Proposition 30 Governor's Sales Tax and Personal Income Tax Increase

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1 PROPOSITION ANALYSIS Proposition 30 Governor's Sales Tax and Personal Income Tax Increase CALTAX POSITION CalTax opposes Proposition 30. This initiative increases the state's reliance on volatile revenue, increases taxes during tough economic times, and provides no structural reforms. SUBJECT Proposition 30 increases the state sales and use tax rate 0.25 percent for four years (from January 1, 2013 through December 31, 2016); and increases personal income taxes (PIT) for single taxpayers with taxable income exceeding $250,000 adding three new tax brackets of 10.3 percent, 11.3 percent, and 12.3 percent for seven years (2012 through 2018 taxable years). The initiative is sponsored by Governor Jerry Brown and the California Federation of Teachers. MAJOR PROVISIONS Tax Provisions: Increases Sales and Use Tax Rate for Four Years. The state portion of the sales and use tax rate would increase 0.25 percent, and the increase would be in effect for four years, from January 1, 2013, through December 31, Increases PIT Rates for Seven Years. For the 2012 through the 2018 taxable years, marginal PIT rates would increase to: o o 10.3 percent for single filers with taxable income more than $250,000, but not more than $300,000; head of household with taxable income more than $340,000, but not more than $408,000; and joint filers with taxable income more than $500,000, but not more than $600, percent for individuals with taxable income more than $300,000, but not more than $500,000; head of household with taxable income more than $408,000, but not more than $680,000; and joint filers with taxable income more than $600,000, but not more than $1 million.

2 o o 12.3 percent for individuals with taxable income more than $500,000, but not more than $1 million; and head of household with taxable income more than $680,000, but not more than $1 million percent, plus a 1 percent mental health surcharge for all personal income taxpayers (individuals, head of household and joint filers) with taxable income more than $1 million. Single Filer's Taxable Income* Proposed Marginal Personal Income Tax Rates Under Proposition 30 (Using Brackets in Effect for the 2012 Taxable Year) Joint Filers' Taxable Income* Head-of- Household Filer's Taxable Income* Current Marginal Tax Rate** Proposed Marginal Tax Rate** Is Over But Not But Not But Not Is Over Is Over Over Over Over $0 $7,455 $0 $14,910 $0 $14, % - 7,455 17,676 14,910 35,352 14,920 35, % - 17,676 27,897 35,352 55,794 35,351 45, % - 27,897 38,726 55,794 77,452 45,571 56, % - 38,276 48,942 77,452 97,884 56,400 66, % - 48, ,000 97, ,000 66, , % - 250, , , , , , % 10.3% 300, , ,000 1,000, , , % 11.3% 500,000 1,000,000 1,000,000 2,000, ,000 1,000,000 Over 1,000,000 Over 2,000,000 Over 1,000, % (+ 1% Mental Health Surcharge for joint filers only) 9.3% (+ 1% Mental Health Surcharge) 12.3% (+ 1% Mental Health Surcharge for joint filers only) (12.3% + 1% Mental Health Surcharge) *Income brackets shown here in effect for the 2012 taxable year, and will be adjusted for inflation in future years. Single filers also include married individuals and registered domestic partners (RDPs) who file taxes separately. Joint filers include married and RDP couples who file jointly, as well as qualified widows or widowers with a dependent child. ** The proposed additional tax rates would take effect beginning with the 2012 taxable year through the 2018 taxable year. Sources: Franchise Tax Board, Legislative Analyst's Office, and Proposition 30 text. State Spending Provisions The revenue generated by the measure's temporary tax increases would be included in the calculations of the Proposition 98 minimum guarantee thus raising the guarantee. A portion of the new revenue, therefore, would be used to support K-12 education and community colleges, with the remainder presumably helping to balance the state budget. However, basic-aid districts likely would not benefit from new revenue generated under Proposition 30 because most, if not all, of education funding for these districts is supported by property taxes.

