not in effect for the purposes of calculating state taxes for California taxpayers. Conforming to federal tax law increases simplicity for tax filers, but there are many provisions of the federal code that don’t align with the state’s policy goals. California practices “selective conformity,” allowing policymakers to conform to some federal tax provisions, but not others. Since the state sets its own tax rates on personal and corporate income, the reductions in federal rates do not apply to state-level taxes. Thus, California can end up with more income tax revenue by conforming to those TCJA provisions that limit tax deductions and exclusions while maintaining current state tax rates.
Corporations that have profits in California currently pay significantly less in state income taxes as a portion of their state profits than they did in the 1980s, partly reflecting the increase in the number and generosity of state tax breaks that have been created over the past few decades. The state can narrow some of these tax breaks by selectively conforming to federal law. While the state’s fiscal situation is currently very positive (the Legislative Analyst’s Office estimates that over $20 billion in discretionary resources is available to allocate through the 2019-20 budget process), Governor Newsom has proposed ambitious new investments that will require new ongoing expenditures, such as more than doubling the total amount of credits provided under the state’s Earned Income Tax Credit (CalEITC). The Governor proposes to offset revenue losses from the CalEITC expansion by conforming to certain federal tax law changes mainly affecting businesses. These include “flexibility for small businesses; capital gains deferrals and exclusions for Opportunity Zones; and limitations on fringe benefit deductions, like-kind exchanges, and losses for non-corporate taxpayers; among others.”
The three revenue-raisers in the Governor’s proposed conformity package — the limitations on fringe benefit deductions, like-kind exchanges, and non-corporate losses — would increase state revenue by $1.2 billion, according to recently-released estimates. The other two provisions noted would cost the state revenue and reduce the net gain to closer to $1 billion. Not mentioned in the budget proposal are two other business-related TCJA provisions that could together bring in another $1.3 billion, according to Franchise Tax Board (FTB) estimates: limitations on Net Operating Losses (NOLs) and business interest deductions. If California were to conform to these two provisions in addition to the three revenue-raisers included in the Governor’s budget proposal, the state treasury could see approximately $2.5 billion in increased annual revenue, which could be used to support investments that improve economic security and opportunity for Californians.
The remainder of this post examines these five revenue-raisers, the two revenue-losing provisions proposed by the Governor, and other revenue-losers in the TCJA that California should avoid adopting.
Revenue-Increasing Conformity Provisions
Limitations on Fringe Benefit Deductions
The TCJA places new restrictions on federal tax deductions employers may take for certain expenses, including entertainment-related activities, transportation benefits, and some meals. Under prior federal law, businesses could deduct 50% of the costs of activities “generally considered to constitute entertainment, amusement, or recreation” (for example, a sporting event or theater performance) as long as they were directly related to the active conduct of the taxpayer’s trade or business. The TCJA disallowed this deduction. The previous federal deduction for transportation-related fringe benefits, such as parking and commuter benefits, is also disallowed except to ensure an employee’s safety. Additionally, expenses related to meals provided to employees through certain on-site eating facilities or for the convenience of the employer, which were previously fully deductible, are now limited to 50% through 2025 and are not deductible in subsequent years. Taken together, conforming to these limitations would raise an estimated $160 million in state revenue.
Limitation on Like-Kind Exchanges
Generally, when taxpayers sell or exchange an asset and make a profit, they owe tax on that capital gain at the time of the transaction. Prior federal law (to which California currently conforms, with modifications) allowed taxpayers to defer taxes on gains from an exchange of a business or investment property (excluding inventory, stocks, bonds, and other securities, and other specified types of property) if it was exchanged for a similar (“like-kind”) property. The capital gain would only be recognized once the taxpayer sold or exchanged the new asset in a later taxable transaction. However, if the new asset was held until the taxpayer’s death and passed on to an heir, the capital gain would escape taxation completely. This is because the federal government and California do not levy capital gains taxes when an heir inherits property — the heir only owes tax on the increase in value between the time the property is inherited and the time it is sold.
Under post-TCJA federal tax law, only real estate properties are eligible for like-kind exchange deferrals. For instance, an exchange of a vehicle used in connection with a business is now taxable at the federal level, but not at the state level. If California conformed to this limitation, FTB estimates that the state could gain $200 million in revenue. FTB’s latest tax expenditure report estimates the total state cost of like-kind exchange deferrals (including real estate property) for 2019-20 to be nearly $1.2 billion, suggesting that the state could gain significantly more revenue by going beyond conforming to the new federal law and simply eliminating tax deferrals for all types of like-kind exchanges. As the FTB report notes, allowing tax deferral for exchanges of some types of property and not others can be economically inefficient because it may encourage unnecessary investment in properties eligible for favorable tax treatment. And let’s not forget that the real estate industry fared quite well in the TCJA (see here and here), being exempted from several restrictions in the new law.
Limitation on Business Interest Deductions
Prior to the TCJA, businesses were generally able to fully deduct business-related interest expense from their taxable income. The new law limits the federal deduction for net interest expense (that is, interest expense minus interest income) to 30% of the taxpayer’s “adjusted taxable income” in a given tax year. Adjusted taxable income is essentially defined as business-related income before taking into account interest expense, interest income, and certain other deductions. An exception is made for interest expense incurred by vehicle dealers who finance their inventory of vehicles held for sale, known as “floor plan financing interest,” which continues to be fully deductible. The TCJA also allows any federal business interest deduction that cannot be used in a taxable year to be carried forward indefinitely and used in future tax years. Special rules apply to partnerships and S corporations to prevent partners and shareholders from double-counting deductions. Businesses with less than $25 million in gross receipts (averaged over the previous three tax years) are exempt from the new limitations, as are certain public utilities. Additionally, real estate companies and farming businesses may opt out of the new limitation.
The major justification for limiting interest deductions is that doing so reduces the tax incentive for companies to take on excessive debt. Since deductions are allowed for interest expense but not for returns to equity (in the form of dividends and capital gains paid to shareholders), the tax code makes it more attractive for businesses to finance investments with debt rather than equity. Businesses that take on high levels of debt are more susceptible to bankruptcy, and this can have ripple effects throughout an entire economy. As discussed in an International Monetary Fund report, the bias toward debt financing likely exacerbated the global financial crisis of 2007-2008 by encouraging high debt levels. Although the TCJA’s limitation on interest deductions will not fully equalize the tax treatment of debt and equity, it will at least reduce the debt bias. Conforming to this provision can raise $650 million for California while further limiting the overall tax preference toward debt.
Limitation on Net Operating Loss Deductions
A net operating loss occurs when a taxpayer’s total tax deductions exceed total income for the tax year. NOLs can be claimed by both corporate and individual taxpayers, but are usually related to losses from operating a business. Pass-through businesses like S corporations and partnerships cannot claim NOLs at the entity level, but their shareholders or partners can claim NOLs based on their respective shares of the businesses’ income and deductions. Before the TCJA, taxpayers were permitted to carry back these NOLs to offset federal taxable income, dollar-for-dollar, for up to two years prior to the year the NOL was incurred. In addition, they were able to carry forward NOLs to offset taxable income for up to 20 years into the future. As a simple example, if a corporation had an NOL of $500,000 in tax year 2017 (prior to the passage of the TCJA) and taxable income of $250,000 in each of the two previous tax years, it could file amended tax returns to claim a deduction of $250,000 in tax years 2015 and 2016, zeroing out its federal tax liability in both years. The corporation would then get a refund for previously paid taxes for those years. If it had no taxable income in the two prior years or if the NOL exceeded the corporation’s aggregate taxable income for those years, it could carry the remainder forward to reduce its tax bill in future years.
Under the TCJA, corporations and other taxpayers are no longer able to carry back their NOLs (with the exception of certain disaster-related farm losses) to offset federal taxable income. Additionally, NOL carryforward deductions are now limited to 80% of taxable income in any given year, but the 20-year limit has been removed so losses can be carried forward indefinitely. California generally conforms to pre-TCJA federal law at present, but in past years has had its own rules concerning NOLs. Prior to 2013, California had not allowed NOL carrybacks, and in certain years had limited or suspended NOL carryforwards.
