Taxpayer Rights Revival in California

A year and a half ago, a colleague and I wrote about California’s need for a revival of fiscal rules. At the time, in November 2022, voters were considering Proposition 30, a personal income tax increase that would have raised the top personal income tax rate to over 15 percent of income earned over $2 million. By 2022 it had become abundantly clear that taxes and the heavy hand of government were chasing families and businesses alike out of California.

Voters rightfully rejected Proposition 30, with just under 58 percent of voters rejecting the ballot initiative. Despite the resounding rejection of another tax hike, Sacramento continued to tax and spend. To the surprise of many, however, Golden State residents are finally fed up with taxes.

A new ballot initiative seeks to make some serious tax cuts and reminds many of the Tax Revolts of the 1970s. Before getting into the current taxpayer revolt, it’s important to understand how California got into this position today.

When the Golden State was the Gold Standard for Fiscal Rules

The Tax Revolts of the late 1970s and early 1980s included two California ballot initiatives in 1978 and 1979 that solidified its status as the “Gold Standard” of Fiscal Rules. In June 1978, voters added Article XIII A to the California State Constitution, which rolled back property taxes, capped property tax rates, and imposed a two-thirds supermajority requirement to raise taxes. 

In November 1979, voters moved to add Article XIII B to the California State Constitution. Known since as the Gann Limit, this language limited growth of appropriations to population growth and the lesser of either CPI inflation or growth in California’s personal income per-capita. Debt service, retirement costs, and unemployment insurance compensation were exempted. Revenues collected that were over the limitation had to be refunded within two years.

Unfortunately, the Golden State did not remain at the top for long. In 1988, voters approved Proposition 98, which changed the refunding mechanism of the Gann Limit. Instead of refunds greater than the Gann Limit going to the taxpayers, they were sent to the education fund. In 1990, voters passed Proposition 111, which was the death-knell for the Gann Limit. First, the limit calculation was dramatically altered. The population growth portion of the Gann Limit was amended to a weighted average of population growth and the growth of K-12 school enrollment. In addition, the CPI inflation portion was eliminated so that California personal income growth was the only variable used for cost-of-living adjustment. These changes to the calculation of the Gann Limit allowed the government to dramatically increase spending. Proposition 111 also expanded the exemptions to the Gann Limit, including qualified capital outlay spending as well as appropriations from gas tax increases and natural disaster relief spending.

By the 1990s, California’s fiscal rules were not worth the paper they were printed on, paving the way for California’s uninhibited government growth. The fiscal rules enacted in the late 1970s were far from perfect; exemptions for debt services and public pensions allowed those two categories to balloon into some of the most expensive spending programs in the state. But Articles XIII A and B, warts and all, helped keep lawmakers in Sacramento more accountable to Californians than a government without fiscal rules.

Off-Budget Activities and DC Dependence: Government Finds Workarounds to the Tax Revolt

The nationwide attempt at tax revolt, unfortunately, did not fully stop the growth of government. Research conducted in the wake of the tax revolt found that local governments pushed billions of dollars in expenditures to limit-exempt programs and “off-budget enterprises” (OBEs). These entities cover spending projects from roads to airports to water and sewer systems, and exist at both the state and local levels of government (such as the Chicago Transit Authority). They are financed by revenue bonds, which usually do not require voter approval. On paper, these entities are described as self-financing, but they often rely on government funds.

Economists James Bennett and Thomas DiLorenzo describe the appeal of OBE’s succinctly:

Since one of the major advantages of OBEs to the politician is the creation of patronage opportunities which don’t appear on-budget, the politician has an incentive to subsidize OBEs, if possible, whenever user charges do not cover expenditures or when they are threatened with default.”

The logic of collective action shines through clearly with OBEs. Some employees and businesses gain concentrated benefits — revenue from bond-financed projects and the implicit backing of state and local governments should they risk default. In exchange, politicians receive political support for reelection. Costs become dispersed among the general population, whose interests are diffuse. 

In addition to the use of OBEs, state and local governments became increasingly dependent on transfer payments from the federal government. As my colleague Peter Earle and I discussed before in this space, since 1991 (the earliest data available), federal funds have steadily increased as a share of total expenditures at the state level. Federal funds have consistently been the second-largest funding source of state expenditures since 1999 (and briefly held the top spot from 2020-2022). Federal spending spikes immediately after a recession or emergency, then lowers when the crisis subsides, but never down to pre-crisis levels, a real-life example of “the ratchet effect.”

