What's Wrong with California?

A defense of the Golden State, and a modest proposal

Californians are perennially dissatisfied with their state and local governments. When polled, they claim that their taxes are too high and that their government services are inadequate.

While that sentiment is shared by many Americans, Californians would seem to actually have a valid gripe. California has some of the highest tax rates in the country. Of the three primary taxes that fund state and local government in the US—sales tax, income tax, and property tax—California has the highest rate in the nation for two of them (sales tax and income tax) and is in the middle of the pack for the third (property tax).

High tax rates in California do not necessarily translate into better funded public services. For state and local governments, K-12 education is the largest single budget item, and here, California is a perennial laggard. In 2011, California’s per pupil education spending was dead last in the nation, although by 2017, it had managed to climb to 41st.¹

The more you think about California’s high tax rates, the more the mystery deepens:

1. California is a high-income state, ranking 5th out of 50 in median household income. All things being equal, one might expect richer states to have lower tax rates, since they have larger tax bases. For example, nearby Washington has similar per-capita income but no income tax at all, getting by with a high sales tax and a middling property tax.

2. California has a lot of extremely rich people and a high income tax. In 2019, the 0.55% of California households making over $1 million per year paid 39% of all California state income taxes, and income taxes are by far the largest source of California state and local revenue.² These few households provide a lot of revenue without consuming proportional public services. One would imagine that California’s reserve of rich people should act like Alaska’s reserve of oil; it should serve as an external source of revenue, allowing the state to have lower taxes on everyone else. Most states have fewer rich people and/or no income tax (examples of the latter include Washington, Texas and Florida), and they still manage to fund their schools while maintaining semi-reasonable tax rates.

3. California has very high property values relative to income, and property tax is simply a wealth tax on property. Again, one would expect this to translate to lower tax rates, since revenues are tied to property values and expenses are tied to incomes. Zillow puts the median California home at $770,000, 9.4 times the California median household income of $81,575. In Ohio, the median home is only $217,000, 3.5 times the Ohio median income of $62,689. High housing prices do inflate the cost of services, but not by that much; starting teacher salaries are only 30% higher in California than they are in Ohio, while California home values are 255% higher than Ohio home values.

There are two common explanations for this puzzle: 

1. California’s sales tax applies to fewer goods than most states’ sales taxes. The theory is that even though the sales tax rate is very high, more goods in California are exempt, so it balances out. However, even factoring this in, California is still in the top third of sales tax revenue per capita, not far behind the leaders, so this isn’t a satisfying explanation. 

2. California’s income tax is more progressive than income taxes in other states; therefore looking at the top rates is a little misleading. This also has some truth, but low to middle income households in California have little income to be taxed anyway (households making less than $50,000 make up 55% of tax returns but only 12% of adjusted gross income), so this doesn’t make much of a difference. Also, the regressivity of California’s high sales tax more than offsets the progressivity of the income tax, as this chart from the Institute on Taxation and Economic Policy shows:

So, what else could explain this puzzle?

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In most states, families in need of public assistance face an uphill battle. Annie Lowrey has regularly chronicled the obstacles ordinary Americans must confront when applying for welfare, food stamps, or unemployment: if they even find out about the program in the first place, the path to benefits is littered with “pointless roadblocks” designed to get the applicant to give up, from lengthy forms to unreasonable demands for evidence. 

If the applicant perseveres, the submitted application is then likely to disappear into a bureaucratic black hole, never to be seen again. In the rare case that the application is eventually approved, the state often later accidentally or intentionally kicks the eligible recipient out of the program. In Louisiana, over one in four eligible food stamp recipients incorrectly lose their benefits at some point in a given year, and must apply to get them reinstated.

The numbers are grim. In Mississippi, less than 10% of poor families that apply for welfare are successful. There, only 4% of families with children in poverty receive cash assistance from the government. Of the $86.5 million per year allocated to Mississippi by the federal government, only $4 million reaches needy families, with the balance left unused or misappropriated by the likes of Brett Favre.

By contrast, California is a shining beacon. California operates the largest, most ambitious social welfare program in the entire country, funded entirely out of its own tax revenue. It costs California $68 billion per year, or $5,200 per household.³ Furthermore, it is unquestionably the most efficient welfare program in existence—the state automatically figures out your eligibility and sends you the exact amount you are entitled to, with 100% accuracy. There are no complicated applications to fill out, no bureaucratic overhead, no waste. The money just automatically flows to deserving Californians that need public financial support.

