Saturday, October 4, 2008

Fiscal implications of Jarvis II, part 2

The Rodda Project: The battle against Proposition 9 (1980)

The background to Senator Rodda's paper

The attempt to follow up the success of Proposition 13 ran into a snag with Proposition 9. Ballot initiatives in California are not required to meet any particular standards of clarity or specificity. The drafters of Proposition 9 neglected to contain any language relating to its effective date. Some suggested that its adoption by the voters in the June 1980 primary election would cut personal income taxes in half for the entire calendar year, retroactively effective back to January. With the state budget due to take effect on July 1, the state could conceivably find its revenue base cut out from under it with only weeks to drastically overhaul that state spending plan.

The Legislature contained a number of so-called “Proposition 13 babies,” freshman assemblymen and senators elected in the wake of the passage of Proposition 13 in 1978. Several of them were eager to ride the tax-cutting bandwagon further. Other conservative legislators, some of whom had opposed Proposition 13 as too extreme, sought to outflank their junior colleagues and atone for their tardiness in embracing the tax-revolt movement. They seized on the ambiguities in Proposition 9 as opportunities to soft-pedal the impact of the initiative and make it appear less draconian. Legislative measures were introduced to stipulate the effective date of the proposition, if enacted by the voters, and to specify the initiative's impact on personal income tax brackets. These bills would have the effect of mitigating the initial impact of Proposition 9, postponing its biggest shockwave till the next year.

Senator Rodda's initial analysis of Proposition 9, Fiscal Implications of Jarvis II, was published on January 15, 1980. It was snatched up as a vital resource by the opponents of Proposition 9. However, Rodda's paper was criticized by the initiative's proponents because it did not address the mitigating legislation being sponsored by Proposition 9 supporters. Rodda recognized this as a legitimate point and hastened to address it. Only three months after his first analysis, the Senator released a 34-page supplement. That supplement provides the content of this article.


Supplement to January 15 Paper on Fiscal Implications of Jarvis II or Proposition #9 as Viewed from the Perspective of a Practical Politician

Part I: Possible Responses to Proposition #9: Three Scenarios

Part II: Impact of Campbell Legislation to Repeal Retroactive Implementation

Part III: Impact of Imbrecht Legislation to Apply 1978 Tax Brackets to Indexing of Personal Income Tax and to Repeal Retroactive Implementation of Proposition #9

Calculations and Interpretation by Senator Albert S. Rodda


The material in this Supplementary Paper is designed to clarify the issues which relate to Proposition #9 and to indicate the impact upon state financing of changes in current law and different estimates of the magnitude of the state's revenues and one-time surplus. Three Scenarios are discussed and projections for Fiscal Years 1980-81 and 1981-82 are made. Totally accurate projections, of course, are impossible; however, if the assumptions are realistic, such forecasts have the ability to indicate the general direction in which trends are developing. That is what these calculations are designed to accomplish: to provide the reader with more than a vague apprehension of the fiscal future for the State of California if it must function after its major source of General Fund Revenues, the Personal Income Tax, is significantly reduced in 1980-81 and succeeding years by Proposition #9. The Personal Income Tax now provides about 35% of the state's General Fund Revenues; Proposition #9 will reduce the future level of support from that source, since the state will receive only 47% of the amount it now receives from the Personal Income Tax. If predictions are accurate, the Personal Income Tax will provide, therefore, only about 19% of the state's General Fund Revenues after Proposition #9 and the fiscal impact upon the state will be very significant. Of particular importance to California will be the fiscal impact upon school funding. The first negative effect will be experienced in the loss of state funding for school facility construction and maintenance because of the transfer of the Tideland Oil Revenues to the General Fund. A second implication will be an almost certain reduction in the level of state funds for allocation to local government in the form of Proposition #13 “bail-out” money, approximately 74% of which is paid to the schools, Kindergarten through the Community Colleges. A third implication will be the possibility of a significant reduction in the state's General Fund apportionment to the School Fund and in State Budget expenditures to finance categorical aid programs.

The standard dictionary definition of the verb “mitigate” is: “To make less harsh, severe, or painful.”

The proponents of Proposition #9, including Mr. Jarvis, are seeking to “mitigate” or make less “painful” the fiscal impact of Proposition #9. The mitigation is to be achieved by raising the Personal Income Tax rates for tax year 1980, and thereafter, above the level provided by Proposition #9.

Under “Minimum Mitigation,” the tax increase will be zero.

Under “Moderate Mitigation,” the tax increase will equal $1.4 billion for Fiscal Year 1980-81.

Under “Maximum Mitigation,” the tax increase will equal $2.0 billion in Fiscal Year 1980-81 and about $600 million each year thereafter.

Part I: Potential Responses to Proposition #9: Three Scenarios

Those who are interested in the fiscal implications of Proposition #9 upon the state and local government, including the schools, should realize that there are several ways of interpreting the effect of Proposition #9. In my original paper, dated January IS, 1980, and the two supplementary analyses which followed, three different sets of assumptions were used. As a consequence, the first-year impact, Fiscal Year 1980-81, is calculated as producing three different outcomes with respect to the state's revenue loss. I have classified them, therefore, on the basis of their net effect on the State Budget for that year as producing:
  1. Minimum Mitigation (Scenario I)
  2. Moderate Mitigation (Scenario II)
  3. Maximum Mitigation (Scenario III)
When the fiscal implications resulting from the three sets of assumptions and fiscal data are projected into the second year, the results or effects are very similar and indicate that the impact of Proposition #9 will significantly impair the ability of the state to fund its fiscal obligations to state, local government, and the schools. Unfortunately, the proponents of Proposition #9 are ignoring Fiscal Year 1981-82, and thereafter, and are claiming that the opponents are employing scare tactics in their opposition to Proposition #9, and that the fiscal effects will be less serious than claimed. They then present an analysis or interpretation of the effect of Proposition #9 for Fiscal Year 1980-81 which is predicated upon assumptions reflected in either Scenario II, labelled Moderate Mitigation, or Scenario III, labelled Maximum Mitigation. In each instance, they assume that current law relating to the Personal Income Tax will be changed prior to the election on June 3rd and that the state's surplus will be considerably larger than was estimated in the early part of the year.

In my Jarvis II paper, written in January, 1980, I made no specific dollar calculations with reference to the effect of Proposition #9 after taking into consideration those variables relating to General Fund Revenue projections, increases in the Tideland Oil Revenues, or the magnitude of the Year-End Surplus. I merely stated that the state was confronted with a potential deficit for Fiscal Year 1980-81 of approximately a billion dollars, had a one-time surplus in June 1980 of $1.8 billion and would lose $4.9 billion in revenue during Fiscal Year 1980-81 if Proposition #9 were approved. I also commented that the Tideland Oil Revenues would be employed to offset future revenue losses from Proposition #9. If the available data had been used to estimate the first-year revenue loss, the conclusion would have been that the net Short-Fall or deficit would amount to approximately $4.5 billion: current revenues of $19.3 billion, plus the one-time surplus of $1.8 billion, minus the $4.9 billion Proposition #9 effect, equals a total revenue, ongoing and one-time, of $16.2 billion. If this is subtracted from the January 10, 1980, Budget of $20.7 billion and the Tideland Oil Revenues in the amount of $400 million are transferred to the General Fund, the Short-Fall will amount to $4.5 billion if $400 million is added to the state's Federal Revenue balance and these funds are maintained as a state Prudent Reserve in the amount of $550 million.

Since the analysis reflects the January 1980 state revenue estimates and surplus, it is no longer meaningful. A more current and responsible analysis produces what I classify as Scenario I, or Minimum Mitigation of the first-year effect of Proposition #9, and it is predicated upon certain assumptions with respect to the implementation of Proposition #9 and a moderate estimate of the increase in the state1s revenues and magnitude of the one-time surplus.

Scenario I — Minimum Mitigation

Assumptions: Current law remains unchanged and Proposition #9 is interpreted as becoming effective on January 1, 1980, and full indexing remains in effect as provided under existing law. The one-time surplus is estimated at $1.8 billion and the unanticipated state revenue increase is calculated to be $600 million, reflecting a 3% error in the January estimate. The Tideland Oil Revenues are estimated to be $500 million and that sum is transferred to the General Fund. The state1s current Federal Revenue Sharing money is calculated to be $150 million and a total of $400 million is added to that balance in order to create a responsible Prudent Reserve of $550 million. If the State Budget is reduced by the $400 million identified in the Duffy Report as a reserve for “economic uncertainties,” the Budget in 1980-81 will be $20.4 billion; however, a minimum of $400 million must be added to that amount to reflect the Tideland Oil Revenues to be allocated under the provisions of SB 1426 for the capital outlay needs of public education, Kindergarten through the University, and for the establishment of an Energy and Resources fund. When these proposed state expenditures are taken into consideration, the state's expenditures subject to reduction in 1980-81, after Proposition #9, will amount to $20.7 billion.

The first-year effect, utilizing these assumptions, is that the state's next year net deficit, or Revenue Short-fall, will amount to $3.8 billion after, of course, establishment of a Prudent Reserve of $550 million.

1980-81 Revenues = $16.9 billion, and Revenue Short-fall = $3.8 billion. When projected into 1981-82, Revenues = $18.8 billion, and the Revenue Short-fall = $4.0 billion, assuming a 13% revenue increase and a Budget increase of 10% over 1980.

Two other calculations, which are predicated upon different assumptions, I classify as Moderate Mitigation and Maximum Mitigation.

Scenario II — Moderate Mitigation

Assumptions: The Campbell legislation to change current law in order to make Proposition #9 effective in June, 1980, and to establish Personal Income Tax rates equal to 71% of the 1978 rates for the 1980 Tax Year, is enacted into law. It is further assumed that the state's revenues exceed the original estimate in the amount of $600 million, that the Tideland Oil Revenues are approximately $500 million, and that the federal Revenue Sharing Reserve is $150 million. The first-year effect, utilizing those assumptions, is that the state's net deficit will amount to $2.4 billion. This calculation is based upon the assumption that the state's expenditure reduction of $400 million through deletion of the appropriation identified in the Duffy Report as a reserve for “economic uncertainties” is offset by the planned $400 million expenditure for the capital outlay needs of public education and for the establishment of an Energy and Resources fund.

Fiscal Year 1980-81 Revenues = $18.3 billion, and the Revenue Short-fall = $2.4 billion. When projected into 1981-82, Revenues = $18.8 billion, and the Revenue Short-fall = $4.0 billion, assuming a 13% revenue increase and a 1980 Budget increase of 10%, and a decline in Personal Income Tax income in 1981-82 of approximately 53.5%.

