Chapter 6: Prop 13 Meets the Internet- How State & Local Government Finances are Becoming Road Kill On The Information Superhighway

Chapter 6:
Prop 13 Meets the Internet- How State & Local Government Finances are Becoming Road Kill On The Information Superhighway

The 1990s have been a time of increasing debate over turning more federal functions of government over to states, cities and counties. While much of the battle between Democrats and Republican forces led by Newt Gingrich focused on the amount of money to spend on such functions, largely undebated was whether state and local governments had a revenue base that could deal with the demands being handed to them.

What is clear is that, while many local governments gained some temporary stability in the boom of the mid-90s after years of cities like New York and Los Angeles teetering on the edge of bankruptcy, the new technology of the Internet and the global economic changes accompanying it promise to deal a final body blow to the financial security of local governments. Local governments could once count on local economic development to produce local jobs where local employees could spend money in local stores, thereby generating local tax revenue for further development. This virtuous cycle has been fatally undermined by the new technology of cyberspace. Even as many states and local areas hope for increased revenue due to high technology-based growth, it becomes harder and harder for local government to capture much of that growth in local tax revenue. There is an irony (or more specifically a strategy) that Newt Gingrich, the leader of the conservative movement to hand government responsibilities to local government, was also the foremost Congressional promoter of Tofflerian views of a "third wave" economy - the very high tech global economy that was rendering local governments unable to deal with taxation of increasingly global commerce.

This chapter will outline not only the fiscal squeeze on local sales taxes due to networking technology, but how that squeeze follows the pattern set by Proposition 13 and other property-tax limitation measures that themselves responded to the earlier wave of increasing global speculation in local housing markets. The pressures of responding to the global economy has fractured the ability of local government to effectively push forward long-term economic development and, as rich communities have increasingly abandoned participation and financial contributions to shared regional economic development, this has increased economic inequality between communities within regions. This "opt-out" by rich communities over shared investment through local government parallels the opt-out by the wealthy from the local banking, power and phone systems that had once promoted some degree of equity within regions.

"A House of Cards"

The key to the fiscal crisis facing local governments is the expansion of interstate retail sales of goods ranging from computers to Christmas sweaters, sales that go untaxed due to Supreme Court ruling barring such state taxes on interstate commerce. That fact is good news for the consumer (and often a key sales advantage of mail-order and Internet sales outfits) but is a potential catastrophe for the state and local governments dependent on sales-tax revenue.

States already lose at least $3.3 billion in revenue each year because of retail sales that have migrated to mail-order businesses, as estimated in 1994 by the U.S. Advisory Commission on Intergovernmental Relations (an agency that brings together representatives of state governments to improve the effect of federal policy on the states.)1 And that estimate is based on pre-Internet technology. With the growth of the Internet and on-line sales, consumer access to a nationwide and worldwide marketplace will expand exponentially. At a push of a button, consumers increasingly have access to the lowest-priced goods nationwide and, with the bonus of avoiding sales taxes, interstate sales promise to explode over the Internet, leaving state and local government in tatters.

Ironically, California, at the heart of the new Internet technology, is likely to feel the most severe effects of this change. Because of Proposition 13's limits on property tax revenue, state and local governments in California are extremely dependent on sales taxes to fund their budgets, so any increase in untaxed interstate sales at the expense of local retail will be magnified there. Wally Dean, mayor of Cupertino (the birthplace of Apple Computer) in 1995, summed up the shock his government colleagues would soon be feeling as Internet sales took off in the next few years, undermining their traditional tax and economic development goals:

The thing that scares us is that cities are run on local sales tax; if stuff is sold on the Internet, there's no sales tax. It's a house of cards for government finances. This could be the Achilles heel for state and local government. And it's an invisible problem. The average retailer has no clue what a computer is... it's not in their vocabulary. It's changing that where you once had a manufacturer selling to a wholesaler to a retailer. If this gets hot, you'll have a manufacturer going on the Internet and selling directly to the mass market--bypassing the sales tax. We once built city government on local manufacturers and sales--you didn't think globally. This will mess with a lot of people's heads.2

How Real is the Danger of the Internet to Local Taxes?

Chapter 4 detailed the explosion of business-to-business sales over the Internet (most of it taxed normally for reasons detailed later in this chapter). Computer companies like Cisco lead the way with over $1 billion in on-line sales in 1996 and companies like General Electric moved $1 billion alone in contracting on-line. Retail sales on-line have lagged behind these amounts, with an estimated $200 million in direct Internet sales in 1994 exploding exponentially each year to reach $2.6 billion in total retail sales by 1997.3 Business web sites exploded in the period with 34% of Fortune 500 companies having a Web site in 1995 growing to 80% by the end of 1996. Computer-related products have led the way on retail Internet sales, with Dell computers, a pioneer in mail-order leading on the Web with $3 million per day of PC sales by 1998.4 Non-computer companies pioneering use of the Web included restaurants like the Virginia Diner which does 75 percent of its business by mail and used a Web page to expand its reach globally5 along with compact disk companies and stores pioneering direct sales of automobiles over the Net. One of the most remarkable retail success stories on the Net became, of all things, a bookstore. Started in 1995,, an Internet-only store based in Seattle, would be making $16 million in sales by the first quarter of 1997 with sales doubling each quarter. (Its summer 1997 IPO would raise $54 million.) While books might be a retro success,'s ability to list 2.5 million in-print books (which it in turn orders from book publishers and warehouses on demand from retail customers) far outstrips the available books at local bookstores. This highlights the advantages of on-line stores that can virtually bring together all the products a consumer might desire. Combined with search engines, on-line reviews, and discounts, became a symbol of the promise of on-line commerce and the threat to local retail merchants.6

Even where sales are not made directly over the Net, an expanded on-line presence has made it easier for many companies to expand and build trust in traditional mail-order operations, even where the final sale may ultimately happen over the telephone. Mark Masotto of CommerceNet observed, "Clearly, you'll see more and more stories emerging of how putting information on the Internet is reducing the number of phone calls and number of brochures distributed. There are intangibles of being able to provide information twenty-four hours a day and not have to have people on the phone all the time to service an international market. The medium provides much more possibility to do interactive support--you can read and search information, immediately pull up the information you are interested in rather than looking through a whole catalog of information. It makes the person reading the information more effective in finding information."7

While full security for Internet transactions have come slower than many companies had hoped, Internet sales have still jumped at such a high rate that fully secure payment schemes promise advances in Internet commerce far beyond the most technologically optimistic earlier predictions.

