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June 6,1 980

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Afte r Three Rounds: 2-1
On Tuesday, a third round came to a close
in the California Tax Movement, but this
time the opponents won for a change.
Proposition 9 -Jarvis II, or Jaws II as it was
also known - was defeated in the statewide
popular vote by a 62-38 percent margin.
Had it won, Prop. 9 wou Id have been the
third recent government-limitation
amendment to the state constitution. Earlier
rounds resulted in the June 1978 passage of
Proposition 13 (the Jarvis-Gann amendment) and the November 1979 passage of
Proposition 4 (the Gann amendment).
The erstwh i Ie coauthors, Howard Jarvis and
Paul Gann, were divided on the next step
after passage of their pathbreaking
Proposition 13, which rolled back local
. property taxes 57 percent statewide. Gann
(Prop. 4) preferred a patient strategy of
opting for a long-term spending limitation
rather than an immediate cutback, while
Jarvis (Prop. 9) argued for an immediate
reduction of state income taxes by 50
percent. Perhaps voters preferred the Gann
to the Jarvis strategy -or perhaps the former
option won out only because it reached the
voters first. Despite the defeat of Jarvis II,
voter pressure had already persuaded the
California legislature to adopt some of its
features, so it is not clearthat Proposition 9's
message was actually repudiated.
The latest tax-reduction amendment
contained three basic provisions. First, it
would have required state personal-income
tax rates not to exceed 50 percent of the rates
in effect in the 1 978 tax year. Second, it
stipulated that the legislature provide a
system of adjusting income-tax brackets to
reflect annual changes in the California
consumer-price index, and finally, it
exempted business inventories from
property taxation. To fend off the 50-percent
reduction, however, legislators moved early
to pre-empt the other two issues. As early as
1 977, they changed the tax law so that

personal-income tax brackets would be
adjusted annually for changes in the
California consumer-price index in excess
of 3 percent. Then, in response to the
Proposition-9
they removed the
3-percent floor so that brackets wou Id be
fully indexed -but only through 1981, after
which time the 3-percent floor would be
reinstated. Also, the legislature exempted
business inventories by statute in 1979,
effective in the 1980-81 property-tax year.

Discourse via the Constitution
Like its predecessors, Jarvis II grew out of the
grassroots initiative process that has come to
characterize California politics. It qualified
easily for the June statewide ballot after Mr.
Jarvis obtained 820,000 signatures-a
quarter-million more than needed. Long ago,
voters found the state constitution to be an
effective medium through which to talk to the
politicians. The constitutional initiative
process has been the focal point of many
controversial issues in California
anti-busing, anti-pay TV, political reform,
anti-open housing, the death penalty, as well
as earlier attempts in 1968, 1972, and 1973 to
limit taxes and spending.
The overwhelming votes in favor of
Propositions 13 and 4 carried an especially
strong message to government. Proposition
13 rolled back taxes on all property to one
percent of 1 975-76 market value, resulting in
a $7-billion (57 percent) reduction in
California property taxes. Under that initiative, assessed market values can rise no more
than two percent per year from the 1 975-76
base. (All new construction or transfers are
reassessed at current market value.) The
amendment locked these restrictions permanently into the constitution, and stipulated
further that other taxes can be increased only
by a two-thirds vote of the legislature (state
taxes) or "qualified electors" (local taxes).
Proposition 4 carried the movement
considerably further by placing permanent

spending to the 1 978-79 real per capita level
(resulting in a sharp curtailment of pasttrends
and a gradual reductionin California
governments' share of real income), Proposition 9 proponents want hard evidence of cuts
now, particularly in light of the escalating
state income tax.

spending limits on all governments and most
special districts in California. It limited
annual government appropriations
(spending) to the 1 978-79 fiscal-year level
with annual adjustments only for consumerprice increases and local population growth.
The ceiling applied individuallyto the state,
every county, city and school district, and
most large special districts. The Gann
amendment also included added stipulations
to prevent circumvention: surpluses are
returned to the taxpayers; direct fees for
government services are free of the limitation
only to the extent they reflect the cost of
providing each service; adjustments are
made to account for changes in government
boundaries or transferrals of functions to
private enterprise; and voter-approved
increases in the appropriations cei ling extend
no more than three years without voter
reconfirmation.

