SUBJECT: BUSINESS TAX MODERNIZATION DATE: July 29, 2016

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1 COUNCIL AGENDA: ITEM: 3.3 CITY OF SAN JOSE CAPITAL OF SILICON VALLEY Memorandum TO: HONORABLE MAYOR AND CITY COUNCIL FROM: Councilmember Donald Rocha SUBJECT: BUSINESS TAX MODERNIZATION DATE: July 29, 2016 That the City Council approve staff recommendation (b) to place a business tax modernization measure on the November 8 ballot, with the amendment that the tax rates proposed in the staff recommendation should be modified to be consistent with the alternative rates for residential rental property businesses and businesses taxed per employee that are outlined in the two charts on page 16 of the staff report dated July 20, The charts are reproduced below. The modified rates that I am recommending are shown in the "Alternative Rate" column. Residential Rental Property Tax Rate Current Rate Staff Alternative Rate Recommendation Base Rate SI 50 $195 $195 Unit Rate (1-2) $0 $0 $0 Unit Rate (3-35) $5 (starts at 31) $20 $10 Unit Rate (36-100) $5 $30 $15 Unit Rate ( ) $5 $40 $20 Unit Rate (501+) $5 $50 $25 Business Tax Rate Current Rate Staff Alternative Rate Recommendation Base Rate $150 $195 $195 Rate (1-2) so $0 $0 Rate (3-35) $18 (starts at 9) $25 $30 Rate (36-100) $18 $35 $40 Rate ( ) $18 $45 $50 Rate (501+) $18 $55 $60

2 ANALYSIS Changing tax policy can be a challenging undertaking, but despite the challenge the City Council, staff, and the business community have all moved very quickly to develop a business tax modernization measure for the 2016 ballot. I think all involved deserve great credit, including Mayor Liccardo, my colleagues on the City Council, city staff, the Silicon Valley Leadership Group, the Chamber of Commerce and especially Professor Scott Meyers-Lipton, who initially proposed the concept. We're very fortunate to have a combination of vigorous advocacy and able leadership on this issue. I'm writing this memo because I want to follow up on an issue I raised when this matter came before the City Council in June. As I pointed out in a memo I wrote at the time, the staff proposal increases the business tax rates for residential rental properties much more than it does for other types of businesses. As a result, the proportion of total tax revenue contributed by rental property owners would increase substantially as against the current tax structure, and the proportion borne by businesses that pay per employee would decrease as against the current tax structure. Charts included on page 14 of the staff report dated July 20 th illustrate how the proportion of the tax borne by different types of businesses would change from the current situation to the staff proposal (I'll discuss the alternative chart shortly.) I've reproduced those charts below. Current Staff Proposal Alternative Mobile Home Water Commercial Parks 0% Companies 0% 10% Residential 7% 83% Commercial 14% Residential 16% Mobile Home Parks 0% Water Companies 1% 69% Mobile Home Parks 0% Water Companies ^.. 1% Commercial Ba l4< ". Residential. 12% 73% As you can see, the proportion born by residential property owners would go from 7% to 16%. My concern is that I still don't think that it's equitable to place such a large proportion of the burden on just one sector of our business community. There's a legitimate question as to what equity means in this case: how should we apportion the tax between residential landlords, commercial landlords, and employers? In my opinion, the fairest approach would be to try to match the proportion of the tax borne by each sector to the relative size of each sector within our economy. I realize that no data has been provided publicly that could help guide us on this question; if staff has any data that may shed light on the relative size of property rental as a share of our economy I would be very interested to see it. In the absence of data, however, it's hard for me to imagine that residential property rental comprises 16% of our economy. Even if we want to increase the proportion of the tax borne by residential rental, 16% is excessive. Thankfully, staff also presents alternative policy options for residential and employer rates on page 16 of their report. I believe this alternative, which follows the proposal I put forward at the June 21 st meeting, is a more equitable approach. It would increase the rates for businesses that pay per employee by five dollars for each tax bracket, and reduce rates for residential rental property owners by an offsetting amount. The end result is that residential landlords would bear 12% of the overall tax instead of 16% (see chart labeled "Alternative" above for comparison.) The share paid