As Internet commerce grows into the tens and hundreds of billions of dollars range in the coming decade, this will just add to the revenue losses by local governments on interstate retail sales. Presently, well over $200 billion in interstate sales, most of it free of sales tax, is generated by mail-order merchandisers, video marketers, credit card processors and similar companies that operate without local offices.8 Driven by an earlier generation of telecommunications and computer technology advances, the mail-order industry has grown phenomenally in the last few decades. Total mail-order sales grew from only $2.4 billion in 1967 to over $237 billion in sales by 1993, extraordinary growth even when accounting for inflation.9

At the same time, sales taxes have emerged as a big revenue source for state governments and often an even larger source of revenue for local governments. Beginning in the early 1980s, the federal government began to cut funding to the states, forcing state and local governments to pay for more and more services out of local budgets. Sales taxes often became the revenue of choice. De facto, state governments substituted local sales taxes for federal income taxes cut in the early Reagan years. Fully 44 states (and the District of Columbia) now impose taxes on retail sales, revenue that accounts for 25 percent of states' annual income. With income taxes increasingly hard to increase (due to the kind of business opposition noted in Chapter 4) and, with tax limitation laws like Proposition 13 making it harder to raise property taxes, sales taxes have become the most attractive way to raise local revenues.10 By 1997, states were raising $132.2 billion from sales taxes, one-third of their total revenue where sales taxes had been just 20 percent of revenue back in 1950.11

These two trends - more out-of-state sales and a greater dependence by local governments on sales taxes - are now on a collision course. Even if smaller out-of-state mail firms are ignored, the U.S. Advisory Commission on Intergovernmental Relations has estimated that $3.3 billion in sales taxes are lost each year by states. Nine states lost over $100 million in 1994 revenue, with California's loss of $483 million topping the list. (See Table 1) These amounts represent 2.4 percent of total sales tax collections.12 As mail-order sales grow under the impact of the Internet and other technologies, the impact is likely to become even more severe. In a report released by the National Governors Association in association in 1997, the increasingly loss of sales tax revenue because of the new technology was cited, along with federal cuts in Medicaid, as one of the top budgetary threats to state government finances.13

For many local governments that suffered budget cutbacks throughout the 1980s and early 1990s, the effect could be even more devastating. While many cities in Silicon Valley became more flush with funds from the economic boom due to the Internet, this new stability hardly made up for the cuts suffered during the bad times. After slashing budgets by $293 million a year in the early 1990s, Santa Clara County finally balanced its budget in 1997 with an $8 million surplus14 - hardly making a dint towards restoring funds previously cut despite the economic boom. And the irony is that Santa Clara County, encompassing much of Silicon Valley, is one of the most vulnerable counties in California to lost sales tax revenue.

At the county level, Santa Clara County actually outpaces the larger Los Angeles, San Diego and Orange Counties not only in the percentage of tax revenue coming from sales taxes but in the total revenue from sales taxes, despite the larger population sizes of those other counties. Cities are even more vulnerable than counties with many smaller cities receiving almost all tax revenue from the sales tax. It is not surprising that the mayor of Cupertino was ahead of the curve in worrying about this threat to his city's finances: Cupertino depends on sales taxes for 81 percent of all taxes collected in the city, making it one of the most sales-tax dependent cities in California. Even including nontax revenue sources such as state aid, fines and service charges for utilities, Cupertino still depends on the sales tax for 45 percent of city revenues. However, in absolute terms it is clear that the large urban cities like Los Angeles, San Francisco, San Diego and San Jose have billions in revenue at threat from the new technology. (See Table 2 and Table 3 for the most vulnerable cities and counties as measured by both absolute sales tax amounts collected and as a percentage of local taxes derived from sales taxes.)15

Total Tax Lost by States to Mail Order (Table 1)

(State By State Comparison), 1994

In Millions of Dollars


Untaxed Sales

















District of Columbia





































Untaxed Sales







New Hampshire


New Jersey


New Mexico


New York


North Carolina


North Dakota










Rhode Island


South Carolina


South Dakota














West Virginia






Total, All States


Source: Advisory Commission on Intergovernmental Relations. Washington, DC
<i>Taxation of Interstate Mail Order Sales, 1994 Revenue Estimates


California Counties Most Vulnerable To Sales
Tax Losses, 1993 (TABLE 2)

TOP TEN Vulnerable Counties by Total Sales Taxes

Total Sales Taxes

(millions of $)

% of Taxes from

Sales Tax




Santa Clara



Los Angeles









San Bernadino



San Diego












TOP TEN Vulnerable Counties by Sales Taxes
as a Percentage of All County Taxes


% of Taxes from Sales Tax

Total Sales Taxes

(in Millions of $)







Del Norte





















Santa Clara



Source: Municipal Analysis Services, Inc. <i>Governments of California: 1993 Annual Financial & Employee Analysis </i>(Austin TX: 1993).

California Cities Most Vulnerable to Sales Tax Losses, 1993
(Table 3)

TOP TEN Most Vulnerable Cities by Sales Taxes as a

Percentage of All City Taxes

% of Taxes from Sales Tax

Total Sales Taxes

(millions of $)










Mammoth Lakes






El Cajon



Carmel by the Sea












TOP TEN Most Vulnerable Cities by Total Sales Taxes

Total Sales Tax

(millions of $)

% From Sales

Los Angeles



San Francisco



San Diego



San Jose






Long Beach















Source: Municipal Analysis Services, Inc. >Governments of California: 1993 Annual Financial & Employee Analysis >(Austin TX: 1993).

Why States Can't Collect Mail Order Taxes: The Quill Decision

The obvious response to the loss of mail-order and Internet-based sales taxes would be to allow states to directly tax such sales. However, the Supreme Court in its 1967 National Bellas Hess Inc. v. Department of Revenue decision prohibited states from taxing out-of-state companies selling to state residents, basing its decision on the Commerce Clause of the U.S. Constitution. The heart of that clause of the Constitution is to take regulation of commerce, including taxation, away from the control of local government in cases where the scale of that commerce has grown beyond the confines of one state. In the case of mail order, the view of the Court was that businesses operating in one state could not be taxed by another state merely because residents of that other state were buying the company's products through the federal mail system. With the explosion of mail order commerce and the ubiquity of catalogs, direct marketing and other changes in technology to reach customers, there had been some hope in states that the Supreme Court might alter what was considered "in-state" commerce, but in its May 1992 Quill Corp. V. North Dakota decision, the Supreme Court reaffirmed that mail-order firms were exempt from state sales taxes. By creating an extremely tough standard in defining "in-state" sales, technically called "nexus" in the law, the Supreme Court made it clear that Internet-based sales would be treated as out-of-state, tax-free transactions.

