(OLA #:015-04)

LEGISLATIVE ANALYST REPORT

To: Members of the Board of Supervisors

From: Adam Van de Water, Office of the Legislative Analyst

Date: June 30, 2004

RE: Economic Impact of Proposed Business and Sales Taxes (File No. 040877)

Summary and Scope of Request

Supervisor Hall, through the Board, requested the Office of the Legislative Analyst (OLA) provide a comprehensive Economic Impact Report of the proposed Transaction and Use Tax and Business Tax increases. The Board approved this request June 22, 2004 and Supervisor Hall requested this information by June 30, 2004.

Executive Summary

Mayor Newsom has proposed ordinances enacting a sales tax increase of 0.25% and a gross receipts tax of 0.1% together with clarification of the payroll expense for partnerships and pass-through entities. Both items are pending final Finance and Audits Committee action prior to Board consideration, and, if approved by the Board, would be subject to voter approval on the November ballot.

The Controller's Office has certified the revenues these two proposals would generate if approved: A sales tax increase of 0.25% would generate between $7 and $8 million and a gross receipts tax of 0.1% together with the payroll expense for partnerships and pass-through entities would generate between $15 and $20 million in FY2004-05.

These two measures would give San Francisco the most expensive business taxes in the region and, along with Alameda County and the City of Avalon, the highest sales tax rate in the state.

The OLA projects that the sales tax: 1) will cost the average San Francisco household $34 per year, 2) may induce a small number of consumers to make large purchases out of county, and 3) could lead to proportional increases in prices in those few highly competitive industries currently competing at the margin.

The OLA projects that enactment of a gross receipts tax of 0.1%: 1) would raise the taxes of businesses with gross receipts over $500,000 by 0.1% of gross receipts, 2) may contribute to the perception that San Francisco is not "business friendly," and 3) will provide the City with data to assess business activity and alternate business tax structures.

Background

Mayor Newsom introduced two ordinances amending the Business and Tax Regulations Code to raise General Fund revenues in FY 04-05. Both are subject to voter approval in November 2004. The first (BOS File #040751) would increase the Transactions and Use Tax (commonly referred to as the sales tax) by one-quarter of one percent (0.25%), from 8.50 percent to 8.75 percent. The second (BOS File #040758) would impose a five-year Gross Receipts Tax of one tenth of one percent (0.1%) on the gross receipts of all persons engaging in business in San Francisco and would clarify the payroll expense for partnerships and pass-through entities¹. The City Controller's Office estimates that voter approval of these two ordinances would generate additional revenues in FY 2004-05 of $7 to $8 million and $15 to $20 million respectively. Both items are currently under consideration of the Finance and Audits Committee.

Gross Receipts Tax

San Francisco first adopted a gross receipts tax based on Los Angeles' gross receipts model in 1968. In the 1970s, the City added the payroll expense tax and allowed businesses to pay either the payroll tax or the gross receipts tax (the so-called "alternative method"), the constitutionality of which the City was later challenged for in court in 1999. In 2001 the City settled the litigation and eliminated the gross receipts tax retroactively to January 1, 2000 resulting in a net loss to the City of approximately $20 million annually³. Prior to that time, the City was collecting 0.3% of total gross receipts from most businesses that paid the tax. These revenues came from the following business categories (see Table II).

Anticipated Impacts of Raising the Sales Tax

The OLA anticipates that raising the sales tax by 0.25% would have the following impacts.

#1: Increased General Fund Revenues of $7 to $8 Million in FY2004-05

If placed on the ballot and approved by voters in November, the 0.25% increase would become effective April 1, 2005. The Controller has estimated that approval of this sales tax increase would generate one fiscal quarter of additional General Fund revenues in FY2004-05, or between $7 and $8 million. In FY2005-06, the sales tax increase would generate an additional four fiscal quarters of revenue or between $28 and $32 million.

#2: Additional Costs to Households of $34 per Year

The Controller has estimated that the proposed sales tax increase will cost the average San Francisco household $34 per year (see attached Controller's Office calculation "Sales Tax Increase - HH Impact (PDF)")⁴. This would likely have little impact at the margin for most San Francisco households and is unlikely to impact countywide consumption patterns.