There is a legitimate rationale for allowing businesses to average income over several years for tax purposes, given that businesses often incur losses in early years and during economic downturns. However, allowing NOL carrybacks can exacerbate state fiscal challenges during a recession, since it requires that the state refund tax revenues that have likely already been spent. Without NOL carrybacks, businesses may still reap the benefits of income averaging by claiming NOL carryforwards. Limiting carryforwards to a percentage of taxable income reflects the concept that even if a business isn’t profitable, it still benefits from public services like education and infrastructure and should thus be expected to pay some level of taxes. The new federal 80% limitation on NOL carryforwards ensures that corporations cannot use NOLs to entirely wipe out their tax liability in a given tax year. If California conforms to the new limits on NOL carrybacks and carryforwards, the state could bring in an additional $650 million annually in revenue.
Limitation on Losses for Non-Corporate Taxpayers
For taxpayers that have interests in so-called “pass-through businesses” such as S corporations, partnerships, limited liability companies, and sole proprietorships, the TCJA limits the federal deduction for business losses that can offset other income, such as salary and investment income. Prior to the TCJA, business losses could be used to reduce or even zero out federal tax liability, even for individuals with significant income from non-business sources. As with any tax deduction for individuals, higher-income taxpayers receive a larger tax benefit per dollar deducted because they are in higher tax brackets. Federal law now only allows taxpayers to deduct up to $250,000 in “excess business losses” (defined as the amount by which business-related deductions exceed business-related income). The threshold amount is $500,000 for married taxpayers filing joint returns. Any excess business losses above the threshold would have to be carried forward to offset income in future tax years as part of the taxpayer’s NOL. This limitation is scheduled to sunset after 2025 for federal tax purposes. FTB estimates that conforming to the excess business loss limitation would generate $850 million for California.
Revenue-Losing Conformity Provisions
The Governor also has indicated that he wants California to conform to two additional TCJA provisions that would result in state revenue losses – losses that would partially offset the increased revenues from the other conformity provisions. Specifically, the Governor is calling for “flexibility for small businesses,” which is likely a reference to the TCJA’s provision allowing more “small” businesses to use simplified accounting methods. Primarily, this provision increases the size threshold for small businesses that may use the cash method of accounting (rather than the accrual method) from $5 million in gross receipts to $25 million. Under the cash method, businesses recognize income when it is received and expenses when they are paid; under the accrual method, income and expenses are recognized when they are incurred. The cash method allows some businesses to defer taxes by recognizing more expenses in the current tax year and postponing income to the next year. As the Joint Committee on Taxation explains, the cash method is “administratively easy and provides the taxpayer flexibility in the timing of income recognition” while accrual methods “generally result in a more accurate measure of economic income.” Conforming to this provision would make filing taxes simpler for California businesses affected by the change in federal law, since it would be administratively burdensome to use different accounting methods for federal and state tax purposes. However, it would also reduce the revenue gains from enacting other conformity items by about $100 million (though this number would likely decrease over the next several years, consistent with the 10-year federal revenue estimates).
The Governor also proposes to conform — at least in part — to the new federal Opportunity Zone tax incentives, which allow individual and corporate investors to defer and reduce their capital gains taxes if they invest in economically distressed communities that meet certain federal criteria and have been designated by states as Opportunity Zones. The tax incentives are very generous to investors and come with few strings attached. Although the incentives may encourage increased investment in some underserved communities, there is also a risk that the subsidies may accelerate gentrification and displacement in some areas or be used for projects that have little benefit for current community residents. Conforming to these tax incentives would cost the state an estimated $37 million in the first year, rising to $70 million in the following year — but the long-term costs would be higher than suggested by the early year estimates since the tax incentives become more generous as Opportunity Zone investments are held longer. The Budget Center will explore these new incentives in more detail in future publications.
Beyond the items highlighted in the Governor’s budget, the TCJA contains some large new unnecessary federal tax breaks for businesses that would cost California significant revenue if the state were to adopt them. For instance, one set of provisions would repeal the federal corporate Alternative Minimum Tax (AMT) and temporarily allow corporations to claim a partially refundable tax credit for AMT paid in previous years. These provisions together would cost the state $300 million or more if adopted by California, according to FTB. Even more concerning is the new federal 20% deduction for pass-through business income, which would reduce state revenues by $2.6 billion per year if adopted. The pass-through deduction is as poorly designed as it is costly; an estimated three-fifths of the federal tax benefits will go to the richest 1%, and this tax break is vulnerable to myriad abuses by higher-income taxpayers. The Governor does not propose conforming to these poorly-conceived federal provisions, and the state should avoid adopting them as they would not enhance state tax fairness.
Looking Forward
Over the next several months, the Newsom Administration and the Legislature will need to carefully consider the various tax conformity options in terms of their effects on the state budget as well as the fairness and efficiency of the tax code. Adopting any provision that increases taxes on any state taxpayer will likely require a two-thirds vote in each house of the Legislature, which could be an uphill battle politically. Conforming to selected portions of the recent federal tax law offers policymakers an opportunity to raise revenues for new investments by limiting inefficient or unnecessary business tax breaks while resisting pressures to adopt new tax breaks that are not needed. Doing so would make California’s tax code fairer, offset some of the harmful and inequitable aspects of the TCJA, and make significant funding available to support state policy goals and invest in the low- and moderate-income Californians who have benefitted less from recent federal tax cuts.
In late 2017, President Trump signed the Tax Cuts and Jobs Act (TCJA) providing corporations substantial cuts in tax rates and other tax breaks. The TCJA means corporations will pay substantially less in federal taxes at a time when they already contribute far less of their California income in state taxes than they did a generation ago.
During the past three decades, the share of California corporate income paid in state taxes declined by more than half. In the early 1980s, corporations that reported profits in California paid more than 9.5% of this income in state corporate income taxes. In contrast, corporations paid just 4.4% of their California profits in income taxes in 2016, the most recent year for which data are available. California’s state budget would have received $10.9 billion more revenue in 2016 had corporations paid the same share of their income in taxes that year as they did in 1981. This amount is more than the state spends on the University of California, the California State University, and student aid combined.
The reduction of tax rates is one reason corporations pay less of their income in taxes today than they did in the 1980s. Since increasing the corporate tax rate to 9.6% in 1980, the state legislature has cut the rate twice: from 9.6% to 9.3% in 1987 and from 9.3% to 8.84%, its current level, in 1997.
In addition to cutting tax rates since the 1980s, lawmakers have enacted a number of corporate tax breaks that reduce the share of income that California corporations pay in state taxes. For example, beginning in 1987, California allowed multinational corporations to lower their tax liability by calculating their California income based on either their total income from worldwide operations or only from their operations within the US. This so-called “water’s edge” provision will cost the state an estimated $2.2 billion in 2018-19. In total, California is projected to spend $6.6 billion on tax expenditures for corporations in 2018-19, more than it will spend this year ($6.2 billion) on the state’s 115 community colleges.
At the national level, last year’s TCJA made several changes to federal tax law that will benefit corporations. The most significant change was slashing the federal corporate income tax rate from 35% to 21%, the largest one-time reduction to this tax rate in US history. Moreover, because the new federal tax law still includes many corporate tax breaks, including the ability to deduct state and local income taxes, the effective federal tax rate for corporations will often be lower than 21%. As a result, California corporations are likely to pay far less of their income in federal taxes beginning in 2018 than they have in recent years.
As the new Governor crafts a policy agenda that may require additional state resources, policymakers should consider the fact that corporations pay far less of their income in state taxes than they have in the past. And now that corporations are likely to pay less of their income in federal taxes as well, they can afford to contribute more to support the state’s public systems and supports. Increasing the state’s corporate income tax rate may be one way to boost revenue. However, policymakers have other options for increasing the amount corporations pay in state taxes. For example, they could review existing corporate tax rules, such as corporate tax credits, exemptions, and deductions, and reduce or eliminate those that are not achieving the state’s policy goals, including limiting state tax breaks in accordance with the new federal tax law. By reducing spending on corporate tax breaks, the state would have more resources available to invest in systems and programs such as higher education and workforce development that would not only help improve the lives of Californians, but also boost the state’s economy and produce an educated workforce that would benefit the state’s employers, including major corporations.
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California has two refundable income tax credits that boost the incomes of people who earn little from their jobs, helping them to afford necessities. These are:
The California Earned Income Tax Credit(CalEITC) – available to families and individuals with annual earnings under $30,000; and
The Young Child Tax Credit(YCTC) – available to CalEITC-eligible families with children under age 6.
These credits reduce the amount of state income tax California families and individuals owe based on how much they earn from work and how many qualifying children they live with. Since these credits are refundable, people who qualify for a credit that exceeds the amount of income tax they owe can receive the balance as a tax refund. This means that families and individuals who do not owe any state income tax can get the full credit that they qualify for as a refund.
