Local government finance can be rather confusing.  Even a basic understanding necessitates a discussion of the evolution of the state:local relationship.  So let’s start there.  History.  The provisions of the state Constitution and regulatory controls placed in and around local government finance have developed almost to the point of bizarre.

In the early years, local government and local government finance was under the strict thumb of the state.  The state Legislature maintained a deep distrust of local affairs while local officials continued to seek more latitude in municipal policy and local control.  Early on, a few landmark court decisions and several prominent legislative acts were enacted to change the landscape of municipal finance and change the state:local relationship.

One of the most consequential was the 1910 “Separation of Sources Act.”  This Act secured property taxes as a local government revenue source and established the principle of separate revenue sources for state and local governments.  Property tax was believed to be best suited to fund local general services such as public safety, parks, schools, libraries, and public health.

In 1914, the California Constitution was amended to provide most cities with the authority to make and enforce laws and regulations with respect to municipal affairs – a significant landmark in local control.  However, local authority remained and remains to this day subject to state pre-emption, a process that occurs with more regularity as the state’s budget evolves every year.

In 1935, the state pre-empted then existing local taxation of motor vehicles as real property and established a statewide uniform value-based tax on motor vehicles.  This tax is more commonly known as the “motor vehicle in-lieu tax” or Vehicle License Fee (VLF).  Allocations from the VLF are made to cities and counties based on their share of county population.  Over time, the state has borrowed, shifted, transferred, re-allocated, re-distributed, swapped, and re-defined the VLF such that local government can no longer depend on its proper allocation.  Belvedere receives on average $173,000 per year through the state VLF “swap” process.

In 1955, the California legislature passed the Bradley-Burns Uniform Sales and Use Tax Act.  This Act pre-empted then existing local sales taxes and and provided for a uniform, statewide system of sales taxation and collection.  The Act authorized cities to adopt local sales and use tax rates up to 1% of taxable sales transacted in their jurisdictions, to be administered and allocated by the state.  Belvedere collects on average $40,000 per year from its local sales and use tax rate of 1% of the gross receipts of the retailer from the sale of all tangible personal property sold at retail in the City.

Through the 1950s and 1960s many federal and state policy initiatives were enacted that provided the opportunity for more funds and incentives to make their way into the state coffers.  However, the programs and incentives enacted by the state also resulted in a significant amount state mandates on local government without the benefit of a funding source with which to implement the mandate.  The Legislature frequently passes laws that contain local mandates but include no appropriation for the programmatic requirements.  In 1972, the Legislature adopted Senate Bill 90 requiring the reimbursement of costs to local agencies for state mandated programs.  Local agencies must pursue reimbursement through a claims process with the state.  In 2008, there were 46 different city, county, and special district programs mandated by the State.  The City regularly applies to the state for funding for the cost of the many state mandated programs that must be implemented locally.  However, during the state’s annual budget challenge, the state regularly “suspends” payment for local mandates – however, compliance with the mandates is not suspended.  In other words, local governments must continue to conduct the state mandated programs but must do so at local expense.  This suspension process has been ongoing since the early 90s.

The Third Rail – Proposition 13

In 1978, the electorate approved and the Legislature codified Proposition 13.  The electorate sought relief from property tax escalation.  Proposition 13 had far reaching consequences and numerous unintended consequences.  Proposition 13 reduced property tax revenues by more than half and effectively abolished any local control with regard to property tax.  There were six key provisions within Proposition 13 affecting local finance:

• 1% Cap:  Proposition 13 capped property tax rates at 1% of the full cash value at the time of acquisition.  Prior to Proposition 13, local jurisdictions independently established their tax rates and the total tax rate was a composite of the individual rates.
• Assessment Rollback:  Proposition 13 rolled back property values as determined for tax purposes to their 1975-76 level.
• Reassessment Upon Change in Ownership:  Proposition 13 replaced the practice of annually reassessing property at full cash value with a system based on cost at acquisition.  Under Proposition 13, property is assessed at market value for tax purposes only when it changes ownership.  Subsequent annual values are limited to this “base year” amount plus an annual growth factor of 2%.
• Responsibility for allocating property tax transferred to the state: Through Proposition 13, the state retains responsibility for allocating property tax revenues among local jurisdictions.
• Voter approval for special taxes:  Proposition 13 requires two-thirds voter approval for taxes raised by local governments for a designated “special” purpose.
• Taxes imposed by the State Legislature require a two-thirds vote of the Legislature.

Prior to Proposition 13, effective total property tax rates varied, but overall, they averaged about 2.5% of market value.  The 1% limitation and the rollback to 1975-1976 assessed values resulted in an immediate 57% reduction in property tax revenues statewide.

In 1979-80, the Legislature used its authority to allocate property tax revenues to cushion the fiscal impact of Proposition 13 on local governments.  The state was able to shift about $2.7 billion of its annual ongoing financial resources to local governments – as a result, the city property tax losses from Proposition 13 were about 28% less than they might have been.

In addition to the assistance to local government, the Legislature established a system for allocating property taxes.  Assembly Bill 8 reduced school shares of property tax revenues and gave cities, counties, and special districts greater shares.  In return, the state assumed a larger financial responsibility for K-14 schools.  The state also increased its share of costs for a number of social service and health programs operated by counties.