Here is how the program works:

1. California automatically calculates how much your real estate holdings have appreciated in value since you acquired them, after adjusting your original purchase price for inflation.⁴

2. Every year, California will automatically send you a check for ~1.2% of the total cumulative appreciation in excess of inflation. For example, if you purchased a home for $1 million (adjusted for inflation), and it is now worth $2 million, you will get a check for ~$12,000 each year.

That’s it. That’s the whole program. 

If this sounds too good to be true, you can go online and check for yourself—you can easily look this up for any home on Zillow, by scrolling to the tax records section. 

Consider the example of this ordinary San Francisco home. Zillow says it was purchased for $880,000 in 1999 ($1,300,008 adjusted for inflation), and is worth $2,775,990 as of this writing. (That is not unusual; the typical San Francisco home goes for $1.5 million.)

At the current San Francisco property tax rate of 1.18%, this homeowner should have had a 2022 tax bill of $32,513 (or thereabouts). But Zillow says that the actual tax bill paid in 2022 was $15,987, based on the inflation-adjusted purchase price. This year, California effectively sent this homeowner a check for the difference of $16,526, which simply represents cumulative appreciation to date multiplied by the property tax rate of 1.18%.

Good accounting helps us frame and understand economic reality, and bad accounting obscures it. California has this incredibly successful welfare program, but it is hidden and misunderstood because it is buried and mischaracterized as some kind of technical tax adjustment. 

This type of program is commonly known as a “tax expenditure”. Getting a check in the mail and getting a discount on one’s tax bill are economically identical for the recipient, and proper accounting should reflect that. Consider the Covid-19 stimulus checks—those were technically refundable tax credits, but everyone treated them as if they received a check in the mail. Unlike California, the Federal government actually does a good job correctly reporting on and accounting for tax expenditures.

Once you adjust for this program, California’s fiscal picture makes much more sense. The $68 billion price tag is a huge sum, approximately equivalent to what California collects each year in sales tax, or comparable to what the state spends each year on health and human services. Properly calculated, property tax should be considered the largest source of revenue, as might be expected for the state with the highest property values, and this unique program would be the second biggest item on the expenditure side, trailing only K-12 education ($120 billion). It turns out that California just suffers from murky accounting.

At this point, you probably still have objections, which I will address below.

You are wrong to assert that getting a check in the mail is the same thing as getting a discount on your tax bill. Taxes are impossibly high in California, and this program just brings them down to normal.

As consumers, we have been conditioned to be skeptical of inflated list prices, which exist solely to trick us into thinking we are getting a bargain when in fact we are paying full price. Consider a sweater at J.C. Penney, with a supposed list price of $100, but advertised at 50% off, or $50. 

There are actually rules that require that the sweater must have been listed at $100 in the past, but there is no guarantee that anyone ever paid that price, or that J.C. Penney even expects anyone to buy it unless it is listed at “50% off”. List prices can be arbitrary and misleading. No one believes they are making $50 when they buy a sweater at J.C. Penney. 

Property taxes are not like sweaters at J.C. Penney. If you squint, you can see a baseline in modern America where almost all income is expected to be subject to taxation, regardless of source—whether it be from labor (wages), capital (corporate profits, dividends and capital gains), or real estate (rents).

Labor income is subject to personal income tax and payroll tax, and profits from capital are first subject to corporate income tax and then subject to (reduced) personal income tax and capital gains tax upon distribution.

Owner occupied real estate is unique because the returns are almost entirely exempt from federal taxation. You get tax-free income from your home by renting it to yourself (“imputed rent”), and capital gains realized from selling your home later are usually also tax-exempt.

Instead, you pay annual property tax to your state and/or local government. Property tax is merely an annual wealth tax applied to the value of your property. A wealth tax may or may not be more fair or more efficient than an income tax, but comparing the two suggests that this particular wealth tax is not that burdensome. 

A 1.2% property tax applied to a home purchased at a typical 6% cap rate (that is, a home that each year is returning 6% of purchase price in income or saved rent) is effectively the same as applying an income tax of 20%. This compares favorably to the combined state and federal marginal income tax applied to labor in California, which is upwards of 30% even at lower brackets and can go above 50% at the top levels.