Two federal refundable income tax credits are also available to families and individuals who earn little from work. These are:
The federal Earned Income Tax Credit (EITC), which is a refundable credit available to families and individuals with low or moderate earnings from work; and
The federal Child Tax Credit(CTC), which is a partially refundable credit available to families with children under age 17 who have low, moderate, or high earnings from work.
This updated interactive tool estimates how much people can expect to receive from all four of these credits in tax year 2019 based on their tax filing status, number of children, and annual earnings from work. The additional chart below the interactive shows on a smaller scale the two credits that individuals without children may qualify for – the federal EITC and CalEITC.
Tax filers, spouses, and qualifying children must have Social Security Numbers (SSNs) that are valid for employment in order to qualify for the CalEITC, California’s Young Child Tax Credit, and federal EITC. For the federal Child Tax Credit, qualifying children must have SSNs that are valid for employment, but tax filers and spouses are not subject to the SSN requirement.
In order to qualify for the federal EITC, tax filers who have no qualifying children must be 25 to 64 years old at the end of the tax year (or they must have a spouse who meets this age requirement and they must file a joint tax return). In contrast, California allows tax filers without qualifying children to qualify for the CalEITC if they (or their spouse) are age 18 or older.
The interactive shows credits for families with annual earnings up to $60,000. However, the federal CTC is available to families with incomes above $60,000. For example, people who have one qualifying child can qualify for this credit if they have incomes under $240,000 (if they file as head of household) or $440,000 (if they file as married filing jointly).
The Young Child Tax Credit provides the full $1,000 credit at the first $1 of annual earnings.
For certain families and individuals, the CalEITC, federal EITC, and federal Child Tax Credit are determined based on annual adjusted gross income rather than on annual earnings. For simplicity, this interactive tool and chart assume that a family’s or individual’s annual earnings equal their annual adjusted gross income.
The number of children specified in this interactive tool pertains to “qualifying children,” who must meet certain age, relationship, residency, and other requirements. For example, qualifying children for the CalEITC and federal EITC must be under age 18, while for the federal Child Tax Credit they must be under age 17, and for California’s Young Child Tax Credit they must be under age 6.
The size of the federal Child Tax Credit depends on the number of qualifying children and there is no limit on how many qualifying children can be claimed. For simplicity, this interactive only allows users to select up to three qualifying children.
“Married” refers to tax filers who file joint returns, while “single or head of household” refers to those who file as single, head of household, or qualifying widower. Tax filers whose filing status is “married, filing separately” are not eligible to claim the CalEITC, California’s Young Child Tax Credit, or the federal EITC.
The credits displayed by this interactive tool are rounded to the nearest dollar and may not sum to the total displayed due to rounding. In addition, the credit amounts are estimates and may not match the amounts that families and individuals actually receive. In particular, this tool estimates the state and federal credit amounts based on the exact amount of a family’s or individual’s annual earnings whereas the actual credit amounts people receive are based on the midpoint of $50 increments of earnings. For example, a family with $5,046 in earnings falls within the $5,000 to $5,050 earnings range and their credit amount is based on earnings of $5,025 — the midpoint of this range — rather than on the family’s exact earnings of $5,046.
For additional information about who qualifies for the CalEITC and Young Child Tax Credit, see this information by the Franchise Tax Board.
For additional information about who qualifies for the federal Child Tax Credit, see this information by the Internal Revenue Service.
For additional information about how the federal Child Tax Credit works, see Policy Basics: The Child Tax Credit by the Center on Budget and Policy Priorities.
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For Thrive, the Alliance for Nonprofits for San Mateo County’s “Tax Time Matters,” Senior Policy Analyst Sara Kimberlin presented on how the California Earned Income Tax Credit (CalEITC) boosts economic security for low-income workers and the Governor’s proposal to significantly expand the credit in the 2019-20 state budget.
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The Center on Budget and Policy Priorities’ annual conference, Impact 2018: Building Momentum for Equity and Opportunity, brought together members of the State Priorities Partnership (SPP), a network of independent, nonprofit research and policy organizations representing more than 40 states, and others interested in state policy. Executive Director Chris Hoene presented to the SPP Leadership Institute on the results of a strategic planning retreat he attended earlier this year and also introduced the conference’s closing plenary speaker, Professor Manuel Pastor of USC. Also, Steven Bliss, Director of Strategic Communications, presented “Using Digital Tools to Expand Reach and Engagement” for the workshop “Digital Advocacy 101.”
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The ongoing US trade war with China, initiated by the Trump Administration, shows little sign of ending soon. After months of escalating tit-for-tat tariffs, the US has now imposed tariffs on $263.1 billion of goods imported from China, and China has responded with retaliatory tariffs on $112.4 billion in goods exported from the US to China. President Trump has recently threatened to impose tariffs on all remaining Chinese imports — representing an estimated $257 billion in goods — by early December, if upcoming trade discussions are not successful. This action would likely trigger further tariffs from China on US goods and/or other retaliatory measures targeting US companies. Tariffs imposed in response to the Trump Administration’s actions are likely to affect businesses in every part of California, because China is a major export market for goods produced in every California congressional district (see maps and link to table below).
The US has legitimate concerns about unfair trade practices in China, including deliberately weak protection of intellectual property rights and restrictions on foreign investment and market access which disadvantage US companies. The US also imports far more goods from China than it exports to China, creating a bilateral trade deficit that is cited by President Trump as a key reason for trade actions against China, though economists disagree about the significance of this trade deficit. Many economists argue that trade deficits are not problematic, and that US consumers and businesses, and the overall US and global economies, benefit from global supply chains that allow countries to specialize in producing certain goods and global consumer markets that allow producers to sell their goods widely and consumers to access goods produced globally. Some economists, however, argue that the trade deficit with China is a problem because of evidence that the increased flow into the US of lower-cost manufactured goods imported from China has triggered a drop in the number and wages of US manufacturing jobs, limiting the job opportunities available to less-educated US workers and pushing a significant number of former manufacturing workers into lower-paying jobs or out of the labor force entirely. But economists on all sides of the debate about the core concerns about trade with China — from those who emphasize the need to protect jobs and wages for US workers or address the needs of workers and communities harmed by trade, to those who believe unfettered free trade promotes the best economic outcomes, to those who support open markets coupled with targeted protections — all oppose the untargeted, broad-based tariffs that the Trump Administration has imposed on China. They argue that these types of tariffs are an inappropriate and ineffective approach to addressing concerns about China’s unfair trade practices or the negative effects of trade with China, because they appear unlikely to lead to desired reforms in China or significantly more jobs in the US, while they cause US businesses and consumers to face higher prices as a result of both tariffs imposed by the US on Chinese goods and retaliatory tariffs imposed by China on US-produced goods.
As discussed in a prior Budget Center blog post, California companies and workers are likely to feel the effects of retaliatory tariffs imposed by China because China is a key export market for California businesses. This is true for businesses in all parts of California that export goods. In fact, as of 2016 China was one of the top five export destinations for goods produced in every one of California’s 53 congressional districts, with annual exports to China valued at more than $100 million in more than 90% of districts, according to figures produced by The Trade Partnership for the US-China Business Council, based on data from the US Census Bureau and US Department of Agriculture (see maps).
This means that the Trump Administration’s tit-for-tat tariff war with China, with no end in sight, can be expected to disrupt operations and revenues of businesses throughout California that produce agricultural, industrial, and manufactured goods for export — with cascading effects on jobs, business profits, and state and local tax revenues. California workers and businesses need a different federal approach to trade policy with China — one that addresses legitimate concerns about unfair competition and the negative effects of trade on workers and communities, without punishing US workers, companies, and consumers through direct and retaliatory tariffs that do not lead to meaningful trade reform.
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Much has been written about how the Tax Cuts and Jobs Act (TCJA), pushed by Republican leaders in Congress and signed into law by President Trump in December 2017, mostly benefits wealthy households while driving up the federal deficit by $1.9 trillion over the next 10 years. This growing deficit — already 17% higher in the federal fiscal year that ended on September 30 than in the previous year — threatens federal funding for critical investments and services that provide economic security and opportunity for low- and middle-income households.
Given that the benefits of the TCJA are grossly skewed toward the wealthiest taxpayers, it is no surprise that the new law also has disparate impacts across racial and ethnic groups, with white households — which already hold a disproportionate share of the nation’s wealth — reaping a disproportionate share of the tax cuts.