3 From an accounting perspective, the new revenue from the tax increase would be deposited into a newly created state Education Protection Account (EPA). Of the funds in the EPA, 89 percent would be provided to schools and 11 percent to community colleges. Schools and community colleges could use these funds for any educational purpose. The funds would be distributed the same way as existing unrestricted perstudent funding, except that no school district would receive less than $200 in EPA funds per student and no community college district would receive less than $100 in EPA funds per full-time student. The budget requires that state spending be reduced by $6 billion if Proposition 30 fails. K-14 education and public universities are scheduled to take the biggest hit from these "trigger cuts." The Legislature and governor could agree to change the budget to avoid some or all of these cuts. Local Government Provisions This measure places into the state constitution certain provisions related to the 2011 realignment of state program responsibilities. In 2011, the state transferred to local government (primarily counties) the responsibility for administering and funding several programs, including correctional functions. The Legislature also approved legislation for an annual allocation from the state to local governments about $6 billion, mostly in sales and use tax revenue. Guarantees Ongoing Revenue to Local Governments. This measure requires the state to continue providing the tax revenue redirected in 2011 (or equivalent funds) to local governments to pay for the transferred program responsibilities. The measure also permanently excludes the sales tax revenue redirected to local governments from the calculation of the minimum funding guarantee for schools and community colleges. Restricts State Authority to Expand Program Requirements. Local governments would not be required to implement any future state laws that increase local costs to administer the program responsibilities transferred in 2011, unless the state provided additional money to pay for the increased costs. Requires State to Share Some Unanticipated Program Costs. The measure requires the state to pay part of any new local costs that result from certain court actions or changes in federal statutes or regulations related to the transferred program responsibilities. Eliminates Potential Mandate Funding Liability. Under the state constitution, the state must reimburse local governments when it imposes new responsibilities or "mandates" upon them. Under current law, the state could be required to provide local governments with additional funding (mandate reimbursements) to pay for some of the transferred program responsibilities. This measure specifies that the state would not be required to provide such mandate reimbursements. This provision appears to conflict with the state's constitutional requirement under the Gann Limit, which was co-sponsored and co-written by CalTax. Ends State Reimbursement of Open Meeting Act Costs. The Ralph M. Brown Act requires that all meetings of local legislative bodies be open and public. In the past, the state has reimbursed local governments for costs resulting from certain

4 provisions of the Brown Act (such as the requirement to prepare and post agendas for public meetings). This measure specifies that the state would not be responsible for paying local agencies for the costs of following the open meeting procedures in the Brown Act. CONFLICTING INITIATIVES What Happens if Voters Approve Both Proposition 30 and Proposition 38? If provisions of two measures approved on the same statewide ballot conflict, the state constitution specifies that the provisions of the measure receiving more "yes" votes prevail. Proposition 30 and Proposition 38 both increase PIT rates and, as such, could be viewed as conflicting, if both are approved. Both contain sections intended to clarify which provisions are to become effective if both measures are approved by voters: If Proposition 30 Receives More "Yes" Votes. Proposition 30 contains a section indicating that its provisions would prevail in their entirety and none of the provisions of any other measure increasing PIT rates in this case, Proposition 38 would go into effect. If Proposition 38 Receives More "Yes" Votes. Proposition 38 contains a section indicating that its provisions would prevail and the tax rate provisions of any other measure affecting sales or PIT rates in this case, Proposition 30 would not go into effect. Under this scenario, the spending reductions known as the "trigger cuts" would take effect as a result of Proposition 30's PIT increases not going into effect. FISCAL IMPACT Unpredictability and Volatility The revenue impact is unknown because taxpayers' behavior is unpredictable, and the volatility described in the "CalTax Analysis and Policy Considerations" below makes it difficult to forecast Proposition 30's state revenue gains from high-income taxpayers. The Legislative Analyst's Office stated that the vast majority of the additional revenue from the PIT increase "is volatile and difficult to predict." While wages and salaries for upper-income taxpayers fluctuate to some extent, their investment income may change significantly from one year to the next, depending upon the performance of the stock market, housing prices, and the economy. Also, if faced with increased taxes, highincome taxpayers may choose to switch their investments to those that are nontaxable, like U.S. Treasury Bonds, defer the sales of capital assets, including stock sales, or may decide to simply move out of California. Higher State Costs State costs could be higher for the programs during the 2011 realignment than they otherwise would have been, because the state loses discretion over cost increases for the programs. Under Proposition 30, the state would be locked into funding these programs. Even though constitutionally required, the state historically has not fully funded all state mandates. Specifically, Proposition 30: (1) guarantees that the state will continue providing funds to local governments to pay for them, (2) requires the state to share part of the costs associated with future federal law changes and court cases, and

