Publicly traded life sciences companies operate under dual regulatory oversight with respect to communications about drugs and devices. The U.S. Food and Drug Administration (“FDA”) oversees the entire product lifecycle, from development and clinical trials to manufacturing, labeling, marketing, and promotional communications, while the U.S. Securities and Exchange Commission (“SEC”) governs public disclosures, requiring timely and complete disclosure of material information.
The intersection between FDA regulatory processes and SEC disclosure requirements creates complexity. While the FDA traditionally treats investigational drug and device applications as confidential proprietary information, giving sponsors discretion over disclosure, the SEC expects timely communication of material developments to investors. Since 2004, a coordination mechanism between the agencies has allowed the FDA to refer potential securities law violations to the SEC and share nonpublic information upon request.[1] With both regulators increasingly engaged, companies must tread carefully: every disclosure decision is subject to scrutiny, and missteps can trigger SEC enforcement. This dynamic compels companies to continuously assess how and when to communicate regulatory milestones and clinical progress to the market, while simultaneously protecting their confidential and proprietary information.
In July 2025, the FDA flipped the script by announcing its commitment to “radical transparency,” signaling a new era of visibility into regulatory decision-making.[2] For public life sciences companies, this shift, paired with the SEC’s enforcement stance, raises the stakes in navigating disclosure obligations with precision and care.
SEC Materiality Standard
The SEC enforces disclosure requirements to protect investors, prevent fraud, and ensure market integrity. SEC regulations require that material information be disclosed in annual reports on Form 10-K, quarterly reports on Form 10-Q, and current reports on Form 8-K, and that such disclosure is not materially misleading. Information is deemed material if there is substantial likelihood that the disclosure would be viewed by a reasonable investor as having significantly altered the total mix of information made available.[3]
The uncertainty inherent in the materiality standard can be problematic for life sciences companies. The historic secrecy of the FDA approval process has afforded companies with broad discretion over when and how to disclose regulatory developments. For example, executives may genuinely believe that a setback, such as a clinical hold or a negative FDA communication, is temporary or based on a misunderstanding that can be resolved through further dialogue with the agency. In that moment, they may conclude the issue is immaterial and choose not to disclose it, hoping to avoid unnecessary investor panic. But this decision could carry significant risk.
Delaying disclosure can result in public statements that misrepresent the company’s regulatory status, either by omission or by painting an overly optimistic picture. Investors may also be misled into believing that development timelines are intact or that approval is imminent, when in fact a product is facing regulatory headwinds.
In December 2024, the SEC announced settled charges against Kiromic BioPharma, Inc. (“Kiromic”) and its former chief executive officer (“CEO”) and chief financial officer (“CFO”) for failing to disclose material information about the status of two of its pending investigational new drug (“IND”) applications.
In June 2021, the FDA called Kiromic and informed the company that the agency was placing two of its drug development programs on clinical hold. Two weeks after the call, Kiromic raised $40 million through a common stock offering, and it did not disclose the clinical holds during investor roadshows, on due diligence calls, or in SEC filings. Kiromic’s subsequent Form 10-Q also omitted information about the FDA clinical hold, and its press release following receipt of an official letter from the FDA downplayed the news, stating simply that the “FDA returned with comments.”
Two internal whistleblowers reported their concerns about Kiromic’s SEC disclosures and public statements. A special committee of the board was formed to review the complaints. Kiromic self-reported to the SEC and took remedial actions, including terminating the CEO and appointing an interim CEO trained in disclosure controls and procedures, establishing a disclosure committee, appointing two new independent directors, voluntarily self-reporting to the SEC, and cooperating with the SEC’s investigation. The CEO and CFO agreed to civil penalties, and the CEO agreed to a three-year director and officer bar.
FDA’s Move Towards Transparency
The dynamics related to disclosure of FDA interactions are shifting. In July 2025, the FDA announced a significant change in its transparency practices, stating that “[b]ecause the FDA has historically refrained from publishing [complete response letters (“CRLs”)] for pending applications, sponsors often misrepresent the rationale behind FDA’s decisions to their stakeholders and the public.”[5]
In a departure from longstanding policy, the FDA has now released more than 200 CRLs and signaled its intent to begin publishing them in real time. CRLs are decision letters issued when the FDA determines it cannot approve a drug or device application in its current form. These letters outline deficiencies, ranging from safety and efficacy concerns to manufacturing and bioequivalence issues, and often include recommendations for remediation.[6]
The FDA believes that public disclosure of CRLs will help prevent other companies from repeating similar mistakes and accelerate the development and delivery of effective treatments. While this new approach may face judicial scrutiny, its immediate impact is clear: information that was once confidential until approval may now be available to the public in real time, creating a new layer of visibility that companies must reconcile with their own disclosure practices.
Best Practices
To navigate these regulatory dynamics, companies should consider implementing the following best practices:
Strengthen FDA Meeting Preparation: Given the increasing emphasis on transparency, invest in thorough preparation for FDA interactions to align messaging and anticipate regulatory concerns. Ensure that all FDA meeting minutes are accurate and complete and reflect the company’s positions clearly.
Audit Historical Disclosures: Review prior public disclosures to identify any inconsistencies with potential interpretations of CRLs. Where necessary, consider issuing clarifications to maintain credibility.
Monitor the Release of CRLs: Review any released CRLs for confidential information, and assess any implications for investor relations and litigation exposure.
Establish a Disclosure Governance Framework: Implement a formal disclosure review process—such as a disclosure committee—comprising legal, regulatory, and investor relations professionals, to evaluate the timing, accuracy, and completeness of public statements, especially those related to FDA communications and clinical developments.
Ensure Compliance with Regulation FD: Align investor communications with Regulation FD requirements to avoid enforcement action. In 2019, the SEC charged TherapeuticsMD Inc. with violating Regulation FD after the company privately described an FDA meeting as “very positive and productive” to sell-side analysts without issuing a public statement. The company agreed to pay a $200,000 penalty.[7]
Ensure Clarity and Objectivity in Communications: Craft public statements about FDA processes with precision and balance. Avoid promotional language or attempts to downplay unfavorable developments. All claims should be evidence-based and presented in a way that supports informed investor decision-making.
Monitor External Communications for Consistency: Regularly review external communications, including websites and social media posts, to ensure consistency across platforms.
Conclusion
As FDA policy and the SEC’s enforcement priorities evolve, life sciences companies must remain informed and proactive in their disclosure practices. Optimism won’t satisfy regulators. Silence can mislead. Transparency is no longer optional. And precision matters more than ever.
TSC Indus., Inc. v. Northway, Inc., 426 U.S. 438, 449 (1976) (“[A]n omitted fact is material if there is a substantial likelihood that a reasonable shareholder would consider it important in deciding how to vote.”). ↑
This is the third installment in a series on damages available for intellectual property (“IP”) claims, focusing on copyright damages. Understanding damages is essential for two reasons: it highlights the potential rewards of building a robust IP portfolio, and it offers a benchmark for assessing risk when facing an IP claim. Our previous articles discussed trademark and patent damages.
Copyright Infringement
Copyright law protects original works of authorship, including literary, dramatic, musical, and certain other intellectual works that are fixed in a tangible form, whether published or unpublished.
Copyright infringement under the Copyright Act of 1976 involves the nonpermissive replication, distribution, performance, display, or creation of derivative works of copyrighted material.[1] Section 504 of this act details the remedies for such infringement, indicating potential awards for actual and statutory damages. The Digital Millennium Copyright Act (“DMCA”), in its provisions for safe harbor and takedown procedures, addresses modern challenges posed by the digital environment, ensuring compliance and protecting copyright in the digital age.[2]
Copyright Damages
To determine copyright damages, courts primarily rely on statutory guidelines under § 504 of the Copyright Act. Section 504(b) authorizes a court to award actual damages and infringer’s profits. Section 504(c) allows recovery for statutory damages; in cases of willful infringement, statutory damages may be enhanced. In some cases, the prevailing party may recover attorney fees under § 505.
Actual Damages and Infringer’s Profits
Section 504(b) states that a copyright owner is entitled to recover the actual damages suffered as a result of infringement and any profits that the infringer made that are attributable to the infringement and are not taken into account in computing actual damages.
This second part of the sentence is meant to prevent double recovery. If a loss to the copyright owner overlaps with profits made by the infringer (e.g., the owner lost a sale that the infringer made), the copyright owner can’t recover both the lost sale and the infringer’s profits from the same event. However, the owner can recover profits that are made in addition to the actual damages from lost sales or are otherwise separate from the harm that the copyright owner suffered.
Actual damages are typically determined by the loss in the fair market value of the copyright, measured by the profits lost due to the infringement or the value of the use of the copyrighted work to the infringer. Infringer’s profits are calculated based on the infringer’s gross revenue attributable to the infringement.
A copyright owner is only required to present proof of the infringer’s gross revenue to satisfy the burden of proof. Once accomplished, it is on the infringer to establish any deductible expenses or profit attributable to factors other than the copyrighted work.
Statutory and Enhanced Damages
Alternatively, § 504(c) of the Copyright Act allows for a recovery method separate from actual damages and infringer’s profits. As long as a plaintiff properly registered the copyright in a timely manner before the infringement took place, a plaintiff, at any time before final judgment is rendered, may elect to collect statutory damages.
Statutory damages are generally unavailable for copyright infringement that occurs before the effective date of registration unless the copyright owner registers the work within three months of its first publication.
Once infringement is proven, the plaintiff does not need to prove actual damages to recover statutory damages. Instead, the court determines an appropriate amount within the statutory range. The statute sets the lower limit at $750 and the upper limit at $30,000—these limits apply per work infringed, not per act of infringement, and courts may assess damages for each separately registered work infringed.
If the court has found that the infringement was committed willfully, the court may increase the award of statutory damages to $150,000. However, if the infringer proves that it was not aware and had no reason to believe that its acts constituted an infringement, then the court may reduce the statutory damages award to $200.
Courts exercise broad discretion in determining the appropriate amount of statutory damages within the statutory range. Factors considered include the expenses saved and profits made from the infringer, the revenues lost by the copyright owner, the infringer’s state of mind, the deterrent effect on the infringer and others, the infringer’s cooperation in providing evidence, and the conduct and attitude of the parties.
Attorney Fees
Section 505 of the Copyright Act makes attorney fees available in some cases. Attorney fees are available to either party at the court’s discretion, hinging on the nature of the case. Even when a plaintiff prevails, attorney fees are entirely subject to the court’s discretion.
In Fogerty v. Fantasy, Inc., the U.S. Supreme Court held that courts should apply equitable discretion when deciding whether to award fees and may do so based on factors like frivolousness, motivation, objective unreasonableness, and deterrent effect.[3]
Attorney fees are generally unavailable for copyright infringement that occurs before the effective date of registration unless the copyright owner registers the work within three months of its first publication.
Summation
Copyright law uses damages not only to make the copyright holder whole but also to incentivize and reward creative expression. Given the equitable nature of these remedies, courts retain broad discretion to tailor damage awards based on the circumstances of each case, balancing compensation, deterrence, and fairness.
* * *
Please tune in next month for part four of our series, in which we will discuss damages for misappropriation of trade secrets.
The U.S. Environmental Protection Agency (“EPA”) published a report in July 2025 containing a sector-wide set of nonregulatory recommendations to strengthen U.S. drinking water and wastewater systems against cyberattacks, alongside new funding for resilience projects.[1] Although the document itself is advisory, it lands amid stepped-up inspections and enforcement tied to Safe Drinking Water Act (“SDWA”) section 1433 risk-and-resilience obligations.[2] Utilities, vendors, investors, and acquirers should treat these recommendations as the new baseline for diligence, budgeting, and compliance planning.
What’s New
EPA’s July 2025 Report
Securing the Future of Water: Addressing Cyber Threats Today, a report issued by EPA in July 2025, consolidates practical steps for both drinking water and wastewater utilities, calling for a “holistic” approach and tighter coordination among utilities, states, federal partners, and sector associations.[3]
Funding Window
On August 5, 2025, EPA opened approximately $9 million in grants for midsize and large public water systems (≥10,000 population) under the Midsize and Large Drinking Water System Infrastructure Resilience and Sustainability program.[4] The solicitation remained open for sixty days on grants.gov. Utilities may consider pairing future grant proposals with the EPA report’s priority actions.
Enforcement Backdrop
EPA’s May 2024 Enforcement Alert (updated July 24, 2025) reports that more than 70 percent of inspected systems since September 2023 violated basic SDWA section 1433 requirements (e.g., incomplete Risk and Resilience Assessments (“RRAs”) and Emergency Response Plans (“ERPs”)) and warns of increased inspections, potential use of SDWA emergency powers (section 1431), and even criminal sanctions for false certifications.[5]
Deadlines Continue
America’s Water Infrastructure Act (“AWIA”) section 2013 and SDWA section 1433 five-year cycles are active. For example, systems serving 50,000–99,999 people have RRA recertifications due December 31, 2025 (and ERPs six months later); systems serving 3,301–49,999 people face a June 30, 2026, deadline for RRAs (and ERPs six months later).[6]
Context
The U.S. Government Accountability Office (“GAO”) 2024 report pushed EPA to adopt a national water-sector cyber strategy. GAO now notes that EPA issued a sector risk assessment/plan in January 2025 and is evaluating further authority needs—underscoring that voluntary guidance is increasingly informing oversight.[7]
The Report’s Ten Core Recommendations
EPA’s task force organizes near-term steps for utilities and partners. We can expect these themes to show up in inspections, grant scoring, and diligence checklists.
In EPA’s July report, the task force highlights the following key areas for water utilities to consider:[8]
Clear ownership and coordination. Assign clear executive responsibility; create standing coordination forums across utility/state/federal partners.
Communication to leaders. Tailor messages and training for boards, mayors, and utility executives; integrate cyber into leadership programs.
The basics. Normalize a short list of “must-do” controls (e.g., leadership commitment, staff training, access control, and incident response planning).
A culture of security. Offer continuous webinars/resources; weave cybersecurity into operator certification and continuing education.
Expanded hands-on help. Prioritize more technical assistance, virtual office hours, Cybersecurity and Infrastructure Security Agency (“CISA”) adviser support, and peer-to-peer mentoring.
Dedicated funding. Budget explicitly for cybersecurity, ensure Water Information Sharing and Analysis Center (“WaterISAC”) access,[9] expand grant/loan eligibility, and resource state resilience roles.
No information gaps. Share sanitized attack summaries and implementation examples; maintain a best-practices hub and model policies.
Expectations for vendors/consultants. Use model contracts and clear principles, raise vendor awareness, and align procurement with security outcomes.
Support for state partners. Train state staff, share successful state program models, and equip field staff with cyber talking points.
Resourced and engaged partners. Leverage national associations and cyber groups to grow the sector workforce and deliver training/assistance.
Legal and Operational Implications
Compliance with the SDWA’s Cybersecurity Provision
While EPA’s July report is not a rule, inspectors already examine cyber elements in RRAs/ERPs under SDWA section 1433. Gaps like unchanged default passwords, shared logins, and no asset inventory have triggered findings. Where risk rises to “imminent endangerment,” EPA signals that it may invoke section 1431 emergency powers.[10]
Diligence and Transactions
We can expect lenders, buyers, and insurers to benchmark utilities against the EPA task force’s ten recommendations and SDWA section 1433 status. Documenting progress (governance, funding, contracts, training, and incident drills) may materially reduce risk in deals and financings.
Grants and Prioritization
Aligning projects with the report’s priority actions (leadership training, direct tech assistance, operator certification integration, coordination with state chief information officer (“CIO”) offices, etc.) can strengthen grant narratives.
The Big Seven: Key Near-Term Actions
Over the next ninety to 180 days, the water sector may want to discuss with counsel the following key considerations and timely moves:
Name an accountable executive (e.g., general manager or utility director) for cyber risk; brief governance quarterly using a simple key performance indicator dashboard.
Validate SDWA section 1433 status against the current five-year cycle; correct RRA/ERP gaps (cyber asset inventory, incident response, backups, operational technology segmentation).
Lock in “Top Actions”: reducing internet exposure, changing defaults, enforcing multifactor authentication (“MFA”), backing up and testing restores, and exercising EPA and CISA incident plans.[11]
Train leadership and operators; add cyber modules to manager briefings and operator continuing education units, join WaterISAC, and subscribe to CISA advisories.
Update vendor contracts: add baseline controls (e.g., MFA, patching service level agreements, remote-access rules), incident notice, logging/monitoring, right-to-audit, and data-handling clauses consistent with the report’s vendor engagement recommendations.
Schedule a third-party assessment (EPA Water Sector Cybersecurity Evaluation Program or equivalent), and convert findings into a funded, time-bound mitigation plan.
Coordinate with your state: engage the state primacy agency and state CIO/cyber office to align resources and messaging. Anticipate increased scrutiny during sanitary surveys and follow-on inspections.
A Final Word
There is no time like the present for public water systems and their partners to (i) align RRAs/ERPs and governance with SDWA section 1433 and EPA’s recommended practices, (ii) structure vendor and integrator contracts to reflect cyber obligations, (iii) prepare targeted grant applications mapped to the task force’s priority actions, and (iv) conduct transactional diligence on cyber risks in utility acquisitions or financings. Consult with counsel to mitigate risk and plan your path forward.
Looking back on when I first wrote about the regulatory circus surrounding Colorado’s groundbreaking AI Act in August, I predicted the upcoming special session would add yet another chapter to this ongoing regulatory saga. We had no idea just how dramatic that chapter would be.
The August 21–27 special session didn’t just add a chapter—it delivered a full-blown political thriller complete with backroom deals, lobbying blitzes, late-night negotiations, shouting in the Capitol halls, and a climactic Monday morning collapse that left even seasoned observers stunned. The headlines rushed to try to turn this into a victory by the tech lobby:
Yet, this was no victory for Big Tech, because even though no one thought it could win, the Colorado AI Act is still standing.
The Setup: Four Bills, 150+ Lobbyists, and a Ticking Clock
Colorado Governor Jared Polis included the AI Act in his special session call, ostensibly to address budget shortfalls but also to give lawmakers one more chance to modify or delay the law before its February 1, 2026, effective date.