Income and Wealth Inequality Are Already Deeply Troubling
Before the TCJA was enacted, the nation’s income and wealth were shockingly unequal in their distribution, both by income group and race/ethnicity. In 2016, just the richest 1% of families received nearly one-quarter (23.8%) of the nation’s income, while the entire bottom 90% of families received less than half (49.7%), according to the Federal Reserve’s Survey of Consumer Finances. The distribution in California is almost identical, where the top 1% received 23.1% of the state’s income and the bottom 90% received 49.6%, according to the Franchise Tax Board.
The inequality in wealth distribution is even more striking. The nation’s wealthiest 1% owned nearly two-fifths (38.6%) of all the wealth in 2016, while the bottom 90% owned just 22.8%.
Decades of discrimination and barriers to economic opportunity for people of color has also led to stark disparities in income and wealth between white families and families of color. In 2016, white families had a median income of $61,200, while median incomes for Latinx and black families were $38,500 and $35,400, respectively. In other words, white families earned more than 1.5 times what Latinx and black families did. Here in California, median incomes are higher for all groups, but the differences between white families and families of color are quite similar to those at the national level. The median income for white families in the state was $100,407 in 2016, versus $57,447 for black families and $53,265 for Latinx families, according to data from the U.S. Census Bureau.
Wealth inequality between racial/ethnic groups is, again, far more startling than income inequality. White families had a median net worth of $171,000 in 2016, more than 8 times that of Latinx families ($20,700) and nearly 10 times that of black families ($17,600).
New Federal Tax Law Exacerbates Existing Racial Inequalities
Tax policies can mitigate economic inequality — or make it worse. Federal lawmakers last year chose the latter path by enacting the Tax Cuts and Jobs Act.
Overall, ITEP’s analysis found that nearly three-quarters (72%) of the tax cuts will go to the richest 20% of taxpayers in 2018, while only 28% of the tax cuts will go to the remaining 80%. The average tax cut for the top 1% of US taxpayers — a group with an average income of $1.8 million — will be nearly $48,000 this year. Meanwhile, households earning less than $23,000 will get an average annual tax cut of $90, equal to about 25 cents a day.
Here, too, the racial disparities are stark. White households, who are overrepresented in higher income groups, will get almost 80% of all the TCJA’s tax cuts this year, even though they make up 67% of all taxpayers. Conversely, black and Latinx households, who are overrepresented in lower income groups, will get a smaller share of the tax cuts than their share of the population of taxpayers (see chart).
In addition to getting a disproportionately small share of the tax cuts, black and Latinx households will also get a much smaller average tax cut than white households. Across all income groups, white households will receive $2,020 on average this year, more than twice as much as the average tax cut for black and Latinx households.
These racial disparities exist even among the highest-income households. Within the top 1% of all households, the average tax cut for white households is $52,400 — again, more than twice the average tax cut for black and Latinx households (see chart).
A major reason for the differences in the average tax cuts among racial groups in the top 1% is that even in this fortunate group, white households have more income from wealth, which the new tax law privileges over earnings from work. The TCJA included a massive cut to the corporate tax rate, as well as a new tax break for non-corporate business owners and a large scaling back of the estate tax. Thus, taxpayers who have large corporate stock holdings, investments in businesses, and valuable homes stand to benefit even more than high-income taxpayers who primarily have earnings from work. This further contributes to the uneven racial impacts of the tax law, as white households are significantly more likely than black and Latinx households to own stock, either directly or indirectly through retirement accounts, to own businesses, and to own their homes.
Beyond the immediate inequities of the TCJA, the resulting increase in the deficit is already being used by congressional leadership and President Trump as justification for cutting spending on federal programs that help improve the lives of lower-income families and individuals in California and across the country, which will disproportionately impact families of color. Such cuts will only serve to increase the existing inequality of opportunity between white families and people of color in the state and the nation.
State Lawmakers Can Work to Counteract Harmful Effects of the TCJA with Tax Policies That Narrow the Racial Wealth Gap
While California’s elected representatives in Washington can continue to call for reversals to provisions in the TCJA that increase economic inequality and that widen the racial wealth gap, California’s state leaders can take proactive steps toward reducing racial inequalities that are made worse by the TCJA. The California tax code is one of many areas where improvements can be made in pursuit of this goal.
For instance, one tool to reduce economic and racial inequality is to implement a state-level estate or inheritance tax. The TCJA drastically cut the federal estate tax by doubling the value up to which estates are exempt from the tax. Even before the TCJA, the federal estate tax only affected a very small number of large estates – 1,179 in California in 2017, according to the Internal Revenue Service. With the TCJA’s increased exemption amount, the number of estates subject to the tax is expected to fall by nearly two-thirds, leaving only 0.07% of estates taxable nationwide. California could enact an estate tax with an exemption level at or below the previous federal level of $5.49 million per person ($10.98 million for couples), which could reduce inequality in two ways. First, an estate tax serves as a curb on dynastic wealth, which well-off (and disproportionately white) families pass from generation to generation, ever widening the racial wealth gap. Second, the tax would provide a new source of revenue that could support more robust services that increase opportunities for low- and middle-income families of color. California voters would need to approve an estate or inheritance tax, since Proposition 6 of 1982 repealed the inheritance tax and prohibited the levying of any estate, inheritance, or wealth tax.
Another way the state tax code could be made more equitable is by reforming or eliminating tax deductions that primarily benefit wealthy homeowners, namely the deductions for mortgage interest and property taxes. White families are not only more likely to own homes, but to have more valuable homes: the average net housing wealth (home value less debts owed on the home) for white homeowners was $215,800 in 2016, compared to $129,800 for Latinx homeowners and $94,400 for black homeowners. Therefore, they benefit more from these deductions than do black and Latinx homeowners. In addition, because these tax breaks are structured as deductions, taxpayers with higher incomes and in higher tax brackets get a larger tax benefit per dollar deducted than taxpayers in lower brackets, intensifying the upside-down nature of these tax breaks. Eliminating or restructuring these tax benefits so they are more targeted to lower-income families would both increase state revenues for critical public services and lessen the tax code’s preference towards wealthier and disproportionately white homeowners.
While the options discussed above could reduce inequality by raising revenues from wealthy taxpayers, other tax provisions lessen inequality by boosting incomes for lower-income taxpayers. One effective example is the Earned Income Tax Credit (EITC). The federal EITC has been successful in reducing poverty, encouraging work, and can even improve the future earnings prospects of children in families receiving the credit. California enacted its own credit (the CalEITC) in 2015 and has since expanded it to reach more families. Lawmakers can build on the success of the CalEITC and further expand it to provide more support to California families that are struggling to make ends meet.
California lawmakers can also help lower-income families and people of color afford the costs of living by expanding the Child and Dependent Care Credit and the Renter’s Credit. Currently, both of these credits are non-refundable, meaning families can only claim the credit against any positive tax liability, so they cannot get a refund if the amount of the credit exceeds their tax liability. Unlike the CalEITC, which is refundable, these two credits provide more benefits to middle-income families than to low-income families. Making the credits refundable would provide another boost to families that are most in need of assistance.
In other words, state leaders and Californians have choices we can make, responding to and irrespective of the TCJA, to reduce the extent to which our state’s tax system exacerbates the racial wealth gap.
As a new Governor takes office, the new legislative session begins in January, and state lawmakers again consider proposals to respond to the new federal tax law, they should not overlook opportunities to reduce the longstanding inequities in the state’s tax code that contribute to the growing racial wealth gap.
Proposition 5, which will appear on the November 6, 2018 statewide ballot, would make significant changes to California’s local property tax system. Local property taxes provide resources that go to support a broad range of local services and systems across our state. Prop. 5 would expand special rules that allow certain property owners to lower their property taxes. The reduced property tax revenue under Prop. 5 over time would result in losses of approximately $1 billion annually for cities, counties, and special districts and similar reductions in state funding available for public services and supports in most years, other than for K-14 education (K-12 schools and community colleges). In addition, Prop. 5 would reduce local funding for some K-14 districts. The ultimate effect of Prop. 5 would be to expand tax breaks for older, wealthier California homeowners at the expense of other homeowners, including those who are younger and less affluent. Prop. 5 is sponsored by the California Association of Realtors and supported by the Howard Jarvis Taxpayers Association. This Issue Brief provides an overview of the measure; discusses what it would mean for homeowners, housing supply and affordability, and funding for public services; and examines other policy issues the measure raises in order to help voters reach an informed decision.