Scenario III — Maximum Mitigation

Assumptions: The Imbrecht legislation is enacted into law and changes the effective date of Proposition #9 to January 1980, as provided in the Campbell legislation, and applies in 1980-81 the full indexing of the Personal Income Tax to the 1978 tax brackets and has the effect, therefore, of increasing the tax payments for this year and the future over the payments which would be made if the current indexing brackets remained in effect. The effect of these two changes in law will be to cause a significant one-year reduction of the state's revenue loss for fiscal Year 1980-81 from Proposition #9, which otherwise would occur in the magnitude of approximately $2.0 billion, and a modest ongoing reduction in the amount of $500 million. In addition, it is assumed that the state's unanticipated revenue increase for next year will be $700 million, that the State Budget contains a $400 million one-time reserve for “economic uncertainties” and that the Tideland Oil Revenues will increase by $400 million. If the Budget is reduced by the $400 million, the reserve for “economic uncertainties,” it will be $20.14 billion, but that will be offset by the $400 million to be allocated under SB 1426 for the capital outlay needs in public education and the establishment of an Energy and Resources fund. If all of the revenue sources are utilized except $400 million, which are added to the federal Revenue Sharing balance of $150 million in order to establish a Prudent Reserve of $550 million, the revenue loss because of Proposition #9 will be significantly reduced.

The first-year effect of Proposition #9, based upon these assumptions, is calculated to be in the amount of a Short-fall in 1980-81 of $1.8 billion, assuming a Prudent Reserve of $550 million is established.

Fiscal Year 1980-81 Revenues = $18.9 billion, and the Revenue Short-fall = $1.8 billion after the elimination from the Budget of the reserve for “economic uncertainties” and an augmentation by an equivalent amount, $400 million, for public education capital outlay needs and the establishment of an Energy and Resources fund. It is, also, assumed that $400 million is allocated from the state's revenues for the creation of a Prudent Reserve of $550 million, of which $150 million is federal Revenue Sharing money. When projected into 1981-82, Revenues = $19.3 billion, and the Revenue Short-fall = $3.5 billion, assuming a 13% increase in the state's revenues and a 1981-82 Budget increase of 10% over the previous year.


Scenario II — Moderate Mitigation seems to be most likely to occur. If that proves correct, the state's estimated Revenue Short-Fall for 1980-81 will be $2.5 billion, assuming a Prudent Reserve, and $4.0 billion in 1981-82.

The two-year average Revenue Short-Fall will be approximately 15% of what could have been budgeted had Proposition #9 not been approved, or approximately 12% in 1980-81 and 18% in 1981-82. It is interesting to note that in Fiscal Year 1979-80, the current year, the state's General Fund expenditures are $18.7 billion. Assuming that Moderate Mitigation occurs, state expenditures will be $18.2 billion in 1980-81, and in 1981-82 they will be $18.8 billion.

In Fiscal Year 1981-82, the state will have a Budget approximately equal to that in Fiscal Year 1979-80, the current year, after two years of unusual inflation.


An alternative analysis predicated upon a projection of the state's revenues for 1980-81, after reduction of the revenue loss from Proposition #9, at a rate of increase equal to 11%1, produces very similar fiscal results with respect to fiscal Year 1981-82 State Revenues and the Budget Short-fall for that year. In the alternative analysis, the assumption is made that the retroactive implementation of Proposition #9 to January 1, 1980, is repealed and that there is no change in the current tax brackets for indexing the Personal Income Tax.

After the revenue calculation which reflects these assumptions is made and the $600 million in Tideland Oil Revenues are added to the state's revenues, the resultant total can be regarded as the General fund Revenues available for expenditure in 1981-82.

Under both the Minimum Mitigation and the Moderate Mitigation Scenarios, given these assumptions, the Revenues = $18.9 billion, and the Budget Short-fall = $3.9 billion.

Under the Maximum Mitigation Scenario, the assumption of which is that the Imbrecht legislation is enacted, the Revenues = $19.5 billion, and the Budget Short-fall = $3.3 billion.

Part II: Impact of Campbell Legislation to Make Proposition #9 effective in June, 1980, rather than in January, 1980

Evidently, Howard Jarvis is apprehensive about the first-year revenue loss estimated to result from voter approval of Proposition #9. That estimated loss is $4.9 billion, or approximately 25% of the state's projected revenues for Fiscal Year 1980-81. Because of his apprehension and because he claims that he did not intend the amendment to become effective as of January 1, 1980, which is a mandate of existing tax law2, Mr. Jarvis is supporting a bill, SB 1464, authored by Senator William Campbell, which will (1) make the amendment effective on June 4th upon its certification of voter approval by the Secretary of State, and (2) provide a 1980 Calendar Year tax rate of approximately 71% of the 1978 tax rate, rather than the 50% required by the specific language in the Jarvis Initiative.

It has been suggested that such action may be of questionable constitutionality; however, it has widespread political support despite the fact that it will increase the 1980 tax rates above the level to be established by Proposition #9, and there is reason to believe that it may become law and its constitutionality upheld.3

If the Campbell legislation is enacted and the tax rate for the Calendar Year 1980 is increased from 50% to approximately 71% of the 1978 rates, the potential $4.9 billion revenue loss in Fiscal Year 1980-81 from Proposition #9 will decline to an estimated $3.5 billion.

The important factor, of course, is that, although this will provide a reduction in the first-year estimated revenue loss because of Proposition #9 from $4.9 billion to $3.5 billion, it will not affect future years. In the years following, the state's revenue loss will be of a magnitude to reflect approximately a 53.5% reduction in the state's Personal Income Tax, a loss calculated in 1981-82 to be approximately $4.2 billion, which will increase in fiscal years thereafter.

The projected state resources for June of 1980 have increased slightly over the estimate which was made in January. The margin of error in the estimate has been calculated to be in the neighborhood of 2% to 4% of the January projection.4 I have concluded that an error in the amount of 3% is responsible and an error of that magnitude will result in revenue receipts of $600 million over the estimate.

Assuming that the Year-End Surplus is increased by that amount, the surplus money available to offset the revenue loss because of Proposition #9 will amount to $2.4 billion and not the $1.8 billion surplus as previously estimated. Furthermore, additional revenues in the amount of approximately $500 million above that anticipated in the Governor's Budget may be transferred to the General Fund as a result of the decontrol of heavy oil prices.5 Since the state normally maintains a Prudent Reserve as security against a decline in its revenues because of adverse economic conditions, it may be assumed that $400 million of the surplus will be used for that purpose and that it will be augmented by the state's Federal Revenue Sharing money, approximately $150 million, which would establish the reserve at a level of $550 million.6

On the basis of these assumptions, one can make some interesting projections about the magnitude of the revenue and expenditure reductions in Fiscal Years 1980-81 and 1981-82 which will result because of voter approval of Proposition #9.

The state's revenues for Fiscal Year 1980-81 were estimated in January to be $19.3 billion. If it is assumed that the state's General Fund Revenues are reduced by an estimated $3.5 billion, to reflect the first-year implementation of Proposition #9, presuming the Campbell legislation is enacted, the state's revenues will decline to the level of $15.8 billion. If the one-time or Year-End Surplus is added to that revenue estimate in the amount of $1.8 billion and if it is further augmented by $600 million from increased state revenues, the General Fund dollars available to fund the 1980-81 Budget will be in the amount of $18.3 billion. That will consist of the state's ongoing revenues after Proposition #9, the Tideland Oil Revenue increase, and all of the one-time surplus, with the exception of the Prudent Reserve in the amount of $550 million.7

The State Budget, however, assuming no augmentations are approved by the Legislature prior to voter approval of Proposition #9, will be in the amount of $20.75 billion. The Duffy Report identifies a $400 million reserve for “economic uncertainties” in the 1980-81 Budget, and if that is deleted, the Budget will be $20.33 billion. It is important to realize, however, that administration-sponsored legislation, SB 1426, to utilize a portion of the increase in Tideland Oil Revenues to establish an Energy and Resources Fund and to finance school construction and maintenance for all segments of education, Kindergarten through the University, will establish the level of support at an annual amount of about $400 million. This expenditure, of course, is not included in the Budget as introduced, and since it is planned to finance those needs with the Tideland Oil Revenue increase which will be transferred to the General Fund as an offset to the Proposition #9 revenue loss, the state will be deprived of the fiscal ability to proceed in the financing of these very urgent needs; it is reasonable, therefore, to include that amount, $400 million, as an ongoing state expenditure. It will offset the $400 million reduction in the Budget which was achieved through the elimination of the reserve for “economic uncertainties”; thus, the state's expenditure level appropriate for calculating the Proposition #9 Short-Fall should be established at the $20.7 billion level provided in the Budget when introduced in January.

If the voters approve Proposition #9, the Budget for 1980-81 will have to be reevaluated and placed upon the Governor's desk in an amount not to exceed the state's projected revenues of $18.3 billion; it will have to be reduced, therefore, in the amount of $2.4 billion, or approximately 12% of the original Budget expenditure.

Projection for 1981-82

In order to determine the impact of Proposition #9 on Fiscal Year 1981-82, an assumption may be made that the state's 1981-82 revenue base will reflect an increase of 13% over the previous fiscal year.8 This increase is equal to a three-year average percentage increase, 1978-79, 1979-80, and 1980-81, and the last year, however, 1980-81, is only an estimate of the increase over 1979-80. It might be argued that the percentage of increase should be estimated at a lower rate because of the fact that full indexing of the Personal Income Tax will be in effect and because Proposition #9 will result in an annual loss of 53.5% of the state's Personal Income Tax, which in 1980-81 was estimated to account for 35.7% of General Fund Revenues.9 The loss of revenues from those two changes in the Personal Income Tax will significantly affect the total revenues that the state can expect to receive, not only in 1980-81, but in 1981-82 and each fiscal year thereafter. That loss will reduce the state's revenue elasticity, or the tendency for revenues to increase at a rate greater than the increase in the state's Gross National Product. A 13% estimated increase in revenues, therefore, considering the impact of indexing and the 50% reduction in Personal Income Tax rates amounts to what I think is a responsible figure.

The assumption is made that the estimated 1980-81 state revenues in the amount of $19.3 billion are augmented by the $600 million increase in state revenues over the $19.3 billion estimate. As a consequence, the revenues are $19.9 billion and that amount is adjusted to reflect a 13% rate of increase for 1981-82.