Four different bills emerged targeting the AI Act, each taking radically different approaches:
SB 25B-004: The “Colorado Artificial Intelligence Sunshine Act”—a complete rewrite focusing on transparency and disclosures, with Colorado Senate Majority Leader Robert Rodriguez one of the lead sponsors
SB 25B-008: Total repeal, replaced with “technology-neutral anti-discrimination” language
HB 25B-1009: Dramatic scope reduction (employment and public safety only) plus delays and exemptions
HB 25-B1008: Another near-total repeal with minimal disclosure requirements
But the real story was about the lobbying tsunami. An Axios Denver analysis of state records found that “more than 100 companies and organizations hired roughly 150 lobbyists to shape Rodriguez’s bill,” with Amazon, major health care companies, and a coalition of tech CEOs among those that hired multiple lobbyists.
150 lobbyists. For a six-day special session. In a state with just under 6 million people.
Act I: The Ambitious Rewrite
Rodriguez started with genuine ambition. His initial SB 4 was a comprehensive thirteen-page replacement that would have created the “Colorado Artificial Intelligence Sunshine Act.” The bill maintained consumer protections while streamlining requirements—exactly the kind of thoughtful compromise that seemed achievable.
The initial engrossed version included new definitions of “algorithmic decision systems,” developer disclosure requirements, individual data rights, and crucially, joint and several liability provisions for developers and deployers. It represented months of behind-the-scenes negotiations aimed at threading the needle between consumer protection and industry workability. It also included delays in the effective dates of key consumer rights provisions, back to May 1, 2026.
Act II: The Sunday Night Deal That Wasn’t
By Sunday night of the special session, August 24, it appeared lawmakers might have reached a deal. “Top Democrats told their colleagues that they had crafted the framework of an agreement,” the Colorado Sun reported. Rodriguez had made several key concessions, including removing from SB 4 a controversial requirement that deployers provide to individuals given an adverse decision from AI a list of the twenty personal characteristics of those people that most influenced the decision. He also offered a three-month delay in implementation of the AI Act.
But then came the liability provision that broke everything.
SB 4 would have amended the AI Act to add a provision creating joint and several liability for developers and deployers for any AI system violating the law, but with some safe harbor protections for some circumstances. During debate on the Senate floor, Rodriguez removed the safe-harbor protections and thus created what the industry, and its horde of lobbyists, viewed as unacceptable legal exposure.
Act III: The Monday Morning Meltdown
By Monday morning, the compromise started to fall apart, mainly over the degree of liability AI developers and deployers should face when their technology leads to discrimination.
The Colorado State Capitol became a pressure cooker. As described by the Colorado Sun, negotiations over the law had “rocked the Capitol since lawmakers returned to the building Thursday for a special session, with shouting at times filling the halls outside of the House and Senate. Democrats have been disagreeing with each other. Lobbyists have been livid. Confusion, anger and rumors have spread like a virus.”
Rodriguez tried to save his compromise by pulling the liability amendment, but it was too late. “Business, consumer protection advocates, labor and educators came together, but big tech didn’t like the bill because they don’t like the liability,” Rodriguez said.
State Representative Brianna Titone, a lead sponsor of both the original AI Act and SB 4—who withdrew her sponsorship of SB 4 on Monday night—summed up the frustration: “we had a good thing going” with the potential compromise. Titone aimed her frustration at the tech companies, accusing them of being unreasonable in how much influence they were seeking over the drafting process.
The Great Pivot: From Rewrite to Delay
By Monday, August 25, facing certain defeat, Rodriguez was forced to make a strategic retreat. He told reporters that it had become “impossible” to find a compromise that would have worked for everyone. In a remarkable legislative maneuver, Rodriguez gutted his comprehensive thirteen-page rewrite and replaced it with a simple find-and-replace operation: every instance of “February 1, 2026” became “June 30, 2026.” The entire scope of the special session’s AI work boiled down to a four-month delay.
After hours of work from the captive legislators who could not leave until there was a resolution on the AI Act, the last vestiges of hope for a deal were gone. Rodriguez opted to release the legislature from what was starting to feel like a hostage situation.
The Real Victory: What Didn’t Happen
Here’s what the breathless headlines about “Big Tech wins” and “AI law gutted” missed: nothing fundamental changed. The Colorado AI Act remains the nation’s first comprehensive AI regulation. All its core provisions survived intact:
Risk assessments and impact assessments: still required
Transparency and disclosure requirements: unchanged
Consumer appeal rights: preserved
Developer documentation obligations: intact
Attorney general enforcement authority: untouched
Anti-discrimination protections: fully maintained
The industry mobilized more than 150 lobbyists, four different repeal/replacement bills, intense pressure campaigns, and months of negotiations. The result? A four-month delay—even though the AI Act proponents were already proposing what was effectively a three-month delay.
That’s not a victory for opponents—that’s a stunning testament to the law’s resilience.
The Broader Context: An AI Regulatory Law That Refuses to Die
Step back and look at the full timeline since Governor Polis signed the AI Act in May 2024:
May 2024: Polis signs with reservations, calls for revisions
June 2024: Unprecedented letter from the governor, the attorney general, and the law’s own sponsors calling for changes
May 2025: Last-ditch filibuster by Titone prevents delay
Summer 2025: Federal preemption efforts in Congress fail
August 2025: Massive special session lobbying blitz achieves only a delay
At every turn, when given the opportunity to gut, delay, or kill the law, Colorado’s political system has ultimately chosen to preserve it. Even Rodriguez’s final floor speech, while announcing the delay, was a passionate defense of the law’s principles: “Should a company whose AI system determines who gets hired and promoted, how much tenants pay for rent, and who receives medical care ever be held to account?”
The Industry’s Pyrrhic Victory
Make no mistake: the tech industry got what it asked for in the short term. The delay provides breathing room and another chance to lobby for changes during the 2026 regular session. Organizations such as the Colorado Technology Association celebrated, with CEO Brittany Morris Saunders stating, “By extending the timeline, we now have the opportunity to work collaboratively on practical solutions that strengthen consumer trust, safeguard jobs, and preserve Colorado’s competitiveness.”
But this “victory” came at enormous cost. The industry revealed the extent of its political muscle, burning goodwill and reinforcing narratives about Big Tech’s outsized influence. Titone captured this perfectly: “They didn’t want to be responsible for the products that they make. And that should be alarming to everybody.”
More importantly, the industry failed to achieve any of its core substantive goals. It obtained no scope reductions, no big carve-out exemptions, no liability safe harbors. No repeating its success in watering down a law until it is simply an empty, sharp suit that contains only provisions that are nearly impossible to prove, which is arguably what happened to the Texas Responsible AI Governance Act (“TRAIGA”). The AI Act the industry will face on June 30, 2026, is identical to what it would have faced on February 1.
What’s Next
The 2026 regular session will likely be the last, best chance for the tech industry to secure meaningful changes to Colorado’s AI Act. But the political dynamics have shifted decidedly against it:
Proven Resilience: The law has survived every major challenge, demonstrating its political staying power.
Implementation Reality: With just months before the new deadline, wholesale changes become practically impossible.
National Attention: Other states are watching Colorado as a model, creating pressure to maintain the law’s integrity.
State Senator Jeff Bridges offered perhaps the most realistic assessment: “There are folks involved in this that have taken Colorado’s first-in-the-country law and worked really hard to find a path forward. . . . We can get this done. This delay buys us that time.”
Practical Advice
For businesses developing or deploying AI to Colorado consumers, don’t let political uncertainty delay practical preparation. The core compliance obligations haven’t changed one bit. Businesses still need:
AI impact assessments, which take significant time and resources to design properly
Risk management programs
Vendor agreement reviews to ensure AI service providers can support compliance obligations
Staff training on AI governance
Process documentation
The only thing that has changed is that businesses have four extra months to get ready.
The Bigger Picture: Colorado’s Regulatory Resilience
The August special session ultimately demonstrated something remarkable: when it comes to protecting consumers from AI discrimination, Colorado’s AI Act has achieved an almost gravitational pull. Multiple attempts to significantly alter or delay it have failed. Even when facing unprecedented industry pressure, the political system defaulted to preservation rather than destruction.
This isn’t just about AI regulation; it’s about how democratically enacted consumer protections can withstand concentrated corporate opposition. In an era when regulatory capture often dominates policy discussions, Colorado’s AI Act represents something different: a law that, once passed, has proven remarkably difficult to undo.
The regulatory saga continues, but the plot has become clearer. This isn’t a story about a law struggling to survive—it’s about a law that has found its footing and refuses to be moved.
The use of tariffs has trended downward for decades, but the current Trump administration has implemented unprecedented mechanisms for imposing tariffs, leading to dramatic changes in scope and impact. As explained by WilmerHale Partner David Ross, President Trump is the first U.S. president to rely on the International Emergency Economic Powers Act (“IEEPA”) to impose tariffs; IEEPA, a federal statute, lacks express provisions granting such use. However, the administration’s reliance on IEEPA, combined with the resurrection of seldom used statutes, such as the Trade Expansion Act of 1962, has raised questions about the future of international trade in North America and beyond.
In September 2025, the American Bar Association held its Business Law Section Fall Meeting in Toronto, Canada, and addressed recent tariff developments in a CLE program entitled “What’s Up with the Tariffs? A Primer on Tariffs, Trade Agreements, Economic Sanctions, Business Impact, and the Economy.” The discussion was moderated by Diana Preston, Attorney and Principal at Preston Financial Law & Consulting. The program featured insights from panelists David Ross, Partner at WilmerHale; Wendy Wagner, Partner at Gowling WLG (Canada) LLP; Jared Grossman, Senior Legal Counsel at Honda Canada Inc.; and Betsey Temple, Senior Vice President and Associate General Counsel at U.S. Bank.
U.S. Tariffs in 2025
As background, a tariff is a form of tax paid by the importer of goods into the country. The intended purposes of tariffs include increasing tax revenue, protecting domestic industries, and exerting influence on other governments.
Since the beginning of 2025, the U.S. imposed tariffs in unconventional and unprecedented ways. As mentioned, the current Trump administration cited IEEPA as a flexible tool to implement tariffs. On February 1, 2025, the U.S. imposed tariffs for the first time via IEEPA to respond to “any unusual and extraordinary threat . . . to the national security, foreign policy or economy of the United States.” Specifically, the administration referenced Canada and Mexico’s alleged failures to address immigration and the flow of fentanyl into the U.S. to impose a 25 percent tariff on both countries (which increased to 35 percent for Canada on July 1, 2025). On April 2, 2025, the administration imposed a 10 percent baseline reciprocal tariff on nearly all U.S. trading partners, a total of fifty-seven countries.
The current administration also relied on Section 232 of the Trade Expansion Act of 1962 (“Section 232”) to impose tariffs. Although reliance on Section 232 for tariff purposes started in Trump’s first term and remained unchanged during the Biden administration, Section 232 has been used more significantly in Trump’s second term. Ross noted, “What makes these tariffs, I think, particularly important is that [the administration] has been applying them not just to your core products like aluminum or steel, but to derivative products that include aluminum or steel. . . . By doing that, it has vastly expanded the scope of the tariffs.” For example, products subject to U.S. tariffs may include timber or lumber as well as their derivative products like furniture and kitchen cabinets—items far removed from the basic core products and not obvious threats to national security.
Currently, litigation in the U.S. regarding the lawfulness of tariffs based on IEEPA is stayed, so the tariffs remain effective. To the extent the IEEPA tariffs are determined unlawful (the consolidated challenges will be heard in November 2025), the administration mentioned considering several alternative tools. Specifically, the administration may rely on Sections 122 and 301 of the Trade Act of 1974 and Section 338 of the Tariff Act of 1903. Although these alternatives do not perfectly replace the IEEPA tariffs, Ross explained that, collectively, the alternatives and the use of Section 232 on derivative products can capture a very significant amount of trade, even if the IEEPA tariffs are struck down.
Responses to U.S. Tariffs
The recent U.S. tariffs have caused another layer of complexity and friction for international trade. To start, Canada imposed a 25 percent retaliatory tariff on about $30 billion worth of imports from the U.S., targeting U.S.-origin products. However, Canada’s global relations and domestic interests ultimately led it to repeal the retaliatory tariffs. Wagner spoke of Canada’s varied pressures in satisfying the demands of the U.S. while maintaining its own diverse trading markets. For instance, Canada was forced to impose tariffs on electronic vehicles and other products from China, which were met with counter-tariffs by China on agricultural and other significant imports to Canada. Similarly, Mexico has been experiencing U.S. pressure to impose a 50 percent tariff on China, but such policy has yet to be decided.
Naturally, China has pushed back on the U.S. by leveraging its unique position to retain exports of critical minerals and products that the U.S. needs. Meanwhile, the collective U.S. tariffs implemented on China since President Trump’s first term set a baseline tariff of roughly 50 percent on China, ranging as high as 100 percent on some products.
Due to the resulting complications for North American trade and global trading partners, Canada heightened protections for its own economy. For instance, Canada enacted a new “Buy Canadian Policy,” which requires domestic and foreign suppliers contracting with Canada to source key materials from Canadian companies and implements local content requirements for procurements that cannot be completed by Canadian suppliers.
Impact of U.S. Tariffs
It is unclear whether the recent U.S. tariffs have achieved their intended overall purpose. Since implementation of the tariffs, inflation rates in North America have increased (by 1.7 percent in Canada, 2.7 percent in the U.S., and 3.51 percent in Mexico), and unemployment rates rose (to 7.1 percent in Canada and 4.3 percent in the U.S.). Although the U.S. experienced an initial increase of tariff revenue of roughly $90 billion since last year, this revenue should decrease over time because of the inherent purpose of reducing imports. Preston noted that, “in contrast to what might have been expected, manufacturing jobs have decreased by 33,000 jobs between January and August [2025], so that’s different than [what] the intent was, and we’re starting to see some feedback on the implementation of the tariffs.”
Above all, the volatility of recent tariffs and trade policies have caused challenges for businesses. Grossman explained that “tariffs create uncertainty, which makes it difficult for businesses to plan,” adding, “Companies are also focusing resources on navigating the tariffs rather than innovating and often commencing new projects.”
Conclusion
It is unlikely that tariffs will revert to the status quo of prior decades. Businesses and attorneys should anticipate a new era of trade relationships and industry dynamics. To minimize tariff impact, Temple described three factors to evaluate: (1) the value of the imported goods, (2) the classification of goods under the applicable tariff regime, and (3) the supply chain location. Overall, as Wagner concisely stated, “It’s not just all about tariffs, it’s about costs.” Wagner further commented that the costs for goods will change and are likely to increase due to business uncertainties. Therefore, attorneys and clients should consider the costs in every agreement, deal negotiation, or project.
The Mendes Hershman Student Writing Contest is a highly regarded legal writing competition that encourages and rewards law students for their outstanding writing on business law topics. Papers are judged on research and analysis, choice of topic, writing style, originality, and contribution to the literature available on the topic. The distinguished former Business Law Section Chair Mendes Hershman (1974–1975) lends his name to this legacy. Read an edited version of this year’s third-place winning essay, submitted by Kurtis Wozniak of Stetson University College of Law, Class of 2026.
Abstract
California’s state taxation system generates significant revenue; however, persistent budget deficits, mismanagement of taxpayer funds, and inefficiencies continue to plague the state’s financial stability. The allocation of taxpayer money is frequently dictated by partisan agendas, bureaucratic inefficiencies, and shifting priorities rather than by the needs and preferences of taxpayers. This has led to chronic underfunding of essential services, erratic spending patterns, and widespread public dissatisfaction with the state’s fiscal governance. Local governments further exacerbate these issues through inefficient budgetary decisions, contributing to misallocated funds and service shortfalls.
This Article proposes the Direct Democracy Tax Credit (“DDTC”), a policy designed to shift the financial decision-making power from government officials to taxpayers by allowing resident Californians—who live, work, and rely on public services in the state—to allocate their state income tax payment to specific public service sectors. This initiative seeks to enhance fiscal accountability, reduce political interference in budget decisions, and create a more transparent and taxpayer-driven allocation system. The DDTC expands California’s tradition of ballot initiatives by letting individual taxpayers annually allocate funds without ballot access barriers, majority vote requirements, or costly campaigns. To ensure stability, a Direct Democracy Fund would collect and distribute taxpayer-directed funds while maintaining oversight at the municipal, county, and state levels. Additionally, safeguards, including state intervention through federal funding, corporate tax revenue, and sales and use tax revenue, would prevent critical service disruptions while preserving taxpayer autonomy.
By placing funding decisions in the hands of taxpayers and enforcing strict oversight on the entities receiving funds, this proposal aims to mitigate bureaucratic inefficiencies, eliminate politically motivated spending, and restore public trust in California’s financial system. Ultimately, this Article offers a practical solution to the state’s ongoing fiscal challenges by aligning budget allocations with taxpayer priorities, fostering government accountability, and promoting more efficient public spending.
Introduction
California’s state income tax system is among the most complex and highly progressive in the nation,[1] generating hundreds of billions of dollars annually to fund essential public services.[2] However, despite significant taxation revenue, the state faces persistent financial challenges, including budget deficits,[3] mismanagement of taxpayer funds,[4] and growing public dissatisfaction over how tax dollars are spent.[5] The current state income tax structure imposes some of the highest marginal taxation rates in the country,[6] yet inefficiencies in revenue allocation have resulted in severe underfunding and mismanaging of crucial sectors in the state.[7] Furthermore, partisan-driven budgetary decisions[8] and bureaucratic inefficiencies[9] have contributed to public frustration, as funds are frequently directed toward specific programs rather than addressing urgent fiscal concerns.[10] These issues are prevalent at all levels of allocation, from statewide budget decisions down to county and municipal spending, where mismanagement and lack of direct taxpayer input exacerbate inefficiencies.[11] The difficulties in reforming California’s tax system are further compounded by deep divisions,[12] bureaucratic inefficiencies,[13] and conflicting public opinions on fiscal policy.[14] These challenges highlight the need for a more transparent and accountable method of tax allocation that better reflects the priorities of the taxpayers who fund the state budget.