3 by residential landlords would still increase substantially from 7% to 12%, for a total increase of 5%~but I think that's more reasonable than going all the way to 16% The other proposal I made at the June 21 st meeting a slight increase to the rate for commercial property owners has already been incorporated into the staff proposal. I thank them for taking the suggestion. What do other cities do? As there may be some difference of opinion as to whether we should reduce the residential rates, let me take a minute to make the case for my recommended approach in more detail. When we discussed the issue of equity back at our June 21 meeting, Mayor Liccardo had a good suggestion: he recommended we ask staff to do research on the business tax rates that other cities impose on rental property. Here's what he said: I do think we need to look at how our tax rate compares to that of other cities if we want to think about equity, and I've certainly heard from some in the industry who say that San Jose's rate is considerably lower on residential property than others in the region. Staff has done research in response to the Mayor's suggestion, and their results are striking. They show that San Jose's proposed tax on rental property would be far higher than any imposed by the nearby jurisdictions they surveyed. I've reproduced the chart from page 11 of the staff report below. Residential A City Base Tax Incremental Tax ^ San Jose's rental property San Jose $ 195 first unit Progressive; $20 to $50 per unit to Cap of j r rates would be much higher $150,000 1 k than other nearbv cities. Campbell $65 - first unit $3 - each additional unit Fremont $30 general fee $1.30 per $ 1,000 gross rental receipts N Milpitas $30 - first four units $2 - each additional unit Morgan Hill $ 15 - base $3 - per rental unit Mountain View $12-first five units $2 - each additional unit Santa Clara $15 - first unit Progressive; $5 to $12 per unit to Cap of $500 Sunnyvale $ one unit Rough ly $10 per unit to Cap of $5,000 As the Mayor said on June 21 st, "we need to look at how our tax rate compares to that of other cities if we want to think about equity." We've looked at how our proposed rate compares, and the conclusion couldn't be more clear: the proposed residential rental property rates would be too high. Again, even under my recommended proposal that lowers rental property rates, San Jose's rates would still be higher than any of the other jurisdictions above, but at least the difference would be more reasonable. Staff argument as to why residential should pay more In their report, staff acknowledges that their proposed rates for residential rental property are higher than other cities, and makes a brief attempt to explain why this difference is justified. Here's what they say on page 11:

4 In summary, it appears that the proposed San Jose Business Tax structure for residential landlords is higher than smaller nearby cities. However, compared to other cities, residential real estate is a more significant business in San Jose, given San Jose's small employment based businesses relative to its population. In addition, residential real estate is a relatively larger component of the tax base and places a higher demand on the use of City services and infrastructure. There seem to be two arguments advanced here: first, that residential rental is a "more significant business" in San Jose, and second, that residential rentals consume more services. As to the first argument, I'm not sure what staff means exactly by a "more significant business," but as discussed above I do think it makes sense to try to apportion the tax between different business categories roughly equal to the size of each category in the overall economy. If that's what staff is getting at here if they are suggesting that the more "significant" portions of our economy should pay proportionally more, and less "significant" portions should pay less, then I agree with them in principle. In practice, however, I have a hard time believing that residential rentals make up 16% of our economy, as I mentioned above. If staff has data that supports the idea that residential rentals are that significant, then they should absolutely provide it to the Council, but in the absence of such data I think we need to adjust the rates to a more reasonable level. In their second argument, staff contends that residential rental business should be taxed at higher rates because such business "places a higher demand on the use of City services and infrastructure." I think this argument oversimplifies the very complex relationship between employers and housing. The fact is, businesses do benefit from the services provided to residential property. Businesses located in San Jose also employ people who live in San Jose. Those businesses benefit greatly from the fact that San Jose provides their employees a place to live. As we have all heard many times, the Silicon Valley CEO Survey, conducted by the Silicon Valley Leadership Group, consistently finds that the availability of housing is the top challenge for doing business in Silicon Valley (I've included an infographic What are the top 5 business challenges in Silicon Valley? $$68% recruitment/ retension costs 63% ic congestion 42% ess regulations 38% Business taxes taken from the 2015 survey to the right.) Given the business community's aggressive advocacy in support of housing, it's very hard to argue that business does not benefit substantially from the provision of housing, and therefore should contribute to support the services that housing requires. It has become fashionable within City Hall over the past decade to try to enforce a rigid fiscal distinction between jobs and housing, but the real world is nowhere near as simple. Jobs and housing depend on one another, and cannot be so easily pulled apart. Polling Finally, I'd like to point out that, based on our polling, the public seems to agree with my take on this issue. Staffs supplemental memo dated July 27 th includes recent polling results on the business tax. Page 3 of the polling results shows the results for questions that tested support for various elements of business tax. They consistently show that there's considerably more support

5 for increasing the tax on employers than on property-based business. Here's a summary of three relevant questions: Question Number 5b 5c 5f Question Increasing the business tax for larger businesses with more employees Increasing the business tax for larger rental properties with more rental units Increasing the business tax for commercial and residential landlords Total Support Total Oppose 68% 25% 50% 41% 44% 47% It's certainly true that poll numbers don't necessarily determine what the right policy outcome should be, but when polls match up with good policy arguments, as I believe they do in this case, then we should sit up and take notice. CONCLUSION I will close by noting that the increase to the tax rate on employers that 1 propose is relatively modest five dollars per employee but by making this small change we can achieve a more equitable tax structure that is a less radical change from our current tax structure. As I have discussed above, I do not believe the policy rationale that has been offered to justify the proposed spike to residential rental property owners is compelling. We're going way above what other cities charge, and even if we wanted to set tax rates based on who benefits from services, it's abundantly clear that employers benefit from services provided to residential property. By any measure, I think the tax needs to be adjusted.