In a sense, Quill Corp at the center of the 1992 decision exemplifies the danger states face from out-of-state sales and new networking technology. Quill is based in Delaware with offices and warehouses in Illinois, California and Georgia. Quill sells office supplies, stationery, and equipment, offering over 9.500 different products ranging from paper clips to computers, with annual sales in excess of $340 million in 1992, making Quill one of the largest mail-order companies in the country, just behind L.L. Bean and Land's End.16

Quill solicits business through its numerous catalogs and flyers, advertisement in nationally distributed "card packs," in national periodicals, and through telephone solicitations. Of the more that 200,000 orders that Quill was receiving by the court decision in 1992, approximately half were by telephone. The remaining half, however, were received by mail, fax, telex and, increasingly, direct computer contact. Utilizing computer technologies to expand its business, Quill leased computer software that permitted customers to directly contact Quill's computers for direct orders.17 Quill rapidly supplemented this with on-line ordering through a Web site as the Internet took off.

When the state of North Dakota attempted to impose state sales taxes on Quill, the state argued to the courts that the nature of direct marketing had created a "ubiquitous presence" in the state through the mail, telephone and electronic solicitations in the state far beyond what the Supreme Court had envisioned when it banned interstate sales taxes in its 1967 decision. If states were to survive as fiscal units, the state basically argued, the courts had to recognize that the new technology made companies a part of the local economy just as much as if they had sales people in the downtown mall. But in the Quill decision, the Supreme Court held to its "bright-line" rule that physical presence by company personnel in a state was required to trigger sales taxes. The logic was that without such personnel present, the company was receiving no benefits from state services so it need not pay taxes. Thus Quill would pay taxes in Delaware, Illinois, California and Georgia where it had employees but in no other states.18

So, rather than the new technologies of direct marketing making companies more subject to sales taxes as they collapse geographic distances for their customers, the use of toll-free numbers, computer databases, and the Internet itself would allow direct marketing companies to further dispense with the need for placing sales personnel, inventory, or showrooms within most states. Such technologies would actually help such companies avoid creating the physical presence that would trigger the "nexus" that would force them to collect sales taxes. As Internet Web pages located on servers in far-distant states increasingly replace catalogs mailed to people's homes, it is clear that the physical connection between retailers and states trying to tax them will increasingly recede even farther.

Why Saving the Sales Tax Requires More Intrusive Government Regulation

The irony of the movement toward "local control" and "decentralizing government" is that the increased dependence on local taxes and revenue in an increasingly global retail market is pushing governments towards policies of more burdensome regulation on business and more intrusive government on the individual in order to collect those out-of-state sales taxes. As local regions becoming increasingly artificial boundaries for government jurisdiction, even more jerry-rigged regulations are attempted to salvage regional financial health.

In the Quill decision, the Supreme Court did leave open the option that, while the states could not unilaterally impose sales taxes on interstate commerce, the Congress itself could establish such a tax and remit the proceeds to the respective states. Senator Dale Bumpers, D-Ark, was author of The Tax Fairness for Main Street Business Act of 1994, which would have established such a tax, but the bill failed in the face of opposition from the Direct Marketing Association and allied business and consumer groups, including the American Council of the Blind, Disabled American Veterans, and the National Alliance of Senior Citizens.19 An earlier similar bill in the House of Representatives back in 1989 never made it out of committee in the face of half a million angry letters to members of Congress generated by the same direct mail technology used by the industry in generating its business nationwide.20 In late 1997, local governments and representatives of the Direct Marketing Association were close to an agreement where firms would voluntarily collect sales taxes for states in exchange for limits on state audits and the right to expand their presence within target states without invoking "nexus" for tax purposes. However, when the imminent deal was reported about in the New York Times, the affluent customers of direct retailers like L.L. Bean generated such a volume of complaining phone calls to the retailers that they backed out of the deal.21 With new legislation moving forward in Congress by 1997, sponsored by Californian Republican Chris Cox, to firmly prohibit states from collecting revenue on Internet-based retail sales, it was clear that any hopes for states collecting on interstate sales was dimming. The worry of Congress was in promoting global commerce on the Internet, not preserving the fiscal survival of local budgets (an issue we will return to at the end of the chapter in discussing the Cox bill in the context of states and economic development).

Aside from the "astroturf" pleas of shut-ins and the disabled, the heart of the argument against compelling the collection of local sales taxes by direct marketers is the administrative burden of national marketing being subject to the ever changing tax laws of thousands of separate government jurisdictions. With 46 states, the District of Columbia, and more than 6000 counties, cities and school districts each collecting their own sales taxes, the complexity of tracking tax rates in each area and dealing with local government authorities would overwhelm many businesses.22 Some argue that the computers that allow direct mail to boom could be used to ease the burden of calculating the tax costs, but the burden of dealing with so many separate government authorities remains.

Arnold Miller, treasurer of Quill, argued in the companies legal brief against the "untold hardship" of paying deposits, quarterly returns and dealing with audits in so many jurisdictions. Miller had once worked at Sears Roebuck and Co., which through its stores had nexus in all states, and noted that Sears underwent at least five audits at any time. Sears could endure the burden because they could afford 25 professionals dealing solely with tax issues, a luxury smaller direct marketing firms could not afford.23 And while local tax issues were probably not the only reason, Sears discontinued its mail order catalog business in 1993 in favor of licensing its database of customers and addresses to specialty catalogs like Hanover Direct of Weehawken, New Jersey, a company that escapes nexus in other states and thereby avoids sales tax burdens.24 When Spiegel, the largest catalog direct marketer in the US acquired retailers Honeybee and Eddie Bauer, it suddenly was hit with nexus in 34 states. "You really do need a lot of computer power," noted Spiegel investor relations officer Debby Koopman. "For example, some states like Massachusetts and Connecticut exclude clothing mail-order sales up to a certain amount, say $75. Other states have one rate for shoes that are classed as clothing and another for shoes that are classed as athletic equipment."25 The exact costs of forcing companies to collect sales taxes in all jurisdictions is unclear but estimates place the costs at a 10 to 20 percent increase in operating costs to comply,26 while other analyses estimate it costs out-of-state companies 50 percent more to collect the same sales taxes as in-state local retailers. All of this is aside from any extra costs of filing statements with all the different government jurisdictions.27