To address these systemic issues, this Article proposes the Direct Democracy Tax Credit (“DDTC”), a policy designed to give taxpayers a greater voice in determining how their state income taxes are allocated. Building on California’s tradition of voter-directed initiatives, such as special taxes and ballot measures, the DDTC allows taxpayers to make personalized allocation choices each year without the barriers of majority vote requirements or costly political campaigns.[15] The DDTC is limited to resident taxpayers to ensure that only those with a direct stake in the outcomes of state spending can participate. Under this model, qualifying taxpayers can designate a portion of their income tax toward specific public service sectors, rather than relying entirely on state and local officials to make those decisions. The proposal includes the creation of a Direct Democracy Fund to collect and distribute these contributions with transparency and oversight. Entities receiving funding must demonstrate measurable outcomes and fiscal responsibility, ensuring taxpayer dollars are directed toward efficient and effective use. By putting allocation decisions into the hands of taxpayers, this proposal aims to reduce waste, increase accountability, and better align California’s budget with the needs and values of its resident taxpayers.
The Mechanics of Taxation in California
Of the fifty states in America, California is the third largest in geographical size,[16] and the most populous state with a population of over thirty-nine million people.[17] For the fiscal year of 2023, California had the highest gross domestic product (“GDP”) in the country, totaling close to $3.9 trillion, which is approximately 14% of America’s total GDP.[18] California’s GDP in 2023 was ranked fifth in the entire world, outperforming countries such as India, Mexico, and Russia.[19]
California has the highest number of ultra-wealthy residents in the United States, with 186 billionaires, primarily stemming from the technology and entertainment sectors.[20] Additionally, in 2020, California was ranked first in America for the number of millionaire households, with 1.14 million households possessing at least $1 million in investible assets.[21] This figure was nearly twice that of Texas, which held the second-highest count at around 650,000 millionaire households.[22] Despite the state’s wealth and high concentration of affluent residents, the average household income in California is $89,870.[23] Although this number seems low, the median home price in California still totals over $850,000.[24] This disparity highlights the significant income inequality present across the state, where high housing costs far outpace the earning potential of many residents.[25] These economic contrasts underscore the importance of examining how California collects and allocates its tax revenue, and whether that system truly serves the needs and priorities of its diverse population. To fully understand whether California’s tax system serves its population effectively, it is necessary to examine the actual tax burden placed on residents across income levels and how these rates compare to other states.
Overview of Taxation Rates in California
While living in California, residents and nonresidents are subject to both federal and state income taxes.[26] At the federal level, taxpayers are required to pay progressive income tax rates ranging from 10% to 37%, depending on their income bracket, and these rates apply uniformly across all states, with higher rates corresponding to higher levels of taxable income.[27]
In addition to these federal taxes, federal payroll taxes are imposed to fund Social Security and Medicare, which are imposed at fixed rates of 6.2% and 1.45%, respectively, on wages and self-employment income.[28] The Social Security tax rate is capped at a specific wage base limit, which for earnings in 2025 is set at $176,100.[29] Wages earned above this rate are not subject to additional Social Security taxes.[30] An additional 0.9% Medicare tax is added to taxable incomes over the $200,000 mark.[31]
California currently has the highest marginal tax rate of the forty-one states that impose an individual state income tax.[32] The standard top marginal rate on taxable income for individuals in California is 12.3%, along with relatively high marginal tax rates for middle-income earners.[33] Additionally, California levies a 1% Mental Health Services tax on taxable income exceeding $1 million.[34] This is not a flat tax on all income but applies only to income above the $1 million threshold.[35] Separately, California also imposes a State Disability Insurance (“SDI”) tax, which is a payroll tax rather than an income tax.[36] Starting in 2025, this SDI tax will be 1.1% on all wages, with no income cap.[37] When combined, the maximum marginal rate on wage income in California can reach 14.4%.[38]
In addition to the SDI tax, California also imposes several state-level payroll taxes on employers, including the Unemployment Insurance Tax (“UIT”), Employment Training Tax (“ETT”), and Personal Income Tax (“PIT”) withholding.[39] California employers are responsible for paying the UIT and ETT, which are based on the first $7,000 of each employee’s wages, with maximum annual costs of $434 and $7 per employee, respectively.[40] Employees pay the 1.1% SDI tax with no wage cap, while employers must also withhold PIT from employee wages based on their tax forms and income level.[41] Together, these payroll taxes form a complex structure in which employers are directly responsible for the UIT and ETT, while also administering SDI and PIT withholdings from employee wages.[42]
Additionally, out of the forty-five states that levy a sales tax, California imposes the highest statewide base sales tax rate at 7.25%.[43] Local jurisdictions in California can also add district taxes, which typically range from 0.10% to 3.00%, depending on the location.[44] In 2024, the cities of Palmdale and Lancaster in northern Los Angeles County raised their sales tax rates to 11.25%, making it the highest combined rate among U.S. cities.[45] Accordingly, California has one of the highest sales tax burdens in the nation.[46] On top of the high sales tax, California’s property tax rates are set by local governments, resulting in variations among counties.[47] Typically, the rate is calculated as a percentage of a property’s assessed value, with the average rate being around 1.1%.[48] However, California’s current effective property tax rate is .071%, which is moderately low compared to other states.[49] This lower rate is largely a result of Proposition 13, a constitutional amendment passed in 1978 that caps property tax rates at 1% of the assessed value and prohibits property reassessment upon change of ownership or new construction.[50] As a result, long-term property owners pay significantly lower property taxes than new buyers, and assessed values often lag far behind market values.[51]
California also imposes a flat 8.84% corporate income tax, which positions California among the higher corporate tax states in America.[52] On top of that, many California cities, including San Francisco and Los Angeles, levy their own form of business taxes.[53] San Francisco imposes a Gross Receipts Tax that applies to most businesses operating within the city.[54] This tax is based on a business’s total revenue, regardless of profitability, and is calculated using different rates and tiers depending on the type of business activity and amount of gross receipts.[55] This tax applies to all revenue attributable to San Francisco, even if the business operates in multiple locations.[56] These high and wide-ranging tax burdens across all income levels help explain how California consistently generates record-breaking tax revenue.
California’s State Taxation Revenue Overview
During the 2023 fiscal year, California generated the highest tax revenue from all sources of any state, collecting a total of $220.59 billion.[57] In comparison, New York ranked second, with tax collections totaling $125.19 billion for the same period.[58] Notably, California was one of only ten states to experience a tax revenue increase in fiscal year 2024, with a significant growth rate of 17.8%, demonstrating how taxpayers in California are paying significantly more to support the state’s expanding budget.[59]
California’s $450.8 billion budget for the 2024–2025 fiscal year was primarily supported by three types of state funds that together account for nearly 66.1% of the total budget.[60] The largest portion of this funding came from the General Fund, which represented 46.9% of the total budget.[61] This fund consisted of revenues that were not earmarked for specific purposes and were primarily used to finance public services, such as education, health and human services, and state prison systems.[62] In addition to the General Fund, special funds, which include more than five hundred state accounts designated for specific taxes, fees, and licenses, contributed a significant portion of the budget, totaling around 18.6%.[63] Bond funds accounted for revenue generated from general obligation bonds and were allocated toward specific infrastructure and capital projects.[64] The remaining percentage of California’s budget came from federal funds, which supported various federally mandated programs and services.[65]
The PIT, Sales and Use Tax, and Corporation Tax are California’s three largest sources of the General Fund revenue, collectively referred to as the “Big Three” taxes.[66] The PIT is the largest contributor, primarily collected from wages, salaries, and capital gains.[67] The second-largest revenue source for California is the Sales and Use Tax, which applies to the purchase of tangible goods within the state (sales tax) and the use of tangible goods acquired outside the state but used within California (use tax).[68] The Corporation Tax is the third-largest revenue source for California, which is levied on businesses that operate in California or earn income from the state.[69] Understanding where this revenue comes from is only the first step, as it is equally important to examine how these taxpayer dollars are ultimately distributed across state programs and services.
The Allocation of Taxation Revenue
California’s state budget functions as both a state and local budget, with most of the spending intended to benefit individuals, communities, and institutions across the state.[70] Under the enacted 2024–2025 state budget, nearly 79.9% of total spending flowed as local assistance to support essential services operated at the local level, including K–12 public schools, community colleges, and programs like CalWORKs for low-income families.[71] Additionally, 18.7% of the budget was allocated to state operations, which funded institutions such as the twenty-three California State University campuses, ten University of California campuses, and over thirty state prisons.[72] A smaller portion, less than 2% of total spending, was designated for capital outlay to support infrastructure projects throughout California, though infrastructure funding was also supplemented by local assistance and state operations allocations.[73]
For the 2024–2025 fiscal year, a significant portion of state funds was directed toward health and human services and education.[74] Together, these areas accounted for nearly 75% of the total spending from the General Fund and special funds.[75] Specifically, 38.9% of these funds supported health and human services programs, 27.3% went toward K–12 education, and 8% was allocated for higher education.[76] Additionally, just over 6% of these funds was directed toward corrections, primarily supporting the state prison system.[77] The remaining funds were used to finance other vital services, including transportation, environmental protection, and the operation of California’s court system.[78] Federal funds also played a vital role in supporting California’s budget, with 75.6% allocated to health and human services programs under the 2024–2025 budget.[79] The remaining federal dollars were distributed to other critical areas, such as labor and workforce development, K–12 and higher education, and transportation.[80]
For the 2025–2026 fiscal year, California’s projected spending allocates tax revenues across a variety of essential services and sectors.[81] The General Fund allocations prioritize education, healthcare, and public safety.[82] According to the budget summary, spending on K–12 education and higher education amounts to 36.3% and 10.2% of the General Fund expenditures, respectively.[83] Health and human services also consume a significant share of General Fund expenditures, while corrections and rehabilitation programs continue to receive steady funding.[84] Additionally, public safety efforts, firefighting, and environmental conservation programs receive funding through both direct appropriations and transfers from other funds.[85] The special funds for the 2025–2026 fiscal year primarily support targeted programs through revenues generated from taxes, fees, and licenses.[86] A substantial portion of these funds supports transportation and infrastructure under programs like the State-Local Realignment, with allocations of approximately $9.9 billion from sales tax revenue.[87] Environmental protection programs are funded through revenue from fuel taxes, while healthcare-specific allocations are particularly directed toward mental health and public health services.[88] Although the state’s budget outlines broad and detailed allocations, a deeper analysis is necessary to uncover the underlying problems with how these taxpayer funds are prioritized and managed.
Special Taxes and Taxpayer Discretion in California
California’s tax system is also unique in the extent to which voters influence taxation and spending through ballot initiatives.[89] Voters in California can enact taxes and earmark revenues for specific public purposes through ballot initiatives, bypassing traditional legislative channels.[90] This approach has allowed for the development of what are known as “special taxes” and fees, where the revenue is hypothecated, meaning it is legally restricted for designated uses such as homelessness programs or transportation.[91] Unlike general taxes, which flow into a general fund and can be used for any purpose, special taxes must be spent only on the specific purpose stated in the ballot measure.[92] Special funds generated from these taxes and fees accounted for 18.6% of California’s total budget in the 2024–2025 fiscal year.[93]
California sparked the first broad tax supermajority requirement wave in 1978 when voters approved Proposition 13, which amended the state constitution to impose a two-thirds vote requirement for the enactment of any new state-level taxes.[94] In 1996, this approach was extended to local governments through Proposition 218, which imposed a two-thirds supermajority vote requirement on local special taxes and imposed new procedural requirements for voter approval of assessments and fees.[95] In 2010, California voters approved Proposition 26, which amended the state constitution to broadly define tax and clarify what types of charges required a two-thirds vote.[96] However, despite these restrictions, courts have held that when special taxes are enacted through citizen-led initiatives, only a simple majority vote is required for approval, allowing voters to bypass supermajority constraints and fund specific priorities directly through the ballot box.[97] This framework has paved the way for a range of voter-approved special taxes that serve targeted public purposes.
Currently, California imposes a variety of special taxes and fees that are narrowly tailored to fund specific programs or address targeted public needs. One of the most prominent examples of a special tax in California is the voter-approved cannabis tax, designed to fund specific programs and services rather than general government spending.[98] Since the legalization of recreational cannabis and the implementation of the cannabis taxation system in January 2018, California has generated over $6.7 billion in cannabis-related tax revenue.[99] These funds are legally hypothecated for designated purposes, including childcare and early childhood development, youth substance abuse prevention, environmental recovery, and medical research.[100] The cannabis excise tax is applied at a rate of 15% on the gross receipts from the retail sale of cannabis or cannabis products.[101] Gross receipts include the selling price of the cannabis products and any additional charges the purchaser is required to pay, such as local cannabis business taxes, delivery fees, and service fees.[102] In addition to state-imposed cannabis taxes, local jurisdictions in California have the authority to implement their own separate taxes on cannabis businesses. These local cannabis business taxes are often calculated as a percentage of gross receipts or as a set amount per square footage of the business premises.[103] Retailers may pass these local taxes on to consumers, further increasing the final purchase price of cannabis products.[104]
Another example includes the California Tire Fee, which is a fee applied to the purchase of new tires to directly support grants, loans, and subsidies to businesses or other entities that promote activities or develop technologies for tire recycling.[105] California further imposes a special excise tax on electronic cigarettes, which applies to all retail sales of e-cigarette products containing nicotine.[106] Revenue from this tax is dedicated to funding public health and education programs, including efforts to prevent youth nicotine addiction and support tobacco control initiatives.[107] These examples highlight how California’s system of special taxes and fees empowers voters to have a say in taxes through ballot initiatives.
The Problems with the Allocation of California’s State Income Taxation Revenue
Overview of the Controversy
California’s state taxation system has sparked ongoing debate as to how taxpayer money is allocated and the lack of public control over government spending. One of the biggest concerns is the erratic and unpredictable nature of state spending, as budget priorities shift drastically from year to year without direct taxpayer input.[108] California taxpayers contribute billions in tax revenue annually, yet they have little say in where their money goes as government officials make spending decisions that can change drastically based on economic conditions, political agendas, or shifting policy priorities.[109] These inconsistent spending patterns create financial instability and uncertainty, leaving taxpayers frustrated by the lack of predictability in government budgeting.
Another major issue is the mismanagement and underfunding of essential services and programs, where taxpayers are forced to accept cuts to critical programs they never voted to reduce. State and local governments determine how funds are distributed, often redirecting money away from essential programs and services like public safety, infrastructure, and emergency response efforts, despite ongoing needs.[110] This results in underfunded programs that struggle to meet demand, leaving residents without the services they expect their tax dollars to support.[111] The disconnect between government spending decisions and taxpayer priorities fuels distrust and frustration with California’s financial management.
In addition, state tax dollars are often directed toward programs aimed at promoting social welfare, environmental protection, and equality, which are core priorities of the state’s progressive agenda. However, the concentration of decision-making power in the state government means that these priorities may reflect the prevailing political majority’s platform more than the full diversity of taxpayer perspectives.[112] This dynamic can create tension in a pluralistic society, where some taxpayers feel excluded even as their contributions support initiatives designed to promote shared prosperity.
Even when public funds are directed toward their intended purposes, bureaucratic inefficiencies within state and local governments often prevent meaningful progress.[113] Simply allocating taxpayer funds does not guarantee success, as poor execution, administrative delays, and management hinder effectiveness.[114] The lack of transparency in government spending further compounds these issues, making it difficult for taxpayers to track where their contributions are going. Without proper oversight and accountability, billions in taxpayer dollars continue to be misused, reinforcing concerns about government inefficiency.
Yet even when Californians are given the opportunity to vote directly on how certain tax revenues are raised or allocated through special taxes, this mechanism alone is insufficient to ensure fair and effective public spending.[115] Special taxes are inherently limited in scope and accessibility, as they rely on ballot initiatives that are often shaped by narrow political interests, constrained by voter turnout, and decided by slim majorities that may not reflect the broader will of the public.[116] While they are intended to enhance democratic control, special taxes can exclude millions of taxpaying residents from meaningful participation.[117]
The Budget Deficit Crisis
A budget deficit is defined as the amount by which outlays exceed receipts during a fiscal year.[118] This means that when the government spends more money than it receives in revenue over the course of a year, a budget deficit occurs.[119] When a government is in a deficit, it must borrow money to cover the shortfall, increasing overall public debt.[120] The more debt a government accrues, the more it must allocate to interest payments, reducing the funds available for essential public services like education, healthcare, and infrastructure.[121]Additionally, large deficits can contribute to inflation, as excessive government spending increases demand in the economy, driving up prices and reducing purchasing power for consumers.[122] On top of that, a government heavily burdened with debt may also cut back on infrastructure projects and education funding.[123] Lastly, if reserves are depleted and borrowing limits are reached, the government may struggle to provide necessary relief measures during economic downturns such as recessions, natural disasters, or unforeseen crises.[124]
Two years ago, California celebrated a $97.5 billion budget surplus for the fiscal year of 2022–2023, largely attributed to surging revenue from the post-pandemic economic recovery.[125] However, by the 2024–2025 fiscal year, Governor Gavin Newsom projected a $38 billion budget deficit, while the Legislative Analyst’s Office estimated the shortfall to be even higher, at $73 billion.[126] This rapid shift in budget amounts highlights the volatility of California’s budget, exposing the state’s reliance on fluctuating revenue sources and its inability to maintain long-term fiscal stability through consistent allocation and spending practices.