The impact will likely be greatest for lower income consumers with little or no savings and for whom higher consumer prices represent a larger percentage of their incomes. However, this disproportionate impact on the poor is offset somewhat by two factors. First, most basic needs such as housing and eligible grocery and medical items are exempt from sales tax. Second, San Francisco households account for approximately one-third of all revenues accruing as a result of the proposed sales tax increase. Businesses, tourists and the daytime population pay the remaining two-thirds.

#3: Marginal Geographic Shifts Related to Large Non-Vehicle Purchases

The proposed sales tax increase would mean San Francisco, along with Alameda County and the City of Avalon in Los Angeles County, would have the highest sales tax rate in the state. To the extent that consumers are aware of this differential, this may induce some to travel outside of the county for some large purchases where prices would be up to 1.5% less. The following example illustrates this potential geographic impact.

In most cases other than motor vehicles (where the county of registration determines the total sales tax rate), the point of sale determines the sales tax rate applied to purchases. As shown in Table III below, all else being equal, the same $2,000 item purchased in San Francisco would cost $30 less in Marin and $10 less in San Mateo, Santa Clara, and Contra Costa counties.

Table III: Total State and Local Sales Tax Rates in Five Neighboring Counties

This not only impacts San Francisco businesses but it also affects revenues to the City and County. As most sales taxes are computed at the point of sale and not the point of use, tax dollars spent out of county are revenues foregone by the City. In the case of a $2,000 item purchased in Marin and not San Francisco, under the proposed San Francisco sales tax rate of 8.75% this would amount to a tax revenue loss of up to $75 to the City⁶.

Given the variety of factors involved in making a large purchasing decision (including customer convenience, product availability and features, travelling time, financing terms, delivery, warranty and maintenance issues, etc.), the OLA does not expect that raising the sales tax by 0.25% would create any new measurable geographic impacts.

#4: Negligible Increases in the Price of Consumer Goods

Economic research suggests that sales tax increases not only increase the cost but also drive increases in the price of the good.⁷ To the extent that businesses are fully competitive at the margin (in other words, where an additional 25 cents on the $100 may change consumer behavior), the OLA expects businesses will pass on this cost to the consumer.

Anticipated Impacts of Enacting a Gross Receipts Tax

The OLA anticipates that enacting a 0.1% Gross Receipts Tax would have the following impacts.

#1: Increased General Fund Revenues of $15 to $20 Million in FY2004-05

If placed on the ballot and approved by voters in November, a Gross Receipts Tax of 0.1% would become effective January 1, 2005 and expire January 1, 2009⁸. The Controller has estimated that approval of this gross receipts tax increase, together with clarification of the payroll expense for partnerships and pass-through entities, would generate two fiscal quarter's worth of additional General Fund revenues, or between $15 and $20 million in FY2004-05. The same ordinance would generate an additional $30 to $40 million in FY2005-06.

#2: Additional Costs to Most Businesses = 0.1% of Gross Receipts

There are approximately 31,000⁹ non-farm private businesses in San Francisco (see Table IV below), grossing approximately $44 billion¹⁰ per year. Most of these businesses have less than ten employees and roughly one-third qualify as `small business enterprises' with gross receipts under $500,000¹¹ which are exempted from the gross receipts tax. The remainder would see their taxes increase by 0.1% of gross receipts for the next four years¹².

Source: CA Department of Finance, Economic Research Division, February 2002

* = Finance, insurance, real estate, rental, and leasing

#3: Possible Further Perception that SF is not "Business Friendly"

The proposed gross receipts tax is in addition to the current 1.5% Payroll Expense Tax and Business Registration Tax of between $25 and $500. In Fiscal Year 2002-03, the City Treasurer/Tax Collector collected from businesses over $10 million in Registration Taxes and $266 million in Payroll Taxes. Adding a gross receipts tax could further the claim that San Francisco is not "business friendly" relative to neighboring cities, which could deter new businesses from locating in San Francisco.

As a means of illustrating a business' tax burden relative to other cities in the Bay Area, the OLA chose two businesses - a mid-sized retail establishment and a large consulting firm - and compared their estimated annual business tax payments in San Francisco and five Bay Area cities. The results are presented in Appendix A and show that, at least for the two examples, San Francisco has the highest business taxes in the region, in some cases by a large factor. To the extent that the benefits of city services and/or a central location do not compensate for this higher tax rate, new businesses could justify locating out of county based, in part, on this tax differential.