What Would Proposition 5 Do?
Prop. 5 would amend both the state Constitution and state law to expand special rules for assessing certain property values that are the basis for calculating property taxes. Property taxes support services provided by local governments, such as cities, counties, special districts, and school districts. When local governments levy taxes on property owners, these taxes equal the taxable value of the property multiplied by a property tax rate. Prop. 13, approved by California voters in 1978, capped property tax rates at 1%, with limited exceptions, and replaced the practice of reassessing the taxable value of property each year at fair market value (what the property could sell for) with a system based on cost at acquisition (what the owner paid for the property).[1] Under Prop. 13, increases in the taxable value of property are limited to an annual inflation factor of no more than 2%, and property is only assessed at market value for tax purposes when it changes ownership.
In the 40 years since Prop. 13 passed, California voters have approved several ballot measures that apply special property tax rules (some of which are described in the following section) to certain types of property owners. Beginning on January 1, 2019, Prop. 5 would expand several of these special rules and apply them to:
Homes purchased or constructed by existing California homeowners who are age 55 or older or who are severely disabled.
Any property purchased or constructed to replace property substantially damaged or destroyed by a disaster.[2]
Any property purchased or constructed to replace “qualified contaminated property,” such as property that is no longer habitable or usable due to the presence of toxic or hazardous materials.[3]
Proposition 5 Would Expand Special Rules for Certain Homeowners
Currently, special rules allow California homeowners who are age 55 or older or who are severely disabled to transfer the taxable value of a home they sell to a new home within the same county, provided that the market value of the new home is the same or less than the market value of the home they sold.[4] California counties also may allow older or disabled homeowners to transfer the taxable value of homes sold in a different county to a home purchased in their county. Currently, 11 counties accept these inter-county transfers.[5] Older homeowners who transfer the taxable value of existing property to new homes purchased within or across counties may only do so once in their lifetime.[6] In most cases, these special rules mean that homeowners age 55 or older who purchase a new home pay less in property taxes than a younger person would pay for the same home, because its market value is often greater than the taxable value of the home sold by the older homeowner.
Prop. 5 would expand the special rules for California homeowners who are age 55 or older or who are severely disabled. Specifically, Prop. 5 would allow these homeowners to:
Purchase or construct a new home that is more expensive than the home they sell, but pay property taxes that are tied to the taxable value of the old home.
Purchase or construct a new home that is less expensive than the home they sell and reduce the taxable value of the new home below the taxable value of the old home.
Transfer the taxable property value under Prop. 5’s special rules anywhere in the state, regardless of whether the county where the new home is located currently allows such transfers.
Transfer the taxable property value under Prop. 5’s special rules to new homes an unlimited number of times, rather than just once per lifetime as under current law.
Proposition 5 Would Expand Special Rules for Any Owner of Contaminated Property or Property Destroyed by a Disaster
Under current law, special rules allow any owner of contaminated property or any owner of property that is substantially damaged or destroyed by a disaster to transfer its taxable value to a replacement property — regardless of whether this property is acquired or newly constructed — within the same county based on certain conditions. Owners of contaminated property may transfer its taxable value to a replacement property if the market value of the replacement property is the same or less than the market value of the contaminated property, assuming the property had not been contaminated.[7] Owners of property destroyed by a disaster may transfer its taxable value to a replacement property assuming the replacement property is comparable in size, utility, and function to the property it replaces and does not exceed 120% of the market value of the replaced property in its pre-damaged condition.[8]
Prop. 5 would expand the special rules for owners of contaminated property or property that is substantially damaged or destroyed by a disaster. Specifically, Prop. 5 would allow owners of contaminated property to purchase or build replacement property that is more expensive than the contaminated property, but pay property taxes that are tied to the taxable value of the contaminated property. Prop. 5 also would expand the special rules for owners of property destroyed by a disaster and allow them to transfer the taxable value of the destroyed property to any replacement property regardless of its size or value. Prop. 5 also would allow the assessment of the value of contaminated or destroyed property under its special rules to be transferred anywhere in the state regardless of whether the county where the new property is located allows such transfers from other counties.
Proposition 5 Would Provide Additional Tax Breaks for Eligible Properties
Prop. 5 would establish two formulas to calculate the taxable value of an eligible property. (As previously described, an eligible property is a new home purchased by an older or disabled homeowner or a property that replaces a contaminated property or property destroyed in a disaster.) Both formulas would tie the taxable value of an eligible property to the owner’s prior property.
The property tax formulas established by Prop. 5 would be based on three factors: the prior property’s market value (the price it sold for), the eligible property’s market value (what it was purchased for), and the prior property’s taxable value. One formula would apply when the market value of the eligible property is greater than the prior property, and the other formula would apply when the market value of the eligible property is less than the prior property.
Prop. 5 Would Establish a Formula That Reduces the Taxable Value of an Eligible Property if It Is More Expensive Than the Prior Property
If an eligible property is more expensive than the prior property, the taxable value of the eligible property would equal the difference between the eligible property’s market value and the prior property’s market value, added to the taxable value of the prior property.
Prop. 5 Would Establish a Formula That Reduces the Taxable Value of an Eligible Property Below the Taxable Value of the Prior Property if the Eligible Property Is Less Expensive Than the Prior Property
If an eligible property is less expensive than the prior property, the taxable value of the eligible property would equal the market value of the eligible property divided by the market value of the prior property, multiplied by the taxable value of the prior property.
What Would Proposition 5 Mean for Homeowners?
Proposition 5 Would Expand Tax Advantages for Older Homeowners
Under current law, special rules provide a tax break to California homeowners who are age 55 or older by allowing them to transfer the taxable value of a home they sell to a new home they purchase, but only if the market value of the new home is the same or less than the market value of the home they sold.[9] These rules usually provide a tax advantage for older homeowners, who pay less in property taxes than a younger person would pay for the same home. This is because the market value of the home that is purchased by the older homeowner is often much greater than the taxable value of the home that is sold.
Prop. 5 would expand this annual tax break in two ways. Prop. 5 would:
Increase the annual tax break for older homeowners who purchase homes that are worth the same or less than the market value of the home they sold. Under current law, an older Californian who sells a home that has a taxable value of $200,000 and purchases a new home for $450,000 pays $2,000 in property taxes ($200,000 x 1%) annually as long as the prior home sold for more than $450,000.[10] In comparison, people under the age of 55 would pay $4,500 in property taxes ($450,000 x 1%) annually for the same home. Prop. 5 would establish a new formula that would actually increase this $2,500 annual tax advantage for older homeowners. For example, under the new formula, an older Californian who sells a $500,000 home that has a taxable value of $200,000 and purchases a new home for $450,000 would pay $1,800 in property taxes annually, increasing the tax break under current law by $200 annually (see Figure 1).
Allow older homeowners to purchase a new home that is more expensive than the home they sell and tie the property taxes for the new home to the taxable value of the old home. For example, an older Californian who sells a $1.4 million home with a taxable value of $200,000 and purchases a new home for $1.5 million would only pay $3,000 in property taxes annually, a $12,000 tax advantage compared to someone under the age of 55 who would pay $15,000 in property taxes annually ($1,500,000 x 1%) for the same home (see Figure 2). In other words, in this example, the older homeowner could purchase a home with a value more than seven times larger than the taxable value of the current home, with only a relatively modest increase in property taxes.
The expansion of these tax breaks under Prop. 5 would provide even more substantial benefits to older homeowners who already, under current law, receive preferential treatment that allows them to pay far less in annual property taxes than younger homeowners.
Figure 1
Figure 2
Proposition 5’s Annual Tax Breaks Would Increase as the Market Value of a Prior Home Increases
Whether older homeowners purchase property that is more or less expensive than the market value of their prior home, the tax break provided by Prop. 5 would increase as the market value of the prior property increases. Using the prior example, under Prop. 5 an older Californian who sells a home that has a taxable value of $200,000 and purchases a new home for $450,000 would pay $1,800 in property taxes annually if they sold their prior home for $500,000. However, if the same homeowner sold their prior home for $1.4 million, they would pay less than $650 in property taxes annually (see Figure 1). Similarly, under Prop. 5, an older Californian who sells a $500,000 home with a taxable value of $200,000 and purchases a new home for $1.5 million would pay $12,000 in property taxes annually, whereas if the same homeowner sold their prior home for $1.4 million, they would pay $3,000 in property taxes annually (see Figure 2). As a result, Prop. 5 would most benefit Californians who have seen substantial increases in their home values, such as people from areas of the state where home values have increased rapidly relative to other areas and those who have owned their properties for longer periods of time.