For the 2025–2026 fiscal year, California is dealing with a deficit of approximately $2 billion, which, while relatively small compared to the overall budget, signals deeper structural imbalances forthcoming.[127] The deficit is largely attributed to higher-than-expected spending increases across various sectors, which have offset recent revenue improvements.[128] California’s spending trajectory has been increasing at an annual rate of 5.8%, outpacing revenue growth, which remains just above 4%.[129] Projections suggest that starting in 2026–2027, annual operating deficits will increase, ranging from $20 billion to $30 billion in subsequent years.[130] One of the main reasons for California’s fiscal strain is a surge in spending across multiple programs.[131] A $2.5 billion increase in required spending for K–12 schools and community colleges under Proposition 98 is a major contributor to these rising costs.[132] Additionally, other state spending, such as increased wildfire suppression expenses, costs associated with recently passed ballot measures, and higher rates of caseloads in Medi-Cal and In-Home Supportive Services, have exceeded initial projections by $8 billion.[133]
Despite strong income tax collections from high-income earners, California’s overall economic growth remains sluggish, with a soft labor market and weak consumer spending.[134] The reliance on stock market–driven taxation revenue introduces volatility, as economic downturns could drastically reduce future collections.[135] Additionally, ongoing spending commitments from past policy decisions, such as expanding Medi-Cal coverage and raising the minimum wage for healthcare workers, continue to strain California’s budget.[136] The Legislative Analyst’s Office warns that without new revenue sources or significant spending cuts, the state will face annual budget deficits ranging from $20 billion to $30 billion in the coming years, making fiscal sustainability a pressing concern.[137]
Challenges in Local Budget Administration and Resource Allocation
Counties in California determine how they allocate their budgets based on a combination of state mandates, federal funding, and local priorities.[138] Counties operate as legal subdivisions of the state, meaning they must adhere to California’s budgetary guidelines while also funding essential local services.[139] While counties receive funding from the state and federal government, local leaders have discretion over how much is allocated to specific services.[140] Public input and local government priorities shape spending decisions, but counties also face constraints based on state funding levels and legal obligations.[141] Since local officials have a level of discretion in budget allocations, their decisions are frequently subject to scrutiny.[142]
A prime example of mismanagement and underfunding in the local sector arises from Los Angeles County and its budget allocated to the Los Angeles Fire Department (“LAFD”). The 2024–2025 wildfire season in California was one of the most devastating in recent history, with fires breaking out earlier in the year and spreading across new, unexpected regions.[143] Four major wildfires in Los Angeles County burned over 38,000 acres and destroyed or damaged at least 10,000 structures.[144] The Palisades Fire in Los Angeles County and the Eaton Fire in the San Gabriel Mountains were among the most destructive, claiming the lives of at least twenty-four people and displacing thousands.[145] The fires led to mass evacuations, with more than 166,000 residents forced to leave their homes as emergency crews struggled to contain the fires.[146] The fires have been fully contained and are no longer classified as active incidents.[147]
As these fires burned through California, severe budget cuts and underfunding of fire prevention efforts came under intense scrutiny.[148] The LAFD faced a $17.4 million cut to its budget in 2025, which resulted in reductions of the department’s technology infrastructure, payroll processing, training, and fire prevention programs.[149] These cuts directly impacted the department’s ability to respond effectively to emergencies, as fewer resources were allocated toward disaster response teams, tactical emergency medical service units, and aerial firefighting operations.[150] A $7 million reduction in overtime pay further compounded the issues, significantly limiting the fire department’s ability to maintain adequate staffing levels.[151] Known as “v-hours,” these fluctuating overtime shifts were crucial for ensuring the availability of personnel during major crises, including wildfires.[152] With reduced overtime funding, firefighters had fewer opportunities to train and prepare for large-scale emergencies, weakening response efforts as multiple fires broke out across Los Angeles County.[153]
The consequences of these cuts were apparent during the Palisades Fire and the Eaton Fire, where more than one hundred fire apparatuses were out of service due to a lack of funding for maintenance and repairs. Without this critical firefighting equipment, response times were severely hindered, leading to greater property losses and prolonged containment efforts.[154] Amid the fires, LAFD Chief Kristin Crowley stated they could no longer sustain where they were, and they did not have enough firefighters to manage the situation.[155] Citizens were critical of Crowley, claiming fire trucks were unable to pump water from fire hydrants due to empty reservoirs during the 2024 wildfires, highlighting concerns about the availability of firefighting resources.[156]
The 2025 budget allocation for the LAFD is $819.64 million, representing 6.36% of the city’s total expense budget.[157] Furthermore, Crowley has vocally emphasized the increasing demand for fire department resources, highlighting that call volumes have surged by 55% since 2010.[158] On average, LAFD responds to 1,368 emergency incidents daily, placing an immense strain on its existing personnel and resources.[159] Crowley has further stated the need for sixty-two additional fire stations to meet the growing demands of emergency response, yet budget reductions continue to prevent necessary expansions.[160] Despite the 6.36% allocation, fire officials argue that the rising demand for emergency response services, combined with staffing shortages and outdated equipment, has left the department struggling to keep up with the city’s needs.[161]
The financial shortfalls faced by the LAFD during the 2024 wildfires point to a broader problem of taxpayer money being poorly allocated by both state and local governments, rather than a choice made by taxpayers to reduce fire service funding. Taxpayers did not vote to reduce funding for emergency response teams, limit firefighter overtime, or leave essential fire equipment without maintenance. Instead, these budget shortfalls stem from local government spending priorities, where funds were diverted elsewhere despite the increasing demand for firefighting resources. County and city officials play a key role in determining how much funding public safety departments receive, yet they failed to keep up with the rising number of emergency incidents, staffing shortages, and equipment failures in this situation. These challenges were foreseeable, but the local budget decisions did not properly address them. The issue is not a lack of available revenue but rather how that revenue was distributed, leaving critical public safety departments underfunded.
Political Alignment in California
California plays a significant role in national elections due to its fifty-four electoral votes, the highest of any state.[162] Politically, California has leaned consistently Democratic for the last nine presidential elections since 1992.[163] Additionally, since 1992, California has exclusively elected Democratic senators, with the state’s house delegation also historically leaning Democratic.[164] California’s state government is dominated by the Democratic Party, with the Democratic Party holding the governor’s office since 2011.[165] The secretary of state, state treasurer, state attorney general, and state controller are all of Democratic affiliation.[166] The 2024 elections in California were historically significant as ten counties, which previously voted Democratic in 2020, flipped Republican.[167] While California is traditionally considered a Democratic state, these results highlight the growing presence of a Republican electorate that continues to challenge the Democratic stronghold.[168]
California is one of the most progressive states in the country, and its legislation tends to mirror priorities of the state’s majority political faction.[169] Governor Gavin Newsom has used this strong backing to champion policies focused on equity, climate action, and expanding opportunity across the state, reforms that often struggle to gain traction in more politically divided states.[170] However, California remains home to millions of residents, including conservatives who may not support many of these progressive initiatives; in fact, over six million out of the nearly sixteen million total votes were in favor of the Republican presidential candidate in 2024.[171] This dynamic underscores the tension inherent in representative democracy when one party’s agenda shapes policy for an ideologically diverse population, compelling all taxpayers to fund initiatives they may fundamentally oppose.
Persistent Underperformance in High-Cost State Programs
Homelessness Programs and Services
California has the largest homeless population in the United States, with over 187,000 people experiencing homelessness in 2024.[172] This accounts for nearly one-quarter of the nation’s total homeless population, highlighting the state’s outsize role in the national crisis.[173] Over the past five fiscal years, California has spent approximately $24 billion in an effort to combat homelessness.[174] Despite these extensive financial investments, the state’s homeless population has continued to rise, growing by approximately 63,000 individuals over the last decade, demonstrating that the funding has not resulted in a substantial reduction in homelessness.[175]
The rise of homelessness in California can be attributed to poor coordination between state and local agencies, slow project implementation, and misallocated funds.[176] For example, nearly $4 billion allocated to local governments for anti-homelessness initiatives has produced limited visible results, as many cities struggle with zoning laws and community resistance that delay housing projects.[177] Additionally, programs like Project Homekey, which received $3.7 billion to purchase motels and convert them into housing, have only completed 13,500 units, a fraction of what is needed to accommodate the state’s growing homeless population.[178] This highlights a broader issue within California’s government, where massive funding is allocated to pressing issues like homelessness but bureaucratic inefficiencies prevent the money from being effectively used to create real solutions. Instead of reaching the right places and making a meaningful impact, funds often get tied up in administrative costs, delayed projects, and poorly coordinated programs, ultimately failing to improve the situation.
Additionally, these problems extend beyond the state level and down to county and municipal governments, where poor data tracking and a lack of oversight further hinder the effectiveness of homelessness spending.[179] A recent audit of the city of Los Angeles revealed that significant information gaps and incomplete data hindered officials’ ability to evaluate the effectiveness of approximately $2.3 billion spent on homelessness initiatives over the past several years.[180] Without accurate tracking and measurable benchmarks, it remains unclear whether these funds had any meaningful impact, raising concerns about mismanagement and wasted taxpayer dollars.[181] These findings underscore the extent to which inadequate oversight, poor coordination, and data deficiencies continue to undermine the effectiveness of California’s homelessness spending efforts.
Prison and Corrections Systems
Another example of significant funding being allocated but the sector still struggling is California’s state incarceration system. California has one of the highest incarceration rates in the country, with only Texas surpassing it in total prisoners.[182] Each year, law enforcement agencies in California make nearly 800,000 arrests, leading to 600,000 bookings into county jails, while courts sentence around 30,000 people to state prisons, resulting in approximately 60,000 individuals in county jails and nearly 100,000 incarcerated in state prisons on any given day.[183] From 2019 to 2023, California’s prison budget steadily increased despite its share of the state’s General Fund declining from 8.6% to 6.5%.[184] However, the California Department of Corrections and Rehabilitation (“CDCR”) budget grew from $12.8 billion in 2019 to $14.8 billion in 2023.[185] The 2025–2026 budget allocated $13.9 billion to CDCR, with $13.5 billion coming from the General Fund and $4.1 billion designated for healthcare programs within the prison system.[186]
Despite billions of dollars in funding, California’s prison system continues to struggle due to overcrowding, high recidivism rates, and inadequate rehabilitation efforts.[187] Even after court-mandated reductions, state prisons still operate at around 112% capacity, reflecting persistent issues in population management.[188] The recidivism rate remains between 50% and 60%, meaning that more than half of those released end up reoffending.[189] Additionally, medical care in prisons remains insufficient, and conditions inside continue to be poor.[190]
A significant issue contributing to California’s struggling prison systems is the lack of transparency in how taxpayer money is spent, making it difficult to track whether funds are being used effectively.[191] In 2022–2023, the state disbursed over $8 billion through the Local Revenue Fund, with $2 billion specifically allocated to counties for Assembly Bill 109 (“AB 109”) programs, yet reporting on how this money was spent remains inconsistent.[192] Some counties provide detailed breakdowns, while others submit vague or recycled reports that fail to clarify where funds are allocated.[193] For example, Fresno County receives $50 million annually in AB 109 funding, but its report was only two pages long and did not account for how most of the funds were spent.[194] Additionally, some counties have amassed large reserves of unspent funds instead of using them for rehabilitation and public safety programs as intended.[195] Without standardized reporting requirements, many spending decisions remain unscrutinized, allowing mismanagement to persist.[196] This is a clear example of bureaucratic inefficiency where funding alone does not guarantee that a system will function effectively. Even when billions are allocated to criminal justice programs, the absence of proper oversight and accountability means that the money is often wasted or mismanaged, preventing real progress in addressing California’s prison system failures.
California’s persistent struggles with homelessness and its prison system illustrate the broader issue that funding alone does not guarantee effective solutions. Despite billions of dollars allocated to these sectors, bureaucratic inefficiencies, mismanagement, and a lack of transparency have prevented meaningful progress. The failure to track how taxpayer money is spent, combined with slow project implementation and administrative problems, has resulted in misallocated resources and underwhelming results. Without proper oversight, massive funding streams continue to be funneled into ineffective programs, delaying real change while burdening taxpayers with little to show for their tax contributions. These systemic failures highlight a fundamental flaw in California’s governance—that is, allocating money to a problem does not ensure its resolution unless accountability measures are in place.
The Limitations with California’s Special Taxes and Taxpayer Discretion
Not Every Taxpayer Participates in Ballot Initiatives
One of the major flaws with special taxes and ballot initiatives in California is that not all taxpayers participate in voting, alienating individuals who contribute to the state’s revenue but do not engage in electoral decisions regarding taxes.[197] In the November 2020 general election, California reported a record-setting voter turnout, with approximately 17.8 million ballots cast, representing 80.67% of registered voters.[198] This figure still only reflects a portion of the state’s total taxpayer base, which includes millions of residents who are ineligible to vote or do not participate in elections. Working minors aged 15 through 17 may pay state income tax but cannot vote until age 18.[199] Individuals convicted of a felony lose their right to vote when they are currently serving a state or federal prison sentence, despite the fact that they still may be paying taxes on any prison labor wages or taxable purchases while incarcerated.[200] Furthermore, nonresidents who perform work in California are subject to income tax and payroll taxes such as the SDI tax.[201] These individuals are generally not eligible to participate in special elections or local tax measures.[202]
On top of that, non–U.S. citizens who are classified as “nonresident aliens” may also be subject to various California taxes.[203] If they earn income from California sources, they are required to pay state income taxes; and if employed in the state, they are also subject to payroll taxes.[204] Additionally, they are paying sales tax on goods and services purchased in California.[205] Non–U.S. citizens are not generally permitted to vote in most state and local elections in California.[206] In 2024, Santa Ana attempted to change this through Measure DD, a ballot initiative that would have allowed noncitizen residents to vote in municipal elections, including in city council races and on local ballot measures.[207] If passed, it would have made Santa Ana the first city in California to extend voting rights to noncitizens in general elections.[208] However, the measure was ultimately rejected by voters in the November 2024 election.[209]
Additionally, low voter turnout and limited political capacity, such as voter confusion or lack of information, can lead to outcomes that fail to represent the true will of the broader taxpaying public.[210] These shortcomings are especially concerning for fiscal matters, which are often complex and prone to misunderstanding, distorting the relationship between public finance and democratic representation.[211] Overall, relying solely on voter-approved special taxes to guide public spending excludes significant portions of the taxpaying population and risks producing policies that neither reflect the preferences nor serve the interests of all those who contribute to the state’s revenue system.
California’s current system of voter-approved special taxes fundamentally undermines the principle of inclusive representation in public finance. By relying on simple majority votes in elections that exclude large segments of the taxpaying population—such as working minors; incarcerated individuals; nonresidents earning California income; and noncitizen residents who pay income, payroll, or sales taxes—the system delegates taxing authority to only a subset of those affected. This exclusion is not merely procedural: it severs the connection between taxation and representation, allowing a politically active minority to determine fiscal policies that impact the broader, more diverse taxpayer base. When ballot initiatives pass or fail by narrow margins and with limited turnout, the resulting tax policies reflect the preferences of the few, not the many.
A Majority Vote Does Not Represent the Decision of the Entire Voting Population
Historically, California has required a two-thirds vote to approve any special tax levied by a local government, pursuant to Proposition 13 and Proposition 218.[212] In 2017, however, the California Supreme Court held that procedural requirements imposed by Proposition 218 on local governments, such as the mandate that special taxes be approved by a two-thirds vote, do not apply to initiatives proposed by voters.[213] This holding clarified that when the electorate, rather than a local governing body, initiates a special tax measure, only a simple majority vote is constitutionally required for passage.[214] Subsequent appellate decisions have reaffirmed this distinction.[215] More recently, the California Supreme Court rejected an effort by state officials attempting to reinstate the two-thirds requirements for citizen initiatives, affirming that the constitutional provisions governing local tax approvals do not apply to voter-initiated taxes.[216] This simplified approval process contains a critical limitation that a measure passed by a bare majority does not necessarily reflect the will of the entire taxpaying public.
Even when there is participation, the requirement that a simple majority approves a special tax can obscure the fact that a substantial portion of the electorate may oppose the measure.[217] Ballot initiatives are often decided by slim margins and on low voter turnout, meaning a small, mobilized subset of voters can approve a tax that affects everyone.[218] This creates the illusion of consensus, while in reality, a substantial portion of eligible voters either opposed the measure or did not participate in the election at all.[219] For example, in the 2020 election, California voters considered Proposition 15, a constitutional amendment that would have shifted tax assessments for commercial and industrial properties from purchase price to market value to fund schools and local governments.[220] Although it was projected to raise $6.5 to $11.5 billion annually, the measure was defeated by a slim margin, as 51.97% opposed versus 48.03% in favor.[221] This outcome demonstrates how a modest majority of voters can ultimately determine the fate of a tax policy that would affect millions of taxpayers, including those who oppose or support the tax.
Allowing a simple majority vote to determine whether a special tax is imposed on the entire public is fundamentally flawed because it permits a potentially narrow, unrepresentative segment of the electorate to dictate how all taxpayers’ money is used. This shift away from the two-thirds supermajority requirement undermines the legitimacy of the taxation process by enabling significant fiscal decisions to be made without broad consensus. Particularly in low-turnout elections, a small, organized voting bloc can pass costly tax measures that bind everyone, including those who either opposed the measure or did not (or could not) participate in the vote. The result is an illusion of democratic agreement that obscures widespread dissent or apathy. As illustrated by Proposition 15, even proposals with sweeping financial consequences can hinge on razor-thin margins, highlighting how this framework allows a bare majority to impose obligations on millions. Such a system risks eroding public trust in taxation and governance by decoupling fiscal burdens from genuine majority will.