The other alternative to having retail companies collect taxes is to have states directly tax consumers on a "use tax" in place of a sales tax. States can already legally do this and they can step up their efforts to collect use taxes directly from end-consumers. Companies with resale permits in any state are already required in their routine sales tax audits to prove they pay tax on everything purchased for their own use. And for individuals, some states are already using computerized records from U.S. Customs to bill residents for purchases made abroad that are subject to use taxes. The Software Industry Coalition, one of the main Silicon Valley voices in the sales tax debate, advocated that all states add a line to their state income tax forms specifically for sales tax on goods purchased out-of-state, thereby transferring the burden of sales tax collection (and possible audits by the government) from business to the consumer.28

To collect such taxes from individuals, some have suggested that states could begin collecting information on sales directly from private sources such as individual credit card and checking account records. No state has dared to do this, but legislators may move in that direction if their sales tax revenues continue to fall. Some states, like California, prohibit such actions with strong privacy guarantees in their state constitutions. But in other places, we have the specter of a consumption-based equivalent of the Internal Revenue Service appearing to audit individual purchases.29 This intrusion of government into peoples' private lives would be an ironic result of the decentralization promoted by conservatives in the name of "getting government off peoples' backs."

Sales Taxes and the Effects on the Poor

The other major problem with the increasing use of the sales tax as a revenue source is its disproportionate burden on the poor and working families. Beyond lobbying on behalf of their own economic self-interest, direct marketers trumpet the burdens on the elderly, the disabled, and poorer rural residents of taxing mail-order sales. While there is a certain cynicism in this "concern" by the Direct Marketing Association as they have trotted out allies from the disabled and elderly communities before the US Congress, there is also a strong truth to their argument that taxing consumer sales impacts the poor more than anyone else.

Study after study has shown the regressive nature of sales taxes as a revenue source. The most comprehensive study was by Citizens for Tax Justice in their 1991 report A Far Cry from Fair. In that survey of all taxes collected by local governments, the report argued that "excessive reliance on sales and excise taxes is certainly the hallmark of regressive taxation." Across the country, the report found that in 1991, the poorest 20 percent of families were paying 5.7 percent of their income in state sales taxes, while the richest 1 percent paid only 1.2 percent of their income in sales taxes--i.e. the poor paid nearly five times the tax rate paid by the rich. This contrasts sharply with the much more progressive state income tax. Across the country, the average state personal income tax for a family of four is only 0.7 percent for the poorest 20 percent of residents and 4.6 percent of the income of the richest 1 percent.30

Because of the regressive nature of sales taxes, those states that depend on them, such as Washington and Texas, have the highest tax rates in the country for the poor. Including in property taxes--which burden the poor as part of their rent--total state and local taxes in Washington state were 17.4 percent of the income of the poorest 20 percent. Contrast that with neighboring Oregon, which has a state income tax, where the poorest 20 percent paid only 9.8 percent of their income in state and local taxes. The results are clear that depending on sales taxes lead to the heaviest taxation burdens on those least able to pay.

Many analysts worry that Internet sales are making this tax inequality worse, since upper-income taxpayers with computers have increasing access to a world of tax-free goods ordered over the Internet, while those with fewest resources are stuck buying locally and paying sales taxes on their purchases. The Center on Budget and Policy Priorities has argued that untaxed Internet sales "create a vicious cycle leading to an ever more regressive sales tax. The erosion of the sales tax base resulting from on-line purchasing by businesses and affluent consumers would force states and localities to raise sales tax rates, encouraging more on-line buying, forcing further rounds of rate increases, until the lowest-income population groups unable to buy on-line would be left paying an ever-greater share of sales taxes."31

Technology, Suburbanization and Prop 13

While the economic losses and regressive tax burden due to dependence on sales taxes is a prime concern for regional economic planners, the deeper problem is the fracturing of the tax base as cities find themselves having to more desperately compete for retail outlet revenue rather than cooperate in expanding general growth. As cities polarize over this competition, it further increases inequality within regions, and given the regressive nature of sales taxes, increases overall inequality.

Before turning to how this regional competition for sales tax is undermining economic development, it is important to understand the context of this problem in a longer history of regional polarization around tax policy and development. With California's growth over the last decades, the polarization there was most intense. This polarization culminated in Prop 13's passage in 1978 based on an earlier round of technologically-induced economic changes that skewed, then exploded regional fiscal stability and planning.

In the post-war period, property taxes, not sales taxes, had been the key tax source for local governments. The economic expansion of the 50s and 60s not only created economic growth by increasing the number of home owners, but it created the funding base for continued local expansion of services through this new class of property tax payers. Homeowners, construction workers, community builders and regional development as a whole supported each other in a virtuous cycle of expansion.32 However, the economic and technological changes of the late 60s and 70s would undermine that virtuous cycle and fracture the political unity that had supported broadly distributed growth.

The same computer and communication technology that was allowing the new middle classes to take their money out of local banks and invest in the global markets was also creating the global investment markets that prowled the country for local property investments as a hedge against the inflation of the 1970s. Investors in the US and around the globe were playing increasingly speculative games in the housing market, especially in the booming growth cities of California. Housing prices began to escalate wildly, setting the stage for the coming tax revolt of Prop 13 and its sisters across the country. Where housing inflation in the 1950s and 60s had been two-thirds of general inflation, in the 1970s that relationship reversed. In some areas of California, housing prices which had been increasing 2-3% every year in the mid-60s were increasing 2-3% every month by 1976.33

It was not just financial speculation that drove these housing prices upwards but a new dynamic of slow growth politics and "suburban separatism" that began to dry up available development areas, increasing the premium on housing prices of those areas that were developed. Especially in the upper-middle class communities of the new high tech millionaires, slow growth ordinances began springing up and were copied on down the economic scale. By 1975, most cities and counties in California had some form of growth control policies, thereby vastly increasingly the value of uncontrolled land. Speculation exploded and in extreme cases, such as Orange County, almost half of all single-family homes built were bought by speculators.34

