While California has shown strong improvement in its fiscal affairs in three years, the state’s revenue base remains unstable. A highly progressive income tax structure, which makes California vulnerable to financial market performance, exposes the state to wide budget fluctuations and the prospect of a structurally unbalanced budget, which could be further exacerbated if another economic recession were to occur.

Among the few certainties in California is that voters will have ample opportunity to express their views. The current crop of probable propositions includes measures addressing recreational marijuana, transgender students’ access to public facilities, and several key fiscal and tax-related issues. We’ll focus here on possible structural changes to the California tax system and their revenue implications.
The November 2016 ballot could be jam-packed with fiscal initiatives. There is potentially an opportunity for voters to help create funding sources or solutions to such varied needs as state budget stability, education and medical funding, transportation infrastructure improvements, sales tax code overhaul, and pension reforms.

Potential Fiscal Initiatives

Of these, the most pressing is deciding whether to extend or let expire the additional income and sales tax revenues of Proposition 30. Back in 2012, we were concerned over the passage of this controversial proposition, in large part because failure would require the state to severely cut both K-12 and higher education funding, as well as to consider additional cuts in pensions and other retirement benefits. Fortunately, California voters approved the proposition.
The narrowing of spreads compared to the AAA Municipal Market Data (MMD) scale since then suggests that the bond market has recognized the advances that California has made in structurally balancing its budget. While we expect that the state will continue to exhibit fiscal discipline by implementing tax and policy reforms, and not financially overburden the underlying entities, we are mindful that failure to do so will cause spreads to widen and the pressures on local entities to increase. Rating downgrades would most likely follow. It is also worth noting that any move to stabilize state revenues by de-emphasizing income taxes would appear to shift the burden from the wealthy to the broader population in a state that is already sensitive to income inequality.
Other potential initiatives concerning Proposition 13 reforms, broadening the sales tax base, implementing a severance tax on oil extraction and raising cigarette taxes, and increasing motor vehicle fees and gas taxes to fund a transportation initiative, are discussed in the back of this report. Evidence of grassroots support of some of these issues remains unclear, as does the funding necessary to drive these proposition campaigns. Although each of the proposals is viable in theory, California’s unique form of democracy requires a lot of money. (Low voter turnout in 2014 means that supporters require fewer signatures to get their proposals on the ballot this time around.1)
Proposition 30: When the state was struggling to recover from the Great Recession, voters in 2012 approved a set of temporary taxes to help close sizable state budget gaps. The measure, Proposition 30, raised income taxes on the wealthiest 4% of Californians (individuals earning more than $250,000 a year) for seven years. In the year prior to the passage of Prop 30, the wealthiest 4% paid 50% of state income tax. In the first year of Prop 30, their contribution jumped to 60%. Prop 30 also raised the sales tax by 0.25% for four years.
The measure is now responsible for $8 billion in annual revenues, nearly $7 billion of it from income taxes. The sales tax provisions will phase out in 2016, and the measure will fully expire in 2018. The 2014 passage of Proposition 2 did strengthen California’s Rainy Day Fund to some extent. It mandated that the state set aside 1.5% of the General Fund and capital gains revenue in excess of 8% of the General Fund (until the Rainy Day Fund is equivalent to 10% of the General Fund).
State leaders could allow Proposition 30’s tax rates to expire as scheduled or they could extend the measure beyond 2018. One major issue is how to balance the progressivity and the volatility of the revenue system. By raising rates on the wealthiest Californians, Proposition 30 has made the revenue system more progressive, while also contributing to its volatility, as there are relatively few individuals who generate significant earnings not only from salary but also from capital gains. By placing a greater burden on the resident rich in this manner, California’s revenues will rise and fall with the equity market (and plunge if many members of this demographic leave the state). Back in 2012, Proposition 30 appealed to many voters since it eased fiscal pressures and provided a boost to education spending. It is less clear how voters would respond in a growth period. It may be difficult for state leaders to extend Prop 30 taxes since that would require two-thirds legislative approval. Therefore, an extension might require going back to the voters that require a simple majority.
California Trading Values: As indicated on the following chart, the municipal market has recognized the progress made by the state based on trading values for 5 to 10 year, non-callable, State of California general obligation debt compared to the MMD AAA-scale. At the widest spreads in 2009, the state was in abysmal financial shape. A voter initiative to raise taxes, similar to Proposition 30, failed miserably. California was also running record deficits and had to resort to delaying payments to local governments, state employees and vendors to manage its cash flow crisis during one of the worst recessionary periods in the state’s history.