Proposition 5 Would Provide Larger Tax Breaks for Older, Wealthier Californians Who Can Afford More Expensive Homes
The tax breaks Prop. 5 proposes for California homeowners who are age 55 or older would be larger for newly purchased homes that are more expensive than prior homes than they would be for newly purchased homes that are less expensive than prior homes. For example, under Prop. 5 an older Californian who sells a home with a market value of $500,000 and a taxable value of $200,000, and then purchases a new home for $450,000 would receive an annual tax break of $200 compared to current law (see Figure 1). By contrast, the annual tax break would be far larger — $3,000 — if the same Californian purchased a new home for $1.5 million (see Figure 2). As a result, Prop. 5 would provide larger tax breaks to wealthier Californians who are able to afford more expensive homes.
Proposition 5 Disadvantages Younger, Less Wealthy Homeowners
As noted in the sections above, Prop. 5 would expand tax advantages for older homeowners, allowing them to pay less in annual property taxes for a newly purchased home than younger homeowners would pay for the same home. These new tax advantages would be larger for older homeowners whose prior home has experienced the most substantial gains in value prior to being sold. The annual tax advantages would be larger for older, wealthier homeowners able to purchase more expensive homes. Prop. 5 also would remove limits on how many times eligible homeowners can transfer the taxable value of their home. In other words, eligible homeowners could carry forward the tax break to all future home purchases.
Younger, less wealthy homeowners, would also be adversely affected by a potential increase in home prices that could result from Prop. 5.[11] This is because the tax advantage provided to older, wealthier homeowners means that they would have more annual resources at their disposal to use in negotiating the purchase price of new homes. Using the earlier example, an older Californian who sells a $1.4 million home with a taxable value of $200,000 and purchases a new home for $1.5 million would pay only $3,000 in property taxes annually. Someone under the age of 55 would pay $15,000 in property taxes each year — a $12,000 annual tax advantage for the older homeowner. That annual tax advantage would likely be used in negotiating the purchase price of new homes, particularly in highly competitive housing markets, and could result in an increase in housing prices.
Prop. 5 would also reduce local property tax capacity, as noted in the section below on local government implications. As a result, local governments would necessarily rely more heavily upon younger and less wealthy homeowners to pay for local services, including the costs of infrastructure financed through local government general obligation bonds that are also tied to local property values.[12]
Characteristics of Eligible Homeowners Under Proposition 5
Homeowners who would be eligible for the special property tax rules under Prop. 5 include people age 55 or older as well as those with severe disabilities.[13] Of these two major eligible groups, older homeowner households make up by far the largest share. Statewide, about 4.1 million older or disabled homeowner households would be eligible under Prop. 5, of which 4.0 million are age-eligible (97.4%) and roughly 100,000 are eligible due to disability only (2.6%), according to a Budget Center analysis.[14]
In fact, a majority of California’s 7.0 million homeowner households (59.6%) would meet Prop. 5’s eligibility criteria. In a given year, however, only a small fraction of these eligible homeowners would be expected to sell their homes, buy new homes within California, and claim the new property tax reductions that would be allowed under Prop. 5.[15]
Homeowner households that would be eligible for special property tax rules proposed by Prop. 5 are relatively advantaged. Their median household income of $77,000 is 14.9% greater than the overall statewide median household income ($67,000). Moreover, eligible homeowner households headed by someone who is younger than the traditional retirement age — those with household heads under age 65 — have a median household income of nearly $100,000 ($98,900), meaning that about half have annual incomes greater than $100,000. These relatively high incomes translate into relatively low poverty rates, as well. While about 1 in 5 heads of household in California overall (19.0%) are in poverty based on the California Poverty Measure (CPM) — an improved poverty measure that accounts for housing costs — only about 1 in 9 homeowner household heads eligible under Prop. 5 (11.8%) are in poverty under the same measure.[16] In terms of sources of income, about 1 in 7 eligible homeowner households (15.0%) receive more than $15,000 in annual investment income. Moreover, only 11.6% of Prop. 5-eligible households depend on fixed retirement or disability payments from Social Security and/or Supplemental Security Income (SSI) for more than three-quarters of their total household income.
The characteristics of Prop. 5-eligible homeowner households contrast sharply with those of older renter households in California, who are much less economically secure. Renter households headed by individuals age 55 or older have a median income of only $32,900, roughly half the overall statewide median household income. Older renter households also have a much higher poverty rate, with 1 in 3 (33.3%) older renter household heads living in poverty based on the CPM (see Figure 3). They are much more likely to rely on fixed Social Security or SSI payments than Prop. 5-eligible homeowners, with more than 1 in 4 older renter households (27.3%) relying on Social Security and/or SSI for more than three-quarters of their household income, including 43.7% of renters with a head of household age 65 or older.
Figure 3
In terms of race and ethnicity, the homeowners eligible under Prop. 5 are primarily white. Nearly two-thirds (64.0%) of eligible household heads are white (and not Latino). In contrast, less than half of all California households (48.3%) are headed by someone who is non-Latino white, while the majority (51.7%) are headed by a person of color. Older renter households are largely similar to California households overall in terms of race and ethnicity.
The advantaged position of Prop. 5-eligible households is perhaps clearest, however, when examining their wealth in the form of the value of their homes. Most are long-term homeowners who have had the opportunity to accrue significant home equity as California’s housing prices have grown over time. About half of eligible homeowner households have lived in their homes for at least 20 years, during which time the median price of a single-family home in California has increased by 280%, or 1.8 times the rate of inflation, according to a Budget Center analysis of home price data from the California Association of Realtors. More than a quarter of eligible households (26.1%) have lived in their homes for at least 30 years.
In terms of the value of their homes, about half of eligible homeowner households (47.7%) own homes worth a half-million dollars or more. About 1 in 7 (13.9%) own homes worth $1,000,000 or more. Furthermore, nearly 4 in 10 eligible homeowners (38.8%) own their homes free and clear, with no mortgage, so that they stand to receive the full appreciated value of their homes if they sell. The typical home values of eligible homeowners vary by region, but home values are relatively high in the top two regions with the largest number of eligible homeowners: Los Angeles and the South Coast, and the San Francisco Bay Area (see Table 1).
Table 1
Because so many of the homeowners eligible under Prop. 5 have lived in their homes for many years, their property taxes tend to be significantly lower than the property taxes paid by younger homeowners who would not be eligible for special property tax rules under Prop. 5. This is because Prop. 13 (1978) caps the allowed increase in annual property taxes at a rate that is typically lower than the annual increase in a home’s market value, as described above. As a result, in 2016 the older and disabled homeowner households who would be eligible under Prop. 5 paid median property taxes of $2,950, equal to only about three-quarters of the median taxes paid by younger homeowners ($4,050).
In summary, taken as a whole the older and disabled homeowner households who would be eligible for special property tax rules under Prop. 5 have higher incomes and lower poverty rates than California households overall, and much higher incomes and lower poverty rates than older renter households. Prop. 5-eligible households are also more likely to be headed by white individuals and much less likely to be headed by people of color than California households overall. Most are long-term homeowners, and nearly half own homes worth a half-million dollars or more. At the same time, their current typical property tax payments are significantly lower than the typical property taxes paid by younger homeowners, who would not be eligible for the special tax advantages provided by Prop. 5.
Though Prop. 5-eligible homeowners as a group are relatively well-off economically, there are some older and disabled homeowners, and homeowners affected by unexpected disasters, with low fixed incomes who would be unable to pay higher property taxes out of their existing incomes if they moved. As a result, they may feel “stuck in place” in homes that are larger than they need or not as close to family or other supports as they would prefer. However, many of these homeowners could likely take advantage of existing special property tax rules for older and disabled homeowners and find suitable new homes of equal or lesser market value within the county where they currently live, or within one of the counties that allows for inter-county transfer of existing property taxes for older and disabled homeowners under current law (as described above). As a result, they could meet their housing needs without the new tax advantages that would be created by Prop. 5. Moreover, many of these homeowners have built up significant home equity over time, and could reasonably afford to pay higher property taxes by withdrawing some of their equity when selling their homes and using some of those funds each year to cover the cost of higher property taxes for their new homes.