Mike Davis in his book City of Quartz contrasts the "Keynesian suburbanization" of the 1960s and early 60s, where local finance supported local growth, with the "new Octopus" of giant developers pulling in financial backing from global markets. With the price of land rising so dramatically, many of the old railroad companies and industrial concerns found their landholdings to be their most valuable resource. Developing land often became their new economic focus. These new developers came into increasing political confrontation with the new upper-income suburbanites who were developing their own strategies to maintain their incomes while severing their ties to general growth politics of the region. The goal of these new suburbanites was to slow development in their own communities in order to preserve their quality of life and escape the economic burden of providing services to new residents, particularly poor residents of the region. This clash between developer and suburbanite elites would culminate in the battle over Prop 13; in its aftermath, both elites would sever almost all remaining alliances with working class and urban forces that had once fueled general growth politics.35

Beginning in the 1950s, wealth and racial divisions had fueled the creation of an escalating number of municipal incorporations divided from urban core areas. Previously, homeowner covenants and organizations had enforced racial segregation while keeping most citizens within the same fiscal and political jurisdiction. When the Supreme Court declared such covenants illegal in the 1940s, the old homeowner associations began to mobilize to find new strategies for racial separation, which would soon be joined with the goal of fiscal separation from the poor as well. In the past, separate incorporation of a municipality had been a possibility only for the wealthiest enclaves like Beverly Hills, but the passage in California of the 1956 Bradley-Burns Act radically changed the fiscal calculus of incorporation. Bradley-Burns allowed any local government to collect a 1 per cent sales tax exclusively for their own use, a key tool for suburban separatism where fringe areas with a shopping center could now finance city government without needing much of a property tax. This was combined with new arrangements by local governments to have counties contract (usually at cut rates) to perform basic services, leaving the new towns with control of zoning without the fiscal hassles of managing most services. As Davis argues, "Sacramento [the capital of California] licensed suburban governments to pay for their contracted county services with regressive sales revenues rather than progressive property taxes - a direct subsidy to suburban separatism at the expense of the weakened tax bases of primate cities."36 The first step on local dependence on sales taxes had begun.

Upper-income homeowners began exiting cities in order to avoid paying the standard taxes to support urban infrastructure. Davis notes the distinct "gradient" of home values between each incorporation with lower middle class, middle class, upper-middle class and wealthy communities neatly divided by the new jurisdictional lines of incorporation and zoning. With poor people and their need for services zoned out of these new towns, this fiscal zoning would help suck jobs out of the inner-city to these minimal service, low tax areas. Racial and income divides would expand between these jurisdictions. As well, federal and state spending on highways and other traditional urban spending would facilitate this fiscal succession by providing the critical infrastructure that once required regional growth alliances and planning. And by creating divisions between municipalities, capital investors interested in development could now more easily demand economic concessions from weaker fiscal units desperate for new revenue sources following the departure of the upper-income municipal residents.37

What is striking is that just as massive regulation was necessary for that same upper-income elite to secede from common banking and utilities systems in regions, it took strong government regulation to assist them in preserving their segregated residential enclaves. From providing them their own sales taxes apart from shared revenue streams to assisting them in delivering basic services separate from regional systems, the state and federal governments nurtured these enclaves. And these upper-income homeowners, normally advocates of free markets in other aspects of the economy, would promote what conservative commentator George Will labeled "Sunbelt Bolshevism"38 in their extensive system of land regulation, growth controls and other zoning to undermine housing markets that might otherwise have brought "undesirables" into their municipal districts.

As the same time it was a combination of government action (and refusal to take action) in support of the developer interests that put the suburban separatists on a collision course with growth economics, leading to the further splintering of economic development due to Proposition 13. Evan as money market funds and other new financial tools were leveraging personal savings out of local finance markets into speculative global markets, thereby naturally fueling intensified investments in real estate, the government actually began expanding subsidies for real estate, adding fuel to an already growing speculative fire. Through an alphabet soup of institutions - FNMA, GNMA, FHLMC, REITs - in combination with a range of tax advantages, the government was encouraging new flows of capital to bid up the price of housing throughout the 1970s.39 The Federal Home Loan Bank Board was well aware that housing was being increasingly priced out of the reach of average homeowners, but it refused to do anything other than issue toothless warning to the Savings and Loan institutions it governed not to lend to speculators who did not plan to reside in property they were buying. Such tighter regulation or a windfall profits tax on speculation could have gone a long way in cooling the speculation that was turning housing from a prop of regional growth economics into a plaything for global investing.40

The result of the clash between speculation and suburban slow growth controls was that in the four years before passage of Proposition 13 in 1978, property taxes on California homeowners doubled. By 1978, the typical homeowner was paying four times as much for property taxes as for mortgage payments.41 Compounding the indignity for property tax payers, the state government was running a budget surplus of $3 billion which Governor Jerry Brown was neither spending on social programs not returning as a tax cut, instead sitting on it as proof of his fiscal responsibility.

The Prop 13 results were not foreordained; the earliest roots of the tax revolt were among lower middle-class property owners feeling the economic squeeze; they were open to alliances that could have been more economically populist. But in both California and Massachusetts (where a similar Prop 2-1/2 was passed soon after Prop 13), initial attempts by progressive tax reform activists to ally with those squeezed by these new global forces of speculation were abandoned in favor of alliances with developers and big business in what became the last hurrah in California of the old broad-based growth coalition. In the fight against Proposition 13, social spending liberals and unions were joined by the broad economic elite of the state, from Bank of America to the California Taxpayers Association, the main lobby for large corporations. The California Republican Party even refused to endorse Proposition 13. The alliance by progressives with the increasingly globally-minded banks and developers, however, meant that no alternative solution to the tax pressures on lower-income homeowners was pushed forcefully.