State of California GOs

Noncallable, 5% Coupon, 5 to 10 Year Maturities

Fiscal  Tremors in California v2_4


The passage of one or more of these still nascent legislative initiatives and propositions could have a significant impact on California. The state’s revenues, which have a propensity for wide swings in performance, mean that the forecasted tax collections aren’t reliably sustainable, and investors, as well as voters, will have to weigh the potential impacts in the context of future recessions along with today’s relatively robust environment. The hard-fought fiscal alignment achievements of the past five years could be easily eroded, exposing Californians to more political and financial uncertainty.
We remain reasonably confident that California will retain its recent fiscal discipline and that the state and most local entities will manage their long-term liabilities while finding new revenue sources to address capital needs. We continue to research and purchase a variety of state and local credits that help provide appropriate risk/return rewards for our clients. We also note that the legislative session ended in early September without any action on the Governor’s major tax proposals concerning motor vehicles or tobacco, so we will have to wait until the next legislative session that begins in January.

Other Potential Fiscal Propositions and Legislation

Proposition 13 Reforms: Proposition 13 limits taxes on both commercial and residential property in California to 1% of the acquisition price, with annual tax increases of up to 2%, depending on inflation. It also set strict voter requirements before other taxes could be raised. Now, Senate Constitutional Amendment 5 is designed to alter the piece of Proposition 13 that covers commercial property. The proposal would phase in full assessment of most commercial property by requiring annual reassessments to full market value. It would generate an estimated additional $9 billion annually for local governments and schools. In an attempt to quell small business opposition, the amendment allows for a $500,000 exemption on personal property taxes used for business purposes, such as machines.
Proponents claim it is fair to close so-called loopholes dealing with business. They often refer to property deals constructed where no single owner takes possession of 50% of a commercial property, so the property is not reassessed as required by Proposition 13 when change of ownership occurs. However, the proposed Constitutional amendment, which would need two-thirds legislative vote to make the ballot, only has a slim chance of passing.2 If the proposal does make it to the ballot, it is sure to face well-funded opposition from both the business and taxpayer advocate communities.
One of the unusual aspects affecting the Proposition 13 business property tax and Proposition 30 extension discussions is the difference of opinions and strategies among public unions. Teachers’ unions have been the biggest beneficiaries of Proposition 30, as the share of school district funding has increased. But other unions, such as the Service Employees International Union, feel left out. A property tax increase would benefit its members, especially on the local government level. Some of the effort behind the Proposition 13 split roll may be a maneuver by these public unions to force the teachers’ unions to work together on one tax issue that would benefit all public labor groups. If two tax increases end up on the ballot, there is less likelihood that either will pass.

Gas Tax for Transportation Infrastructure: Governor Brown proposed $3.6 billion a year in new revenues for repairs to California’s crumbling transportation infrastructure. The state gas tax is currently 42.35 cents per gallon, unchanged since 1994. The Governor proposed to raise the gas tax by six cents a gallon and the diesel excise tax by 11 cents a gallon, with further rises correlated to inflation, and to impose a new $65 per vehicle highway user fee that would apply to all vehicles, even electric cars. He is also recommending taking $500 million from the cap-and-trade program, which generated $2.2 billion this year from fees on carbon emissions to pay for public transit investments.
A key to this plan is an expected $100 million in savings through cost cutting and efficiencies at the California Department of Transportation. However, a recent study by the California Transportation Commission3 estimates the costs of maintaining the state’s transportation infrastructure at more than $500 billion over the next 10 years. Between federal, state and local sources, the state has only half that amount.
Alternatives to an increase in the gas tax could include fees charged for using the roads. These fees could come in several forms: It could directly measure a vehicle’s miles traveled (an idea currently being tested in Oregon); or it could also be levied through a vehicle license fee or attached to insuring a car. Raising the vehicle license fee by 1% from its current 0.65% would maintain an element of progressivity, since more expensive cars are required to pay more. It would also allow many drivers to deduct 25%-30% of the fee from their federal taxes each year. Any increase or establishment of a new statewide tax would require two-thirds approval of the state legislature.
New regional sales taxes are another possibility. While counties could continue to levy a 0.5 cent sales tax to support transportation operations and expansion, the state could provide new authority to regions to levy a similar tax to support transit investment across county lines. To support these regional transportation investments, it is also proposed that voter thresholds could be lowered from two-thirds to 55% for special taxes aimed at local congestion relief.