Based upon those data, the state's total revenues in 1981-82 would, under the current tax rate or voter rejection of Proposition #9, amount to $22.5 billion. This may be increased by its augmentation of $600 million in Tideland Oil Revenues.10 The total revenues would be $23.1 billion and these revenues would constitute the only source of funding available to the state in Fiscal Year 1981-82 since there will be no “carry-over surplus,” all of it having been exhausted in Fiscal Year 1980-81 as an offset to Proposition 9.11

The 1981-82 Budget may be assumed to increase at a rate of 10% over that of 1980-81: $20.75 billion plus $2.07 billion. The amount, therefore, will equal $22.8 billion.

The Personal Income Tax currently is producing about 35.7% of the state's General Fund; therefore, assuming that Proposition #9 is approved, the loss in revenue from that source will amount to 53% of 35.7%, or 19% of the state's General Fund. Such a percentage of the state's tax base would amount to a $4.3 billion reduction in the revenues which would have been collected absent approval of Proposition #9. Deducting that revenue loss from the estimated $23.1 billion of the state's total revenue, the result is $23.1 billion minus $4.3 billion, or $18.8 billion, and that will be the General Fund revenue base for Fiscal Year 1981-82, or $100 million more than is being spent in Fiscal Year 1979-80, the current year. The Short-Fall will be $4.0 billion, or a Budget of $22.8 billion minus revenues of $18.8 billion.

Interestingly, the result is the same for the Minimum Mitigation Scenario if a 1981-82 projection is made, since the basic assumptions are the same and since the Campbell legislation is effective only in the first year and has no impact upon the second year, 1981-82, or succeeding year revenues.


The critical factors affecting the state's fiscal situation if Proposition #9 is approved are:
  1. There is no huge, $1.8 billion, one-time surplus remaining after Fiscal Year 1980-81, only a Prudent Reserve of $550 million, the maintenance of which is essential to sound fiscal management and the protection of the state's fiscal solvency.
  2. Since the State Budget must not exceed estimated revenue projections for any fiscal year, future revenues will determine the level of state expenditures, unless, of course, a one-time surplus develops, or if Proposition #4 mandates a spending level below revenues.
  3. Personal Income Tax Revenues, as a consequence of Proposition #9, will decline by approximately 53.4% and will contribute about 18.6% of the General Fund Revenues instead of the 35.7% as estimated in the Budget for 1980-81. This estimate is for Fiscal Year 1981-82.
The state has two basic options: (1) imposing the reduction in expenditures totally upon state allocations and subvention to schools and local government, particularly county health and welfare allocations; or (2) distributing the state's revenue loss in such a manner as to reduce total government expenditures in California—state, cities, counties, special education, and the schools.

To accomplish the above result, the state will have to enact a number of changes in current law:
  1. Modify the deflator mechanism in AB 8.
  2. Reduce the amount of school property taxes transferred to other segments of local government as provided in AB 8.
  3. Reduce the amount of tax relief allocated to local government because of the homeowner exemption, the business inventory buy-out, the Williamson Land Conservation Act and revenues raised by the cigarette tax and transferred to local government.
In any event, substantive changes in the present state response to Proposition #13 will result and government will experience a decline in its level of support.

The fiscal impact of Proposition #9, assuming (I) the Campbell legislation is enacted, (2) the state's revenues are $600 million above the January estimate of $19.3 billion, and (3) the Tideland Oil Revenue increase in the magnitude of about $500 million is transferred to the General Fund, is calculated as follows:
  1. Fiscal Year 1980-81 estimated Budget reduction of about 12%, or $2.4 billion if a Prudent Reserve of $550 million is maintained.
  2. Fiscal Year 1981-82 estimated Budget reduction of about 18% from the normal State Budget for that year, or approximately $4.0 billion.
  3. Two-year revenue loss of $6.4 billion, assuming a Prudent Reserve is maintained of $550 million.
State level of General Fund expenditures will be as follows:

1979-80 $18.7 billion

1980-81 $18.3 billion (assuming a Prudent Reserve of $550 million)

1981-82 $18.8 billion (assuming a Prudent Reserve of $550 million)

Obviously, drastic Budget reductions will have to be made over the two-year period.

It is now recognized that the state's economy may experience a decline beginning in the third quarter, July to September. If this occurs, the state revenues may decline in Fiscal Year 1980-81. That could easily exhaust the Prudent Surplus. If the result were greater than the magnitude of the surplus $550 million, the effect in 1981-82 would be more serious than the 1981-82 revenue loss of $4.0 billion. It could rise to $4.5 to $4.8 billion, depending upon the magnitude of the economic slowdown; a 5% reduction in state revenues could produce a net $800 to $900 million revenue loss.

Furthermore, if inflation continues at a high rate into 1980-82, the 10% Budget increase may be inadequate. If it were increased by 2%, to 12%, the normal Budget would increase by about $500 million in 1981-82, which would increase the revenue deficiency that Proposition #9 would produce in that year.

Part III: Impact of Imbrecht Legislation re Indexing of Personal Income Tax and Implementation of Proposition on January 1, 1980

The Vice Chairman of the Assembly Ways and Means Committee, Assemblyman Gordon Duffy, has published a very scholarly paper on the impact of Proposition #9.

It presents a number of options for estimating the first- year effect of Proposition #9 if approved by the voters on June 3. This is an analysis of that impact based upon three assumptions which will most significantly reduce the first-year (1980-81) revenue loss resulting from Proposition #9.

The assumptions are:
  1. A very liberal estimate of the state's surplus at the end of Fiscal Year 1979-80.
  2. Enactment of legislation to repeal the retroactive provisions of current tax law which relate to the implementation of Proposition #9, SB 1464, Campbell, and AB 3020, Imbrecht.
  3. Enactment of AB 3020, Imbrecht, to implement Personal Income Tax indexing in Tax Year 1980, as required by the Bergeson Act, AB 276, 1979 Session, but at the tax brackets in effect for Tax Year 1978.
The total fiscal effect of a very liberal estimate of state revenues and a Personal Income Tax increase in Tax Year 1980, which are the essential elements of these assumptions, would be significantly to reduce the state's revenue loss from proposition #9 in Fiscal Year 1980-81. The effect will be substantively to mitigate, therefore, the negative impact of Proposition #9 during the first year of its implementation. In the second and succeeding years, however, the state's Revenue Short-Fall will become quite large and, unfortunately, the second-year, or 1981-82, impact of Proposition #9 is being ignored by the proponents of Proposition #9, and it was not addressed in the Assembly Ways and Means Committee Report.

The general consensus is that, predicated upon the above-mentioned assumptions, the first-year (1980-81) effect will be to reduce the projected state revenue loss, as a consequence of voter approval of Proposition #9, from an estimated amount of $4.9 billion, if the state's revenue increase and its one-time surplus are disregarded, to a level of $1.8 billion. Since the legislative change to reduce the Revenue Short-fall from Proposition #9 will be effective only for one year, fiscal Year 1980-81, and since the state's 1980-81 Year-End Surplus will be exhausted, the state will experience in Fiscal Year 1981-82 to a much greater degree the adverse fiscal effects of Proposition #9. As a consequence, the state's revenues for that year, 1981-82, and thereafter, will decline significantly from the level which normally would accrue to the General fund, and this could prove of critical importance to the state. The following calculations indicate the basis for that revenue projection.

If the state's estimated 1980-81 General Fund Revenues of $19.3 billion are increased by $700 million, the revenue increase which the Duffy Report indicates to have occurred over the original January 1980 projection, the state's General Fund Revenues will equal $20.0 billion. If a transfer of Tideland Oil Revenues to the General Fund in the amount of $500 million is made, the total revenues available to the state will attain a level of $20.5 billion for Fiscal Year 1980-81. If from that amount the $3.0 billion tax reduction which is estimated to result from Proposition #9 is deducted12, after enactment of the Imbrecht legislation, the state’s available revenues will amount to $17.5 billion. If that revenue base is augmented for 1980-81 by the addition to it of the estimated $1.8 billion, one-time Year-End Surplus for Fiscal Year 1979-80, the state will have a total revenue source to fund the State Budget in 1980-81 in the magnitude of $19.3 billion. If $400 million is added to the $150 million Federal Revenue Sharing Reserve, the state will have a Prudent Reserve of $550 million and a revenue source of $18.9 billion. State expenditures, as provided in the Budget as introduced on January 10, 1980, will amount to $20.7 billion, and if the assumption is made that that amount is reduced by $400 million, the amount budgeted for “economic uncertainties,” the Budget will amount to $20.3 billion. Since that reduction will be offset by the $400 million to be allocated from Tideland Oil Revenues for the creation of an Energy and Resources Fund and for public education capital outlay under the provisions of SB 1426, the Budget must be reduced by $1.8 billion, assuming the maintenance of the $550 million Prudent Reserve, and by $1.4 billion if only the $150 million in Federal Revenue Sharing is retained as a State Budget Reserve.

Projections for 1981-82

In making an estimate of the state's revenues for the next year, 1981-82, I utilized the estimated General Fund Revenues of $19.3 billion for Fiscal Year 1980-81 as a base and increased that amount by the addition of the unanticipated revenue increase of $700 million. The result is an ongoing revenue base of $20.0 billion for Fiscal Year 1980-81. By adjusting that amount for a 13% increase, which is 1% less than the average rate of increase for the last two years, the total revenues available to the state for General Fund expenditures for 1981-82 can be expected to attain a total of $22.6 billion, and if $600 mil1'ion from the Tideland Oil Revenues is added to that amount, the General Fund Revenues will be $23.2 billion.

That $23.2 billion in revenues available for 1981-82 must be reduced, however, if Proposition #9 is approved, since the Personal Income Tax rates will be established at 50% of the 1978 rates. That reduction can be estimated through a calculation of the personal Income Tax loss. In 1980-81, the Personal Income Tax Revenues produced approximately 35.7% of the General Fund income; if that percentage were to continue into 1981-82, the Personal Income Tax could be expected to generate $8.3 billion of the state's $23.2 billion in revenues for that year. Because of the effect of Proposition #9, however, that revenue estimate must be reduced and the reduction will be in the amount of $4.39 billion, or 53% of the Personal Income Tax which otherwise would be collected.13 If that amount is deducted from the estimated revenues of $23.2 billion, the General Fund income source will decline to $18.8 billion in Fiscal Year 1981-82. Since the Imbrecht legislation will increase state Personal Income Taxes because of its reversion to the 1978 tax brackets, an additional $400 million should be added to that amount for a total revenue base of $19.2 billion. In addition to this revenue, however, the state will possess as a carry-over the Prudent Reserve of $550 million established in the previous year, 1980-81.