This in turn left the way open for upper-middle class homeowners in rich communities like Sherman Oaks to give a more conservative bent to the tax revolt. Clarence Lo in his classic study of the class dynamics of the Proposition 13 battle describes how:

upper-middle class homeowners drove down from the scenic hills of the Palos Verdes peninsula...back to the unwashed Toyota Tercels gridlocking Ventura Boulevard [where] they mingled with the K-Mart shoppers of Van Nuys...Joining the less affluent in mass meetings, the homeowners of Rolling Hills Estates and Sherman Oaks eventually took the lead in organizing and shaping the entire tax limitation movement."42

The new tax revolt was linked to anti-school busing movements and other political campaigns that race-baited welfare programs. With the help of right-wing politicians like Howard Jarvis, this alliance of suburban separatists would surge to an overwhelming margin of victory, 65-35 percent. Despite the racial overtones of the tax revolt movements, the reality of a broad-based problem with property taxes was shown in a victory where even 42% of African Americans voted for the measure.

However, Proposition 13 would have devastating effects on local governments' financial stability, especially those in poorer inner-city areas, and would lead to the final fracture of any growth alliances between city and suburb, and, as importantly, between the global economic investors and their traditional urban-union partners in regional growth alliances. Large corporations had opposed Prop 13 partly fearing it would be followed by a round of increases in corporate and bank taxes to make up for the shortfall. When that populist reaction failed to appear, they began to enjoy their economic windfall from the tax revolt and much of the corporate elite shifted political allegiances to the emerging Reaganite tax revolt nationally. Of the $5.5 billion in taxes cut by Proposition 13, $3.5 billion went to businesses and landlords, a model of corporate enrichment that would be replicated nationally. While particular battles over development would be fought between the suburban separatists and the corporate developers, they soon made peace over a shared enthusiasm over the mutual benefits they received from the tax revolt. (At the same time, the results of cumulative tax changes, including increases in Social Security taxes, meant that between 1977 and 1990, the poorest 90% of taxpayers ended up paying more, not less in taxes than before the "tax revolt.")43

Sales Taxes and the Distortions of Economic Development

Lenny Goldberg, the head of the progressive California Tax Reform Association in the 1990s, has written that "The most noted irony of Proposition 13 is the extent to which it decimated the fiscal powers of local government and transferred power decisively to Sacramento - an irony because the major source of tax problem in 1978 was Sacramento, not local government." 44 After worries about local control, the post-Prop 13 result was, to take one example, a change from state government supplying less than 25 percent of school funding before the tax initiative to the state supplying over two-thirds of school funding by the 1990s. Local government lost almost all fiscal power to leverage new growth and the divisions between the fractured municipal jurisdictions made regional economic planning a near impossibility.

The shift from property taxes to sales taxes as the main source of local tax revenue created further distortions and perversities in how economic development impacted upon communities. The inflexibility of Proposition 13 funding formulas - all property assessed at its 1975 value or whenever it last changed hands adjusted for inflation by no more than two percent each year - meant that governments could not capture most of the results of growth as reflected in increasing property values. Since new housing developments often would not pay for themselves, especially over the long-term as the inflation-adjusted value of taxes paid would fall, local governments began increasing up-front fees on construction - $3 billion a year in California in fees with an average of $10,000 per unit. Essentially, while the old homeowners who pushed Prop 13 would reap a massive capital gains windfall, new homebuyers (including any inner-city residents seeking to move to the suburbs) would have to "prepay" a large share of development costs. Since growth could not generate the tax revenue needed to sustain many of the social services and amenities that once accompanied such growth, from schools to parks to museums, Proposition 13 further justified slow growth policies. And since commercial property is covered by Prop 13, the measure breeds inefficient uses of property by businesses that survive only because they are paying so much less in property taxes than new businesses that have to pay dramatically higher taxes.45

With Californians paying less in property taxes (in real dollars) than they did back in 1977, and 75% less in property taxes than if Prop 13 had never been passed, local governments have had to increasingly depend on sales taxes to pay for social services of all kinds. This has led to a desperate competition between cities for the location of retail outlets, a competition that itself not only prevents strong regional cooperation but itself undermines revenue as cities financially subsidize such outlets. Even as Silicon Valley boomed, cities like San Jose still found themselves subsidizing retail expansion as the simplest way to capture the fruits of that growth. The San Jose Mercury News highlighted the example of San Jose offering the electronics superstore Fry's Electronics a no-interest loan amounting to a $1 million subsidy. The paper bemoaned the fact that "reliance on sales tax leads some cities to favor building superstores over industries that offer good-paying jobs. It discourages cities from adding housing, since more residents mean more city costs but not necessarily more revenue."46

Greg LeRoy, now research director at the Service Employees International Union, described in his book No More Candy Store how local and state government subsidies create a desperate competition for the location of retail establishments with little evidence that such subsidies create any new jobs overall; they merely move them from one location to another. The tax revolt that started in 1978 has just accelerated that trend of subsidies. LeRoy notes that in 1977, only nine states gave tax credits for research and development; by 1993, 34 states did. In 1977, only eight states allowed cities and counties to lend for construction, and now 45 do; only 20 states gave low-interest, tax-exempt revenue-bond loans, now 44 do; only 21 states gave corporate income tax exemptions, now 36 do.47 In the Federal Reserve of Minneapolis economic newsletter, The Region, in March 1995, Melvin Burstein and Arthur Rolnick (general counsel and director of research respectively for the bank) argued that in regards to the competition between states over economic subsidies:

...though it is rational for individual states to compete for specific businesses, the overall economy is worse off for their efforts. Economists have found that if states are prohibited from competing for specific businesses there will be more public and private goods for all citizens to consume...In general, it can be shown that the optimal tax (the tax that distorts the least) is one that is uniformly applied to all businesses. Allowing states to have a discriminatory tax policy, one that is based on location preferences or degree of mobility, therefore, will result in the overall economy yielding fewer private and public goods.48

While six states have begun prohibiting cities from using tax subsidies purely to lure retail across municipal borders and some try to block subsidies to "footloose" companies, only one city, Gary Indiana, has an ordinance that specifically denies tax abatements to projects that will relocate jobs from other cities. Unfortunately, the federal government has contributed to such wasteful relocation subsidies, since its biggest job programs, such as Industrial Revenue Bonds, the Department of Housing and Urban Development's Community Development Block Grants, and most Commerce Department programs have no rules against using such funds to encourage relocation. Only two small job subsidy programs have such rules, but states and cities can elude the rules by shuffling money from other federal sources to fund questionable projects.49

The competition for retail has created a ludicrous distortion of economic development patterns, as cities have had to desperately bid for successive waves of retail evolution. First, shopping in urban centers gave way to downtown retail in the suburbs. Then, downtowns began to weaken in the face of movement to concentrated suburban malls. Now, general purpose department stores in malls are giving way to discount "big box" retailers like Home Depot and Toys'R'Us. There was once some expectation that a residential population would generate proportionate retail revenues. Now, competing cities work to attract discount giants that suck in business from a whole region, oftentimes devastating the more dispersed retail that local governments depend on for financing their budgets. An extreme example is the small city of Emeryville which has attracted a large number of discount retailers. Emeryville now has over five times the retail sales per resident as surrounding cities like Oakland whose own retail has suffered from the competition.