Effects of tax cuts
Like Proposition 13, the new amendment
would have resulted in an immediate rollback in taxes of dramatic proportions. Hence
a heated debate arose over the amendment's
potential effects on the level of the state's
economic activity and the provision of
government services.
Proponents argued thata 50-percent
reduction in (and permanent restriction on)
state income taxes would have greatly
stimulated private income and spending
while eliminating government waste. The
result, they said, would have been a
magnified positive stimulus to statewide
employment, production, and real incomes
-as was demonstrated earlier in the wake of
Proposition 13.

Given the apparent stringency of
Propositions 13 and 4, what prompted Mr.
Jarvis to pursue a third round? The answer
seems to lie in the failure of the earlier
amendments to bring about major reductions
in public expenditures within California.
Specifically, Proposition 13's drastic
reduction of property taxes lost much of its
punch when the state used its rapidly
J
accumulating surplus to "bailout" local
governments to the tune of $4.4 billion and
$4.9 billion, respectively, in the first two years
of operation. Moreover, Proposition 4's
spending ceiling is unlikely to bite until
several years from now, because governments inflated their 1 978-79 appropriations
bases in anticipation of its passage.

It is true that Proposition 13 stimulated the
state's economy. But the short-run stimulation came not so much from the reduction in
the size of the public sector as from the fact
that taxes were reduced far more than
expenditures. In the first year alone, the state
funded $4.9 billion (70 percent) of the
$7.0-billion cut in local tax revenue, by
sharing its rapidly accumulating budget
surplus with local governments through a
complicated "bail out" formula. Hence,
some short-run stimulus occurred because
Californians received large tax cuts with a

The voter thus has not yet seen much tangible
evidence of reduced government spending in
California. Although the growth rate of
spending has declined, many voters have
seen only the significant shift in taxes from the
local to the state level-particularly
to state
income taxes which have been rising recently
at a 33-percent annual rate according to
some analysts. Although Proposition 4's
spending ceiling will limit government

muchsmallerreductionin public
expenditures.
But the present state surplus is much smaller
-on the order of $2.1 billion, according to
the most recent state estimate. Furthermore,
with the prospect of a deep recession in 1 980,
little or no increase in the surplus may be
expected in the next fiscal year. A surplus of
2

Size of government

this size would have only partly offset the
$4.9 billion and $4.2 billion income-tax cuts
officially forecast for the next two fiscal years
under Proposition 9. Thus, Proposition 9
would have come closer than Proposition 13
to a matched reduction in government
receipts and expenditures
-and its one-time stimulus accordingly
would have been smaller.

Proponents of the tax-limitation movement
argue that to focus only on the sensitivity of
tax revenues to statutory rates is to miss the
underlying issues of the tax-limitation
choices between public
and private decision-making in the
economic, political, and social arena. To
these individuals, a redistribution of
production (even of the same goods) from
public to private enterprise would enhance
productivity, and ultimately, total real
income. Moreover, the private sector would
likely produce goods more highly valued by
society. But the controversy also deals with
other issues: whether government expenditures should be directed toward current
consumption (for example, transfer
payments) or toward activities that enhance
our future capacity to produce (such as
effective education or highways), and
whether government intervention leads to a
more or less equitable (or efficient)
distribution of income.