5 (3) authorizes local governments to refuse to implement new state laws and regulations that increase their costs, unless the state provides funding. These potential costs would be offset in part by the measure's provisions eliminating any potential state mandate liability from the 2011 program transfer and Brown Act procedures. The net fiscal effect of these provisions is not possible to determine and would depend on future actions by elected officials and the courts. Higher Local Government Revenue Under Proposition 30, local government revenue could be higher than it otherwise would have been, because the state would be required to: (1) continue providing funds to local governments to pay for the program responsibilities transferred in 2011, and (2) pay all or part of the costs associated with future federal and state law changes and court cases. This increased local revenue would be offset in part by the measure's provisions eliminating local government authority to receive mandate reimbursements for the 2011 program shift and Brown Act procedures. The net fiscal effect of these provisions is not possible to determine and would depend on future actions by elected officials and the courts. Government Forecasts For the budget, the Legislative Analyst's Office (LAO) forecasts Proposition 30 would generate about $6 billion of additional revenue annually, while the Department of Finance (DOF) forecasts $8.5 billion of additional revenue. The Board of Equalization estimates that the sales and use tax portion of the increase would generate $1.3 billion. The LAO forecasts that, in the following five fiscal years, there would be an average annual increase in state revenue of $5.4 billion, while the DOF forecasts an average annual increase in state revenue of $7.6 billion. In , the measure's PIT increase would be in effect for only six months of the fiscal year before expiring, and thus would generate lesser amounts of state revenue. These estimates appear to be inaccurate, as they are not based on dynamic modeling and do not reflect taxpayers' behavior, including moving out of California. Migration According to the Tax Foundation, California has lost billions of dollars in tax revenue as a result of net taxpayer migration since If Proposition 30 is approved by voters, the impact on future migration numbers is unknown, as is the potential revenue impact. However, if Proposition 30 is approved, migration may be accelerated. Taxpayers have been eschewing California for years, according to the Tax Foundation. From 1993 to 2009, the AGI migration-related figures for key states are shown in the following chart.

6 Taxpayer Migration Out of California Between 1993 and 2009 Destination State Net California Returns Into Net AGI Into Destination State Destination State Alaska 2,024 $63 million Nevada 171,317 $11.08 billion Texas 110,128 $6.25 billion Washington 75,137 $5.75 billion Source: Tax Foundation And the Manhattan Institute Report, using IRS data, concluded that California lost a net aggregate income of more than $26 billion from resident migration out of California during the years Based on Franchise Tax Board data for 2009, the three new top brackets would affect 3 percent of California taxpayers. However, if their taxes increase, it is unknown if these high-income earners would move out of state or find non-taxable sources of income. BACKGROUND California's budget has posed significant challenges for lawmakers in recent years as they have struggled to balance the state budget. The state's general fund has experienced chronic shortfalls in recent years due to trends in state spending and revenue collected. State budgetary problems have been caused by a number of factors, including the economic downturn, overly optimistic revenue projections and continuous overspending. To deal with the state's shortfalls, lawmakers have reduced program expenditures, temporarily raised taxes, and taken a variety of other measures, including various forms of borrowing from special funds and local governments. Proposition 30 is one of three competing tax increase initiatives that will appear on the November 6 ballot. The others are Proposition 38 (Molly Munger's PIT increase) and Proposition 39 (mandating single sales factor earmarked for green projects). Below is a table showing the differences between Propositions 30 and 38, both of which contain competing PIT increase provisions. Key Differences Between Proposition 30 and Proposition 38 Proposition 30 Proposition 38 Taxes Affected PIT and SUT PIT PIT Rate Increase 1% - 3% 0.4% - 2.2% (Retroactive to 2012) (Starts in 2013) SUT Rate Increase 0.25% N/A Estimated Revenue Raised Based on a Static Model Up to $8.5 Billion $10 - $11 Billion PIT Brackets Impacted Graduated for >$250,000 Graduated for >$7,316 Affects Proposition 98 Yes No Operative Time 7 years (PIT) and 4 years (SUT) 12 years Sources: Text of Proposition 30 and Proposition 38.