Direct marketing through phone, cable or the Internet takes this economic cannibalism to a new level. Cities and states are fighting to attract "call centers" to service direct marketing companies, since such jobs are seen as non-toxic and "high tech." To cite one example, Oklahoma has done well in replacing lost oil patch jobs with telecom-based jobs, but the price has been massive subsidies to encourage companies to locate in the state. Oklahoma offers tax incentives, including a law exempting business from sales tax on 800-numbers, WATS and private line systems. There is one-stop environmental permitting, tax exemptions on distribution facilities, and major support for training and re-training workers. Data processing firms get a five-year property tax exemption.50 In pursuit of jobs, other states and local areas have created similar subsidies. In the end, they merely subsidize the flight of local retail to tax-exempt mail order.

Even though all local governments as a whole lose out in this competition, the hope for the individual areas is that jobs from such call centers will be long lasting, and the gain in long-term jobs will offset the cost in local subsidies. But even that hope may wither in the face of new technologies. Bruce Lowenthal, Tandem Corporations's Program Manager for Electronic Commerce over the Internet, predicts that the Internet will eliminate the need for much of the work done by such call centers. The Internet will be an "interface" for finding out what customers need and letting them directly indicate what they want. Presently, "Such 'interfaces' are done by data entry clerks," argues Lowenthal. "So many call centers may be replaced. You'll still need some people to deal with hysterical customers, but that's about it."51 The whole industry of entry-level data clerks at call centers may melt away, leaving only a much smaller set of more specialized trouble-shooters. With companies like Federal Express and Quill allowing business customers to place orders electronically, the elimination of data entry positions is already in motion.

State governments are already fighting to attract electronic and Internet-based commerce, starting another round of self-inflicted revenue loss in pursuit. In 1994, the state of California quietly passed a law, AB 72 sponsored by Assemblyman Klehs, that allows out-of-state businesses to advertise on on-line services based in California without thereby being subject to state sales taxes. This law was passed at the request of Apple Computer, which feared that its now defunct on-line commercial service, E-World, would lose out to commercial services based in other states that could promise tax-free sales in California. So, even as Silicon Valley cities are losing local tax revenue, Silicon Valley businesses like Apple Computer were leading the way in the hemorrhage of on-line sales tax revenue.

Mack Hicks, Vice-President of Electronic Services Delivery at Bank of America and chair of CommerceNet in 1995, summarized the economic development logic of the new on-line services:

If the Bay Area wanted to be the Information area, we should call ourselves an Information-Tax Free Zone and we'd clean up. Everyone's trying to figure out how to tax it, because it crosses borders. It's too young to tax. If they tax it, they'll kill it. How are you going to tax goods when they're over the Internet? You could tax the money, but what if it's bartered. If I'm in Tennessee, I log onto a server in Ireland, I buy software with a credit card based in California. The software is delivered, which taxes should be paid? Import taxes, sales tax, etc. What a mess.52

It was out of this priority of promoting growth of the industry over the fiscal needs of regions that Internet companies began promoting the "Internet Tax Freedom Bill", sponsored by Congressman Chris Cox (R-CA) and Senator Ron Wyden (D-OR), to exempt all on-line transactions from local taxes. As Cox aide Peter Uhlmann argued, the priority of Congress is to "help ensure that state, local and foreign tax policies don't interfere with the potential for economic growth over the Internet."53 As with bank, utility and telecommunications "deregulation", local power over economic development has to be reduced to serve the ambitions of industries looking to global markets.

In the fight over the Internet Tax Freedom Bill, local governments represented by the National League of Cities and National Governors' Association fiercely criticized the federal government preempting their tax powers and businesses that would see only an acceleration of their tax disadvantages versus mail-order businesses. Brian O'Neill, head of the National League of Cities, condemned Congress harshly: "This is unfair to Main Street business people. This is as un-American as it gets."54

While local governments worried that the Bill would institutionalize tax losses from Internet sales, they were outraged that the ambiguity of the language banning taxes on Internet transactions would likely repeal existing taxes on a range of local telecommunications. Most versions of the bill would repeal taxes in twelve states collected on local Internet Service Providers,. But the real worry was that the bill, by banning "indirect" taxes on the Internet, might be used by courts to repeal local taxes on telephone service, especially as more and more phone calls were projected to use Internet protocols in coming years. This would cost local governments billions of dollars and give further advantage to Internet-based telecommunications at the expense of local phone companies serving non-Internet users.55


The loss of local control over sales and telecommunications taxes just adds to the general fracturing of local economic development due to the interaction of technological and the increasingly global economy. All of this should coerce a reevaluation of the push to "decentralization" of government responsibilities to local government. Such responsibility makes little sense in a world where multinational corporations often outpower whole states in total assets and can pit local governments against each other in the competition for jobs and local revenue. While much information-age rhetoric harkens to images of small firms and decentralization, the reality is of soon-to-be trillion-dollar corporations straddling the globe. Even modest-sized enterprises operate more and more on a global basis. Faced with such a disparity in power and the fracturing of the ability of such governments to cooperate easily, local governments can hardly be expected to devise fair and efficient systems of taxation that can deliver the social goods and economic development needed. The result is that the poor and working class face increased tax burdens under such decentralized revenue approaches. The rise of national and global commerce calls for national and even global revenue approaches. While the microchip may be getting smaller, the plane of economic activity encouraged by this technology is national and global.

As the next chapter will detail, the decentralization of the responsibility for building the "last mile" of the information superhighway to homes and schools across the country has led to the exact disparities in services that would be expected due to this local polarization of revenue collection. Instead of a focus on serving their communities, local governments find themselves implementing a public version of the Internet in much the same way they have deployed tax credits: as a way to attract business to their communities in the short-term that undermine local economic development decision-making over the long-term. This disparity, as will be detailed, just fuels the economic inequality already existing between rich and poor communities.