For the purpose of further analysis, one may assume that the Budget for 1980-81, as introduced, is not increased by 13%, the percentage increase applied to the state's revenue, but by only 10%. That would constitute a very responsible level of increase and will produce an hypothetical level of state expenditures for the 1981-82 Budget Year equal to $22.8 billion. In addition, of course, there will be available the previous year's Prudent Reserve of $550 million, apart of which is the $150 million in Federal Revenue Sharing money.

Since expenditure reductions will have to be made, because the amount of the state's General Fund Revenues will determine the amount the state may spend, the Budget may not exceed $19.2 billion, which is $3.6 billion below the “normal” expenditure level.


In the 1979-80 Budget, the one now in effect, the expenditure level for General Fund purposes is $18.7 billion. On the basis of my estimate of the “Imbrecht effect,” or the Maximum Mitigation of the first-year revenue loss from Proposition #9, the estimated state expenditures which may be incurred in 1980-81 will be $18.9 billion. On the basis of the calculations which I have explained and which are also predicated on the “most favorable” assumption, the state may project an expenditure level for Fiscal Year 1981-82 of approximately $19.2 billion. In effect, after three years of severe inflation, the state may spend in 1981-82 approximately $500 million more than was budgeted in Fiscal Year 1979-80, the current year.

The deflator mechanism will be implemented, as provided in AB 8, in Fiscal Year 1980-81 since that must occur if the state's fiscal resources, both ongoing revenues and the Year-End Surplus, are estimated to be $100 million less than $20.5 billion. When that takes place and if no reductions in the state's Budget are implemented, and if the deflator mechanism is applied pursuant to current law, 50% of the reduction must be experienced by the schools for a total state revenue loss of approximately $900 million in 1980-81. An equal amount would also be withheld from state allocations to other segments of local government. As a consequence, the bail-out, which began in 1978 at $4.3 billion, would be reduced in 1980-81 from a level of $5.3 billion to considerably less, or about $3.9 billion, an amount below that provided in 1978-79 in SB 154.

The impact will be so dramatic that the deflator will have to be rewritten. Of course, those expenditures which relate exclusively to state services could be reduced and that action would mitigate the impact of the deflator mechanism upon the schools and other segments of local government; but even if that were done, the revenue loss to local government would still be substantive.

Furthermore, in the following year, 1981-82, the state's fiscal situation will be even more tenuous, and there is no question that very significant and controversial decisions will have to be made in the determination of the appropriate expenditure reductions, state and local. It will not be as simple a challenge as was that in 1978, when the state responded to the implications of Proposition #13 in SB 154.

1The Legislative Analyst's Budget Analysis for 1980-81 indicates that state revenues increased in 1979-80 over 1978-79 at a 16.8% rate. It is estimated, however, that the increase in 1980-81 revenues over 1979-80 will be at an 8.5% rate, the decline being largely the result of the impact of the 1978 one-time tax credit and full indexing of the Personal Income Tax upon Tax Years 1980 and 1981. Had the one-time 1978 tax credit and the full indexing effect been disregarded, the estimated revenue increase for 1980-81 would have been 12.3%. To assume a revenue increase in the magnitude of 11% is, therefore, a responsible compromise which, if it has a bias, has one favorable to Proposition #9.

2Revenue and Taxation Code, Div. 2, Part 10, Section 17034.

3Legislative Counsel's Opinion, March 7, 1980, re the constitutionality of the provisions of SB 1464. If a bill authored by Assemblyman Imbrecht, AB 3020, is enacted, the tax savings from the retroactive implementation of Proposition #9 will be repealed and, also, the indexing of the Personal Income Tax, as provided in current law, will be repealed and the 1978 tax brackets made applicable in 1980. This will result in another tax increase for 1980-81 in the magnitude of $500 million in addition to the $1.4 billion which will result from the repeal of retroactivity. .The Imbrecht bill will, therefore, increase Personal Income Taxes in 1980 by $1.9 billion over what is current law in the event that Proposition #9 is approved.

4As of February 29, 1980, the revenues were 2-1/2% greater than estimated, the same percentage as that produced on January 31, 1980. Report on General Fund Disbursement issued by Kenneth Cory, State Controller.

5SB 1426, legislation sponsored by the administration, and now in the Assembly, will provide that a large percentage of this money will be used to finance Capital Outlay for the schools, K through the University, and the Energy and Resources Fund. If transferred to the General Fund, money for school construction and conservation and development of renewable energy sources will be practically unavailable.

6Federal Revenue Sharing money may not be regarded as on-going income since there is a strong likelihood that the program will be repealed by Congress in its attempt to balance the Federal Budget.

7The Reserve, as stated, will consist of a $400 million one- time allocation from the state's increased revenues and $150 million in Federal Revenue Sharing money.

8Legislative Analyst Analysis of the Budget Bill for Fiscal Year 1980-81, p. A-29, Table 15. Had the effect of the one-time tax credit increase and full indexing of the Personal Income Tax been excluded, the revenue increase would have averaged over the three-year period, 1978-79, 1979-80, and 1980-81, at 14.5%.

9This revenue reduction will occur even if the Imbrecht bill to change the tax brackets is enacted, since full indexing will begin in 1981-82.

10Tideland Oil Revenues are anticipated to reach a maximum level in 1982-83, between $600 and $700 million, and to decline thereafter. This is the most optimistic projection of the State Lands Commission.

11If in Fiscal Year 1980-81 the Prudent Reserve remains intact, it will be available to offset a Budget deficit which might result as a consequence of a serious slowdown in the economy and a decline in revenues.

12This reflects a reduction from the $4.9 billion revenue loss as a consequence of the enactment of the Imbrecht legislation to repeal the retroactive implementation of Proposition #9 and to initiate indexing of the Personal Income Tax in Tax Year 1980 based upon the 1978 tax brackets.

13This percentage reflects the fact that Proposition #9 will halve the tax rates, but cause a 53% to 54% loss of revenues to the state because of the fact that tax credits remain at current levels.

Fiscal implications of Jarvis II

The Rodda Project: The battle against Proposition 9 (1980)

The background to Sen. Rodda's paper

Howard Jarvis and his allies hit the ground running after their success with Proposition 13 in 1978. After slashing California's property taxes, the tax rebellion forces offered up a state spending cap (passed by the voters as Proposition 4, the Gann initiative) and then took aim at the state personal income tax. Proposition 9 on the June 1980 primary ballot mandated a 50% cut in income tax rates.

Senator Rodda and his legislative colleagues had swung into action after the passage of Proposition 13 and enacted legislation that distributed the state surplus in such a way as to soften the initiative's impact on schools and local government. Their success, however, enabled Jarvis and others to crow that pre-election predictions of disaster had not come to pass. Proposition 13 had obviously not destroyed the state.

The surplus, however, was rapidly vanishing and the Proposition 13 bail-out could not continue indefinitely. Jarvis decided to strike with Proposition 9 (often called Jarvis II) in 1980 before any long-term effects of Proposition 13 were experienced. The anti-13 legislators were, he said, already exposed as mendacious doomsayers, so why believe them if they declared that Proposition 9 was an even worse idea than Proposition 13?

Undeterred, Albert Rodda delved into the provisions of Proposition 9 and carefully analyzed the initiative's scope and the magnitude of its potential impact on California's fiscal health. He drafted a detailed report and released it to the public. Many copies flowed out of his office as people clamored to learn more about the likely impact of enactment of Proposition 9. The eventual defeat of the measure was in large part due to Rodda's trenchant document.

Rodda's report sparked some quick political maneuvers by Proposition 9 supporters in the legislature, some of whom introduced bills to soften (at least initially) the impact of the measure. A follow-up to this report presented the Senator's detailed analysis of the mitigation measures.


Fiscal Implications of Jarvis II for the State of California and Agencies of California Local Government, including the Schools, as Viewed from the Perspective of a Practical Politician

January 15, 1980

The first three parts of the paper are an exposition of different aspects of the state's fiscal situation, present and future. The parts are related to each other, however, and, thus, are combined into one package. This tripartite approach to the problem accounts for the fact that portions of the paper are quite repetitious. Style and form have been sacrificed for substance and analysis. The fourth part is a brief analysis of the effect of Oil Deregulation on California Revenues. The fifth part is an article written in response to a request by the Capitol News Service and it presents an overall perspective of the impact of Proposition #13 (Jarvis-Gann), Proposition #4 (Gann), and Jarvis II. The sixth is an analysis of the basis for determining the first-year loss of revenue to the state as a result of approval of Jarvis II.


Last Fall, I was impressed with statistical material prepared by the Legislative Analyst's Office which related to the state's fiscal situation. The data indicated that the state was experiencing ongoing annual deficits which were dramatically reducing a very substantial General Fund Reserve. This trend, since it is still in effect, must be interpreted to mean that the state's fiscal future will not be bright and that reductions in state expenditures and “bail-out” to local government will have to be implemented. Because of the implication of these conditions, I became very apprehensive about the potential effect upon the state of voter approval of the initiative being circulated which would mandate that the state personal income tax be reduced by 50%. These concerns convinced me to write a paper which would present as clearly as possible the implications of both the current deficit and the income tax reduction initiative. In doing so, I addressed a number of issues which related to r my concerns, knowing that there would be discrepancies between the projections of revenues and expenditures that I would have to use in the analysis and the actual data which would ultimately be developed as a reflection of the fact of reality. I intended to release the paper in December, 1979, but the complexity of the issues prevented me from meeting that deadline. I decided, therefore, to postpone the completion of the paper until the full data relating to the State Budget for 1980-81 were available for inclusion in the estimates and predictions. Thus, the delay. The reader should use the paper in order to gain a better understanding of the fiscal problems which will confront the state and local government in 1980 and thereafter, and the potential responses which will be available to the Legislature for introduction into the 1980-81 Budget. Care should be exercised in the presentation or interpretation of the data because of the lack of certainty or accuracy which exists with respect to such complicated fiscal projections , given the uncertainty of economic and political conditions and circumstances which affect such data. The same caution should be exercised with regard to the validity of data used in contradiction of the conclusions presented to the readers. All of us suffer from the same deficiency—the inability to forecast with accuracy complicated data projections. I am convinced, however, the deficiencies which emerge will be of a marginal character only.

In conclusion, I must comment that all of the data have been carefully reviewed by the Legislative Analyst and constitutes the most accurate and meaningful material that is available to me, as a State Senator and Chairman of the Senate Finance Committee.

