California Property Tax System - Case Study Example

California Property Tax

California property tax on commercial and residential real estate continues to elicit heightened debates. One hand, the property tax is a basic source of revenue for local and state governments. On the other hand, the property tax represents a substantial operating cost for enterprises and homeowners. Besides, the tax accounts for a large portion of the housing costs paid by consumers. Therefore, the property tax has significant implications for government, businesses, and individual consumers. Indeed, the Split Roll property tax bill is a contentious proposal. This bill is an amendment to the current Proposition 13, a popular initiative and law that governs California property taxes and assessments. The general idea is that the Split Roll taxes would facilitate a different structure of property assessment and taxation for commercial property and residential property. In light of the debates surrounding the California property tax policies, this paper explores the consequences of the Split Roll taxes. The main hypothesis is that the Split Roll taxes represent a progressive force towards reforming California’s property tax policies, albeit with undesirable consequences for the state. Therefore, this indicates the need for an alternative solution.

California Property Tax System

California has a diverse property tax base, but research shows that tax on property represents one of the largest taxes paid by Californians. The existing property taxes law is based on Proposition 13, approved by California voters as a popular initiative in 1978 to contain rising property taxes (California Tax Foundation, 2015). In particular, the initiative helped in decreasing property taxes by establishing rules for assessing property values using the 1975 value, as well as restricting the annual increment of assessed real property value (California Tax Foundation, 2015). In addition, the Proposition prohibited reassessment of new base-year-value excluding when property undergoes change in ownership or completion of new construction. Essentially, the initiative provides that all locally assessed real property in California should be taxed at a rate that does not exceed 1% (ad valorem tax) of a property value (California Tax Foundation, 2015). The law stipulates that counties should collect the tax and apportion it to the districts according to the law.

Since the passage of Proposition 13, critics have sought to introduce the Split Roll property tax in which business property and residential property would be taxed differently. According to the California Tax Foundation (2015), the proposed law may require businesses to pay higher rates of property taxes compared to residential homeowners. Therefore, a Split Roll tax system could create major changes to the existing law in which the purchase price of a property provides an objective value. The new law may require property assessors to estimate the fair market value of business property, periodically.

Consequences of Split Roll Tax

If passed, the Split Roll tax would have both positive and negative consequences to property owners, consumers, and the government.

Positive/Intended Consequences

Proponents of the new property tax regime argue that business property owners are not paying the fair share under Proposition 13 (California Tax Foundation, 2015). They also argue that residential property owners pay the greatest (72%) share of the tax compared to businesses, which pay 28%.

Further analysis shows that the idea behind a Split Roll tax regime is to ensure that residential property taxes are lower than business property taxes. There is relative consensus in existing literature about the objective of reducing tax rates for residential properties. However, the approach and the potential consequences remain contentious. The first approach to the new property tax regime is to apply different tax rates, which will shift some of the tax burden from homeowners to business. The second approach is to assess residential properties at a lower percentage of the market value and then apply a single tax rate. Therefore, the intended effect of the new regime is to reduce property taxes paid by homeowners.(Frates and Shires, 2012). Essentially, implementing the proposed law would mean that homeowners pay less property tax due to preferential treatment. This is an approach to property tax relief that favors homeowners but detrimental to business properties.

Unintended Shortcomings

Further investigations reveal that a Split Roll tax has its own unintended shortcomings. First, a Split Roll tax will increase the property tax paid by businesses. From an economic perspective, increasing taxes paid by businesses would lead to increased operational costs. Consequently, businesses would lose due to decline in economic output and decreased employment. Preliminary research indicates that the property tax rate may increase by an estimated $6 billion (Frates and Shires, 2012). Estimations also show that increased property tax would cost the California economy a total of $71.8 billion in lost output and about 396,345 in terms of lost jobs for a period of five years into the new regime (Frates and Shires, 2012). In the long-term one would expect a faster increment in property tax due to the elimination of the current law that enforces 2% valuation growth cap. While the estimations rely on various assumptions about the real estate market, the economic effects appear significant.