Endnotes for Chapter 6

1Taxation of Interstate Mail Order Sales: 1994 Revenue Estimates, U.S. Advisory Commission on Intergovernmental Relations. (Washington, D.C.: 1994), SR-18.

2Interview with Wally Dean, April 5th, 1995.

3 Ferguson, Tim W. "Web grab? If it moves, tax it. State and local governments smell revenue in the Internet." Forbes. March 9, 1998.

4 "In search of the perfect market." The Economist. May 10th, 1997.

5 Watson, Tom. "Click here for a slab of peanut pie." Restaurant Business v94, n5 (Mar 20, 1995):15-18.

6 "A river runs through it." The Economist. May 10th, 1997.

7Masotto interview , Ibid

8 Srodes, James. "Murdering Mail Order." Financial World v161, n7 (Mar 31, 1992):64-67.

9 O'Connell, Daniel. "U.S. Supreme Court Reviews State and Local Taxation Issues." CPA Journal v62, n3 (Mar 1992):16-21.

10 Srodes, Ibid.

11 Johnston, David Cay ."Online Sales Collide With Off-Line Tax Questions." New York Times. November 10, 1997.

12 Taxation of Interstate Mail Order Sales, Ibid.

13 Stevenson, Richard. "Governors Stress Tax Cuts and Austerity." The New York Times. May 8, 1997.

14 Gaura, Maria Alicia. "Santa Clara County Coffers Should Jingle With $8 Million Surplus; Lower welfare costs, higher property values -- $8 million surplus." San Francisco Chronicle. February 17, 1998.

15 Figures are from Municipal Analysis Services, Inc. Governments of California: 1993 Annual Financial & Employee Analysis (Austin TX: 1993). Note that San Francisco is unique in that there is no difference between city and county borders, unlike with Los Angeles and San Diego, where the county and city borders are separate.

16 Taxation of Interstate Mail Order Sales, Ibid.

17 O'Connell, Ibid.

18Genetelli, Richard W.; Zigman, David B.; Bencosme, Cesar E. "Recent U.S. Supreme Court Decisions on State and Local Tax Issues." CPA Journal v62, n11 (Nov 1992):38-44.

19 Gattuso, Greg. "Tax Fairness Act unfair: DMA." Direct Marketing v57, n2 (Jun 1994):6.

20Glass, Brett. "The Real Cost of Mail-Order PCs." InfoWorld v13, n48 (Dec 2, 1991):45-46.

21 Johnston, David Cay. "Sales Tax Proposal Angers Mail-Order Customers." New York Times. November 7, 1997.

22Gattuso, Greg. Ibid.

23Glass, Ibid.

24Miller, Cyndee. "Catalogs alive, thriving." Marketing News v28, n5 (Feb 28, 1994):1,6.

25 Srodes, James, Ibid.

26Gwaltney, John R. "Fallacies of Sales-Tax Loophole for Mail-Order Firms." Small Business Reports v15, n4 (Apr 1990):26-29.

27Srodes, James, Ibid.

28 Caldwell, Kaye K. Solving State and Local Use Tax Collection Problems: A Necessary First Step Before Dealing With Use Tax Problems Of Electronic Commerce.. Discussion Draft by Software Industry Coalition. 1996.

29Glass, Brett. "The Real Cost of Mail-Order PCs. " InfoWorld v13, n48 (Dec 2, 1991):45-46.

30Citizens for Tax Justice. A Far Cry From Fair: CTJ's Guide to State Tax Reform (Washington DC: April 1991). A joint project with the Institute for Taxation and Economic Policy.

31 Mazerov, Michael and Iris J. Lay. A Federal "Moratorium" on Internet Commerce Taxes Would Erode State and Local Revenues and Shift Burdens to Lower-Income Households. Report by the Center on Budget and Policy Priorities. May 11, 1998.

32 See Schneiderman, Anders. The Hidden Handout. Dissertation. University of California. Berkeley. 1995.

33 Eichler, Ned. The Merchant Builders. MIT Press. Cambridge, MA. 1982, p. 219, 259.

34 Kuttner, Robert. Revolt of the Haves: Tax Rebellions and Hard Times. Simon and Schuster. New York. 1980, p. 51.

35 Davis, Mike. City of Quartz: Excavating the Future in Los Angeles. Vintage Books. New York. 1990, p. 130-131.

36 Davis, Ibid, p. 166.

37 Molotch & Logan, P. 187.

38 Will, George. "'Slow Growth' is the Liberalism of the Privileged." The New York Times. August 30, 1987.

39 Mayer, Martin. The Builders: Houses, People, Neighborhoods, Governments, Money. W.W. Norton & Company. New York. 1978.

40 See Schneiderman, Chapter 6.

41 Goldberg, Lenny. Taxation with Representation: A Citizen's Guide to Reforming Proposition 13. A report by the California Tax Reform Association and New California Alliance. Sacramento. November 1991.

42 Lo, Clarence Y. H. Small Property Versus Big Government: Social Origins of the Property Tax Revolt. University of California Press. Berkeley. 1990, p. 154.

43 Kuttner, Ibid, p. 193

44 Goldberg, Ibid, p. 42-43.

45 Goldberg, p. 50, 78.

46 "Tax Facts: The System Sets Cities Up To Be Squeezed By Superstores." Editorial. San Jose Mercury News, July 24, 1995

47Leroy, Greg. "No more candy store: states move to end corporate welfare as we know it." Dollars & Sense, n199 (May-June, 1995):10 (5 pages).

48Burstein, Melvin L; Rolnick, Arthur J. "Congress should end the economic war among the states." Federal Reserve Bank of Minneapolis: The Region v9, n1 (Mar 1995):3-20.

49 LeRoy, Ibid.

50Harler, Curt. "Why Governments Want Your Network Center." Communications News v29, n12 (Dec 1992):30.

51Interview with Bruce Lowenthal, Tandem, 7-21-95.

52Interview with Mack Hicks, June 22, 1995.

53 "Bill to Prohibit Internet Taxation Moving Forward." Reuters New Media. May 12, 1997.

54 "Lawmakers Criticize Internet Bill." The Associated Press. March 10, 1998.

55 Ferguson, Tim W. "Web grab? If it moves, tax it. State and local governments smell revenue in the Internet." Forbes. March 9, 1998. 4 1 75 1