Justification for support of the personal income tax amendment reflects, of course, the conviction that the statistical data are supportive of such a reduction in the state's revenues. Arguments to that effect were presented by Howard Jarvis in the form of two letters distributed to voters last year. The first was mailed in May and the second in early Fall. Copies are included as pages (i) and (ii).

Part I

Fiscal Background for Analysis of Jarvis II

The California economy experienced an unusual rate of growth during the second half of the decade of the 1970'5. During part of this period, because of the elasticity 0£ its tax base, state revenues grew much faster than state expenditures. As a consequence, when Proposition #13 was approved by the voters on June 6, 1978, the state had accumulated a General Fund surplus of $3.7 billion. The first and immediate impact of Proposition #13 was a $6.9 billion reduction in local property tax revenues. Because of its accumulated surplus, the decision was made at the state level not to expose local governments to the full and adverse impact of such a huge loss in their revenues. Instead, it increased its surplus by a reduction of state expenditures by approximately a billion dollars and, through the utilization of that augmentation of the surplus in conjunction with a large portion of the previously accumulated surplus, provided a massive amount of fiscal relief to local governments and the schools. The first-year replacement revenue was $4.3 billion in the 1978-79 fiscal year and that amount was increased to $4.8 billion in 1979-80, the second year.

Fortunately, the state through this action replaced about two-thirds of the Proposition #13 property tax loss and, as a result, local governments, including the schools, were spared the economic and social disruptions which normally would have accompanied such a dramatic change in their finances. State government, however, paid a price for coming to the aid of local governments because the state committed itself to spend a substantial portion of its revenues for the support of local government and the public schools and, as a consequence, diminished its ability to finance areas of public service traditionally recognized as the responsibility of the state. The response to Proposition #13 resulted, therefore, in a fundamental change in state finance.

During the four years prior to the enactment of SB 154, the Proposition #13 “bail-out” legislation in June, 1978 , state revenues exceeded state expenditures; immediately upon its enactment, however, the state's fiscal condition was reversed and state expenditures, including those for local government “bail-out,” increased to a level which exceeds revenues by about a billion dollars per year and the excess of expenditures over revenues, or deficit, had to be offset at the end of each fiscal year by a draw-down of the state's accumulated surplus. This was an unprecedented phenomenon. Never in its history, as I recall, had the state experienced such a situation—annual deficits during a period of unusual inflation and economic growth. The reality of the state's fiscal situation, despite this unique trend, is that if California does not experience a recession, because of the existence of a General Fund Reserve of more than a billion dollars, the state probably can continue its current level of local governmental aid for at least one more year (i.e., 1980-81). Thereafter, however, the situation is less favorable, since no longer will there be sufficient surplus funds in the State Treasury to offset the deficit, or the ongoing deficiency between General Fund revenues and total expenditures, and fully fund the “bail-out” of local government at the current level of $4.8 billion.

These fiscal observations are related exclusively to the relation between current expenditures and current revenue sources only; they do not reflect the potential effect upon the state's fiscal situation of voter approval of the Income Tax Initiative, or the so-called Jarvis II Initiative, which will be on the June 3, 1980, ballot. That action would reduce state revenues by an estimated $4.9 billion in 1980-81, which is the equivalent of a 25% loss in state General Fund revenues. Obviously, if that were to occur, the state's fiscal situation must be analyzed from a totally different perspective from that of “business as usual.” The loss of state revenue will be of such a magnitude that the ability of the state to provide replacement revenues for the Proposition #13 local tax reduction and at the same time finance its own services and public education will be dramatically and negatively affected.

One of the unfortunate aspects of the current fiscal situation is the confusion which relates to the mechanics of state finances, especially as it relates to the terms of annual surplus, or deficit, and “Year-End Surplus” or General Fund Reserve.1 These concepts, however, are important for an adequate understanding of state finances and an evaluation of the state's ability to continue local fiscal relief and to withstand the possible impact of Jarvis II.

The Annual Surplus, or Deficit, represents the difference between revenue collections and expenditures during a single year. In terms of personal experience, it may be compared to the changes which occur in one's monthly checking account. For example, since during some months one spends less than one's paycheck, one experiences a surplus which increases the checking balance. That excess may then be deposited in one's savings account and be available for future needs. If one spends more than one receives in income over a period of time and incurs a deficit, money may be transferred from the savings bank into the checking account. If too many deficits are incurred, the savings account will decline to zero and one will have to reduce one's spending and balance expenditure with monthly income. The history of state finance reveals that a similar situation can occur, and has occurred, on an annual and continuing basis. Chart I portrays that situation. During 1977-78, when General Fund revenues were $13.7 billion and expenditures were $11.8 billion, the state experiences an annual surplus of $1.9 billion. In the following year (1978-79), when revenues increased to $15.2 billion, expenditures rose to $16.2 billion, and, therefore, the state incurred a $1 billion annual deficit.

Annual surpluses add to and annual deficits subtract from the Year End Surplus, and this is what confuses the public—the distinction between the Annual Surplus, or Deficit, and the Year-End Surplus, or General Fund Reserve. They fail to realize that, at the end of each fiscal year (June 30), when the State Controller computes the total or accumulated surplus, he includes in the total the excess of revenues over expenditures during that fiscal year and, also, any surpluses carried forward from all previous fiscal years. The so-called surplus represents, therefore, the total amount of uncommitted General Fund money at that particular point in time. In effect, it is a one-time surplus, as distinct from an ongoing surplus, and, unless it may be counted upon to continue over time because of favorable Budget conditions, it may not be used to finance expenditure which will persist on an ongoing basis. During the past three years, the public has become confused and has become convinced that the Year-End Surplus will continue into the future and this confusion has engendered the public's frustration with the Legislature and reinforced its demand for a tax reduction. The citizenry is convinced that such a reduction in revenues would not impair the quality of government but would merely return the “Surplus” to the people or the taxpayers—a “rightful” thing to do.

Hereafter, I shall refer to the Year-End Surplus as the General Fund Reserve, or all of the accumulated liquid assets which the state possesses and which it may use to fund its operations, or to balance the Budget. Chart I shows the history of the relation between the state's Annual Surplus and General Fund Reserve over the last five years. It indicates:
  1. The General Fund had an annual deficit of about $440 million during 1973-74. This occurred because the state sales tax rate was temporarily reduced during that year. Because of a General Fund Reserve, this deficit did not result in an unbalanced State Budget.
  2. The state had modest annual surpluses during 1974-75 and 1975-76, which, because of the strong resurgence in the economy, grew dramatically during the next two years and reached a peak of $1.9 billion in 1977-78. The trend reversed itself in 1978-79, and the state experienced a .$1 billion annual deficit.
  3. The General Fund Reserve grew from $180 million on June 30, 1974, to $3.7 billion on June 30, 1978, a growth which was directly related to consecutive occurrences of annual surpluses.
  4. In 1978-79, the General Fund Reserve declined to $2.7 billion, a direct result of the fact that state expenditures exceeded revenues by about $1 billion and that deficiency in revenues was offset through a withdrawal from the Reserve.
The fiscal outcome for 1979-80, the current fiscal year, is somewhat uncertain, since we are halfway through the year and the data with respect to expenditures and revenues and their effect on the Annual Surplus are estimates only and remain contingent upon events which will transpire between now and July.

The Governor's Budget, which was presented to the Legislature on January 10, 1980, indicates that the General Fund Reserve will be in the neighborhood of $1.8 billion as of June 30, 1980 (Year-End Surplus). The Budget contains the administration's recommendations for spending during the next fiscal year, but historically the Budget, as introduced, is modified as the result of extensive review by the Legislature. Changes certainly can be expected to result from that review—some in the form of expenditure reductions and others in the form of augmentations. Predictions, therefore, at this time as to the next fiscal year situation, 1980-81, contain definite uncertainties. To make forecasts beyond the next fiscal year is even more difficult and, obviously, any estimates projected for 1981-82 must be understood to be very tenuous, at best.

We can, however, gain an insight into the trend of state finances over the next two years if we make the assumption that total state expenditures, including local fiscal relief, will not be allowed to grow faster than the rate of inflation, plus the growth in population, and compare estimated expenditure figures predicated upon those assumptions with the long-term revenue projections prepared by the Legislative Analyst last summer.

This comparison, which is the “projected” portion of Chart I, indicates that the General Fund Reserve will continue to decline during 1980-81, and that by the end of 1981-82 there will be a potential for a $900 million deficit. Since the State Constitution prohibits state government from incurring a “real deficit,” or to incur expenditures which exceed its fiscal resources, revenues plus appropriate augmentations from the General Fund Reserve, the state must, if its fiscal situation beginning July 1981 is as calculated, exercise one or a combination of three possible actions:
  1. Increase state taxes—a highly unlikely course of action during this period of “taxpayer revolt,” especially in view of the fact that a two-thirds vote is required and the increase must be in the personal income and sales taxes or the tax on corporations, banks, and insurance companies.
  2. Allow the deflator mechanism specified in AB 8 of the 1979 Session to operate, which would reduce state payments to schools and other local governments by the full amount of the deficit.
  3. Implement an appropriate reduction in state expenditures, including allocations to the schools and local governments.
None of the options will be easy to make or properly understood by the public unless the state's fiscal condition is more clearly explained to the citizenry. Without an understanding of the present fiscal trend resulting from the state's “bail-out” of local government and the substantive loss of revenue to the state because of the action taken to “index” the Personal Income Tax, the “man in the street” will react to the fiscal problems indicated above in a negative manner. That is what we do not need at a time when positive thought and constructive action are required if the current fiscal problems of the state are to be addressed in a responsible manner.

Part II

The Jarvis II Initiative: Its Fiscal Implications for State and Local Government

On January 10th, the Governor introduced the State Budget for fiscal year 1980-81. After it has been evaluated by the Legislative Analyst's Office, the Legislature's two fiscal committees will hold lengthy Budget hearings, beginning in the latter part of February and continuing through May, for the purpose of determining the magnitude and composition of the Budget, given the state's revenue expectations and the need for services of government and education, both state and local.

Under the provisions of the California Constitution, the Legislature is required to place the Budget on the Governor's desk for his signature no later than June 15th. For the past two years, the Legislature has not met that deadline because of the problems which have confronted the state as a consequence of court decisions and Congressional action with respect to abortion and public. approval of Proposition #13; nevertheless, at a time very near the first of July, the beginning of the fiscal year, 1980-81, the Legislature will comply with the Constitution and present the Governor with a Budget Bill for his signature.