Of course, the lion’s share of transfer payments from federal to state governments are Medicaid spending. Federal government requires the states to follow core matching requirements to receive federal matching dollars. These core matching requirements include covering specific groups (parents, pregnant women, and adults at or below 138 percent of the Federal Poverty Level) as well as providing specific benefits (physician services, inpatient and outpatient hospital services, laboratory and x-ray services, family planning). Ultimately, state policymakers are incentivized to follow these program requirements, then exempt this spending from tax and expenditure limits to maximize federal dollars coming into the state.

Government spending has grown massively, but most taxpayers weren’t watching carefully. Now as inflation is shrinking the purchasing power of their dollar and many are faced with higher tax bills because of “bracket creep,” taxpayers are starting to push back against wasteful government spending again.

The New Tax Revolt

Returning to 2024, the latest ballot initiative in California (Initiative #21-0042) hopes to achieve the same success as Propositions 13 and 4 (which enacted Articles XIII A and B) did in the late 1970s. The current initiative, also known as the Taxpayer Protection and Government Accountability Act, according to The Wall Street Journal “would define all levies, charges, and fees as taxes and require a two-thirds public vote to raise local taxes. It would also nullify some post-2022 tax increases that didn’t meet the new two-thirds threshold.” The bill is sponsored by the Howard Jarvis Taxpayers Association (named after the same Howard Jarvis who spearheaded Proposition 13 in 1978).

Meanwhile, on the east coast, New York taxpayers are pushing back against congestion pricing in New York City, which has been delayed until mid-June because of political backlash from New Yorkers. While congestion pricing can help regulate the flow of traffic with a heavy hand of government, it is politically unpopular, especially in the Empire State where (when accounting for federal, state, and city payroll taxes) the top marginal personal income rate exceeds 50 percent. New Yorkers see this attempt at congestion pricing for what it is: a desperate attempt to raise revenue amid New Yorkers fleeing the city and the state at large in record numbers.

These two tax revolts come on the heels of the nationwide State Flat Tax Revolution. As of 2024, 12 states have a flat income tax, one state (Iowa) is in the process of changing from a progressive income tax structure to a flat income tax, and nine states do not levy a personal income tax on wage or salary income at all.

Long-term success of the contemporary tax revolts depends on state and local government’s ability to cut spending. Current trajectories of spending can be financed only with debt. When government spending is paid for by issuing debt, tax burdens do not disappear. They simply shift from the current generation to future generations.

How Can We Make Sure the Tax Revolts Survive?

To effectively cut spending, policymakers need to consider a wide range of options. No single policy solution is a “silver bullet” to stopping all wasteful government spending. The two most difficult hurdles to overcome will be off-budget spending and dependence on federal funds.

First, states can look at Colorado’s Taxpayer’s Bill of Rights (TABOR) Amendment as a model for a strong fiscal rule. Approved by voters in 1992, TABOR limits the growth of government to the maximum growth of population plus inflation, requires any taxes collected in excess of that limit to be refunded to taxpayers with interest, and requires voter approval of proposed new taxes. This rule also applies to local governments, so the state cannot grow government by way of unfunded mandates on local governments. TABOR, however, does not apply to federal funds given to Colorado.  

Of course, TABOR is also not perfect, and contains exemptions for education spending as well as public pension liabilities. The best fiscal rule would be one that applies broadly to state and local spending without exemptions. However, fiscal rules may run into legal challenges if applied to unfunded liabilities from public pensions and OPEB because they are contractually promised (and in some cases legally protected) benefits offered to public employees. Sound pension reform, such as closing the current pension plan and enrolling new hires into a 401(k) defined contribution plan, can help keep pension systems solvent and lower costs to taxpayers.

States would also need to reduce dependence on federal funds. One way to tackle this problem is to follow Utah’s example of Financial Ready Utah. Enacted in the wake of the Great Recession to prepare for a sudden lapse in federal funds, this package of bills requires state agencies to have emergency plans in place for anywhere between a 5-percent to 25-percent reduction in funding and requires state agencies to seek legislative approval before applying for federal funds.

While the current tax revolts show promise in protecting taxpayer’s hard-earned money, they must avoid the pitfalls of the previous tax revolts. If state policymakers can make meaningful spending cuts and reduce their dependence on federal funds, the current tax revolts can rescue the financial future for ourselves, children, and grandchildren.