7 Single-Filer's Taxable Income Example of a Single-Filer's Tax Liability Under Proposition 30 and Proposition 38* Current Tax Liability Tax Liability Under Prop. 30 Tax Liability Under Prop. 38 Net Tax Increase Under Prop. 30 Net Tax Increase Under Prop. 38 $35,000 $1,114 No Change $1,308 No Change $194 $65,000 $3,648 No Change $4,288 No Change $640 $125,000 $9,228 No Change $10,877 No Change $1,649 $265,000 $22,248 $24,409 $26,432 $2,161 $4,184 $550,000 $48,753 $58,774 $58,402 $10,021 $9,649 $1,500,000** $142,103 $185,635 $171,252 $43,532 $29,149 * Calculations are based on the Franchise Tax Board "Schedule X" income tax brackets for **Calculations include a 1 percent surcharge for mental health services for taxpayers with a taxable income in excess of $1 million. Sources: Text of Proposition 30 and Proposition 38 Ordering of Ballot Propositions Qualified initiatives traditionally are given numbers by the California Secretary of State and are placed on the ballot in the order in which signatures were submitted and they qualified for the ballot. Molly Munger's campaign team submitted signatures for her initiative before Governor Brown's team submitted signatures for the rival Proposition 30. In June, Governor Brown signed SB 1039 (Ch ), a bill that changes the way ballot propositions are numbered and ordered on the ballot. The change benefits his Proposition 30, because it says that all proposed constitutional amendments will appear first on the ballot, before any proposed state statutes. The Munger measure is a proposed state statute and, as a result of this new legislation, her measure appears well after Governor Brown's measure. As a result of SB 1039, Ms. Munger went to court seeking relief from the ballot-ordering change. Judge Timothy Frawley issued a temporary restraining order (TRO) on June 29, forbidding Secretary of State Debra Bowen from assigning ballot numbers based on the new ballot-numbering system until he had a chance to fully assess the merits of the lawsuit. Ms. Munger's lawsuit said that although the law that changes the way ballot propositions appear on the ballot was part of a package of budget bills, it in fact "was in no way, shape or form related to the budget." The lawsuit also contended that the bill is an "abuse of political process and legislative power." Ultimately, however, the judge ruled July 9 that Governor Brown's change could proceed. CALTAX ANALYSIS AND POLICY CONSIDERATIONS The state's PIT has marginal rates ranging from 1 percent to 9.3 percent on the portions of a taxpayer's income in several income brackets, with the 9.3 percent rate applying to taxable income in excess of $48,942 for single filers and $97,884 for joint filers. PIT revenue is deposited into the general fund, and totaled $49.5 billion in A 1 percent surcharge applies to taxpayers with taxable income that exceeds $1 million, with associated revenue dedicated to mental health services.