Outside Influences of Lobbyist and Special Interest Groups in Ballot Initiatives
The nature of special taxes means they often reflect the priorities of well-organized interest groups rather than comprehensive statewide needs.[222] The system of special taxes leads to a disproportionate influence of wealthy special interest groups, which can distort outcomes to reflect private economic agendas.[223] While special and local taxes are designed to empower ordinary citizens, the high costs of qualifying initiatives for the ballot, especially through petition referenda, give commercial entities a clear advantage, allowing them to hire professional signature gatherers and dominate public messaging campaigns.[224] This imbalance means that only initiatives with well-financed backing are likely to make it onto the ballot, and even once these initiatives are on the ballot, corporate and trade groups often use their financial resources to influence public opinion through advertising and lobbying.[225] As a result, tax policy shaped through special taxes and ballot initiatives may reflect the priorities of wealthy interests rather than delivering a comprehensive or equitable distribution of public funds across all sectors of citizen need.[226]
A real-life example stems from Proposition 87, a ballot measure that would have imposed a modest severance tax on oil extracted within the state, using the proceeds to invest in alternative energy programs.[227] Initially supported by over 60% of Californians, Proposition 87 was ultimately defeated 55% to 45% on Election Day, reflecting a dramatic five-month shift in public opinion.[228] The reversal was largely driven by the overwhelming financial influence of the oil industry, which spent over $100 million to defeat the measure.[229] Oil giants like Chevron, ExxonMobil, Shell, and Occidental funneled their contributions through front groups like Californians Against Higher Taxes and relied on a relentless campaign of fear messaging that warned voters the tax would cause gas prices to rise and push companies out of California.[230] The campaign also leaned on an “independent” report produced by a consulting firm paid nearly $100,000 by the opposition, further muddying public understanding.[231] Despite economists debunking the claim that such a small tax would meaningfully impact prices or drive out producers, the strategy worked: voters cited fear of rising gas costs as the primary reason for rejecting the measure.[232]
The defeat of Proposition 87 illustrates a fundamental flaw of California’s special tax system—that is, tax policy is manipulated by powerful private interests. This example underscores how the influence of special interest groups can override both expert consensus and majority opinion, resulting in the failure of potentially transformative public policy. When private wealth dictates public outcomes, especially in matters as consequential as taxation, the democratic integrity of the process erodes.
The Difficulties in Fixing These Problems
The Political Divide
One of the biggest obstacles to effective tax allocation in California is the extreme political divide that prevents bipartisan cooperation.[233] Entrenched polarization has created a political climate where each party prioritizes its own fiscal policies, leading to unstable and inconsistent tax allocations.[234] Instead of making long-term budgetary decisions based on economic needs, tax revenue is often redirected based on which party is in power, resulting in fluctuating funding for essential programs.[235] This divide is further reinforced by media and political rhetoric that frame tax allocation debates as ideological battles, making compromise nearly impossible.[236] As a result, government officials often prioritize partisan agendas over sound financial planning, leading to budget deficits, inefficient spending, and misallocated taxpayer funds.[237]
Shasta County in California demonstrates how political division leads to inefficient tax allocation, mismanagement of public funds, and budgetary instability.[238] Rather than prioritizing urgent local issues such as homelessness, infrastructure, and public safety, tax dollars have been redirected toward political-driven initiatives and ideological conflicts.[239] For example, instead of investing in essential services, county leaders allocated resources toward overhauling election systems based on partisan disputes, leading to unnecessary expenditures and legal challenges.[240] The lack of bipartisan cooperation has resulted in reckless fiscal decisions, preventing taxpayer money from being used effectively.[241] In Shasta County, budget discussions have been consumed by ideological battles, with factions advocating for deep cuts to public services while simultaneously pushing for costly political initiatives.[242] As a result, taxpayer funds have been wasted, with necessary programs such as public health and infrastructure maintenance suffering from chronic underfunding.[243]
Furthermore, taxpayer money is often wasted on reactionary spending rather than strategic planning, leading to budget shortfalls and inefficiencies.[244] In the same county, efforts to replace voting systems with a hand-count method lacked proper financial planning, resulting in significant costs with no clear benefits.[245] These spending decisions exemplify how political polarization prevents tax revenue from being utilized in a way that benefits all residents, leading to frustration and declining public trust.[246]
Shasta County serves as a clear example of how extreme political division disrupts tax allocation in California, leaving essential programs underfunded while taxpayer dollars are wasted on ideological conflicts.[247] When government officials prioritize partisan agendas over responsible budgeting, public funds are mismanaged, financial instability worsens, and taxpayers bear the burden of inefficient governance.[248] This reflects a broader challenge across California, where polarized leadership prevents tax revenue from being allocated effectively, further exacerbating the state’s fiscal and social issues.[249]
Bureaucratic Inefficiency
Another obstacle in resolving California’s tax-allocation issues is bureaucratic inefficiency, which prevents government agencies from effectively distributing funds and ensuring oversight.[250] Bureaucracies are meant to act as intermediates between taxpayers and public services, but their structure often leads to delays, misallocation of resources, and ineffective decision-making.[251] This is evident in California’s homelessness crisis, where billions are spent without meaningful results due to slow project implementation, excessive administrative costs, and mismanagement at the state and local levels.[252] Similarly, the prison system receives substantial funding in California yet remains plagued by overcrowding, high recidivism rates, and inadequate rehabilitation efforts, further highlighting how inefficient bureaucratic processes undermine effective tax allocation.[253]
A key issue is that bureaucratic oversight mechanisms do not always ensure efficiency, as decisions are frequently made based on rigid rules rather than practical outcomes.[254] Instead of adapting policies to improve tax allocation, bureaucracies tend to ignore legitimate complaints, delay necessary reforms, and mismanage funds due to excessive administrative hurdles.[255] This is evident in the mismanagement of homelessness funds, where programs like Project Homekey have failed to produce enough housing units despite billions in funding.[256] Similarly, in the prison system, taxpayer money is allocated to healthcare programs that lack proper oversight and remain ineffective in addressing critical inmate needs.[257] Even in cases where funding is allocated correctly, bureaucratic inefficiencies prevent resources from reaching their intended targets, leaving taxpayers frustrated as public services continue to deteriorate. The absence of direct consequences for inefficient spending creates a cycle where funding increases fail to produce tangible improvements.[258] Without proper oversight and performance-driven evaluations, bureaucratic agencies continue to request more funding while failing to address underlying structural inefficiencies.[259] As a result, taxpayer dollars are absorbed by excessive administrative costs, slow project implementation, and redundant oversight measures instead of being used effectively to improve public services.
Bureaucratic inefficiency continues to be a fundamental barrier to effective tax allocation in California, preventing public funds from being used in a way that directly benefits residents. When government agencies fail to function as effective intermediaries between taxpayers and public services, funding is absorbed by administrative inefficiencies rather than being directed toward meaningful solutions, leaving critical issues like homelessness and the prison system unresolved. Without strong oversight, accountability measures, and incentives to correct inefficiencies, taxpayer money is repeatedly misallocated and wasted, preventing it from being effectively used to address pressing issues.
Public Opinion
Public opinion also plays a significant role in California’s tax-allocation process, making it nearly impossible for the government to implement policies without facing backlash.[260] Regardless of how tax revenue is distributed, there will always be opposition as different groups of taxpayers have conflicting views as to how their tax dollars should be spent.[261] The media and interest groups amplify these divisions, often framing budgetary decisions as ideological battles rather than practical economic policies.[262] The constant scrutiny of government spending makes long-term budget planning difficult as elected officials are often forced to make politically safe decisions rather than necessary structural reforms.[263] Additionally, tax policy decisions often prioritize political survival over economic necessity as officials fear alienating key voter bases.[264] Over time, this instability creates uncertainty for both taxpayers and government agencies, making it difficult to maintain efficient public services.[265]
Ultimately, California’s tax-allocation challenges are deeply tied to public opinion, making it very difficult to implement policies without facing criticism from some segment of the population. With ideological divisions shaping debates over government spending, every decision is seen as either benefiting one group at the expense of another or failing to meet public expectations. This cycle of dissatisfaction and political pressure results in unpredictable budget allocations, forcing officials to navigate a landscape where taxpayer frustration and media scrutiny dictate fiscal policy as much as economic realities do.[266]
The Practical Limits of Taxpayer Mobility in California
A long-standing theoretical response to dissatisfaction with government services is the Tiebout Hypothesis, which posits that individuals can “vote with their feet” by relocating to jurisdictions in which tax-and-spending policies align with their preferences.[267] This theory is highly unrealistic, however, as the creator himself even described it as an “extreme model.”[268] Barriers such as limited financial resources, job constraints, or family obligations reduce individuals’ ability to freely relocate, thereby distorting the economic signals that such moves are supposed to send about public services.[269] When people face real-world obstacles like incomplete information about tax burdens or disparities in service quality, or when one jurisdiction’s decisions affect neighboring areas, relocation choices often fail to reflect clear preferences.[270] Consequently, the Tiebout model tends to overlook the fact that many households lack meaningful opportunities to choose among communities in a way that truly aligns with their values or needs.[271]
Applying the relocation theory to California taxpayers dissatisfied with how their tax dollars are being allocated is highly impractical due to numerous real-world constraints. Financially, relocating from California to another state involves significant up-front costs, including traveling, securing new housing, transporting belongings, and often losing local job opportunities.[272] For homeowners, Proposition 13 discourages relocation by locking in artificially low property tax rates, which are based on the home’s original purchase price and increase only minimally each year.[273] Selling the home would trigger reassessment on any new property purchased, likely resulting in significantly higher property taxes.[274] This lock-in effect creates a powerful financial disincentive to move, even for those who might prefer to relocate to another state or community with different political and social priorities.[275] Social and familial factors further complicate relocation. Many Californians have children enrolled in local schools, care responsibilities for extended family members, or cultural and community roots that make leaving emotionally difficult. Moreover, job opportunities, professional networks, and licensing requirements may not be easily transferable across state lines. As a result, for a substantial number of taxpayers, leaving California simply is not a realistic solution, even when they disagree with how their tax dollars are spent.
Furthermore, taxpayers should not be forced to uproot their lives and move simply because they are dissatisfied with how their government functions or how their tax dollars are spent. The basic structure of society, including its political, legal, and economic institutions, have a deep and lasting impact on individuals’ opportunities, values, and sense of belonging.[276] These institutions shape everything from the quality of education and healthcare people receive to how they are treated in public life.[277] Because of this significant impact, these institutions must be structured in ways that are fair and justifiable to all.[278] When individuals, specifically taxpayers in this case, feel alienated or disadvantaged by how these institutions operates, the solution should not be to expect them to leave.[279] To suggest that dissatisfied taxpayers simply “vote with their feet” ignores the structural inequalities that constrain mobility and wrongly places the responsibility for systemic shortcomings on the individual.[280] A just society should be responsive to the voice of all its members, not just those with the financial or social capital to leave.[281] Instead of forcing people to choose between their values and their homes, governments must strive to create inclusive institutions that reflect the diverse needs and perspectives of the entire population.[282]
Ultimately, expecting taxpayers to move away from California as a means of resolving their dissatisfaction with how the state spends public funds is unrealistic and ineffective. Relocation does nothing to address the underlying structural problems that drive frustration, as these issues will persist regardless of who stays or leaves, and mass taxpayer flight may even worsen the state’s fiscal and social challenges by shrinking the tax base and deepening divisions. Moreover, relying on mobility as a corrective mechanism unfairly assumes that only those with the resources and flexibility to relocate deserve representation. Real solutions must come from within the system itself, as the answer is not to abandon the state but to improve it.
The Direct Democracy Tax Credit
Addressing the Need for Direct Democracy in Taxation for California Residents
Direct democracy is a system in which citizens have the power to vote directly on laws, policies, and constitutional amendments rather than relying solely on elected representatives.[283] This form of governance is often implemented through mechanisms such as referenda and citizens’ initiatives, allowing the public to have a direct voice in shaping policies that affect their lives.[284] One of the primary advantages of direct democracy is that it promotes political participation, encouraging citizens to engage in the decision-making process and fostering a greater sense of civic responsibility.[285] Additionally, it serves as a check on elected officials by allowing voters to override legislative decisions or force representatives to address issues they might otherwise avoid.[286]
California already incorporates elements of public control in fiscal policy through ballot initiatives, special taxes, and referenda that allow voters to earmark funds for specific purposes.[287] While these mechanisms reflect a long-standing tradition of voter-driven policymaking, they are often constrained by procedural, fiscal, and structural shortcomings.[288] Ballot initiatives require costly, complex campaigns to qualify, which gives disproportionate influence to well-funded special interests and makes it difficult for grassroots ideas to gain traction.[289] Even when a measure reaches the ballot, low turnout and slim majorities mean that major tax decisions may be determined by a small, unrepresentative portion of the public.[290]
A more tailored form of citizen participation, one focused specifically on the direct allocation of state tax dollars, could overcome these limitations and expand public influence in a more inclusive and sustained manner. Unlike voting on ballot measures, which occurs infrequently and is shaped by campaign finance and majority-rule dynamics, a system that empowers individual taxpayers to allocate their contributions annually would offer a continuous and accessible method of engagement. This approach would not seek to replace California’s existing democratic structures but would strive to complement them by introducing a more granular, nonelectoral tool for shaping public spending. In doing so, it could foster broader civic involvement, reduce reliance on intermediary political processes, and ensure that fiscal decisions reflect the diverse and evolving priorities of the people who fund the state.
Applying direct democracy to California’s tax-allocation problems could create a more transparent, efficient, and accountable system. By giving individuals a role in budget allocation, government officials would be held more accountable for how funds are used, reducing financial waste and inefficiencies.[291] This approach would help address public frustration with government spending, giving individuals a tangible way to influence how their tax contributions are used.[292] One of the biggest advantages of this approach is that it would create a more stable and predictable tax system by aligning with public preferences rather than shifting political priorities.[293] Currently, tax revenue is frequently reallocated in ways that do not reflect the will of taxpayers, leading to frustration and a disconnect between government decisions and public expectations. Direct democracy in tax allocation would ensure that funding for critical services remains consistent and better reflects taxpayer priorities. Additionally, by increasing transparency and public oversight, this system would reduce opportunities for financial mismanagement, helping to mitigate bureaucratic inefficiencies that have prevented effective public spending.
One of the biggest obstacles in fixing California’s tax-allocation system is the difficulty in implementing meaningful reforms due to bureaucratic delays, partisan gridlock, and public dissatisfaction. Applying direct democracy to tax allocation would bypass these roadblocks by allowing taxpayers to directly participate in budget decisions, ensuring that funding reflects public needs rather than political priorities or an inefficient bureaucracy.[294] Instead of relying solely on elected officials, taxpayers would have a mechanism to guide tax dollars toward the issues that are most pressing in their opinion, increasing public confidence in how their money is spent. This approach would also encourage fiscal responsibility as government officials would be more accountable for how funds are allocated when taxpayers have a greater say in spending decisions.
Direct democracy could help stabilize California’s budgeting process by preventing abrupt shifts in tax allocation due to changing political leadership. One of the biggest issues with California’s tax system is that budgetary priorities fluctuate based on political cycles rather than long-term planning.[295] Allowing taxpayers to direct a portion of their taxes would create a more predictable and responsive allocation system, ensuring that public funds are used effectively even when political leadership changes. Ultimately, this approach would empower Californians to take an active role in shaping the state’s financial future, fostering a tax system that is more transparent, efficient, and aligned with the needs of its taxpayers.
Overview of the Direct Democracy Tax Credit
The Direct Democracy Tax Credit (“DDTC”) aims to bridge this gap by empowering taxpayers with the ability to direct the allocation of their state taxes. This proposal introduces a $500 tax credit, a deliberately modest amount aimed at minimizing the fiscal impact on state revenue while granting resident taxpayers meaningful participation in funding decisions. This tax credit empowers resident taxpayers to take an active role in allocating their state income tax contributions across a diverse range of public service sectors that are vital to California’s infrastructure and well-being. Taxpayers participating in this program can direct their funds to fourteen different sectors, including law enforcement, fire protection and emergency services, the healthcare sector, K–12 education, higher education, infrastructure development, environmental protection, housing and community development, economic development and job creation, consumer protection and financial services, civil rights and social services, emergency and disaster response efforts, corrections and rehabilitation, and veterans and social welfare programs.
A Direct Democracy Fund (“DDF”) would be established to receive and distribute taxpayer-directed contributions, ensuring that allocated funds are transparently managed and efficiently directed to the selected public service sectors. This fund would operate under public oversight, with clear tracking mechanisms, public reporting, and safeguards to ensure that allocations reach their intended programs. Taxpayers would be able to designate their contributions through an online platform or tax-filing system, and all fund distributions would be publicly recorded, allowing for real-time transparency and accountability in how state tax dollars are spent.
To ensure informed participation, taxpayers must complete a brief questionnaire after selecting their preferred sectors. This questionnaire is designed to enhance taxpayer understanding of the programs they support and to gather insights on the values and priorities guiding their choices.[296] Additionally, all participants must complete a twenty-minute educational course outlining the basic functions of the California state budget, the fiscal responsibilities of each public sector, and the implications of public funding allocations.[297] This mandatory course aims to promote civic education, deepen public engagement, and prevent misuse or uninformed decision-making in the allocation process.
Taxpayers could distribute their contributions based on personal priorities or beliefs, whether evenly across multiple categories or disproportionately toward specific sectors. This flexibility enables individuals to support causes aligned with their values, ensuring their taxes reflect their personal ideologies. Additionally, this tax credit allows taxpayers to respond dynamically to changing social and economic needs, allocating funds where they believe resources are most urgently required.
This tax credit would provide a direct reduction of $500 from a taxpayer’s state tax bill, provided they allocate 100% of their state income tax through the program. While tax rates would remain unchanged and at the discretion of the legislature, this proposal shifts power away from government officials and into the hands of taxpayers, ensuring that taxpayer funds are directed toward services that align with voter priorities. Taxpayers whose state income tax liability falls between $999 and $100 can participate in the program at a prorated level, receiving a $50 tax credit for allocating their tax obligation. Taxpayers who owe $99 or less in state taxes will not qualify for the tax credit.
In cases where married couples filing jointly disagree on how to allocate their taxes, the program could allow for split allocations. Each spouse may choose to divide their half of the joint tax liability independently across sectors of their choice. This option preserves individual discretion while maintaining the administrative simplicity of joint filing. If no split is requested, the default would be a unified allocation, requiring consensus between spouses. This added flexibility ensures that both taxpayers’ preferences are reflected in the allocation process, even under a joint-filing structure.
Listed below are four real-time situations illustrating how the credit could be utilized:
Example 1: A taxpayer owes $5,000 in state taxes, and they opt in to this tax credit. They receive a $500 tax credit and allocate their remaining payment of $4,500 to the corrections and rehabilitation budget. In addition to having to pay $500 less in state taxes, the taxpayer would gain the assurance that their money is transparently directed toward a cause they prioritize. With all allocations publicly recorded, this taxpayer could verify that their state tax dollars are used as intended.