Tobacco Tax: The proposal would add an additional $2.00 per pack tax on cigarettes. The current tax is 87 cents a pack, which is lower than most other states and far lower than New York, which levies $4.35 a pack. (The federal government also puts a $1.01 tax on cigarettes.) $1.3 – $1.5 billion is projected to be raised and could help the state pay for healthcare costs for low-income residents. A coalition of medical organizations is determined to better reimburse providers who accept Medi-Cal, California’s insurance policy for low-income residents funded by the cigarette tax. Absent the measure, there may be some pressure for the state to increase reimbursement to other types of Medi-Cal providers to ensure that beneficiaries have adequate access to healthcare services.

Senate Bill 8 Upward Mobility Act: This proposed tax code overhaul would smooth out state revenue while also promoting growth by taxing services sold and consumed, lessening the state’s reliance on personal income taxes and better reflecting large segments of the economy. Fifty years ago, 60% of disposable income was spent on durable goods; today, 60% of disposable income is spent on services ranging from legal advice to landscaping.4 Expansion of the sales tax could include professional, financial and construction services, and agricultural services.
Advocates for this broader sales tax base hope that it can also reduce the rate to lower the tax’s economic impact and stabilize the budget. States that have broadened their bases of taxation typically have applied sales taxes to services already connected to retail transactions, such as auto repair services, that can be taxed along with the purchase of tires or a new engine.

Oil Severance Tax: Billionaire environmental activist Tom Steyer is considering putting a 10% oil-extraction excise tax on the 2016 ballot and directing its estimated $2 billion in revenue toward higher education. California is the only one of the nation’s 22 major oil-producing states without an oil severance tax (although the state does collect property taxes from oil companies on the assessed market value of their oil fields). This proposal will be popular with progressives, environmentalists and students but will draw strong opposition from the oil industry and anti-tax and business groups. The biggest fiscal questions surrounding the measure concern its mechanics. It is not clear how this system would interact with the property tax, how funds would be collected, and how they would be allocated.

Pension Reforms – Voter Empowerment Act: Not all potential 2016 fiscal propositions deal directly with changes to the tax code. As we observed in California – First in Pension Reform?5 the state’s 130 public-pension systems had a combined unfunded liability of an estimated $198 billion in 2014, up from $6.3 billion in 10 years. The proposal to amend the state constitution to require voter approval for defined-benefit pensions for new public employees, any enhancements to current employees’ pensions, and the establishment of any pensions in which government subsidizes more than half of a public employee’s retirement benefit, would effectively close existing governmental defined benefit pension plans for new employees.
This new initiative effort comes in the wake of several failed attempts to address the pension issue. In 2012, San Jose voters approved a measure that would have given city employees a choice between a less-generous pension or staying in the current system but contributing a larger portion of their salaries toward paying down the pension liability. Notably, a Santa Clara County Superior Court Judge later overturned that measure for violating the vested rights of public employees. San Jose is now in the midst of trying to get new voter approval for a revised pension plan.
By applying mostly to new employees, the Voter Empowerment Act attempts to get around the so-called California Rule, which affords public employees the right to pensions that they have already earned and to continue earning pensions based on rules that are at least as generous. The only provision of the Voter Empowerment Act that would impact current workers is the requirement that voters approve any pension enhancements. While there is nothing in the ballot proposal that addresses California’s current unfunded liability, it would go toward preventing that liability from continuing to grow. Under this measure, defined benefit pension plans would not be available to new employees unless specifically authorized by voters. It is therefore likely that these benefits would be reduced or eliminated in many jurisdictions.


1 The number of signatures required to get a measure on the ballot is reset every four years, based on the votes cast for governor in the previous general election. Since only 42% of the state’s registered voters – a record low – turned out in November 2014, it will be easier to put a proposed law before the people. Also, state law now requires that all citizen initiatives go before voters in November. Over the past four years, 504,760 signatures were required to get on the ballot an initiative that seeks to change state law – and for a constitutional amendment it took 807,615. Those numbers have dropped to 365,880 and 585,407 respectively.
2 Voters may still have an opportunity to approve or reject a change to Proposition 13. The same public unions and grassroots groups that supported SCA 5 are preparing to file their own initiative if it fails in the legislature.
3 California Transportation Commission 2011 Statewide Transportation System Needs Assessment
4 “Financing the Future: How will California pay for tomorrow?” Chapter 3 From revenue to results: considering today’s tax proposal. California Economic Summit
5 Cure, Howard. “Howard Cure: California – First in Pension Reform?” n.p. January 21, 2014. Web. September 21, 2015. <>.

Howard Cure is Director of Municipal Research at Evercore Wealth Management. He can be contacted at

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