California State-Local Fiscal Relationship

This month, the Legislative Analyst's Office issued a report - Ten Events That Shaped California State-Local Fiscal Relations (12/15/09) for a hearing of the Senate and Assembly Select Committees on Improving State Government (Assembly page + Senate page). The 10 events:

1. 1910 Separation of Sources Act
2. 1930s New Deal
3. 1952 Proposition 18
4. 1972 SB 90
5. 1978 Proposition 13
6. 1979 AB 8
7. 1991 Realignment
8. 1992 and 1993 ERAF Shifts
9. 2004 Triple Flip/Swap
10. 2004 Proposition 1A

It's a bit of a cryptic list without the brief explanation of each event offered by the LAO (you can find that here). It also sounds like an odd list with words like "realignment," "shift," "flip" and "swap." The word "proposition" also showing up three times indicates that the voters rather than elected officials created some of the events.

As some of the words used in the list of events indicates, there are oddities in the California-local government relations. While Number 1 on the list - separation of sources, sounds like authority and accountability at each level of government (a good thing), such separation is limited and has been modified since enacted in 1910. Per the LAO report, the Act called for the state to tax railroads, telegraph and telephones while the local governments would tax property and set the rate.

While the bulk of property taxes are collected and used at the local level, the system for how they are allocated among local governments is controlled by the state (Numbers 5 & 6 on the list above - Prop 13 & AB 8). This makes it difficult for local governments to do their job - they can't necessarily allocate revenues to their best need.

Another problem in the state-local fiscal relationship is lack of transparency. Taxpayers don't really know where their taxes go and how they are spent. Part of this is due to oddities in the flow of some tax funds. For example, Event Number 8 on the LAO list - the Triple Flip. To help fund state bond payments, 0.25% of the local sales and use tax was shifted to the state for the Fiscal Recovery Fund. To replace the lost sales tax, cities and counties received funds from the Education Revenue Augmentation Fund (ERAF). The State then uses General Fund monies to replace the ERAF dollars. [ABX1 7 (2003) and Prop 57 (2004)]

Another problem in the state-local fiscal relationship is the sometimes opposing strategies that exist due to flaws in the tax system. For example, cities seeking revenues might aim to get a "big box" retailer to locate inside city borders. This generates sales tax revenues. However, these are not high wage/high skill jobs that would be more advantageous to the state's income tax base and prospects of attracting manufacturing and R&D businesses to the state.

A final problem I'll note is that while the state has a fair amount of control over local revenues (and some expenditures) locals are often forgotten at the state level. A recent example is the final report of the California Commission on the 21st Century Economy. One of the recommendations was a Business Net Receipts Tax (BNRT). This would replace the corporate income tax and the state-level general sales tax. One reason for this proposal was to use a more administratively simple approach to extending the sales tax to services (the BNRT is a type of subtraction method VAT making it similar in collections to a sales tax). However, no comment or effort was made to find a way to update the sales tax base for local governments or to have them share in the BNRT revenues.

It is important for any state level fiscal discussion or action to consider the effect on local governments. The National Conference on State Legislatures (NCSL) includes this in their 9 principles of a high-quality state revenue system - "A high-quality revenue system comprises elements that are complementary, including the finances of both state and local governments."

What do you think of the LAO top 10 list? What do you think are key problems with the California-local government fiscal relationship?