In the past, there have been J.C. Penney sweater-type situations where there was a “sticker” tax rate that no one paid. In the 1950s and 1960s, the top income tax bracket was raised to over 90%, but it was coupled with so many loopholes that virtually all high income taxpayers were actually paying lower rates than they had before.⁵ At the time, the journalist John Brooks observed that “the evolution of our income tax has been from a low-rate tax relying for revenue on the high income group to a high-rate tax relying on the middle and lower-middle income groups”. In that case, the supposed baseline rate was clearly for show; almost no one paid it.

This is decidedly not the case for property taxes in California. Everyone who has bought a house recently is absolutely paying the full property tax rate, and the full property tax rate in California is perfectly average compared to the property tax rate in other states. Furthermore, the full property tax on owner-occupied homes in California is actually still very low when compared to the effective tax rates on all other sources of income.

You don’t understand this program at all. The primary purpose of this program is to keep seniors from getting kicked out of their homes due to rising property taxes.

Even though California is the only state to have this kind of program, there is no epidemic of senior citizens getting kicked out of their homes elsewhere over rising property taxes, even in other states with higher property tax rates and expensive homes.

First, many states, including California, have a program where seniors can apply to defer payment of property taxes (with interest) until the property is sold. There is no need to exempt property owners from property taxes to allow them to stay in their homes; the state can easily finance tax deferral as needed.

Second, if California’s program was designed to help senior citizens with moderate incomes, then you would expect it to be limited to senior citizens with moderate incomes, like New Jersey’s “Senior Freeze” program. (New Jersey has the highest property tax rates in the nation, at an average of 2.5%, more than double the standard rate in California.) California’s program is much more broadly targeted: It is open to rich people, young people, corporations, anyone that owns a property that has gone up in value. It is clearly designed to redistribute wealth to entities who have made a lot of money by investing in California property. This is clear when comparing the cost of the programs: New Jersey’s Senior Freeze costs $67 per household, while California’s program costs $5,200 per household.

Well, in that case, this is a really bad welfare program. This just redistributes money from renters to landlords, from workers to real estate speculators, from working families who rent apartments in Bakersfield to wealthy executives that own mansions in Los Angeles, etc. Since benefits are mostly tied to historical land appreciation, it doesn’t even incentivize economic investment.

Now we are getting into the realm of value judgments. This program, although underappreciated, is still very popular in California, and therefore must reflect the values and priorities of Californians. Those of us who live in other states should try to respect the culture and values of California residents, even if we do not share them.

That said, it is undeniable that California has developed a very efficient welfare program. Everyone that is eligible receives benefits automatically, and there is almost no bureaucratic overhead at all. That is something other states can learn from.

Even taking value judgments into account, we should remember that welfare programs don’t all have to be about needy families. Landlords have needs, too. 

Also, needy families are unlikely to be long term residents of California, because rents are rising faster than incomes. It only makes sense that California would take money away from transient renters who will eventually have to move to more affordable states like Nevada or Arizona, and give it to wealthier homeowners that will be able to stay in California for the long haul.

Finally, California should be lauded running a uniquely fair program; the largest individual beneficiaries don’t even live in California. The landmark 555 California building in San Francisco is 30% owned by the Trump Organization, and 48 Hills estimated in 2020 that the Trump Organization is receiving around $3.5 million a year from this program. What other state is so generous toward non-residents? 

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Wherever you drive in America, when you pass a construction project, you usually see a sign like this:

These signs are effective marketing. They connect the tax dollars you pay to a tangible benefit you can see with your own eyes, something you will remember when you go to the polls to vote on the next highway bill.

And therein lies the solution to California’s problem. California has this very successful program that is misunderstood because it isn’t tangible enough—people can’t connect the taxes they are paying to the benefit they are receiving. They just need some help connecting the dots, something to do what this sign does. This is a simple marketing problem.

Here is a modest proposal:

1. Earmark specific taxes to pay for this program. The cost of this program happens to match total revenue from California’s state and local sales taxes, so let’s use that in this example. From now on, whenever people buy something at the store, they know that the sales tax they pay goes to fund this program.