On June 3, 1980, however, the date of the June Primary Election, the voters will act upon the Jarvis II “Income Tax Initiative”, and if they approve it by a simple majority, its provisions will have an immediate impact on the 1980-81 Budget.

An appropriate question is: What is Jarvis II? Jarvis II is a constitutional amendment initiative sponsored by Howard Jarvis and supported by those who are involved in what is known as the “Spirit of 13.” It is drafted to accomplish three objectives: (1) fully index the state's personal income tax; (2) totally repeal the business inventory tax; and (3) reduce California personal income tax rates by 50%. Legislation enacted in 1979 has already totally repealed the business inventory tax and fully indexed the income tax for a two-year period. These changes are now California law. The Initiative would, therefore, make these two changes a mandate of the Constitution, rather than part of statutory law, and, in doing so, terminate the current two-year sunset of full indexing of the personal income tax.

The main feature of the Initiative is the third provision, which, through an amendment to the Constitution, would require a 50% reduction in the personal income tax rates. This, of course, constitutes a very serious change in the state's revenue base. An analysis of the fiscal implications of the Initiative, as stated by Attorney General George Deukmejian in a letter to Secretary of State March Fong Eu, indicates that approval of the Initiative by the voters would deprive the state of $5.1 billion of revenue in the fiscal year 1980 and approximately $4.2 billion in 1981-82. A later estimate by the Legislative Analyst, William Hamm, establishes the potential loss of revenue for fiscal year 1980-81 at $4.9 billion and $4.4 billion in 1981-82. The Analyst's estimate includes the impact from full indexing of the Personal Income Tax which, through statutory change, will take effect in Calendar Year 1980. This feature accounts for part of the disparity in the revenue estimate, since the effect of the full indexing legislation is to lower the state's revenue from the Personal Income Tax and reduce, therefore, the potential tax loss from Jarvis II.2

The loss of state revenues resulting from Jarvis II will impact upon the state and local government immediately, since it will drastically reduce the state's ability to finance the State Budget, beginning July 1 for the next fiscal year, 1980-81. The Legislature will, therefore, within four weeks have to reconsider the Budget and make the difficult decisions necessary to reduce the level of Budget expenditures and submit a balanced Budget, one which does not exceed the level of revenues projected for the year.

An examination of Charts II and III indicates the magnitude of the problem. Chart II compares the growth of the total income of the state, including current revenues and carryover reserves, and total state expenditures. The data are predicated upon estimates of existing revenue and expenditure trends and clearly indicate that expenditures are growing faster than total income, primarily because of the exhaustion of the state's carry-over reserve and the loss of revenues in excess of a billion dollars annually because of the indexing of the Personal Income Tax. At some time during the 1981-82 fiscal year, the level of General Fund expenditures will exceed available revenues, and, at that point, either taxes will have to be increased or expenditures reduced if a balanced Budget is to be achieved.

Chart III embodies the same expenditure figures as used in Chart II but it reflects a reduction in state revenues of $4.9 billion in 1980-81 and $4.4 billion in 1981-82 in order to portray the impact upon the state's fiscal situation of voter approval of Jarvis II. This chart dramatically indicates the immediate Budget implications from such action by the voters. In 1980-81, there would be a potential gap of $4.5 billion between total expenditures ($20.9 billion) and revenues ($16.4 billion) , and since, as previously observed, the State Constitution prohibits the state from operating with a deficit, state expenditures must be drastically reduced to eliminate this gap. This is clearly the only reasonable course of action that can be anticipated to be implemented since there is little or no possibility that a tax increase of an appropriate magnitude could immediately be voted into effect as a means of balancing the Budget, given the present attitude of the public toward government and government taxes.

An Examination of Budget Totals

A breakdown of the State Budget into its components is interesting and, I am sure, most surprising to the average citizen. It is an analysis which is made in order to portray to the public the magnitude of the revenue deficiency which will confront the state and, therefore, the schools and local government if Jarvis II is given voter approval. It also indicates where possible Budget reductions might be made and which spending programs, therefore, could be affected.

Total spending, from all state funds, will be about $22 billion during the current fiscal year and approximately 85% of these expenditures will be financed from the state's General Fund. Special Funds, primarily those relating to highways and .motor vehicles, finance about 14% of total expenditures, and bond funds account for the remaining 1%. These figures are contained in Table 1.

The personal income tax reduction which will result from Jarvis II will affect only General Fund revenue, and since, under the State Constitution, most Special Funds can only be spent on certain functions, such as highways, these revenues may not be used to offset a reduction in income taxes. As a result, the impact of Jarvis II will fall dramatically upon the General Fund. The remaining portion of this discussion will examine which major expenditure programs are supported by the General Fund and at which level of government the actual expenditures are made.

When the typical voter reads about the billions of dollars in the State Budget, he or she visualizes money spent on the Governor's Office, the Legislature, tax collection agencies, the University and State Colleges System, prisons, mental hospitals, and a few other categories. All of these, of course, are traditional state expenditures with which the public is familiar, but in total amount they account for only about one-fifth of the total State Budget. The public does not realize that approximately four-fifths of the State Budget is state money which is spent at the local governmental level to support such programs as education, health and welfare services, and property tax relief. In effect, the state uses its superior tax collection abilities to finance programs which are administered locally.

Table 2 shows that during the current Fiscal Year (1979-80) spending on traditional “state services” will be about $4 billion, while state payments to local governments and property tax relief will total $14.7 billion, of which $4.8 billion (not identified in the Table) is being allocated to government, including the schools, to replace revenues deprived them by Proposition #13. These data indicate that if all state employees whose services were financed from the General Fund were fired, and the universities, state colleges, prisons, mental hospitals, etc., were closed, the expenditure savings (about $4 billion) would not be sufficient to offset the revenue loss from Jarvis II.

Education, both higher and lower, accounts for over half of the total State Budget. During the current year, the state will spend about $2.8 billion on higher education, $6.9 billion on K-12, for a total of $9.7 billion. This is indicated in Table 2, which also indicates that the next largest expenditure category is health and welfare. The combined or total costs of those programs is $5.9 billion, or about 32% of the State Budget.

Property tax relief is the third largest expenditure category in the Budget, and it adds up to a cost of slightly over $1 billion, and the legislative, judicial and executive expenditures account for less than 2% of the Budget.

Chart IV summarizes these major categories of General Fund expenditures and, also, shows the relative magnitudes of Special and Bond Fund expenditures.

A slightly different breakdown of the State Budget is reflected in Chart V. It delineates more clearly the relation of the “bail-out” expenditure to the other components of the Budget. The statistical data have been represented as percentages of the total Budget and are very general, and were developed only for the purpose of providing a slightly different representation of the allocation of the state's revenues. Of particular importance is the fact that of the 25% of the total General Fund allocation to “bail out” local government, three-fourths was distributed to the schools, K-14; one-fourth to other agencies of local government, which, by virtue of the enactment of AB 8, are now almost fully financed by the local property tax and are almost fiscally independent of the state. The major exceptions are the large allocations to county governments for health and welfare services, which are traditional state allocations and are unrelated to Proposition #13 and AB 8. The response to Proposition #13 did, however, expand the state's fiscal support for programs in the health and welfare areas which are administered at the local level and were previously financed largely from property tax revenues. This increase in state funding was provided in the local government portion of the AB 8 allocation.

Part III

Alternative Approaches for Response to Jarvis II

The facts indicate that California's General Fund Revenues in 1980-81 will be reduced by approximately 25% if Jarvis II is approved by the voters on June 3, 1980. Obviously, a revenue loss of this magnitude, $4.9 billion, will impose a serious mandate upon the Legislature and the administration drastically to reduce government expenditures. Unfortunately, this will occur at a time when the State Legislature has completed its hearings on the Budget Bill and is prepared to present to the Governor a very austere Budget for 1980-81, which will reflect only a modest increase in the state's expenditures over those of 1979-80. The necessity for an austere 1980-81 Budget is the fact that at sometime during Fiscal Year 1981-82 the state will almost certainly be confronted with a deficit. Two significant factors will account for this probability. They are (1) the inadequacy of the state's General Revenues, and (2) the rapid decline in the state's General Fund Reserve.

The fact that the state will be confronted with such a serious fiscal situation, apart from voter approval of Jarvis II, is not unusual in recent California history. For example, in 1959-60 the state was confronted with a deficit situation and Governor Brown, Sr., in order to avert its occurrence approved the enactment of a tax increase. Governor Reagan, during his first year in office, was also threatened with the possibility of a major General Fund deficit and was compelled to sign a $1 billion tax increase in 1967. His administration was confronted with another revenue deficiency in 1971 and responded through the enactment of personal income tax withholding with a resultant revenue increase which was adequate to eliminate deficit.

There is no question that the Legislature and the administration will be able to address the fiscal situation which confronts the state. But implementation of the appropriate fiscal action will mean that Fiscal Year 1980-81 will not be a year in which costly new programs can be undertaken or existing programs dramatically expanded, and that is the fact of reality which we in government must recognize. Hopefully, in moving toward a balanced Budget, it will not be necessary significantly to curtail or reduce the quality of state services. But if Jarvis II gains voter approval, the magnitude of the revenue loss will be so substantive that an unprecedented and dramatic reduction in the State Budget will have to be achieved immediately. Several courses of action will be available for the Legislature to pursue. None, however, is encouraging. They are:
  1. Activate the AB 8 deflator mechanism;
  2. Reduce the State Budget 25% across-the-board;
  3. Reduce the AB 8 appropriation by 50% and all other Budget expenditures by an appropriate percentage.

Option 1. Activate the AB 8 deflator

When the Legislature passed the local fiscal relief bill (AB 8) in 1979, it incorporated a mechanism to protect the state's General Fund against the possibility of significant and uncontrollable losses in revenue. This mechanism is called the AB 8 deflator. On June 10, 1980, the newly created Commission on State Finance must under the provisions of law estimate revenues for the 1980-81 fiscal year, and, also, determine the magnitude of the June 30, 1980, General Fund Surplus. If these two amounts, in total, fall short of $20.6 billion by at least $100 million, state fiscal assistance to local school districts and local assistance payments to other local governments will be reduced fully to offset the loss, unless the Legislature through enactment of a Concurrent Resolution prohibits such action. One-half of the reduction in the “bail-out” appropriation would be made in apportionments to school districts, and the other half would be made to the state's subvention payments to local governments for the homeowners' exemption, the business inventory exemption, open space contracts, cigarette taxes and motor vehicle license fees. These reductions can only be made, however, to the extent there are sufficient funds in the specified categories to absorb such reductions.