Example 2: A taxpayer owes $100,500 in state taxes and chooses to opt in to the tax credit. They receive a $500 tax credit, reducing their bill to $100,000. An example of an allocation could include assigning 25% to infrastructure development, 25% to law enforcement, 25% to higher education, and 25% to fire protection and emergency services, with each amount totaling $25,000. The taxpayer would pay $500 less and have the assurance that their funds are distributed transparently to sectors that they deem important.
Example 3: A married couple filing jointly owes $20,500 in state income taxes. They opt in to the tax credit, reducing their bill to $20,000. They choose to allocate $10,000 to environmental protection and $10,000 to K–12 education. This couple would save $500 and have the ability to allocate their taxes to the sectors they personally choose.
Example 4: A single filer owes $150 in state taxes and opts in to this credit. They receive a $50 credit, reducing their bill to $100. They choose to allocate $25 to infrastructure development, $25 to environmental protection, $25 to housing and community development, and $25 to economic development and job creation. While saving $50, the taxpayer would get to choose the sectors of the fund to which their payment is allocated.
Based on filing data from 2021, California processes approximately 17.8 million personal income tax returns annually.[298] If 10% of California’s 17.8 million taxpayers, approximately 1.78 million individuals, opt in to the DDTC, the estimated cost to the state would vary based on the taxpayers’ liability levels. Assuming that 75% of participants qualify for the full $500 credit and 25% qualify for the reduced $50 credit, and not accounting for a change in the number of taxpayers since 2021, the program would cost the state approximately $690 million annually. This projection includes around 1.335 million full-credit participants ($667.5 million) and 445,000 reduced-credit participants ($22.25 million). The total cost remains modest relative to the state’s overall budget and is deliberately limited by the credit’s capped value. Over time, gains in fiscal efficiency, increased taxpayer engagement, and reduced waste could help offset the program’s short-term revenue impact.
The Creation of the Direct Democracy Fund and the Allocation System
The DDF serves as the primary financial pool where taxpayer-directed contributions from the tax credit are collected and distributed. This fund ensures that every dollar allocated by taxpayers is properly directed to the essential public service sectors they have chosen, creating a transparent, efficient, and publicly accountable system. This fund is designed to ensure that all taxpayer-directed contributions are managed with full transparency and accountability, guaranteeing that all allocations, disbursements, and expenditures are publicly recorded and easily accessible through an official state-run platform. A real-time tracking system will be implemented through a state-managed website, allowing taxpayers to view live updates on contributions and distributions while maintaining anonymity for individual contributors to protect privacy. This platform will provide detailed reports, allocation summaries, and spending breakdowns, ensuring that every taxpayer can verify their contributions and see exactly where their money is being used.
A key concern with taxpayer-directed allocations is the possibility of underfunding or overfunding certain public service sectors. To address this concern, other forms of taxation revenue will serve as safety nets, ensuring that no taxpayer-directed allocations go unfulfilled due to sectoral imbalances. This safeguard prevents funding shortages from disrupting critical services while maintaining the integrity of taxpayer-directed contributions. If a particular sector receives fewer taxpayer contributions than necessary, the government will intervene to stabilize funding using federal funding, the corporate tax revenue, or sales and use tax revenue, depending on economic conditions, overall budget priorities, and the financial health of the state. To ensure continuity and planning stability, the government will be required to supplement underfunded sectors so that the total funding remains within 2% of the previous year’s allocation for that sector. This approach allows flexibility in addressing funding gaps, ensuring that vital programs remain operational even when taxpayer contributions fall short. Government officials will not have discretion over taxpayer allocations, but they will be responsible for ensuring that all sectors remain adequately funded in accordance with state and public needs.
To maintain fairness and prevent corporate influence in public budgeting, only individual taxpayers will be eligible to qualify for the DDTC. Corporations will not be permitted to direct tax allocations, as their tax contributions will be reserved for stabilizing underfunded sectors at the discretion of the elected officials. This restriction prevents corporations from exerting undue influence on budget allocations, ensuring that public funding decisions reflect the collective priorities of individual taxpayers rather than corporate interests.
Requirements to Qualify for the Direct Democracy Tax Credit
Requirements to Qualify
The DDTC will be limited to resident California taxpayers to ensure that tax allocations are made by individuals with a tangible connection to the communities affected by public spending decisions. Allowing nonresidents to direct the allocation of state tax dollars introduces serious risks. Individuals who do not live, work, or vote in California could have policy preferences or ideological goals that diverge from the state’s long-term interests. Without a meaningful connection to the communities impacted by public spending decisions, nonresident taxpayers will therefore be excluded from participating in the DDTC. To further strengthen the DDTC’s connection to local accountability, only taxpayers who have been California residents for at least one full tax year will be eligible to participate. This requirement ensures that only individuals with a demonstrated, sustained presence in the state are granted the authority to direct public funds.
Just as California’s special tax system limits participation in ballot initiatives to registered voters, the DDTC likewise sets eligibility based on state residency. However, rather than leaving nonvoter contributors without any voice, the DDTC ensures that every resident taxpayer can participate. By grounding eligibility in tax contribution and physical residence, not just voter registration, the DDTC more equitably aligns fiscal influence with the individuals who live in and financially support the state.
Local tax systems, especially when they grant broad discretion or adopt targeted models, are vulnerable to distortion when influenced by parties who do not share in the local consequences.[299] Even well-meaning policies can produce unintended economic harms when designed without proper consideration of community investment.[300] Nonresident influence could similarly skew the DDTC away from sustainable, locally grounded allocations.[301] For instance, outsiders might direct funds toward high-profile or politically charged departments while neglecting essential but less visible services such as road maintenance or local housing programs. Additionally, jurisdictional accountability breaks down when individuals who are not subject to the lived realities of a place are granted fiscal authority over it.[302] Unlike residents, nonresident taxpayers do not experience the effects of underfunded schools or rising housing insecurity.[303] Limiting participation to state residents ensures that allocations reflect the needs, priorities, and values of those who rely most directly on the state’s services and who are best positioned to evaluate the effectiveness of public investment over time.
Additionally, to maintain fairness and reflect actual taxpayer contributions, part-year residents will also be eligible to qualify for the DDTC. In California, part-year residents are taxed on all income earned during their time residing in the state, as well as income derived from California sources while living elsewhere.[304] Since these individuals contribute to the state’s tax base and may rely on California’s public services during their residency, it is appropriate to grant them proportional allocation authority through the DDTC. However, their participation will be limited to the portion of the year they were California residents, and any allocations must correspond to their prorated state income tax liability during that period.
This eligibility restriction is a deliberate safeguard to protect the integrity, sustainability, and local responsiveness of the program. Residents are uniquely positioned to understand the challenges their communities face and are directly affected by the outcomes of public spending decisions. In contrast, nonresidents, who neither live in California nor rely on its public services, may lack the practical insight or long-term accountability needed to make responsible allocation decisions. Their involvement could lead to funding choices based on ideology and publicity rather than necessity, which risks diverting resources away from critical infrastructure, education, and safety programs. By limiting participation to those who are part of the social, civic, and economic fabric of California, the DDTC ensures that fiscal influence remains aligned with those who are most invested in the state’s success.
Constitutional Considerations
While limiting DDTC participation to California residents serves the legitimate interest of preserving local fiscal accountability, any residency-based eligibility requirement must also conform to constitutional constraints.[305] Under the Equal Protection Clause, distinctions between residents and nonresidents are permissible when they are rationally related to a legitimate state interest, but more stringent scrutiny applies to classifications based on the duration of residency.[306] In Zobel v. Williams, the Supreme Court invalidated a law that created permanent classes of residents based on length of stay, emphasizing that newcomers must be treated equally upon establishing bona fide residency.[307] To avoid such constitutional pitfalls, the DDTC avoids privileging long-term residents over recent arrivals and instead applies uniformly to all individuals who meet a baseline threshold of residency. Additionally, the program’s exclusion of nonresidents aligns with Article IV’s Privileges and Immunities Clause, which permits differential treatment when it is closely tied to substantial state interests, such as ensuring that only those with a meaningful presence and reliance on California services direct the use of state funds.[308] By excluding nonresidents and allowing proportional participation for part-year residents, the DDTC remains focused on individuals with direct investment in the state’s infrastructure and services while respecting constitutional safeguards regarding discrimination and the right to travel.
Managing the Allocations from the Direct Democracy Fund
The DDTC ensures that taxpayers decide how their contributions are allocated among essential public services, but the responsibility of managing and distributing these funds remains with government officials at the city, county, and state levels. Unlike the traditional budgeting process, where elected officials determine funding priorities, this system requires them to abide by the allocations set by taxpayers. This shift not only enhances government accountability but also ensures that taxpayer dollars are spent in alignment with public priorities. All municipal, county, and state employees who previously influenced budget allocations must now follow taxpayer-directed allocations, creating a system that is more transparent, equitable, and reflective of public interests.
Elected officials, who are entrusted with representing the interests of the people, will now be responsible for ensuring that taxpayer-directed allocations are properly disbursed. Their role is limited to confirming that funds are distributed within the designated sectors and that all taxpayer-allocated funds reach their intended destinations. This structure eliminates opportunities for discretionary spending, political manipulation, or direction of funds toward unrelated initiatives. By minimizing waste and bureaucratic inefficiency, this system effectively ensures that government officials serve as facilitators of public funding decisions rather than decision-makers themselves.
While taxpayers determine the specific sectors their contributions will support, government officials at the city, county, and state levels will still be responsible for selecting the entities that receive the funds within each category. This ensures that while taxpayer allocations guide overall funding priorities, the government retains the ability to assess and direct funds toward the most qualified, efficient, and accountable organizations, agencies, programs, and other entities. This structure maintains necessary administrative oversight, preventing arbitrary and ineffective distribution of funds, while still ensuring that allocations align with the priorities of individual taxpayers.
The burden of ensuring efficient use of allocated funds is shifted to the entities receiving the funds, including, but not limited to, government agencies, public institutions, nonprofit organizations, and service providers. These organizations must demonstrate financial accountability, maintain detailed records of how funds are spent, and adhere to oversight requirements to confirm proper use of taxpayer-directed allocations. This system ensures that funding responsibility rests with the recipients rather than government officials who previously exercised discretion over financial distributions.
Under this structure, government officials ensure that allocated funds are directed to the appropriate departments, institutions, and organizations as determined by taxpayers. Entities receiving funding are responsible for using these resources effectively and transparently, with strict reporting requirements to prevent waste, inefficiency, or misallocation. Public oversight mechanisms, including financial disclosures and audits, confirm that funds are spent in compliance with taxpayer directives. Additionally, if a sector receives insufficient taxpayer contributions, the government is responsible for ensuring funding stability by supplementing shortfalls using federal funding, corporate tax revenue, or sales and use tax revenue.
By removing political interference from budget allocation, this system enhances fiscal responsibility, reduces inefficiencies, and ensures that every dollar is directed toward essential public services. By shifting financial decision-making power from government officials to the taxpayers themselves, this initiative strengthens public trust, government transparency, and taxpayer confidence in how their contributions are used.
State Government Oversight and Supplemental Funding
While the DDTC empowers resident taxpayers to allocate their state income tax contributions to different sectors, the responsibility for translating those choices into actual budget allocation lies within the state government. Rather than altering individual taxpayer choices, the state serves as the administrator of the system, responsible for organizing, distributing, and monitoring funds to ensure that directed allocations are effectively delivered to the appropriate local jurisdictions. Under this system, the state will review the aggregate taxpayer allocations to each of the fourteen designated sectors and then determine how those funds are distributed to fifty-seven counties and 482 cities, towns, and villages in California.[309] This structure preserves taxpayer intent while allowing the state to ensure that allocations reflect the functional responsibilities and needs of each level of government. For example, if a majority of taxpayers direct their contributions toward healthcare, the state will distribute those funds to the localities responsible for delivering healthcare services, considering the scope, capacity, and population served by each jurisdiction. Municipalities may receive funds for local clinics and public health programs, while counties may receive funding for regional hospitals and emergency health infrastructure.
If certain sectors receive inadequate taxpayer contributions from the fund, the state will intervene not by redistributing taxpayer-allocated funds, but by supplementing shortfalls through alternative revenue sources. To stabilize funding imbalances, the state will strategically utilize federal funding, corporate tax revenue, and sales and use tax revenue as necessary. State revenues that are not directed toward the DDF will be prioritized before tapping into supplemental funding sources. Federal funds will serve as the first line of support, allowing California to maximize available resources before relying on state revenues. If federal funds are insufficient, corporate tax revenue may be used to reinforce underfunded sectors, ensuring businesses contribute to the stability of public services. Finally, sales and use tax revenue will act as a last resort, providing financial safeguards to prevent disruptions in critical programs. However, these interventions will be strictly regulated and publicly disclosed, ensuring that taxpayer-directed allocations remain the primary funding mechanism while government supplementation remains transparent and predictable. In all cases, the state will be required to supplement any sector that receives insufficient taxpayer-directed contributions so that the total annual funding for that sector remains within 2% of its prior year’s allocation. This threshold establishes a predictable baseline for public service providers, enabling them to plan operations, staffing, and resource distribution without the volatility that might result from fluctuating taxpayer preferences. By capping year-over-year deviation at 2%, the state ensures that essential services are not disrupted while still honoring the intent of taxpayer direction.
To achieve this balance, state officials will systematically track how taxpayer-directed funds are distributed across the fourteen designated sectors. This analysis will include identifying funding trends, assessing potential geographic disparities, and detecting fluctuations that could indicate financial instability. Rather than reacting to funding shortages after they occur, the state will take a proactive approach by forecasting potential imbalances and preparing contingency plans to prevent disruptions. Government officials will monitor taxpayer allocation trends in real time, identify early warning signs of instability, and ensure emergency funds are available if contributions unexpectedly decline in any sector. Additionally, all instances of state intervention will be made publicly accessible, allowing taxpayers to track where supplemental funds are being used and ensuring that government involvement remains limited to maintaining financial stability rather than exercising discretionary control over tax allocations.
This system establishes a delicate balance between taxpayer autonomy and necessary government oversight. By allowing individuals to direct their tax contributions while ensuring supplemental funding is available when needed, the DDTC creates a more transparent and responsive budgetary process. Through continuous monitoring, responsible intervention, and strict public accountability, the state government plays a supportive rather than controlling role, ensuring that California’s tax-allocation model remains both taxpayer-driven and structurally sound.
Requirements for Entities to Receive Distributions from the Direct Democracy Fund
To ensure transparency, accountability, and responsible use of taxpayer dollars, any public service or department receiving distributions from the DDF must adhere to strict financial reporting and operational requirements. Organizations must maintain detailed records of their employees, including salaries and compensation structures, to prevent wasteful spending and ensure that taxpayer funds are not misused for excessive administrative costs. Additionally, recipients must provide a clear breakdown of how state-allocated funds are spent, demonstrating that resources are directed toward essential services rather than unnecessary expenditures. To maintain ongoing accountability, quarterly financial reports must be submitted, allowing for continuous oversight and evaluation of how these funds are being utilized. Furthermore, every organization receiving over $1 million in funding must develop and maintain a public-facing website that outlines its mission, financial disclosures, and the impact of taxpayer contributions, ensuring that taxpayers in California have direct access to information about how their tax dollars are being used.
To further enhance financial oversight, all organizations receiving funds over $10 million must undergo annual third-party audits conducted by an independent agency. These audits will ensure that state funds are being used efficiently, detect potential mismanagement, and identify areas for improvement. In addition to audits, recipients of over $25 million must participate in public transparency hearings held every six months, where they will be required to present an overview of how taxpayer funds have been used, outline future spending plans, and allow taxpayers the opportunity to ask questions. These hearings will be organized and overseen by county, state, and municipal officials who are responsible for managing the fund, ensuring neutrality and fairness in financial disclosures. These officials will be tasked with moderating discussions, reviewing compliance with financial regulations, and addressing public concerns about how tax dollars are being allocated.
All budget meetings will be internal discussions among organizational leadership regarding financial planning, resource allocation, and spending strategies for the upcoming fiscal period. To promote full transparency, all budget meetings must be live-streamed and archived for public access, ensuring that taxpayers can observe real-time financial decision-making processes. While public transparency hearings focus on external accountability, budget meetings allow taxpayers to monitor the internal financial deliberations of the organizations receiving state funds.[310] The agency managing the fund will also oversee the live-streamed budget meetings to ensure compliance with transparency requirements and prevent any potential misuse of funds.
To prevent the hoarding or misallocation of taxpayer funds, all recipients will be required to return any unused or misallocated funds to the state. This ensures that excess funds are redirected to underfunded programs and essential services, rather than being wasted or sitting in accounts with no immediate use. To promote efficient use of public funds, all allocated taxpayer contributions must be used within the fiscal year or forfeited. This policy ensures that organizations do not sit on large reserves of funds while critical services remain underfunded. If funds are not spent on essential services within the designated time frame, they will be redistributed to areas of higher needs, preventing financial stagnation. This measure also discourages financial mismanagement by incentivizing organizations to plan and execute their budgets effectively. Additionally, regular monitoring and enforcement of this policy will ensure that taxpayer dollars are being actively used to improve public services rather than accumulating in unused reserves.
The implementation of strict financial reporting requirements, regular audits, and public transparency measures ensures that all recipients of the DDF remain accountable in their use of taxpayer-directed allocations. The role of municipal, county, and state officials in overseeing compliance guarantees that funds are distributed efficiently and in alignment with taxpayer priorities while maintaining essential oversight to prevent mismanagement. By requiring entities to disclose financial data, participate in public hearings, and adhere to spending deadlines, this framework fosters a system of responsible fiscal management. Through these safeguards, the fund remains a transparent and effective mechanism for directing taxpayer contributions toward meaningful public services while upholding accountability at every level along the way.
