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Press Release · July 8, 1999

Pursuit Of Sales Tax Revenues Driving Development Decisions In California Cities

But Local Efforts to Encourage Retail Growth Have Modest Effect Overall

SAN FRANCISCO, California, July 8, 1999 – In an effort to boost sales tax revenue, city governments systematically favor retail development over other land uses, such as housing, according to a study released today by the Public Policy Institute of California (PPIC). But ironically, the fierce competition for retail business among cities has had little effect on their relative success in boosting sales tax funds.

Under state law, a 1 percent locally-levied sales tax is collected by the state but returned to the jurisdiction where the sale occurred. As a result, there is an incentive for cities to promote the location of retail businesses within their boundaries, an incentive that does not exist for residential or industrial development. The fact that sales tax revenues represent a major share of cities’ discretionary income makes the argument for retail development all the more powerful for many cash-strapped cities. However, the evidence of this “fiscalization of land use” – development decisions favoring tax-generating activities – has been largely anecdotal until now.

The study, authored by Paul Lewis and Elisa Barbour, surveyed city managers and other top administrative officials in 330 California cities about their local development strategies. The findings provide strong evidence that city governments do prefer retail development; for three-quarters of cities with vacant land to develop, no other type of land use ranked higher. Cities rated the desire for sales tax revenues at the top of a list of motivations guiding development decisions – above such factors as job creation and affordable housing. Moreover, respondents indicated that retail projects were the most likely to receive favorable zoning changes or financial incentives, including waivers or reductions of development fees.

“We know that cities across the state are engaged in intense competition for retail businesses and that they have often been quite entrepreneurial at pursuing these developments,” said Lewis, a political scientist and PPIC research fellow. “However, the results of their efforts are a bit more murky. While there is certainly fallout at the local level from retail competition among neighbors, we see little evidence overall that efforts to increase sales tax revenues have had much effect.”

Indeed, the study found that the total sales tax revenues of all cities, measured in real dollars per capita, have only grown marginally in the last two decades. This lack of growth is explained by the relatively fixed nature of retail spending per capita, the many exemptions that state law provides from sales taxation, and the increasing share of consumer spending going to transactions that are not subject to the sales tax (including catalog and internet sales). “Ultimately, the cities in each region are competing over a relatively fixed pie; they will not be able to induce ‘extra’ retail development if the additional retailers cannot hope to make a profit,” said Lewis.

And while cities’ success in the sales tax game does vary a great deal – the amount of local sales tax revenues per resident received by California cities ranged from $2.25 to $56,891.84 in 1995-96 – Lewis and Barbour discovered that the overall hierarchy of cities in terms of their success has been quite stable over time. In other words, whatever their efforts in recruiting retail, most cities have not risen or sunk a great deal relative to their competitors.

“It appears that the primary effect of cities’ actions in favor of retail is simply a transfer of resources from local government to retailers, developers, and landowners,” said Lewis. “Given the favorable attention that cities show to retail, it is also likely that residential and industrial development are somewhat more difficult and expensive to develop than would be the case if the incentives were different.”

The effects of the sales tax on land-use decisions, along with the vast disparities in sales tax revenues among cities, often lead reformers to urge a change in the way sales taxes are distributed. However, the authors argue that merely tinkering with the sales tax allocation rules would fail to solve the broader incentive problems with California’s system of local finance.

Instead, they recommend that policymakers explore the development of a local revenue system that makes other types of development, especially housing, less burdensome for cities. They suggest that reallocating a substantially greater share of local property taxes to cities and counties – perhaps in exchange for returning other, narrower revenue bases to the state – may be a promising reform.

The Public Policy Institute of California is an independent, nonprofit organization dedicated to nonpartisan research on economic, social, and political issues that affect the lives of Californians. The Institute was established in 1994 with an endowment from William R. Hewlett. David Lyon is President and CEO of PPIC.