For the small number of older, disabled, and disaster-affected homeowners who are truly “stuck in place” — those with low fixed incomes and limited home equity who cannot find a suitable new home where they can carry over their current property tax amounts within the geographic limits allowed by current law — more narrowly targeted policies could be developed that would help these homeowners specifically. Better targeted policy approaches, such as tax credits for homeowners who meet specific income and asset limits as well as criteria related to age, disability, and/or disaster, would allow for more efficient use of limited public resources, and would be preferable to Prop. 5, which offers tax breaks to many homeowners who do not need public financial assistance, at the expense of local and state government budgets and the key services they support. Alternatively, if the policy goal is to address the housing needs of older Californians with low or fixed incomes, focusing on older renter households would make much more sense than focusing on older homeowners, since older California renters, as a group, face much greater economic insecurity.
How Would Proposition 5 Affect Housing Mobility, Supply, and Affordability?
Many parts of California face a range of housing affordability challenges, including a lack of supply to meet the demand for housing, higher housing prices resulting from increased competition for available housing, and a lack of housing mobility because people are less able to afford changing homes and/or are unable to find available housing. How would extending tax breaks to older homeowners affect these forces?
As noted earlier, Prop. 5 could lead to an increase in home prices. [17] The annual tax advantage for older homeowners would likely be used in negotiating the purchase price of new homes. Because Prop. 5 changes existing law to allow older homeowners to base their property tax bill for a more expensive newly purchased home on their prior home, the effect on home prices might be particularly notable for already higher-priced markets. In addition, as noted earlier, the tax advantages from Prop. 5 will largely accrue to wealthier, older homeowners who can already afford to move.
In terms of housing supply and mobility, the Legislative Analyst’s Office (LAO) projects that the number of potential movers as a result of Prop. 5 could increase by “a few tens of thousands” and that there could be some effect on home building.[18] But, the potential impact would be small relative to the total number of homeowners in California and the demand for housing. California has 7 million homeowner households and the state Department of Housing and Community Development estimates that California needs 1.8 million new homes to meet demand by 2025.[19] If some increase in home building results from increased demand from Prop. 5-eligible homeowners, this additional supply would simply be meeting a corresponding increase in demand that is also due to Prop. 5 — in other words, Prop. 5 would do little to address the state’s current shortage of housing. In short, Prop. 5’s effects on housing supply and mobility would be marginal, and largely accrue to a set of homeowners in California who can already afford to move.
What Would Proposition 5 Mean for Public Services?
Proposition 5 Would Reduce Funding for Local Governments
Prop. 5 would reduce funding for local governments including cities, counties, and school districts. This is because the measure would reduce the taxes paid from people who would have moved anyway. The LAO notes that, at current, about 85,000 homeowners who are 55 and older move to different homes each year without receiving the tax break provided by Prop. 5, resulting in these homeowners paying higher property taxes.[20] Prop. 5 would reduce their property taxes and, therefore, reduce property tax revenue available to local governments. Prop. 5’s tax break would result in more people moving, with the number of movers increasing by “a few tens of thousands,” and could also have some effect on home prices and home building that would lead to more property tax revenue.[21] Since Prop. 5 would increase home sales it would also affect local property transfer taxes collected by cities and counties, likely in the tens of millions of dollars per year. The LAO analysis finds that the potential revenue losses from people who would have moved anyway are larger than the gains from higher home prices and home building. As a result, property tax revenues available to local governments would be reduced. In the first few years, the losses would be over $100 million per year for local governments and over $100 million per year for school districts, growing to approximately $1 billion annually for both over time.[22]
Reductions in local property tax revenue caused by Prop. 5 would decrease the amount of funding available for an array of local government services including schools, police, fire services, housing, infrastructure, and human services. The reduction in local property tax revenues would also lower local governments’ bonding capacity — the ability to issue bonds to finance local infrastructure projects.
What Would Proposition 5 Mean for Total K-14 Education Funding?
Prop. 5 would reduce the amount of annual property tax revenue available to K-12 school and community college districts by about $1 billion over time, according to the LAO.[23] In most years, however, the total amount of dollars provided to K-14 education statewide would not be affected by this reduction in local property tax revenue, due to provisions in California’s Constitution — added by Prop. 98 in 1988 — that guarantee K-14 education a minimum level of funding each year.
Under the Prop. 98 guarantee, two revenue sources together fulfill the state’s funding requirement for K-14 education: local property tax revenue and state General Fund dollars.[24] In most years, property tax revenue represents the first dollars applied toward meeting the Prop. 98 minimum guarantee, and the state’s General Fund fills the gap between the property tax revenue and the minimum funding level.[25] In such years, reductions to local property taxes under Prop. 5 would not affect the total amount of K-14 education funding statewide. This is because any reduction in property taxes would be offset by a corresponding increase in the amount of state General Fund dollars used to fulfill the Prop. 98 guarantee. In these years, the fiscal effects of extending property tax advantages to older homeowners under Prop. 5 would come at the expense of other vital state services that are supported with state General Fund dollars.
In certain other years, however, total K-14 education funding declines dollar for dollar with any reduction in property tax revenue. In these years, an alternative provision of Prop. 98 (known as “Test 1”) requires the state to provide K-12 schools and community colleges with a specific percentage of total General Fund revenue regardless of the amount of local property taxes that K-14 districts receive.[26] As a result, to the extent that Prop. 5 reduces local property tax revenue in Test 1 years, the total Prop. 98 funding level for K-14 education would fall because the state would not be required to spend General Fund dollars to make up the difference. Moreover, any reduction to local property tax revenue in a Test 1 year could affect calculations of the Prop. 98 guarantee in future years because the base for calculating the guarantee in most years is the prior-year Prop. 98 funding level.
Proposition 5 Would Reduce Funding for Some K-12 School and Community College Districts
While Prop. 5 would reduce local property taxes for K-14 education statewide, total annual revenue for most individual districts would not change. This is due to the difference between formulas in the state Constitution that determine the annual Prop. 98 funding guarantee for K-14 education and other formulas in state law that determine the amount of dollars allocated to individual K-12 school and community college districts. Annual revenue for a large majority of the state’s individual K-14 districts comes from a combination of sources that include local property taxes and the state budget. For these districts, reductions in local property taxes are backfilled by the state.[27] As a result, most California K-14 districts would not experience a change in their total revenue if Prop. 5 reduces the amount they receive from local property taxes.
In contrast, reductions in local property taxes under Prop. 5 would decrease funding for a small but significant share of K-12 and community college districts. Roughly 10% of California’s K-14 districts receive local property tax revenue beyond the amount of funding to which they are entitled based on formulas in state law.[28] The state does not backfill reductions in local property tax revenue for these so-called “excess tax” districts.[29] As a result, any decline in local property taxes caused by Prop. 5 would mean a dollar-for-dollar reduction in funding for K-12 school and community college “excess tax” districts.
What Would Proposition 5 Mean for the State Budget?
Prop. 5 would increase state spending to support K-14 education and, in turn, reduce the amount of General Fund dollars available for other state budget priorities. Over time, the LAO estimates that the measure would cause annual state spending for K-14 districts to increase by about $1 billion, though without raising the total amount of funds available to schools and community colleges.[30] This is because, as described above, Prop. 5 would reduce the amount of property tax revenue received by K-14 districts, which in most years would require the state General Fund to backfill the local property tax shortfall dollar-for-dollar up to the total funding level required by the Prop. 98 funding guarantee.[31] In these years, reductions in local property tax revenue caused by Prop. 5 would reduce funding available for programs other than K-14 education, such as health care, housing, human services, and higher education.
What Do Proponents Argue?
Proponents of Prop. 5, which is sponsored by the California Association of Realtors, include the Howard Jarvis Taxpayers Association, Californians for Disability Rights, Inc., and the California Senior Advocates League. Proponents argue that the measure “gives all seniors (55+) and severely disabled the right to move without penalty” and “empowers retirees living on fixed incomes.”[32] They state that “Prop. 5 helps Californians who want the opportunity to move,” “does not take funding away from public schools,” and “does not take funding away from public safety.”[33]
What Do Opponents Argue?