Very relevant to the entire issue of “bail-out,” including the deflator mechanism, is the fact that Jarvis II will be voted on one week before the Commission must make its findings for the 1980-81 fiscal year. It is admitted by all of those involved in the development of AB 8 that the deflator mechanism was never designed to handle a revenue shortfall of the magnitude that would result from Jarvis II. The Legislative Analyst has informed me that there are not sufficient funds in the specified categories to absorb a $4.9 billion loss in income tax revenues during the 1980-81 fiscal year. Implementation of the deflator mechanism is, therefore, not an option which would be utilized as a response to Jarvis II. It was not designed to address Budget problems of the state of such a magnitude as those which might prevail.

Option 2. 25% Across-the-Board Reduction in the State Budget

If a proportionate, or 25%, reduction were applied across-the-board, the impact would be quite dramatic. While we do not have final estimates at this time on total 1980-81 spending, we can use the data from Table 2 to illustrate what the impact would have been during the current fiscal year.

These data show that the following reductions would have to be made in major program areas:

Millions (rounded)

1. Higher Education, $ -700
2. K-12 Education, -1,700
3. Health & Welfare, -1,500
4. Property Tax Relief, -250
5. All Others, -500

Total: $ -4,650

Under this approach, all major program areas would share proportionately in the Budget reductions. Such cuts, however, could not be made in each Budget category. For example, it would be illegal to reduce the $198 million (Table 2) earmarked for debt repayment. Also, many of the programs funded in the State Budget are mandated by state law or the Constitution. The state tax relief payments to local government, for example, to offset the revenue loss resulting from the homeowners' exemption are mandated in the Constitution and the payments to local government to reimburse them for revenue loss resulting from the repeal of the business inventory tax are specified in statutory law. In order to withhold these funds from local. government a constitutional amendment and a change in statutory law would be required. There are many other statutory requirements with respect to the funding of programs, and in these instances, also, new legislation would be needed before the funding reductions could be achieved. Other programs, especially in the health and welfare areas, are integrated with federal law and some of them, as a consequence, may not be reduced without incurring substantial losses in federal funds. When the effect of the constitutional and statutory mandates are taken into consideration, it becomes obvious that a 25% across-the-board reduction in expenditures could not be responsibly implemented and, therefore, discretionary decisions would have to be made in which some programs would experience a disproportionately higher expenditure reduction in order to compensate for the state's inability to achieve reductions in other programmatic areas of the Budget.

When Governor Reagan came into office in January of 1967, he attempted to make a 10% across-the-board reduction in most of the state's so-called controllable expenditures, but after examining the host of problems associated with such an approach to fiscal. responsibility, the Governor realized that such a course of action was not feasible and the concept was abandoned. The problem, of course, would be grossly more complex if a 25%, not a 10%, across-the-board cut were attempted. Furthermore, this approach has the weakness of not achieving expenditure reductions which relate to the total funding sources for particular programs. As a consequence, a program which is entirely funded by the state would be reduced by 25%; whereas, another one which is partially supported from local or federal funds would have a smaller total reduction. An adequate judgment with respect to the effect on the quality of government services would not be made and program results would be confusing and totally irrational.

A responsible analysis of the ramifications and complexities of implementing the 25% option indicate, frankly, that it is not feasible.

Option 3. Reduce AB 8 Appropriation by 50% and Reduce All Other Budget Expenditures by an Appropriate Percentage

In 1980-81, the AB 8 appropriation will be $5.3 billion, reflecting about an 8-1/2% increase over this year. If this appropriation were cut in half, the state would save $2.65 billion, and the remaining portion of the State Budget would have to be reduced by $2.25 billion to cover the Jarvis II revenue loss. The Governor's 1980-81 Budget message proposes total General Fund spending of $20.7 billion, and if the AB 8 appropriation were deducted, the funding level of the Budget would be $15.4 billion. If a $2.25 billion reduction were made to this amount, it would be equivalent to a lowering of the $15.4 billion to $13.5 billion, or 15% across-the-board.

Under this option, expenditure programs for local education, which amount to 74% of the AB 8 allocation and are also significantly funded in the regular Budget, would be very adversely affected, since they would be victims of what I describe as a “double whammy.” There are also several programs in health and welfare which would experience the same result. They would bear heavier reductions than programs which are funded only in the regular Budget. The effect on local education, for example, would be a reduction in its AB 8 funds by $1.5 billion and its regular Budget appropriation by an additional $0.5 billion, for a total reduction of $2.0 billion, which is equivalent to a cut of 28% of total state funding. By contrast, the higher education programs, which are funded exclusively in the State Budget, would experience only the 15% reduction, or an appropriation loss of $460 million. Health and welfare expenditures would be reduced by $0.9 billion from the AB 8 appropriation, and $0.75 billion from the regular Budget, for a total reduction of 24%. Cities and special districts would lose $130 million and $115 million, respectively, from their AB 8 appropriations.

This option, or some variation thereof, would put local governments, particularly the schools, K-14, and health and welfare, in a serious financial squeeze, and would be very discriminatory in its treatment of different programs. It has, therefore, very dubious viability.

Needless to say, response to Jarvis II is not going to be easy or simple to accomplish, either in the short term or the long term. Unfortunately, the “insurmountable opportunity,” to use Pogo's descriptive terminology, which will confront the Legislature beginning June 3 must be responded to within three to four weeks. The Legislature has a constitutional mandate to place the Budget on the Governor's desk on June 15; the Governor has a mandate to sign it before July 1. I guarantee that the impossible will not be met.

Part IV

Analysis of the Effect of Oil Deregulation on California State Revenues

There is likely to be a substantive “windfall” revenue gain to the state as a consequence of the decontrol of the price of domestic oil, but there is some disagreement among the experts with respect to the amount of revenue that California will derive. Many uncertainties exist.

The enhancement of revenues to the state will consist of two elements: (1) an increase in the income derived from state-owned tideland oil, currently estimated to reach $500 million in 1981-82, or about $390 million greater than 1978-79 actual revenues, and to continue a gradually declining level during the decade of the eighties; and (2) an increase in state revenues generated from corporate profit taxes paid by the petroleum industry in California.

The State Lands Commission estimates that, beginning in 1979-80, the accumulated or total revenue increase to the state will be approximately $6 billion over the next decade. Adjusted for inflation, the total amount would increase significantly, perhaps even to a $10 to $12 billion level. Another estimate, one made by the United States Treasury, I understand, is that the ten-year accumulated revenue increase to California will be approximately $22 billion. The estimate of the State Lands Commission assumes, because of deregulation, an immediate oil price increase, an increase in new oil discovery, and an expansion in the level of recovery from existing oil fields. Since these are variables which will be modified as a consequence of many unknown factors and must be recognized as being subject to change, the estimated revenue increase must be regarded as somewhat fragile. The larger projection by the United States Treasury is predicated upon the assumption of an increase in the price of oil to a price of $75 per barrel. Such a large increase in the price of oil would have far-reaching repercussions upon the rate of inflation and the national economy, and, because of the effect of these and other economic variables, the reliability of such a ten-year forecast would be subject to serious question as to its validity. In fact, several fiscal experts whom I have contacted contend that the State Lands Commission's estimate of an aggregate revenue increase is more responsible and they have expressed serious reservations about the credibility of the United States Treasury aggregate figure.

The increase in state revenues resulting from price decontrol, obviously, could be utilized to address the state's fiscal deficit, but, considering the fact that the current revenue deficiency is approximately $1 billion annually, the revenue windfall, if so utilized, would address only a portion of the state's current deficit. Under no circumstances is it responsible to contend, therefore, that the added revenues will compensate for the unusual tax revenue loss which will result from implementation of Jarvis II in the next fiscal year if it is approved by the voters. For the Fiscal Year 1980-81, that revenue loss is estimated to be $4.9 billion. It will decline to $4.4 billion in 1981-82 and continue thereafter on an ongoing basis. Interestingly, the aggregate revenue loss predicted to result from Jarvis II over a ten-year period, beginning in 1980-81, will be a total of $45 billion, and that aggregate figure does not reflect an annual increase over time which will result from expansion of the state's population, the impact of inflation, or growth in the state's economy—all of which were factored into the estimates of the potential revenue increase for the next decade, beginning in 1982, as a consequence of domestic oil price decontrol. If a 10% increase in the Personal Income Tax were factored into the ten-year projection of the state's revenue loss from Jarvis II in order to adjust for the effect of these economic variables, the ten-year total revenue loss to the state will be $62 billion, and if a 13% annual increase were used in the calculation, the total revenue loss will attain a level of $70 billion. In any event, the projected increase in oil revenues, even when calculated at the aggregate $22 billion figure in order to reflect a potential increase in the price of oil from the current $13 price to that of $75 a barrel, will fall far short of replacing the state's revenue loss to result from Jarvis II because of its 50% reduction in the state's Personal Income Tax revenues. Any argument to the effect that Jarvis II will not adversely affect the state's fiscal condition because of the magnitude of replacement revenues to be derived from “decontrol” of domestic oil prices can only be regarded as irresponsible propaganda because it will constitute a distortion of the fiscal situation with which the state must cope immediately and for an unknown time in the future if the voters approve the Jarvis Constitutional Amendment Initiative.

Part V

5052 State Capitol
December 18, 1979

Article in Response to Request from Capitol News Service

On June 6, 1978, the voters in the State of California approved Proposition #13 and voted themselves a substantial. amount of property tax relief. The total loss of money to local government which resulted from that action was $6.9 billion. Subsequently, within a three-week period, the Legislature, utilizing its surplus reserves and state funds already being allocated for property tax relief, provided financial support to local government in the magnitude of $4.4 billion. This action enabled local government and the schools to survive during the first year of the implementation of Proposition #13.

In the 1979 session the issue was addressed again by the Legislature and a solution—which was looked upon as permanent to Proposition #13—was enacted into law in the form of AB 8, Leroy Greene. It increased the state's allocation to local government from approximately $4.4 billion to $4.8 billion and provided for a modest cost-of-living increase each year. Estimated cost in 1980-81 will be about $5.3 billion.

The legislation also contained what is known as a deflator mechanism to implement a reduction in the allocation for 1980-81 in the event that the state anticipates on June 10, 1980, that its revenues and carry-over surplus will be $100 million or more below a critical level of $20.6 billion.