8 California's sales and use tax (SUT) is levied on the final purchase price of tangible consumer goods, except for food and certain other items. The SUT rate consists of both a statewide rate and a local rate. The current statewide rate is 7.25 percent. Some of the revenue generated from the SUT is earmarked, and the balance is deposited into the general fund. Localities also have the option of imposing, with voter approval, add-on SUT rates to raise revenue for cities, counties, or special districts. As a result, SUT rates in California differ by county and locality, with an average combined state-local rate of about 8.1 percent. Ballot-Box Budgeting The use of an initiative to lock specified levels of funding into the state constitution for various programs, also known as ballot-box budgeting, has severely limited the state's ability to reduce spending or redirect resources in difficult economic times. Notwithstanding the potential importance of some of these programs, mandating funding levels for specific programs restricts the state's ability to make cuts. Increases Income Tax Volatility The state budget already relies too heavily on the very volatile personal income tax, and this measure would exacerbate this problem. Policymakers have repeatedly blamed California's current fiscal crisis on the state's heavy reliance on income tax revenue. The state's revenue stream follows the boom-and-bust business cycle in part because of overdependence on personal income taxes. Revenue volatility is worsened by raising income taxes. Most of the income reported by California's upper-income filers is related in some way to their capital investments, rather than wages and salary-type income. In 2008, for example, only about 37 percent of the income reported by PIT filers reporting more than $500,000 of taxable income consisted of wages and salaries. The rest consisted of capital gains and pass-through entity income. While high-income filers' wage and salary income is volatile to some extent (due to the cyclical nature of bonuses, among other things), their capital income is highly volatile from one year to the next. For example, the current 1 percent surcharge for mental health services on taxable income in excess of $1 million generated about $734 million in , but raised as much as $1.6 billion in previous years. Given this volatility, estimates of the revenue to be raised by this initiative will change between now and the November election, as well as in subsequent years. Fails to Address Reforms Proposition 30 does not address any budget or fiscal reforms, nor does it address education program inefficiencies or accountability concerns. Before raising taxes, lawmakers should consider such reforms and efficiency measures higher taxes may not be necessary if other reforms are put in place. Experience shows that reforms don't occur until there is financial incentive. Before placing Proposition 30 on the ballot, lawmakers did not consider addressing the state's debt or the state's spending limit. Instead, the Legislature approved funding for a $200 billion bullet train, legislative staff had their pay increased, the State Parks Department fiscal scandal was uncovered, a mockery of the budget process ensued, and state spending grew by $5 billion. What confidence do taxpayers have that their money will be spent wisely? Lawmakers ought to be asking fiscal policy experts: "How are we doing? How can we do things

9 better?" In April 2012, CalTax offered lawmakers more than $7.3 billion worth of tangible reforms in our Government Cost Savings Report, which could have helped mitigate budget constraints. Raising taxes should not be the first line of action in attempting to fix California's dysfunctional budget process and structural deficit only reforms can accomplish this. PIT Increase Is Retroactive, Affected Taxpayers Will Be Underpaid If Proposition 30 is approved by voters in November, it will impose a retroactive tax increase, more than 10 months into affected taxpayers' 2012 taxable year. Many of these taxpayers will be severely underpaid on their 2012 tax liabilities. This underpayment would affect both taxpayers who are employees subject to withholding and taxpayers subject to estimated tax payments. It is unclear whether the 2012 tax year withholding tables will be changed to reflect the new tax rates, and if so, to what extent they will be changed. If the tables are fully changed, affected employees could have just two months to accommodate increased PIT withholding to catch up to their new tax liabilities. In such a scenario, some taxpayers subject to the revised withholding tables may find themselves with very small paychecks at the end of the year, as they try to catch up to their liabilities. Proposition 30, however, provides that affected taxpayers who are underpaid could be held harmless from the FTB underpayment penalty under R&TC Section Sales Tax Increase Hurts Manufacturers and Other Businesses California is one of the few states that requires businesses to pay sales and use tax on manufacturing and R&D equipment they buy and use in the state. This makes California a very expensive state for manufacturers and companies engaged in R&D work to operate in, particularly when the sales tax rate is close to 10 percent in some California counties. This extra cost alone can be reason enough for companies not to locate manufacturing and R&D operations in California. The current sales tax imposition on business inputs violates several tax policy principles, including economic growth, efficiency, equity, and simplicity. This causes a number of economic distortions, including what economists call "pyramiding": Tax imposition at multiple levels such that the effective tax rate exceeds the retail sales tax rate. A sales tax on manufacturing and other equipment imposes a particular burden on in-state businesses selling in regional or national markets. These businesses are less able to pass the added cost on to customers, and thus, are likely to reduce their activity in California, providing fewer jobs and reducing in-state investments in equipment, vehicles and buildings. PIT Increase May Hurt Elderly Homeowners, Some Not Wealthy Taxpayers, especially seniors, who have lived in their homes for many years and who have a low tax basis may use the capital gains exclusion, but still have substantial gains to report. These taxpayers would be hit with heavier tax liabilities under Proposition 30. For example, if a widow sells her Silicon Valley home that she has lived in for 35 years, she may have to report a gain of $600,000, thus subjecting her to a 12.3 percent tax rate under Proposition 30, instead of a 9.3 percent tax rate absent Proposition 30. This would result in an $18,000 tax increase for the widow. PIT Increase May Hurt Owners of Pass-Through Entities Owners of pass-through entities (S corporations, estates and trusts, partnerships, and LLCs) that are taxed under California's Personal Income Tax Law could face a tax

