Hot Topics in California Municipal Finance
Death, Taxes and Other Unavoidable Things: A Municipal Finance Update
Michael Coleman is principal fiscal policy advisor to the League and can be reached at firstname.lastname@example.org. More information on city finance is available at www.californiacityfinance.com.
At the League of California Cities 2019 Annual Conference & Expo, attendees will have the opportunity to learn about several important new developments in the financing of municipal services in California. This article and its companion article, “Recent Important Changes in Municipal Finance Law,” provide an overview of issues that the session will cover in depth.
A Financially Healthy State Is Good News for Cities
The strength of municipal finances is inextricably intertwined with the financial condition of the state government and actions of the Legislature. Among the thousands of proposed laws that run through the Legislature are ideas that could help or harm the funding or costs of city programs. And when the state runs into financial difficulty, local government finances are also in jeopardy.
But today, city finances are more protected from legislative interference than ever. A series of constitutional measures, beginning with Proposition 1A (in 2004), strictly limits the state’s ability to take, shift, divert or delay all major sources of city revenues. The Legislature may not:
- Reduce the local Bradley-Burns Uniform Sales and Use Tax rate or alter its method of allocation except to comply with federal law or an interstate compact;
- Shift property taxes from cities, counties or special districts;
- Take local revenues from locally adopted taxes or fees;
- Borrow, delay or take transportation tax allocations made to local agencies, including from the Road Repair and Accountability Act of 2017 (SB 1).
The constitutional measures also:
- Require the state to suspend state mandates in any year the Legislature does not fully fund those laws; and
- Stipulate that a state mandate includes the transfer of responsibility of a program for which the state previously had full or partial responsibility. In other words, such a transfer of responsibility is deemed a mandate regardless of how it is named or labeled.
The risk of state actions that may harm city finances has also been significantly reduced by the substantial strengthening of the state’s financial condition over the past 10 years. The state has eliminated a General Fund operating deficit that was in the tens of millions of dollars and now has budget stabilization reserves that will total nearly $20 billion — or 13 percent of revenues — by the end of the 2019–20 fiscal year.
These reserves and more will likely be needed when an economic downturn occurs. The state’s tax structures — especially the personal income tax — are highly sensitive to economic conditions. Nevertheless, the state is in a comparatively strong position to weather an economic downturn. These factors, combined with strong constitutional protections in place for local governments, reduce the risk of fallout for local finances.
It’s Here: Better Collection of Sales Tax Due on Out-of-State Transactions
In April 2019, California began enforcing the collection by out-of-state vendors of sales and use tax due on transactions made by California purchasers. The landmark June 2018 U.S. Supreme Court decision in South Dakota v. Wayfair, Inc. opened the door for a state to compel out-of-state retailers — who conduct substantial commercial activity in that state — to collect and remit sales taxes. The decision reversed the 1992 ruling in Quill Corp. v. North Dakota that a retailer must have a physical presence in a jurisdiction before that retailer has an obligation to collect the jurisdiction’s sales and use tax. The court signaled that Congress could compel out-of-state retailers to collect tax. But since 1992, Congress had not come close to acting on the issue. Many retailers argued that the physical presence rule gave out-of-state sellers an unfair advantage.
In a 5-4 decision, the 2018 court in Wayfair held that the physical presence rule, as first formulated and as applied today, is an incorrect interpretation of Congress’s power under the so-called Dormant Commerce Clause to regulate taxation of interstate commerce. The decision noted that South Dakota limited its tax requirement to vendors with $100,000 in receipts or 200 transactions per year and its tax is therefore not an undue burden on interstate commerce.
In a follow-up action to implement the Wayfair decision, California enacted AB 147 (Burke, Chapter 5, Statutes of 2019) to provide important clarity about its use of this new authority to impose a use tax collection duty on retailers, even those without physical nexus in the state. The bill:
- Adds “economic nexus” provisions stipulating that a “retailer engaged in business in this state” includes any retailer that — in the preceding calendar year or the current calendar year — has cumulative sales from the sale of tangible personal property for delivery in California that exceed $500,000;
- Makes conforming changes to the Transactions and Use Tax law, ensuring that retailers also collect those taxes if they meet the $500,000 statewide threshold; and
- Defines a “marketplace facilitator” as the retailer responsible for collecting and remitting sales and use taxes, effective Oct. 1, 2019. Marketplace facilitators contract with sellers to sell goods and services on their online platforms. Facilitators generally list products, process payments, collect receipts and in some cases, take possession of a seller’s inventory, hold it in warehouses and ship it to customers.
Under AB 147, the obligation to collect applicable transactions and use tax on all sales made for delivery in any city or county that imposes a transactions and use tax applies to a retailer whether inside or outside of California if, during the preceding or current calendar year, the total combined sales of tangible personal property in California — or for delivery in California by the retailer and all persons related to the retailer — exceeds $500,000. This new collection requirement supersedes prior California Department of Tax and Fee Administration (CDTFA) direction on transactions and use tax collection requirements, and it will increase transactions and use tax collections from both in-state and out-of-state sales.
Digital commerce has been growing at more than 10 percent annually in recent years, more than four times the pace of overall economic growth. California’s large size means that compared with other states, online businesses more likely already have a physical presence and therefore have already been collecting and remitting California sales and use tax. Nevertheless, the U.S. Government Accountability Office estimates that between $1 billion and $1.7 billion of California sales and use taxes went unpaid in 2017.
Out-of-state small businesses with less than $500,000 total annual taxable sales transactions in California are not obligated to collect and remit tax. Based on U.S. Census data, CDTFA estimates that this affects less than 5 percent of taxable sales from out-of-state sellers. Sellers are still liable for the sales tax due on transactions where the seller does not collect and remit — but the compliance rate, other than for businesses that are audited, is expected to be low.
California’s sales and use tax comprises several state and local rates and allocations. Of the $1 billion to $2 billion in annual uncollected sales and use tax revenue, about $125 million to $250 million would go to cities and counties for the 1 percent Bradley-Burns local rate. A similar amount would go to local transactions and use tax rates (local add-on sales taxes). This would be a boost in sales and use tax revenues of about 1.8 to 3.5 percent. Under current CDTFA rules, this out-of-state use tax is distributed through state and countywide “pools” in proportion to the rest of taxable sales within the county.
The provisions of AB 147 requiring collection and remittance of sales and use tax by out-of-state retailers took effect April 1, 2019. However, the marketplace facilitator requirements are effective Oct. 1, 2019. Moreover, there are substantial hold-harmless provisions for marketplace facilitators for compliance errors until Jan. 1, 2023.
Learn More at the Annual Conference Session
These issues will be covered in a session titled, “Death, Taxes and Other Unavoidables: A Municipal Finance Update” at the League of California Cities 2019 Annual Conference & Expo, Friday, Oct. 18, from 9:30–10:45 a.m. For location details, see the conference brochure or the League’s mobile app.
For a detailed legal analysis of AB 147, see “Wayfair Decision Means More Sales and Use Tax Revenue for Cities”.
This article appears in the October 2019 issue of Western City
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