Another factor to consider when introducing the new valuation system based on Split Roll is the impact to local government finances. Increasing property taxes would lower property values and potentially disrupt finances for local government. Furthermore, a Split Roll tax that ties commercial property taxes to the existing property value would lead to increased volatility in local government finances. According to Frates and Shires (2012), instability in finances would arise because they would become directly susceptible to historic volatility in the state’s real estate market. This means that local governments would struggle to predict future trends in property tax income and thereby complicate future budgetary processes. The ultimate impact would be disruption of local government services.

Similarly, the Split Roll tax system would affect the attractiveness of California as a place of conducting business. Typically, small businesses seeking to lease property opt for markets where the lessee bears the cost of property tax. The small businesses are particularly vulnerable because of the employment losses. Whether small businesses owners rent or own property, the new property tax regime will likely damage the business climate. A recent study demonstrated that the new tax would affect mainly small businesses, especially those owned by women and minority groups (Frates and Shires, 2012).

Largest Tax Burden

An important factor to consider when implementing a tax bill is whom it would affect the most. In the case of the proposed tax law, one would expect businesses that have owned their properties for the longest period to have valuations that vary the most from the current market values. However, the effect is not clear when considering business characteristics such as size. Nevertheless, a previous research by Frates and Shires (2012) found that small firms would bear the greatest impact of the proposed tax regime. This is especially important because larger firms will have more resources and capital available to help in absorbing negative effects of increased operational costs due to additional tax payments. Frate and Shires (2012) postulate that small firms will not have sufficient resources to enable them absorb the effects of tax increase. For this reason, they should be considered more vulnerable to failure due to anticipated increment in operational costs.

Alternatives to the Proposed Law

In order to address to potential unintended consequences of the proposed tax system, it would be imperative to explore other tax relief mechanisms. One idea is to use homestead tax exemptions, which aims to achieve the same goal by reducing the tax rate for residential property owners by using a fixed amount. This approach is available to all taxpayers but provides greater relief to low-income homeowners. Furthermore, the homestead exemptions approach provides a more targeted mechanism to tax relief. One case of successful homestead exemption is the Florida homestead law. According to Ross (2015), the Florida homestead law has three components: exemption from real property, restrictions on devises, and limits on annual increment in property tax. Therefore, this approach provides an alternative way of reducing tax rates paid by homeowners, especially the low-income groups.

Another alternative is to use the circuit breaker mechanism. Anderson (2012) describes a circuit breaker as “a mechanism that provides a state income tax credit for selected taxpayers with high local property tax burden”. This mechanism provides a more targeted way of providing tax relief. It should be considered a viable option when targeting taxpayers who are overburdened with property tax. In order to implement circuit breaker, California would need to specify two important parameters. Firstly, it would need to define property tax burden and specify a threshold proportion of income that qualifies a taxpayer to be regarded tax overburdened. Typically, many jurisdictions use credit C, a form of mechanism in which a taxpayer qualifies for the relief if property tax liability exceeds income (Anderson, 2012). California can also establish other parameters including other income groups. For instance, they can incorporate tax relief programs targeting the disabled, and veterans.

Income tax credit for residential property is another potential mechanism. The state can reduce the property tax by providing income tax credit to homeowners. The credit amount would depend on the property tax amount due. It would also be prudent to consider optional tax freeze and property tax deferrals as targeted tax relief mechanisms for certain demographic group.

Conclusion

In conclusion, Split Roll property taxes represent a progressive effort towards tax reliefs for homeowners. However, this tax regime is too broad with significant negative effects. Reducing tax for residential property would ultimately shift the tax burden to small businesses, which will likely fail because they lack the resource capability to absorb the increased tax payments. Therefore, California should consider alternative tax relief mechanisms targeting specific taxpayers such as low-income groups. Some of the potential options include homestead tax exemptions, the circuit breaker mechanism, and tax credits.