Avoiding Private Interests and Maintaining the State’s Best Interests
To preserve the legitimacy of the DDTC and ensure that taxpayer contributions are used solely to advance the public good, strict ethical guidelines must be enforced across all stages of the program’s implementation. These safeguards apply to every level of government and every entity receiving funds. Preventing private influence, personal enrichment, and political favoritism is essential to maintaining the state’s best interests and sustaining public trust in this system.[311]
At the government level, all municipal, county, and state officials who play a role in managing or distributing taxpayer-directed funds must comply with robust conflict-of-interest restrictions. In decisions involving sector-specific distributions, county and municipal allocations, entity selection, and government supplementary funding, public officials must act impartially and without personal benefit. These conflict-of-interest safeguards are mirrored at the organizational level. Any nonprofit, governmental department, educational institution, public agency, or private-sector partner that receives funds from the DDF must certify that it is free from any undisclosed relationship with elected officials or government administrators responsible for its funds allocation.[312]
Ultimately, this commitment to integrity extends to the program’s broader philosophy. The DDTC is not only about shifting fiscal control to the taxpayers but also about protecting that control from being stolen by special interests, corrupt actors, or political entities. By embedding strong accountability at every level of governance and distribution, this system ensures that taxpayer contributions are managed ethically, equitably, and in the best interests of the taxpayers in California.
Boosting Taxpayer Morale
Research in behavioral economics and public finance shows that taxpayers are more likely to comply with tax obligations when they perceive a direct benefit from their contributions.[313] This phenomenon, often referred to as “tax morale,” is rooted in a psychological contract between taxpayers and the government.[314] When individuals feel that their tax payments result in meaningful, efficient, and observable outcomes, their willingness to pay increases.[315] Conversely, when public funds are mismanaged or their use is opaque, the taxpayers are more likely to view the fiscal exchange as unfair, leading to frustration, distrust, and decreased compliance.[316] Importantly, giving taxpayers even limited discretion over how their taxes are used can strengthen this sense of fairness and foster a deeper sense of civic engagement and responsibility.[317] Thus, public policy designs that allow individuals to direct or observe the use of their tax dollars can improve not only perceptions of government accountability but also taxpayer satisfaction and compliance.[318]
The DDTC applies these insights by giving taxpayers meaningful control over how their contributions are used, strengthening the psychological link between paying taxes and receiving public value in return. Rather than viewing tax payments as disappearing into a bureaucratic system, participants in the DDTC can allocate their dollars to specific public sectors that align with their values, such as education, healthcare, or environmental protection. This creates a more transparent and rewarding fiscal exchange, enhancing the perception of fairness and increasing the likelihood of voluntary compliance. By reinforcing the belief that one’s tax dollars directly contribute to visible and efficient outcomes, the DDTC promotes a cooperative mindset and civic responsibility. Just as research has shown that perceived benefits raise tax morale, the DDTC operationalizes this principle through a simple but powerful design, bridging the gap between obligation and ownership and fostering a culture of trust, engagement, and fiscal integrity within California’s tax system.
Distinguishing Between the Already-Existing Taxpayer Discretion and the Direct Democracy Tax Credit
California’s existing system of taxpayer discretion largely operates through ballot initiatives, special taxes, and petition referenda, which are mechanisms intended to give voters a say in public finance decisions.[319] However, ballot initiatives require costly, complex campaigns to even qualify for the ballot, giving an upper hand to corporate-backed proposals while excluding grassroots efforts lacking financial resources.[320] Even when a measure reaches the ballot, low voter turnout and slim margins of victory mean that major tax decisions may be determined by a small, unrepresentative subset of the population.[321] Further compounding these issues, only registered voters, who may not represent the full breadth of the taxpaying population, can participate in these decisions, leaving out individuals who may pay into the system.[322]
Unlike traditional forms of direct democracy in California, which rely on ballot initiatives and majority vote requirements,[323] the DDTC applies the principle of direct democracy to the allocation of tax dollars rather than the voting process itself.[324] The DDTC addresses long-standing limitations in the state’s fiscal decision-making by empowering resident taxpayers, not just voters, to allocate their state income tax directly to the public service sectors they prioritize. The distinction is fundamental because, unlike California’s ballot-based model, which offers an occasional and indirect mechanism for public input, the DDTC provides continuous, individualized discretion over public spending. Public trust in the initiative process has eroded in recent decades, with polling data showing that many Californians believe ballot outcomes are shaped more by organized special interests than by the will of the people.[325] The DDTC directly addresses this concern by eliminating the financial and logistical barriers of ballot initiatives while extending fiscal influence to the broader taxpaying public. Moreover, because the DDTC operates through the tax-filing process rather than the electoral system, it avoids many of the cognitive, informational, and structural limitations that hinder meaningful voter participation in complex fiscal matters.[326] Importantly, the DDTC does not require majority approval to take effect. Every qualifying taxpayer, regardless of political affiliation, voter status, or participation in prior elections, can allocate their funds annually without relying on majority consensus or political campaigning.
Conclusion
California’s tax system has long struggled with inefficiency, misallocation, and a lack of transparency, leaving taxpayers frustrated with how their contributions are spent. These challenges are not merely technical or bureaucratic, but they reflect a deeper issue of trust between the public and California’s government. When citizens feel excluded from fiscal decision-making, confidence in state institutions erodes and engagement in the democratic process declines. The DDTC offers a bold and innovative solution to this crisis of trust. Limiting participation to residents who have established a clear connection to the state ensures that allocations are grounded in local knowledge, lived experience, and long-term accountability.
The DDTC builds upon California’s long-standing tradition of special taxes and ballot initiatives but corrects many of the system’s flaws. While ballot initiatives have empowered voters to earmark funds for specific programs, they remain subject to potentially low participation, majority rule limitations, and manipulation by well-funded interest groups. The DDTC overcomes these shortcomings by offering every qualified taxpayer, not just voters, a personal and annual opportunity to direct funds without needing to organize campaigns or win popular votes. In doing so, the DDTC complements California’s existing framework of special taxes while extending fiscal discretion more equitably and efficiently.
Critically, this system does not abandon structure or oversight. With robust accountability mechanisms, such as financial audits, mandatory reporting, and conflict-of-interest safeguards, this model blends empowerment with responsibility. The system protects against misuse, ensures equity across regions, and adapts to fiscal challenges through supplemental government support for underfunded sectors. While no system is without challenges, the DDTC represents a necessary step toward restoring balance, transparency, and fairness in California’s tax-allocation system. It signals a shift from opaque, top-down budgeting toward a participatory model that honors the voice of every taxpayer. By giving individuals a real stake in how their money is spent, California can lead the nation in building a more democratic, responsive, and fiscally responsible government.
See, e.g., Alexi Chidbachian, These California Counties Flipped from Blue to Red This Election Year, Fox KTVU (Nov. 8, 2024) (illustrating the political polarization and shifting voter sentiments across California counties, which contribute to conflicting public opinions on fiscal matters). ↑
See Ariel Jurow Kleiman, Tax Limits and the Future of Local Democracy, 133 Harv. L. Rev. 1884, 1929–37 (2020) (explaining how formal mechanisms of taxpayer control, like voter approval requirements, often fail to capture general public will, as ballot measures are shaped by limited voter capacity, low participation, and disproportionate influence from interest groups and elite actors); see also Andrew Appleby, Designing the Tax Supermajority Requirement, 77 Syracuse L. Rev. 960, 974–77 (2020) (explaining how California’s tax system, shaped by voter initiatives like Propositions 13 and 218, has enabled direct taxpayer influence over fiscal policy but also created procedural hurdles and inequities in access that favor well-funded interests over broad public participation). ↑
See High-Tax California Keeps Increasing Upper Tax Rate, supra note 33; see also Cal. Rev. & Tax. Code § 17043(a) (“For each taxable year . . . an additional tax shall be imposed at the rate of 1 percent on the portion of a taxpayer’s taxable income in excess of one million dollars.”). ↑
See Cal. Const. art. XIII A, §§ 1(a), 2(a), 2(b) (limiting ad valorem property tax rates to 1% of full cash value and restricting reassessment unless there is a change in ownership or new construction); see also Cal. Const. art. XIII A, § 3 (prohibiting state and local governments from imposing new ad valorem property taxes beyond the 1% cap, unless specifically authorized by a supermajority vote). ↑
See Investopedia Team, Understanding the Lock-in Effect: How It Affects House Prices, Investopedia (Jan. 23, 2024) (explaining how California’s Proposition 13 limits property tax reassessment, contributing to a lock-in effect that discourages homeowners from selling and reduces housing supply). ↑
See Gross Receipts Tax Overview, Treasurer & Tax Collector (last visited Apr. 4, 2025); see also Know Your Rates, City of L.A. Off. of Fin. (last visited Apr. 5, 2025); Andrew Appleby, Targeted Taxes: Localities Take Aim at Large Employers to Solve Homelessness and Transportation Challenges, 98 Or. L. Rev. 477, 492–95 (2020) (explaining that local governments have increasingly used targeted business taxes, such as gross receipts and per-employee taxes, as policy tools to address localized challenges like homelessness and transit infrastructure, often placing disproportionate burdens on large employers). ↑
Id.; see also Appleby, supra note 15, at 974–77 (2020) (explaining how California’s constitutional framework enables local governments to impose “special taxes” with two-thirds voter approval, and how this authority extends to ballot initiatives). ↑
See Appleby, supra note 53, at 524–28 (explaining that special taxes, such as San Francisco’s homelessness tax, explicitly designate revenue for specific funds and purposes). ↑
Id. at 492 (explaining that San Francisco initially planned to present its IPO tax as a special tax, which would earmark revenue for specific purposes, but later postponed the measure). ↑
See Cal. Const. art. XIII A, § 3; see also Kathleen K. Wright, The Aftermath of California’s Proposition 26, 62 Tax Notes State 471, 471 (2011). ↑
See City & Cnty. of San Francisco v. All Persons Interested in the Matter of Proposition C, 51 Cal. App. 5th 703 (2020) (holding voter-initiated special taxes require only a simple majority for passage, not a two-thirds supermajority, because constitutional supermajority requirements apply only to taxes imposed by legislative bodies, not by citizen initiatives); see also City of Fresno v. Fresno Building Healthy Communities, 59 Cal. App. 5th 220 (2020) (holding voter initiatives that impose local special taxes do not require a two-thirds supermajority under Propositions 13 or 218; such measures are validly enacted by a simple majority vote). ↑
See Gabriel Petek, The 2025–26 Budget: California’s Fiscal Outlook 3 (Legis. Analyst’s Off. 2024). ↑
See, e.g., Ellis, supra note 7 (illustrating how government budget decisions can deprioritize critical services like emergency response, even in the face of escalating public safety needs). ↑
See Sabalow, supra note 8 (illustrating how one-party rule leads to decisions and legislation being passed that reflect the priorities, beliefs, and ideologies of the controlling party). ↑
See, e.g., Watt, supra note 9 (illustrating how bureaucratic inefficiencies and poor implementation can undermine the effectiveness of public spending, even when funds are allocated to urgent social issues). ↑
See The Budget and Economic Outlook: 2024 to 2034, at 13 (Cong. Budget Off. 2024). ↑
See Int’l Monetary Fund, Confronting Budget Deficits, No. 3 Econ. Issues 1, 3 (1996) (explaining that persistent government deficits can lead to increased public debt, higher interest obligations, inflationary pressures, and reduced fiscal capacity to respond to crises). ↑
See California, 270toWin (last visited Mar. 10, 2025) (illustrating California’s consistent support for Democratic presidential candidates and its long-standing Democratic dominance in statewide and federal elections). ↑
See Kleiman, supra note 15, at 1930 (explaining that the representative power of voter approval is undermined by low voter turnout and the exclusion of nonvoting taxpayers, which distorts public finance and alienates segments of the taxpaying population). ↑
See Shirley N. Weber, Who Can Vote in California, Cal. Sec’y of State (last visited Apr. 20, 2025) (“To register to vote in California, you must be: A United States citizen and a resident of California. . . .”). ↑
See Kitson, supra note 203 (noting that undocumented residents in California pay state income taxes, payroll taxes, and sales taxes on goods and services). ↑
Weber, supra note 202; see also Non-Citizen Voting Rights in Local Board of Education Elections, S.F. Gov’t (last visited Apr. 20, 2025) (explaining that noncitizen residents can vote in San Francisco Board of Education elections if they meet specific residency and registration requirements). ↑
See Kleiman, supra note 15, at 1930–32; see also Richard Briffault, Distrust of Democracy, 63 Tex. L. Rev. 1347, 1353 (1985) (“Initiative measures are more than mere voter opinion polls; they are intended to make law. As a result they often are written in technical, legal language with cross-references to other provisions of law and use terms of art impenetrable to the lay person.”). ↑
See Appleby, supra note 15, at 974; see also Cal. Const. art. XIII A, § 3. ↑
See Cal. Cannabis Coal. v. City of Upland, 3 Cal. 5th 924, 944 (2017) (“We conclude that article XIII C, section 2, subdivision (b) does not limit voters’ power to propose and adopt initiatives concerning taxation. Neither the provision’s text nor anything else shedding light on its intended purpose support a contrary conclusion.”). ↑
See City & Cnty. of San Francisco v. All Persons Interested in the Matter of Proposition C, 51 Cal. App. 5th 703 (2020); see also City of Fresno v. Fresno Building Healthy Communities, 59 Cal. App. 5th 220 (2020). ↑
See Legislature of the State of Cal. v. Weber, 16 Cal. 5th 237, 274 (2024) (holding that Proposition 218’s supermajority requirement applies only to taxes imposed by local governments—not to voter initiatives—rejecting a proposed amendment that sought to apply the requirement to citizen-led tax measures). ↑
See Kleiman, supra note 15, at 1930–34 (explaining how lower voter turnout, limited political capacity, and cognitive biases can undermine the representative power of voter approval by allowing a simple majority of participants, not the broader electorate, to determine tax policy outcomes). ↑
See Kleiman, supra note 15, at 1934–37 (explaining how special interest groups can disproportionately influence earmarked revenue initiatives, leading to allocations that favor politically active constituents rather than addressing broader or more equitable public policy goals). ↑
Id.; see also Richard L. Hasen, Assessing California’s Hybrid Democracy, 97 Cal. L. Rev. 1501, 1502–03 (2009) (“[T]he devices of direct democracy remain too blunt and expensive as tools for anything but interstitial governance. . . . While initiative supporters who have enough money can qualify just about anything for the ballot—and those lacking money often can qualify for nothing—significant negative spending has derailed many measures.”). ↑
See Kleiman, supra note 15, at 1938–40 (explaining that the high cost of qualifying ballot initiatives provides commercial interests with a significant advantage, effectively ensuring ballot access and influencing public perception). ↑
See id. at 1936–38 (explaining that the significant financial advantages held by corporations and trade groups allow them to dominate both the qualification of ballot initiatives and the public discourse surrounding them, using extensive advertising and lobbying to influence outcomes); see also Lynn A. Baker, Constitutional Change and Direct Democracy, 66 U. Colo. L. Rev. 143, 148–49 (1995) (“One-sided spending has been successful in persuading people to vote against an initiative. . . . Even when spending is more equalized, those seeking to block an initiative are much more likely to succeed than its proponents.”). ↑
Id.; see also Thad Kousser & Matthew D. McCubbins, Social Choice, Crypto-Initiatives, and Policymaking by Direct Democracy, 78 S. Cal. L. Rev. 949, 969 (2005) (“A large and increasing number of initiatives are designed by agenda setters, often from outside the state or locality in which the initiative is being run, who have other goals in mind; for them, affecting policy is often at most a secondary concern.”); Michael S. Kang, Democratizing Direct Democracy: Restoring Voter Competence Through Heuristic Cues and “Disclosure Plus,” 50 UCLA L. Rev. 1141, 1153 (2003) (explaining how voters in initiative elections often make decisions in an “informational vacuum,” leading to unpredictable or uninformed outcomes that distort public policy). ↑
Id.; see also Daniel M. Warner, Direct Democracy: The Right of People to Make Fools of Themselves; The Use and Abuse of Initiative and Referendum, a Local Government Perspective, 19 Seattle U. L. Rev. 47, 81 (1995) (“When the inevitable consequence of government without a plan, or with a poorly-thought-out plan, manifests itself, it is no wonder that people complain.”). ↑
Id.; see also Ethan J. Leib, Can Direct Democracy Be Made Deliberative?, 54 Buff. L. Rev. 903, 905 (2006) (“Legislators routinely have perverse incentives in their law-making activities and they are notoriously constrained by the need to finance their campaigns and pander to the wealthy and powerful.”). ↑
See Lee Anne Fall & Richard H. McAdams, Inversion Aversion, 77 U. Chi. L. Rev. 797, 803–05 (2019) (explaining the Tiebout Hypothesis, which models local governments as competing providers of public goods and services, and individuals as “consumer-voters” who choose jurisdictions based on tax and spending preferences, under assumptions such as perfect mobility and no interjurisdictional spillovers); see also Charles M. Tiebout, A Pure Theory of Local Expenditures, 64 J. Pol. Econ. 416 (1956). ↑
See Fall & McAdams, supra note 267, at 804 (quoting Tiebout, supra note 267, at 419). ↑
See Investopedia Team, supra note 51 (explaining how Proposition 13 limits reassessment, discourages homeowners from selling, and reduces housing supply). ↑
See Leif Wenar, John Rawls, Stan. Encyclopedia of Phil. (2021) (explaining that institutions such as the political constitution, legal system, and economy distribute the main benefits and burdens of social life, shaping citizens’ life prospects, goals, relationships, and characters). ↑
Id. (explaining that because the basic structure of society distributes fundamental rights and opportunities, its legitimacy cannot rest on continued residence alone, particularly when most individuals cannot feasibly exit the system). ↑
Id. (explaining that justice requires fair terms of cooperation among free and equal citizens, and that individuals should not bear the burden of unjust institutions they did not choose and cannot realistically escape). ↑