#4: Improved Assessment of Business Activity

Taxing the gross receipts of a business rather than its payroll is a more common form of local government taxation in the Bay Area and better represents the total sales activity of that business. Under the current San Francisco tax structure, businesses such as restaurants and retail with high payroll costs and lower gross receipts pay a larger percentage of their revenues in taxes than do businesses such as commercial real estate interests that tend to have high gross receipts and low total payroll.

San Francisco had a gross receipts tax until January 1, 2000, when it was repealed on a constitutional technicality. On June 5 and June 12, 2002, the Board's Finance Committee held public hearings to explore the possibility of restoring the gross receipts tax as a "broad-based" and "fair" means of assessing business activity.

Conclusion

Should the Board forward, and the voters approve, a sales tax increase of 0.25% and a gross receipts tax of 0.1%, the OLA projects the following impacts:

• FY 04-05 General Fund revenues of $7 to $8 million and $15 to $20 million, respectively,

• Additional costs to households of approximately $34 per year in additional sales taxes and to businesses equal to 0.1% of gross receipts for four years (other than small businesses with gross receipts under $500,000),

• Establishment of San Francisco as the highest sales tax rate in the state (along with the City of Avalon and Alameda County) and the highest business taxes in the Bay Area,

• Minimal increases in the cost of goods and possible isolated geographic impacts,

• Possible furtherance of the perception that San Francisco is not "business friendly", and

• Creation of a more accurate means for the City to assess business activity.

Appendix A: Total Business Taxes Paid in Five Neighboring Cities by a Mid Sized Retail Establishment and a Large Consulting Firm

Sources: Office of the SF Treasurer/Tax Collector, Telephone Conversations with City Agencies.

¹ Such as certain law, architectural and engineering, medical/dental, accounting and other consulting firms where the principals have an ownership interest.

² County pool sales activity includes the sale of used cars between private parties as well as large or specialized equipment purchased from an out-o-area manufacturer, but which is put into `use' in San Francisco.

³ Controller's presentation to Finance Committee, June 12, 2002.

⁴ Conversation with Todd Rydstrom, Director of Budget and Analysis, Controller's Office, June 25, 2004. The median annual household income in San Francisco, according to Census 2000, was $57,259. $34 per household per year is the equivalent of spending roughly 1/5^th of gross household income on goods subject to sales tax.

⁵ Alameda County will increase its sales tax rate by 0.50% effective July 2004 due to the passage of Measure A.

⁶ Depending on state re-allocation. 5.0% of California's overall sales tax rate is dedicated to the State General Fund and another 1.0% is collected by the state and redistributed to local governments for health, welfare, and public safety. For San Francisco, the remaining 2.75% is collected by or allocated to cities and counties for transportation (including 0.5% to BART, 0.25% to MUNI and 0.5% to the Transportation Authority), schools (0.25% to SFUSD), and general fund purposes (1.0%).

⁷ Looking at clothing price reactions to changes in state and local sales taxes in two periods - the interwar period of 1925-1939 when many states first enacted sales taxes and the postwar expansion of 1947-1977 - MIT Economist James M. Poterba concluded that "retail sales taxes are fully forward shifted, raising consumer prices by the amount of the tax increase." See "Retail Price Reactions to Changes in State and Local Sales Taxes" National Tax Journal; June 1996; 49, 2; ABI/INFORM Global, pg. 165.

⁸ As amended in Finance Committee June 29, 2004.

⁹ Nearly 65,000 businesses are registered with the City. The majority of the difference are likely sole proprietorships which would likely qualify as a small business and therefore be exempt from the gross receipts tax.

¹⁰ Controller's estimate of SF County's share of the $93 billion regional Gross Metropolitan Product, minus public sector revenues.

¹¹ Section 954.1 of the proposed Business Tax exempts businesses who filed a tax return last year and "whose tax liability under this Article, but for the small business exemption in this Section, would not exceed $500." With a gross receipts tax of 0.1%, a business would have to generate over $500,000 to pay the gross receipts tax. $500 = $500,000 x 0.001.

¹² As amended June 29, 2004.

¹³ Mid-sized retail defined as 15 employees, with a Total Payroll of $350,000 and Gross Receipts of $750,000.

¹⁴ Large Consulting Firm defined as 35 employees, with a Total Payroll of $3m and Gross Receipts of $6m.