Tax experts are divided over whether or not a
permanent reduction in tax receipts with a
matching reduction in expenditureswould
provide a lasting stimulus to economic
activity. At its simplest level, the answer
depends on the extent to which our current
tax structure deters incentives to work and
invest within the private sector. Proponents of
Proposition 9 have carried this argument to its
extreme, utilizing the widely-touted "Laffer
curve" devised by Professor Arthur Laffer of
the University of Southern California. Given
the burdensome level of taxes, in Laffer's
view, a reduction in statutory tax rateswould
so stimulate the economy (and reduce tax
avoidance/evasion) that tax revenueswould
actually increase. Laffer's argument has been
used also in support of the Kemp-Roth tax-cut
movement at the national level. Although his
thesis has more merit when applied to states
and localities (where migration is sensitive to
tax rates), many supporters of the
government-limitation movement argue that
Laffer's claims are overstated.

By most estimates (except, of course, Mr.
Laffer's), Propositon 9 would have led to a reduction of 1O-per-centor more in state-andlocal government expenditures after
drawdown of the state surplus. As the
election date approached, Californians saw
the main issues as these: Who would gain
and lose most from the tax and expenditure
reductions? What public services or transfer
payments might be cut? Might the state
merely replace the lost income-tax revenues
with a less-desirable combination of higher
sales and business taxes. And finally, might
Proposition 4 by itself provide an adequate
control on the size of government? In
answering these questions, voters were
wi II ing to settle at this time for the already
legislated portions of Proposition 9, and to
reject the proposal for a massive income-tax
cut. But further rounds in the tax revolt may
yet be fought in California, as well as in other
states and the nation's capital.

In contrast, California's Legislative Analyst
took the opposite extreme in his official
estimate of Proposition 9's effecton state-tax
receipts by assuming no stimulus at
all-even with a complete drawdown of the
state budget surplus. In other words, he
estimated the decline in state income-tax
receipts$4.9 billion and $4.2 billion in the next two
fiscal years -by assuming that receipts
would decline exactly in tandem with the
50-percent reduction in rates. The truth
probably lies somewhere in between this
estimate and the "Laffer curve" estimate.

JackBeebe

3

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BANKINGDATA-TWELFTH
FEDERAL
RESERVE
DISTRICT
(Dollaramounts millions)
in
Selected
Assets liabilities
and
large Commercial
Danks
Loans
(gross,
adjusted) investments*
and
Loans
(gross,
adjusted) total#
Commercial industrial
and
Real
estate
Loans individuals
to
Securities
loans
U.s.Treasury
securities*
Othersecurities*
Demand
deposits
-total#
Demand
deposits adjusted
Savings
deposits total
Timedeposits total
#
Individuals, & corp.
Part.
(Large
negotiable
CD's)
Weekly
Averages
of Daily Figures
MemberDankReserve
Position
Excess
Reserves )/Deficiency )
(+
(Borrowings
Netfreereserves )/Netborrowed( )
(+
-

Amount
Outstanding

Change
from

5/21/80
136,745
115,105
32,839
46,322
23,902
1,135
6,352
15,288
41,166
29,703
26,398
64,185
55,334
22,853

5/14/80
582
559
309
79
+
117
38
9
+
32
1,054
751
+ 207
289
231
165

Change
from
yearago
Dollar
Percent

+
+
+
+
+

10,423
11,702
2,079
8,811
1,998
472
1,396
117
+
687
+
110,
+
3,473
+ 13,602
+ 14,083
+ 5,491

Weekended

Weekended

5/21/80

5/14/80

199
2
197

285
4
281

+
+
+
+
+

8.3
11.3
6.8
23.5
9.1
- ,29.4
18.0
+ 0.8
+ 1.7
+ 0.4
- 11.6
+ 26.9
+ 34.1
+ 31.6

\

Comparable
year-ago
period
31
218
187

* Excludes
tradingaccount
securities.
# Includes
itemsnotshownseparately.
Editorial
comments
maybeaddressed theeditor(WilliamDurke) to theauthor. , .• Free
to
or
copies this
of
andotherFederal
Reserve
publications beobtained calling writingthePublicInformation
can
by
or
Section,
Federal
Reserve
Bank SanFrancisco, Box7702,San
of
P.O.
Francisco
94120.Phone
(415)544-2184.