Opponents of Prop. 5 include the California State Association of Counties, Middle Class Taxpayers Association, National Housing Law Project, California Alliance for Retired Americans, and the League of Women Voters of California. Opponents argue that Prop. 5 will “further raise the cost of housing,” and “lead to hundreds of millions of dollars and potentially $1 billion in local revenue losses” and that it “gives a huge tax break to wealthy Californians.”[34] Opponents state that “Prop. 5 does nothing to help most low-income seniors but does help corporate real estate interests who are funding it.”[35]
Conclusion
Prop. 5 would make changes to California’s local property tax system by significantly expanding tax breaks for certain property owners. These tax breaks would provide advantages to older, wealthier homeowners at the expense of younger, less affluent homeowners and would do little to address the state’s current housing shortage. Voters should weigh Prop. 5’s tax breaks against annual revenue losses that would reduce funding available for local services and state programs. Prop. 5 would reduce annual funding for local governments by $1 billion over time, dollars that would no longer be available to support an array of local services including schools, police, fire services, housing, infrastructure, and human services. Another important consideration is the measure’s impact on the state budget. Prop. 5 in most years would reduce funding available to the state by $1 billion over time for key programs such as health care, housing, human services, and higher education.
[2] A property is considered substantially damaged or destroyed if the physical damage it sustains is more than 50% of its value immediately before the disaster. California Constitution, Article XIIIA, Section 2(f)(1).
[5] The 11 counties that allow inter-county transfers are Alameda, El Dorado, Los Angeles, Orange, Riverside, San Bernardino, San Diego, San Mateo, Santa Clara, Tuolumne, and Ventura. However, El Dorado County repealed its acceptance of inter-county transfers effective November 7, 2018.
[6] SB 1692 (Petris, Chapter 897 of 1996) created one exception to this one-time limit by allowing homeowners age 55 or older who transfer the taxable value of existing property to a new home to do so twice in a lifetime if they subsequently become disabled.
[7] California counties also may allow owners of contaminated property to transfer their taxable value from another county to a property that is acquired or newly constructed in their county.
[8] Property owners can still transfer the assessed value of a damaged or destroyed property to a replacement property that is greater than 120% of the market value of the destroyed property, but any amount over the 120% threshold is assessed at the full market value and added to the taxable value of the destroyed property.
[9] As noted above, these rules apply to homes purchased in the same county and in 11 California counties that allow older homeowners to transfer the taxable value of homes sold in a different county to a home purchased in their county.
[10] The taxable value of property typically increases each year based on an inflation adjustment that Prop. 13 limits to no more than 2% annually. This Issue Brief does not include annual inflation adjustments in calculations of annual property taxes in order to simplify the discussion.
[11] Legislative Analyst’s Office, “Proposition 5. Changes Requirements for Certain Property Owners to Transfer Their Property Tax Base to Replacement Property. Initiative Constitutional Amendment and Statute. Analysis by the Legislative Analyst,” in Secretary of State’s Office, California General Election Tuesday November 6, 2018: Official Voter Information Guide, p. 37.
[13] As noted earlier, owners of property that has been substantially damaged or destroyed by disaster or contamination would also be eligible for the special property tax rules under Prop. 5. However, these owners would likely make up a very small share of the total number of eligible property owners. For example, the 2017 Tubbs Fire in Napa and Sonoma counties — the most destructive in California history as of August 2018 — destroyed 5,636 structures, a tiny number compared to the 4.0 million households estimated to be eligible under Prop. 5 due to the age of the homeowner.
[14] Unless otherwise indicated, all statistics in this section are from a Budget Center analysis of US Census Bureau, American Community Survey data for 2016.
[15] The Legislative Analyst’s Office (LAO) notes that about 85,000 homeowners age 55 or older currently move to different homes each year without receiving a tax break, and estimates that the number moving might increase by “a few tens of thousands” if Prop. 5 were to pass. See Legislative Analyst’s Office, “Proposition 5. Changes Requirements for Certain Property Owners to Transfer Their Property Tax Base to Replacement Property. Initiative Constitutional Amendment and Statute. Analysis by the Legislative Analyst,” in Secretary of State’s Office, California General Election Tuesday November 6, 2018: Official Voter Information Guide, pp. 36-37.
[16] The California Poverty Measure (CPM) is a state-specific measure of poverty modeled on the US Census Bureau’s Supplemental Poverty Measure. The CPM provides a more accurate measure of economic hardship than the official federal poverty measure and is particularly appropriate to measure poverty for this analysis, because it accounts for local differences in the cost of housing and differences in housing costs across renters, homeowners with mortgages, and homeowners without mortgages, among other improvements. See https://inequality.stanford.edu/publications/research-reports/california-poverty-measure.
[17] Legislative Analyst’s Office, “Proposition 5. Changes Requirements for Certain Property Owners to Transfer Their Property Tax Base to Replacement Property. Initiative Constitutional Amendment and Statute. Analysis by the Legislative Analyst,” in Secretary of State’s Office, California General Election Tuesday November 6, 2018: Official Voter Information Guide, p. 37.
[18] Legislative Analyst’s Office, “Proposition 5. Changes Requirements for Certain Property Owners to Transfer Their Property Tax Base to Replacement Property. Initiative Constitutional Amendment and Statute. Analysis by the Legislative Analyst,” in Secretary of State’s Office, California General Election Tuesday November 6, 2018: Official Voter Information Guide, p. 37.
[20] Legislative Analyst’s Office, “Proposition 5. Changes Requirements for Certain Property Owners to Transfer Their Property Tax Base to Replacement Property. Initiative Constitutional Amendment and Statute. Analysis by the Legislative Analyst,” in Secretary of State’s Office, California General Election Tuesday November 6, 2018: Official Voter Information Guide, p. 36.
[21] Legislative Analyst’s Office, “Proposition 5. Changes Requirements for Certain Property Owners to Transfer Their Property Tax Base to Replacement Property. Initiative Constitutional Amendment and Statute. Analysis by the Legislative Analyst,” in Secretary of State’s Office, California General Election Tuesday November 6, 2018: Official Voter Information Guide, p. 37.
[22] The LAO’s long-term estimates reflect inflation-adjusted figures. Legislative Analyst’s Office, “Proposition 5. Changes Requirements for Certain Property Owners to Transfer Their Property Tax Base to Replacement Property. Initiative Constitutional Amendment and Statute. Analysis by the Legislative Analyst,” in Secretary of State’s Office, California General Election Tuesday November 6, 2018: Official Voter Information Guide, p. 36.
[23] The LAO’s estimate reflects annual property tax losses adjusted for inflation. See Legislative Analyst’s Office, “Proposition 5. Changes Requirements for Certain Property Owners to Transfer Their Property Tax Base to Replacement Property. Initiative Constitutional Amendment and Statute. Analysis by the Legislative Analyst,” in Secretary of State’s Office, California General Election Tuesday November 6, 2018: Official Voter Information Guide, p. 37.
[24] Prop. 98 states that K-14 education is guaranteed an annual funding level that is the greater of a fixed percentage of state General Fund revenues (Test 1) or the amount that K-12 schools and community colleges received in the prior year, adjusted for enrollment and changes in the state’s economy (Test 2 and Test 3). For an explanation of the Prop. 98 guarantee, see California Budget & Policy Center, School Finance in California and the Proposition 98 Guarantee(April 2006).
[25] In Test 2 and Test 3 years, the state is required to provide General Fund dollars equal to the funding level guaranteed under Prop. 98 less local property tax revenue provided to K-12 schools and community colleges.
[26] Test 1 has been operative five times since the Prop. 98 guarantee was established in 1988-89 and ties the minimum funding level for K-14 education to a percentage of General Fund revenue, which has ranged from 35% to 41%. For a description of the history of Prop. 98, see Legislative Analyst’s Office, A Historical Review of Proposition 98 (January 2017).
[27] Under current formulas in state law, reductions in local property taxes for individual K-14 districts are backfilled by the state even in Prop. 98 Test 1 years when reductions in overall statewide local property tax revenue cause the Prop. 98 guarantee to fall.
[28] In 2017-18, so-called “excess tax” districts, excluding county offices of education, comprised 10.6% of K-12 school districts and 9.7% of community college districts.
[29] Similarly, any boost to the amount of property taxes that “excess tax” districts receive results in a dollar-for-dollar increase in their total funding.
[30] The LAO’s estimate reflects annual state spending for K-14 education adjusted for inflation. See Legislative Analyst’s Office, “Proposition 5. Changes Requirements for Certain Property Owners to Transfer Their Property Tax Base to Replacement Property. Initiative Constitutional Amendment and Statute. Analysis by the Legislative Analyst,” in Secretary of State’s Office, California General Election Tuesday November 6, 2018: Official Voter Information Guide, p. 37.
[31] As noted above, in Prop. 98 Test 2 and Test 3 years the state is required to provide General Fund dollars equal to the funding level guaranteed under Prop. 98 less local property tax revenue provided to K-12 schools and community colleges.
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