Despite its goals, some of the intended and unintended consequences of Proposition 13 have been:

• Proposition 13 effectively lowered tax burden for elderly and low income homeowners (proportionate to income)
• Proposition 13 allowed for disparate treatment of similarly situated properties
• Proposition 13 results in a disconnect between service costs and revenues deterring any form of balanced planning
• Proposition 13 cut local agency property tax revenues by nearly 60%
• Proposition 13 does not allow tax rates and shares to stay in sync with service demands
• Proposition 13 results in a greater reliance on the state General Fund for county and school spending
• Proposition 13 forces a greater reliance by cities and counties on user fees and local taxes

In the years following Proposition 13, local governments faced substantially constrained revenues both from reduced property tax revenues but also from substantial reductions in state and federal aid.  The reduction in revenues did not coincide with a reduction in demand for services.  The state, after shifting resources to cushion the local impact of Proposition 13, also put itself into fiscal trouble.  To adjust, over time the state has repealed various state aid programs and even shifted local revenues to state coffers.  Between 1981 and 1984 the state shifted over $700 million in VLF revenues from cities, revenue that had never before gone to the state General Fund.

During these same years, the state repealed an assortment of local aid subventions (revenues and reimbursements to local agencies).  To address the ever-increasing gap, local governments began to increase fees to recover full costs and eliminate subsidies.  They sought out ways to raise existing taxes such as business licenses and hotel taxes.  Many adopted new taxes such as utility user taxes, admission and parking taxes.  With statutory authorization from the state, they adopted new forms of assessments to provide needed funds for such things as streets, parks, lighting, and landscaping.

Belvedere presently receives an estimated of $3 million per year in secured property taxes.  The City receives approximately $70,000 in business license revenue from a local business license tax enacted in 1975.  The City does not have a utility users tax, a hotel tax, or parking taxes.  The City does have a Fire Tax in support of fire services for the City.  Funds that are raised through the fire tax provide approximately 53% of the cost to provide services.  The City’s General Fund subsidizes the difference – approximately $$560,000 in FY 2010-11.

Recent trends in municipal finance continue to indicate that there is a decline in predictable discretionary funding available to local governments.  Further that population growth and other factors continue to result in an increase in service delivery demands against which revenues are not keeping pace.  Infrastructure in many communities face significant neglect and environmental issues continue to require expensive mitigation measures.  Over time, issues get worse – not better.

Moving Toward To Today

The courts have given the state more discretion over “issues of state concern” thereby weakening local control over revenues.  The most dramatic example of the shift of power from local governments is the state Legislature’s use of local property taxes to balance the state’s budget troubles beginning in the early 1990s.  To meet its obligations under Proposition 98, voter-initiated, minimum constitutionally mandated funding for schools, the state enacted legislation to shift partial responsibility for funding education to local government.  The state did this by instructing county auditors to shift the allocation of local property tax revenues from local government to “educational revenue augmentation funds” (ERAFs), directing that specified amounts of city, county, and other local agency property taxes be deposited into these funds to support schools.

In FY 2008, the annual impact of the ERAF shift removed $7.3 billion from cities, counties, and special districts.  The state has provided some funding to local governments that it considers “mitigation” for the ERAF shift, but the vast majority of these funds are earmarked for particular purposes instead of the general use funds that were taken.  One such earmark is Proposition 172 that provides funds for police, fire, and other public safety programs using sales taxes.  In 2008, Proposition 172 funds provided on $3 billion annually to local government leaving a $4.3 billion net ERAF gap.  Considering all the ERAF mitigation funds, the net ERAF impact on cities stood at nearly $800 million in 2008.  Although ERAF shifts ended in 2007, the original ongoing shifts that began in 1992 have not been reduced.  Belvedere receives approximately $14,500 a year in Proposition 172 funds.

In 1996, voters approved Proposition 218 expanding restrictions on the ability of local government to raise revenues.  The measure allows voters to repeal or reduce taxes, assessments, fees, and charges through the initiative process; reiterates the requirement for voter approval for both special taxes and general taxes; and imposes substantive procedural limitations on benefit assessments imposed on real property and on certain types of fees.

Under Proposition 218, no local government may impose, extend or increase any general tax until such tax is submitted to the electorate and approved.  In some communities, there is general support expressed for particular issues of local concern – fire, police, library, parks, etc.  In many others, there is not.  But in both communities, the demand for local services often does not change, but instead will increase with demographic changes.  Because of the high threshold of Proposition 218 and the potential for the process to be hijacked by special interests or derailed by situational apathy, local government often turns to rely on fees or charges for services.

Taxes and assessments are subject to regulatory control under Proposition 218.  A tax need not be levied in proportion to a specific benefit to a person or property.  Fees or charges are not taxes.  A fee or charge must represent the actual cost of providing the service.  If a fee or charge is not commensurate with the reasonable cost to provide the service, commodity or facility for which they are imposed they will be considered a tax and become subject to Proposition 218.  Proposition 218 covers the imposition of taxes and most new special assessments.  The key distinction between an assessment and a tax is that an assessment is based upon the special benefit that a property will derive from the improvement or service provided by the assessment.

Annually, the Belvedere City Council evaluates its fees and charges for service to ensure that they are commensurate with the actual cost to provide the service.  These include such fees as planning fees, building permit fees, copy fees, publication and material fees, etc.  The City receives an average of $250,000 in service charges and fees for ongoing projects and operations.  The City does not maintain or receive revenues from any Assessment Districts, such as flood control, lighting, or landscaping.  There are special benefit assessment districts in the City related to utility undergrounding.  These districts were formed consistent with Proposition 218 and Improvement Act of 1911 requirements.

For more information on local government finance and Belvedere specific issues, feel free to contact me at 435-3838.

Next in the Local Government Finance Series:

Part II:  Today’s Revenue Alternatives