The legislation also transferred a significant portion of property tax revenues to cities, counties, and special districts and virtually liberated them from financial dependence upon the state. The property tax revenues so allocated to local government constituted a transfer of almost all of the property tax revenues normally utilized to finance the schools and that revenue loss to the schools was compensated for through an increase in the state's allocation for education in the “bail-out” legislation; so the schools became very dependent fiscally upon the state, and local agencies such as cities and special districts became more independent of the state. Despite this constructive action by the state, there are problems which remain as a result of Proposition #13. It introduced a grossly inequitable provision into the California Constitution with respect to the assessment of property and, as a consequence, recent and new home buyers will pay a substantially higher property tax than will homeowners who occupied their homes at the time Proposition #13 was approved and have experienced property tax increase at the rate of only 2% per year since that time. As inflation continues, these disparities will become greatly aggravated over time and considerable public discontent will emerge. Ultimately, this issue will have to be addressed through a constitutional amendment. Such a change cannot be made now because it would be interpreted as an “end-run” around Proposition #13.

An additional problem is the fact that local agencies of government, including the schools, because of Proposition #13, will have a very limited ability to finance construction of new government and school structures. Reliance in the future for such funding will, it appears, shift to the state, but, as of this time, the problem is not fully appreciated or understood as to its magnitude, and significant fiscal and policy issues, therefore, remain unresolved.

Furthermore, Proposition #13 did not adequately address the issue of the shift of the local property tax from rental, commercial, and industrial to residential property —a shift which has been dramatic in the last decade and was one of the factors which contributed to dissatisfaction with the property tax and voter approval of Proposition #13. The latest data indicates that the trend has been reduced, but that it has not been terminated. That issue, also, may have to be addressed in the future.

The voters approved Proposition #4 in November of 1979. Known as the Gann Initiative, it has placed a limit on increases in spending of state and local governments which is equal to the CPI, plus population growth.3 A number of unresolved issues relate to the meaning of several important provisions of that amendment and those issues will have to be addressed in the current session of the Legislature. The impact of the Gann Amendment will not be as substantive as was originally thought because of the high rate of inflation, but there are gross differences in the degree to which many local agencies of government have received or will receive tax revenues in the future, and because of these disparities there will be some segments of government, especially school districts, which will be adversely affected by Proposition #4.

On June 3, 1980, the day of the next Primary Election, the voters will, it now appears, have to consider whether or not to approve the new Howard Jarvis Initiative, generally referred to as Jarvis II. It will reduce personal income tax rates by 50%. In addition, it will fully index the personal income tax and provide for the complete elimination of the business inventory tax. Both of the latter changes have been enacted into law, so the only change that the amendment will achieve is a substantial reduction in the state's Personal Income Tax revenues.4 But that will constitute a most substantive change in state government, since its impact on state revenues will be dramatic. It will reduce the state's income for the next Fiscal Year, 1980-81, by $4.9 billion. That loss will come at a time when the Legislature will have under consideration for fiscal enactment the new State Budget, one which incidentally must be very austere, since currently the expenditures of the state exceed revenues and a deficit is only being avoided through a draw down from the state's accumulative surplus, or carry-over surplus of previous years. The fiscal situation, furthermore, is such that unless the deficit currently being experienced is corrected by the end of 1980-81, the accumulative reserve will be exhausted and the state will enter into Fiscal Year 1981-82 with the potential for a significant deficit. The Budget for that year will have to be balanced, which will require either a reduction in expenditures or an increase in revenues through a tax increase, which is very unlikely. The voters must be made aware of these facts and appreciate that a loss of state revenues of $4.9 billion will be traumatic and adverse to state and local government. It cannot be compensated for through the use accumulated surplus because the state's accumulated surplus will become non-existent at the end of next year. So drastic Budget reductions must be implemented within a very short period of time—three to four weeks.

The revenue loss from Jarvis II corresponds to about 25% of the state's Budget and if that percentage were applied across-the-board in reductions in expenditures at the state and local government level, the effect on the quality of government services would be very adverse and, also, uneven because of constitutional and statutory limitation on the state's budget flexibility. In effect, the State Budget would be reduced by 25%, the schools apportionment would be reduced by 25%, and health and welfare allocations to local government agencies, counties particularly, for assistance to the needy will be reduced by 25%. These reductions in the Budget would have to be accomplished within a four-week period so that the Budget could be signed into law by the first of July, or soon thereafter. It will be an incredibly difficult task for the Legislature and will be impossible to accomplish in a way which will reflect careful and constructive implementation of priorities—an identification or differentiation between the “fat” and “sinew.” But the action will have to take place and the “meat cleaver” approach w111 take precedence over that of the “scalpel.”

One fact which is interesting is that Proposition #13 and Jarvis II will, together, provide an ongoing tax cut, state and local, of about $11.3 billion and, of that amount, the net loss to local government in 1978-79 was a short-fall of $2.0 billion; and if “bail-out” is abandoned and the full impact of Proposition #13 is imposed upon local government, the total short-fall will equal about $7 billion. That is unlikely to occur, in my opinion, and the $4.9 billion state revenue loss will probably be shared at both the local and state levels, and education and state and local government services will all have to be curtailed.

Incidentally, the Federal government increased its Federal Income Tax revenues from California when Proposition #13 was approved by $1.9 billion, because taxpayers experienced a decline in their tax deductions by the amount of their Proposition #13 tax benefit. If Jarvis II is approved, the Federal Personal Income Tax will be increased, for the same reason, by up to $1.5 billion. So Washington will, as a consequence of the two initiatives, experience a revenue increase of up to $3.4 billion 1 from California taxpayers. The net tax reduction to California taxpayers will not be $11.3 billion, but $7.9 billion, a state and local tax reduction of $11.3 billion and a Federal tax increase of $3.4 billion.

Part VI

Basis for Estimate of First-Year Revenue Loss Under Jarvis II

The language of the constitutional initiative provides that it will become effective immediately upon approval by the voters. Critical to this fact is that under existing law any modification which occurs in the state's personal income tax rates before the end of a Calendar Year will apply to taxable income for the whole year. As a consequence, the income tax reduction initiative, if approved, is being interpreted as having the effect of bringing about a reduction in the state's personal income tax rates for the entire 1980 income year, even though five months of the year will have elapsed before the initiative is voted upon by the voters.

Of significance to the fiscal situation for the Fiscal Year 1980-81 is that tax experts generally acknowledge that approval of Jarvis II would occur too late in Fiscal Year 1979-80 to affect the amount of revenues received by the state during that year; as a consequence, the entire fiscal impact of the revenue reduction in the tax year 1980 will occur after July 1, 1980, and impact only on Fiscal Year 1980- 81. The loss will not, therefore, be one-half of one-half of the normal personal income tax revenues for six months of Fiscal Year 1980-81 but, rather, one-half of the personal income tax revenues which, absent Jarvis II approval, would have been received by the state. At the time this paper was being prepared, it was unclear precisely as to how the issue of income tax withholding would be addressed, but it appeared that there were three options or courses of action which might be taken.

Current law requires that withholding rates be changed in the tax or calendar year following the tax year in which a change in the tax rate is made. If this statute is observed, no reduction in withholding rates would occur during the months of June through December, 1980. At the beginning of the 1981 tax year when taxpayers file their income tax returns for the 1980 income year (which coincides with the calendar year), they would qualify, as a result of the application of the rate reduction imposed by Jarvis II, for a very substantial tax refund. As an alternative procedure, the state withholding rates could be suspended or reduced for the months of June through December, 1980, on the grounds that Jarvis II becomes effective immediately and, since it is a constitutional amendment, would be “self-implementing” and would, thus, supersede the existing statute. The Legislature could, also, through the enactment of urgency legislation, take action to amend or repeal the statute mentioned above and, thus, authorize an immediate reduction in the withholding rate. In either event, whether the payment of unusually large refunds in 1981 or a significant reduction in income to the state in 1980 after July 1, or a combination of both, were to take place, the reduction in revenue would amount to an estimated total of $3.5 billion for the 1980 income year.

The $3.5 billion revenue loss for the 1980 Calendar Year in state tax collections, however, does not constitute the full revenue loss to the state. During the first half of the 1981 Calendar Year, an additional $1.4 billion decline in personal income tax payments will occur because of the permanent, or ongoing, 50% tax rate reduction. The combined impact of Jarvis II during the 1980-81 fiscal year, therefore, is estimated to be state revenue loss of $4.9 billion.

In subsequent fiscal years, the revenue effects of Jarvis II obviously will apply to each Calendar Year, and the Legislative Analyst has estimated that loss in the 1981-82 fiscal year to be approximately $4.4 billion.

Another factor of significance is that because the income tax initiative does not change the current deductions for charitable donations and business expenses, or repeal or reduce the personal income tax credit, the actual revenue loss to the state is not 50%, but is estimated at 53.5%. This, of course, inflates the revenue loss to a higher level than that which a strict 50% reduction in personal income tax revenues could produce. This percentage, 53.5% instead of 50%, has been used in the calculation of the revenue loss. I mention it here merely to indicate that a simple 50% reduction in the personal income tax rates actually produces about a 53.5% reduction in the revenues which the state otherwise would receive.

1Chart #1 illustrates the historic growth and decline pattern of the two concepts: Year-End Surplus (General Fund Reserve) and Annual Fiscal Balance (Surplus-Deficit). It also illustrates the future trend for two fiscal years based upon projected revenue and expenditure levels. General Fund Reserve on June 30, 1980, does not include $290 million in Federal Revenue Sharing Fund.

2Partial indexing was enacted in 1978 for implementation in 1979. Full indexing was enacted in 1979 for implementation in 1980, subject to a two-year sunset provision. Indexing the Personal Income Tax, incidentally, will result in an annual state revenue loss in the amount of $1.2 billion in 1980-81 and that amount of lost revenue will increase annually. It has contributed significantly to the fiscal problem that will confront the state in fiscal year 1981-82, when the General Fund Reserve will be exhausted and the state's expenditures will exceed projected state revenues.

3Under certain conditions, the control mechanism would become the rate of increase in Personal Income plus population growth. School districts experiencing declining enrollment and higher expenditure levels will be the ones most likely to experience a serious limit on their authorized expenditures and their educational programs could be adversely affected as a consequence. The Legislature will explore the implications of these aspects of the Gann Amendment and will attempt, where possible, to address its deficiencies in the coming session through the enactment of clarifying legislation.

4The Initiative will, of course, place these changes in the state's tax structure in the Constitution and, also, eliminate the two-year sunset provision which relates to the full indexing of the personal income tax as provided in the Bergeson legislation.