10 increase under Proposition 30. Unlike federal law, California does not have a favorable tax rate for capital gains. Rather, capital gains are taxed as ordinary income. With an increase in personal income taxes under Proposition 30, the extra state tax paid on capital gains can be significant, particularly when a taxpayer is in an alternative minimum tax position and is unable to get a federal deduction for the state taxes paid. Impact of Budget Triggers on School Funding Under current law, a portion of the money for schools spent in one fiscal year comes out of the state budget for the subsequent budget year. This is an accounting maneuver or "deferral" that the state has used for several years. Proposition 30 reverses some of this deferral; however, it does not provide additional funds for school spending, since the schools are spending the money as if the deferral does not exist. If Proposition 30 fails and the triggers are pulled, according of the Legislative Analyst's Office: "The backup plan rescinds the proposal to pay down outstanding K-14 payment deferrals, resulting in $2.2 billion in general fund savings. The rescinding of these payments would have little programmatic effect, but it may require some school districts and community colleges to increase their short-term borrowing." Tax Increases Harm the Economy, Hurt Small Businesses Raising taxes in the midst of a fragile economy, high foreclosure rates and a high unemployment rate would hurt recovery efforts. Increasing personal income taxes would hurt many small, unincorporated businesses that pay personal income taxes. Currently, in California, 70 percent of all tax returns report business activities as sole proprietorships. A tax increase would inhibit their ability to thrive in this state. Sales Tax Increase May Mean Gas Tax Increase The proposed sales tax increase would appear to be a trigger for a gas tax increase under the "Fuel Tax Swap." The Fuel Tax Swap provides for a combination of lowering the sales and use tax rate applicable to sales of motor vehicle fuel, excluding aviation gasoline, and simultaneously raising the state excise motor vehicle fuel tax, effective July 1, The Board of Equalization is required to adjust the gas tax rate for motor vehicle fuel to bring in the same amount of revenue that would have been raised if gasoline was no longer exempt from sales tax. R&TC Section 7360(b)(2) states, " the board shall adjust the rate in a manner as to generate an amount of revenue that will equal the amount of revenue loss attributable to the exemption provided by Section based on estimates made by the board " Capital Gains Lock-In Effect Proposition 30 increases income tax on capital gains by up to 3 percent. The effect of this change is to increase the "lock-in" effect that causes taxpayers to reduce sales of assets, particularly stock. As an example, if a stock is providing a dividend of 4 percent, and the investor is seeking a 4 percent return, it will be less financially desirable to sell the stock and invest in another, due to the reduction of the principal because of increased taxes. Simply, there will be less capital to invest and one would have to buy a potentially more risky stock with a higher dividend payout to get the same return. Because of federal tax rates combined with the high California tax rate imposed by this proposal, some taxpayers will be financially better off keeping the stock they own, rather

11 than selling it, as they will have up to only 75 percent of the proceeds to reinvest in another stock, since as much as 25 percent could be lost to taxes. Studies have concluded that the "lock-in" effect reduces the amount of capital for investment, particularly for new start-ups and companies in emerging sectors. BALLOT SUPPORTERS AND OPPOSITION The supporters and opponents below are only those who signed the ballot arguments and rebuttals in the Official Voter Information Guide for the November 6 statewide election. PROPOSITION 30 SUPPORTERS Jennifer A. Waggoner President, League of Women Voters of California Dean E. Vogel President, California Teachers Association Keith Royal President, California State Sheriffs' Association Joshua Pechthalt President, California Federation of Teachers Scott R. Seaman President, California Police Chiefs Association PROPOSITION 30 OPPONENTS Jon Coupal President, Howard Jarvis Taxpayers Association Tom Bogetich Executive Director (Retired), California State Board of Education Doug Boyd Member, Los Angeles County Board of Education Joel Fox President, Small Business Action Committee John Kabateck Executive Director, National Federation of Independent Business/California Kenneth Payne President, Sacramento Taxpayers Association