Saturday, October 4, 2008

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.

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