2. At the beginning of each year, calculate how much each household paid into this program in the previous year. Since we are using sales taxes, this will have to be inferred based on income. For example, research shows that a median California household making $82,000 will typically end up paying $3,700 in sales taxes.⁶

3. Write a software application that matches program beneficiaries with a household (or more likely, a combination of households) that paid an equivalent amount in the same year. For example, our San Francisco homeowner from earlier that received $16,500 might get matched with five middle class families that rent in Fresno who pay $3,300 each in sales taxes each.⁷ Now we have made it into an “adopt-a-property owner” program. This makes the benefit much more tangible for taxpayers.

4. Create a state holiday, one day each year where program beneficiaries host an open house for the specific family or families that sponsored them. (There would have to be extra days for the people that own multiple properties.) This is the most important part, as it would allow taxpayers to actually see where their money is going; the private school tuition subsidized, the Tesla payments covered, the kitchen remodel underwritten. This would also allow them to speak to program recipients, and gain an understanding that they are making a real difference in the lives of real families. The state could even issue physical vouchers to taxpayers representing the amount they paid into the program in the past year, so that they could have the pleasure of handing them over to the people they are sponsoring.

A program like this would have the added benefit of increasing empathy and understanding statewide, by bringing together Californians whose lives don’t usually cross. It would pair renters and their landlords, young new homeowners and 40-year residents, rural farm workers and big city lawyers.

This would be a particularly fun program for taxpayers that draw commercial and industrial recipients. One of the largest single recipients is Disneyland, which supposedly benefits to the tune of $20 million or more per year. A thousand or so lucky California families would get a private audience with Donald Trump. Lots of families will get to visit shopping malls and oil wells.

If this scheme works, Californians may even push to expand the program. Either way, once Californians understand exactly where their taxes are going, they will no doubt have fewer complaints about their government.

1. Education funding in California is volatile because it is tied by law to income tax receipts, which are very lumpy as they are dependent on realized capital gains. Capital gains income has been exceptionally high the last couple of the years because of the frothy market, but that tends to go to zero when the market is down.

2. If you are curious how unequal California is compared to the rest of the country, the IRS reported that households making over $1 million accounted for 0.35% of returns and 14.5% of the adjusted gross income in 2019, compared to 0.55% and 19.8% in California.

3. I calculated this based on the Census’s American Community Survey (ACS) for 2019, which surveys homeowners about (among other things) home values and property tax paid, to calculate the gap between the stated property tax rate and the effective property tax after accounting for this program. I extrapolated this to 2022 based on California’s budget numbers and actual home price changes between 2019 and 2022. Finally, I extrapolated this to cover multifamily and commercial and industrial properties as well; single family homes and condos make up 60% of the California property tax base, while commercial and industrial accounts for 20% and multifamily accounts for 10%.

There was a failed voter initiative in 2020 to end this program solely for commercial and industrial properties valued at over $3 million, which was at the time estimated to bring in $8 billion to $12.5 billion. This also maps to my estimate, if you extrapolate it.

This is an expensive program because coastal California real estate has gone up in value a lot in recent years, and this program discourages housing turnover, which keeps assessments from resetting. In Los Angeles, the average homeowner had spent 18.1 years in their home, compared with an average tenure 13.2 years nationally; Los Angeles home prices are up 2.4x in the last 10 years and 5.2x over the last 25 years.

4. Annual inflation adjustments are capped at 2%, some years (like 2022) the adjustment will lag actual inflation.

5. Brooks describes the exemptions at the time, the most important of which allowed people in the highest paying professions, specifically corporate executives and entertainers, to characterize most of their labor income as long-term capital gains, which were taxed at half the normal rate. Also, at the time, investments in oil threw off tax losses amounting to many times the cost of the actual cost of drilling the well (the “depletion allowance”, and tax-free municipal bonds offered generous interest rates. Most of these programs were curbed later on, particularly with the Tax Reform Act of 1986, which lowered the top income tax rate to 28% while limiting the use of deductions.

6. This is also from the Institute on Taxation and Economic Policy. It includes excise taxes (gas, alcohol, tobacco) as well, so it’s a little bit of an overestimate, but it’s good enough for this exercise.

7. Actually, you’d have to adjust it because each homeowner pays sales taxes as well; after accounting for that, maybe it would only be four families.