Id. (explaining that all citizens are free and equal, and that political and social institutions must be justifiable to everyone affected by them—not only the most advantaged). ↑
Id. (supporting Rawls’s view that the basic structure of society must be justifiable to all citizens in a pluralistic society and should support fair terms of cooperation among free and equal individuals). ↑
See Elliot Bulmer, Direct Democracy: International IDEA Constitution-Building Primer 3, at 3 (2d ed. 2017) (defining direct democracy as a process enabling the public to vote directly on proposed constitutional, legislative, or policy decisions); see also David A. Marcello, Direct Democracy in the United States 2–3 (Tul. Univ. L. Sch., Pub. L. Rsch. Paper No. 04-13, 2004) (explaining that direct democracy in the United States allows citizens to bypass legislatures and vote directly on laws through mechanisms like initiatives and referenda). ↑
See id. at 8; see also Marcello, supra note 283, at 3–4 (explaining that direct democracy was originally promoted as a means to empower ordinary citizens, allowing the “wage-working majority” to challenge the political dominance of elites and give voters a direct voice in lawmaking). ↑
See Bulmer, supra note 283, at 9 (noting that instruments of direct democracy such as referenda and initiatives can be used to challenge legislative inaction or reverse unpopular decisions by elected officials); see also Marcello, supra note 283, at 4–5 (explaining that direct democracy was embraced during the Progressive Era as a nonpartisan tool to combat corruption and force accountability on legislatures that ignored public demands); Elizabeth Garrett, The Promises and Perils of Hybrid Democracy, 59 Okla. L. Rev. 227, 241 (2006) (“Although direct democracy was primarily a populist reaction against industrial interests . . . early supporters also saw it as a way to circumvent self-interested legislators who would block governance reforms . . . to eliminate corrupt political practices.”). ↑
Id.; see also Anthony B. Schutz, Direct Democracy: From Theory to Practice, 101 Neb. L. Rev. 1, 16 (2022) (“[A] successful petition effort requires at least $1 million for paid circulators and administrative costs. . . . As it stands, very few causes can generate the funding necessary to pursue direct democracy.”); David A. Carrillo et al., California Constitutional Law: Direct Democracy, 92 S. Cal. L. Rev. 557, 600 (2019) (“We conclude that California’s low voter turnout . . . is not a reaction to direct democracy.”). ↑
See Kleiman, supra note 15, at 1934–37; see also Karl Manheim & Edward P. Howard, A Structural Theory of the Initiative Power in California, 31 Loy. L.A. L. Rev. 1165, 1186–90 (1998) (explaining how California’s initiative process emerged from “a long-standing, deeply ingrained mistrust of any instrument of statewide governance, particularly targeting the relationship between state lawmaking representatives and powerful, well-heeled corporate interests,” but has since been co-opted by those same interests). See generally Keith Osentoski, The Antidemocratic Cost of California Direct Democracy, 56 Loy. L.A. L. Rev. 679, 696–97 (2023) ([T]he original intent of direct democracy in California was to protect against corrupt corporate influences that could sway officeholders.”). ↑
See Bulmer, supra note 283, at 10 (explaining that direct democracy mechanisms such as participatory budgeting can increase transparency, reduce corruption, and improve the efficiency of public spending); see also Marcello, supra note 283, at 5 (noting that early proponents of direct democracy saw it as a tool for empowering ordinary citizens to challenge corruption and inefficiency in government institutions). ↑
See Bulmer, supra note 283, at 4 (explaining that direct democracy enables citizens to take part in shaping fiscal decisions, which can increase trust in government and improve perceptions of fairness). ↑
See Robert D. Cooter & Michael D. Gilbert, A Theory of Direct Democracy and the Single Subject Rule, 110 Colum. L. Rev. 687, 699 (2010) (“Direct democracy empowers the majority of citizens and enfeebles special interests that hold sway over state legislatures. . . . At its best, direct democracy can empower democratic majorities, weaken special interests, and enhance political transparency.”). ↑
See Bulmer, supra note 283, at 10 (explaining that participatory budgeting can improve the responsiveness and efficiency of public spending by aligning allocations more closely with community needs); see also Marcello, supra note 283, at 1–5 (explaining how direct democracy emerged as a mechanism to circumvent legislative gridlock and redirect policymaking authority to the electorate when representative bodies failed to act on public demands). ↑
See Glen Staszewski, The Bait-And-Switch inDirect Democracy, 2006 Wis. L. Rev. 17, 32–39 (describing structural features of the initiative process that make it possible to mislead voters and produce “collateral consequences” that they do not intend, and arguing for reforms that promote deliberation and voter understanding). ↑
See Appleby, supra note 53, at 512–19 (explaining that targeted local taxes often create harmful economic distortions, including business relocation, reduced job creation, and workforce shifts, that disproportionately affect local residents, particularly lower-wage workers, and that such harms are magnified when tax design lacks alignment with local economic realities or long-term community needs). ↑
See Part-Year Resident and Nonresident, supra note 201. ↑
See U.S. Const. amend. XIV, § 1 (“No State shall make or enforce any law which shall abridge the privileges or immunities of citizens of the United States[.]”); see also U.S. Const. art. IV, § 2 (“The Citizens of each State shall be entitled to all Privileges and Immunities of Citizens in the several States[.]”). ↑
SeeU.S. Const. amend XIV, § 1; U.S. Const. art. IV, § 2; Hooper v. Bernalillo Cnty. Assessor, 472 U.S. 612, 105 S. Ct. 2862 (1965) (explaining that durational residency classifications must be justified by a compelling state interest and narrowly tailored to that interest). ↑
See Zobel v. Williams, 457 U.S. 55, 102 S. Ct. 2309 (1982) (invalidating Alaska’s dividend program that distributed state funds based on length of residency, holding that it unconstitutionally created permanent classes of residents and lacked a legitimate state interest). ↑
SeeU.S. Const. amend XIV, § 1; see also Sup. Ct. of N.H. v. Piper, 470 U.S. 274, 105 S. Ct. 1272 (1985) (holding that states may discriminate against nonresidents under the Privileges and Immunities Clause only where there is a “substantial reason” for the difference in treatment and the discrimination bears a “close or substantial relationship” to that reason). ↑
See Jonathan L. Entin, Responding to Political Corruption: Some Institutional Considerations, 42 Loy. U. Chi. L.J. 255, 258 (2011) (“[P]ublic access can educate citizenry in the workings of government, which in turn facilitates informed political discussion and debate.”). ↑
See id. (“[O]penness promotes the appearance of fairness and enhances public confidence in the integrity of official proceedings.”). ↑
Id. at 259 (“[O]penness serves as a check against incompetence, venality, or bias. This consideration explicitly reflects the framers’ concerns with faction as a principal evil to be addressed in any system of effective government.”). ↑
See Guglielmo Barone & Sauro Mocetti, Tax Morale and Public Spending Inefficiency 5–6 (Bank of Italy Temi di Discussione, Working Paper No. 732, 2010) (explaining how taxpayers’ willingness to comply with tax obligations increases when they believe public resources are used efficiently and decreases when spending is perceived as wasteful or misaligned with community needs); see also Erzo F. P. Luttmer & Monica Singhal, Tax Morale 5–6 (NBER, Working Paper No. 20458, 2014) (explaining that voluntary compliance increases when taxpayers believe their contributions benefit society and are used effectively). ↑
See Barone & Mocetti, supra note 313, at 12–15 (explaining how tax morale reflects a psychological contract between taxpayers and the state, and that perceived inefficiency in public spending reduces taxpayers’ intrinsic motivation to comply); see also Luttmer & Singhal, supra note 313, at 2–3 (describing tax morale as the nonpecuniary motivation to comply with tax laws, often based on perceptions of reciprocity and fairness in the taxpayer-government relationship). ↑
See Barone & Mocetti, supra note 313, at 6; see also Luttmer & Singhal, supra note 313, at 6 (noting that 20% of individuals complied with a nonenforced church tax in Bavaria, Germany, indicating that perceived civic benefit can drive voluntary tax compliance). ↑
See Barone & Mocetti, supra note 313, at 6; see also Luttmer & Singhal, supra note 313, at 11 (noting how perceptions of unfairness or government inefficiency in public spending can erode reciprocal motivations and reduce tax compliance). ↑
See Barone & Mocetti, supra note 313, at 15; see also Luttmer & Singhal, supra note 313, at 11 (nothing how perceptions of fair public spending influence willingness to comply with tax obligations and how civic engagement may reinforce voluntary compliance). ↑
See Barone & Mocetti, supra note 313, at 15; see also Luttmer & Singhal, supra note 313, at 12 (“If tax payment is motivated—at least in part—by the benefits provided by taxation or perceptions of the legitimacy of the state, the possibility of multiple equilibria arises.”). ↑
See Portia Pedro, Making Ballot Initiatives Work: Some Assembly Required, 123 Harv. L. Rev. 959, 960 (2010) (“It is counterproductive to attempt to fix the problems inherent in a majority-rule voting system by stressing voting systems and elections even more. Addressing these problems likely requires not that we increase the number of elections, but instead that we stress elections less and supplement them with other forms of citizen interaction.”). ↑
See Richard L. Hasen, Rethinking the Unconstitutionality of Contribution and Expenditure Limits in Ballot Measure Campaigns, 78 Cal. L. Rev. 885, 911–14 (2005) (explaining that while Californians broadly approve of the initiative process, public opinion data shows widespread concern that outcomes are controlled by special interests, with many voters supporting reforms to reduce financial influence). ↑
See generally Sherman J. Clark, Ennobling Direct Democracy, 78 U. Colo. L. Rev. 1341, 1343–52 (2007) (arguing that reforms to direct democracy can transform it from a practice that risks disengagement and anonymity into one that fosters civic virtue, responsibility-taking, and a deeper public character by encouraging citizens to stand behind their collective decisions and embrace the moral weight of exercising power in a democracy). ↑
What happens when a jeweler offers a 103-carat diamond, previously obtained from a thief, as collateral for a loan? When does a cannabis license create a property right that can be offered as collateral? If a factor recoups its investment from a fashion designer in an Article 9 sale, then attempts to resell those goods, do the security interests and priorities in the underlying licenses transfer as well? These are just a few of the questions litigated recently that were discussed at the ABA Business Law Section CLE 2024 Commercial Law Developments during the Section’s 2025 Fall Meeting. This engaging program featured insights from Teresa Harmon, Partner, Sidley Austin LLP; Steven Weise, Partner, Proskauer Rose LLP; and Stephen Sepinuck, Special UCC Advisor, Paul Hastings LLP. For full details, in addition to viewing the program recording, you’ll want to familiarize yourself with the written materials, which summarize more than 300 recent commercial law decisions.
The panel began with an overview of cases that address the basic elements of security interests.
Scope of Article 9
Pursuant to § 9-109(a)(1) of the Uniform Commercial Code (“UCC”), Article 9 applies to any transaction that creates a security interest in property. Weise noted that form or labels do not govern the applicability of Article 9 and subjective intent is irrelevant, highlighting In re Stephenson, 728 F. Supp. 3d 1181 (D. Colo. 2024). In In re Stevenson, the court upheld a bankruptcy court’s ruling that a sale of a vintage automobile for $120,000 with an option to buy it back anytime within one year was a true sale, not a loan, particularly because the parties understood it to be a sale. Sepinuck noted that the court did not consider the value of the collateral in its analysis, which should be a significant factor in assessing the true nature of these transactions.
Attachment: Description of Collateral
Under Article 9, a security agreement must include a description of its collateral. While the description need not be descriptive, it must make the collateral reasonably identifiable. Weise offered insights on In re Genesis Global Holdco LLC, 658 B.R. 31 (Bankr. S.D.N.Y. 2024), in which the court considered a security agreement that described the collateral to include “all property from time to time transferred by or on behalf of [the debtor] to or for the benefit of [the secured party].” The description was later updated to provide that the debtor’s remote parent would transfer 31,180,804 additional shares of stock to the debtor, which the debtor would promptly thereafter “transfer or cause to be transferred” to the secured party. Because the additional shares were never transferred, the court held that there was no security interest in those shares.
The panel also discussed the distinction between commercial tort claims, which arise out of a duty under the law and require a more robust description of impacted collateral, and contract claims, which arise out of a contractual dispute and simply require that the collateral is reasonably identifiable from the description. See In re Main Street Business Funding, LLC, 2024 WL 4056601 (3d Cir. 2024), 2024 WL 1296907 (Bankr. D. Del. 2024).
Rights in the Collateral
For a security interest to be enforceable, a debtor must have rights to pledge or transfer the collateral in question. Harmon discussed United States v. Lee, 748 F. Supp. 3d 1142 (M.D. Fla. 2024), in which a jeweler pledged a stolen 103-carat diamond as collateral on a $4 million loan. In this instance, there was an understanding of the security interest between the parties, but no written security agreement. The jeweler transferred the diamond to the lenders. The diamond was later seized in a forfeiture collection, and the lenders tried to retrieve it. The court held that the lenders did not have a valid security interest in the diamond because the jeweler had no rights to pledge the stolen diamond as collateral.
After addressing these foundational elements of security interests, the panel went on to discuss additional issues related to the enforcement of security interests, including priority, disposition, liability (including in consignment transactions), bankruptcy, guaranty, contract interpretation, contract remedies, forum selection, and hybrid contracts.
In AmeriCredit Financial Services, Inc. v. Bell, 707 S.W.3d 639 (Mo. Ct. App. 2024), Clover Private Credit Opportunities Origination (Levered) II, L.P. v. Sanberg, 212 N.Y.S.3d 287 (N.Y. Sup. Ct. 2024), and In re Strudel Holdings, LLC, 659 B.R. 659 (Bankr. S.D. Tex. 2024), courts considered whether sales of collateral were commercially reasonable. This analysis includes a number of factors, including, but not limited to, the timing of the sale and effective notice of the sale, third-party interest in the sale, public advertisement of the sale, bidding qualifications, the pricing of the assets in relation to the value of the security interest, and efforts to preserve the value of the assets leading up to the sale. In considering third-party interest in the sale, the panel noted that courts do not necessarily consider the absence of third-party interest to be a determining factor, but they will treat high third-party attendance as evidence that notice and advertisements were effective.
Sepinuck deemed Intellectual Tech LLC v. Zebra Technologies Corp., 101 F.4th 807 (Fed. Cir. 2024), the “best case of the year” for secured parties. The case involved an intellectual property owner’s standing to sue for infringement after granting a security interest, an issue on which courts have been divided. Sepinuck noted the differences between constitutional and statutory standing for these issues and discussed the court’s holding that a licensee retains all exclusionary rights unless those rights are expressly transferred away. A debtor’s default on a loan obligation does not impact these rights, and a secured party cannot exercise any exclusionary rights unless the security agreement expressly transfers them away from the debtor.
The panel was a timely reminder that trends in commercial law will continue to evolve as technology, goods, and services grow in sophistication. Relatedly, the 2022 UCC Amendments, which were drafted to address these evolving trends, have passed the legislature in all states and are already effective in some jurisdictions. Other notable efforts include an initiative from the Permanent Editorial Board for the UCC to identify ways to try to use controlled electronic records to transfer securities. The Permanent Editorial Board is also exploring efforts to combat fraud in connection with wire transfers and funds transfers. Finally, the BLS Commercial Law Education Task Force is working to ensure commercial law continues to be taught in law schools and tested on bar exams, particularly given the proliferation of tokenization and digital asset transactions.
Stay tuned for next year’s update, which we already know will feature cases involving cattle as collateral, broken hyperlinks, and transactional scandals involving your favorite luxury goods.
A company may think it owns a trademark, but if it isn’t using it, it may not own it. On September 18, 2025, Sarah Gatti, Head of Legal at Zappi, moderated a CLE panel for the American Bar Association Business Law Fall Meeting 2025 held in Toronto, Canada, entitled “Who Owns IT? IP Ownership Conundrums in Business Transactions.” Gatti was joined on the panel by Marco Ciarlariello, General Counsel at Wynd Labs; Scott Lashway, Partner at Mintz; and Steven Kennedy, Partner at Cassels Brock & Blackwell LLP.
What Are the Different Types of IP?
The panel began with a brief overview of the most common types of intellectual property (“IP”) at issue in a business transaction, including copyrights, trademarks, patents, and industrial designs. Trademarks are a type of IP that protects identifying marks of a company, including logos and words, but also nontraditional marks such as scents and packaging designs. The panel discussed common forms of IP ownership, including traditional filings and common law ownership, highlighting that actual use of the mark is required for ownership in either instance. They continued to explain that copyrights are legal rights that protects creators of original works such as books, music, and art. Patents were defined as the protection of products against reverse engineering. Industrial designs protect the aesthetic aspects of a product, such as its shape, configuration, pattern, color, or lines. Finally, the panel reminded the audience that items such as manuals, handbooks, and training materials could all fall under the IP of an entity, and practitioners should consider advising clients to protect them.
How Does One Transfer IP to a Company?
The panel continued their discussion by exploring how IP gets transferred to a company once it is created. They emphasized that without action, a transfer of IP is not automatic. Gatti posed the question of whether employee-generated work was automatically owned by a company. The short answer by the panel was that some form of transfer agreement is needed to make this transfer effective. This document could be either an IP transfer agreement or a confirmatory agreement. Both documents are used to confirm or clarify the transfer of ownership of IP and provide documentary evidence of the transfer. To assist in identifying which IP needs to be transferred to the company by employees, the panel discussed requiring that employees execute agreements identifying any IP that they own, or claim to own, outside of their employment.
AI and IP Ownership
Next, the panel addressed artificial intelligence (“AI”), how it creates content, and IP ownership of that content. As the conversation transitioned into a discussion of the complexities of AI and intellectual property ownership, Ciarlariello emphasized the importance of AI and privacy by urging the panel and practitioners to consider who owns the datasets that fuel a company’s AI model—“Whose data does the company have?” He noted that companies are in a race to determine “who can get access to the best data for their model.” In a theoretical exploration, which most discussions surrounding AI seemed to become, Lashway questioned whether companies that use licensing agreements would begin sending addendums to those agreements to protect the ownership of AI-created work or AI models created by the company, and to disclose the use of AI in the target licensing agreement. Gatti said that she foresees complexity in licensing agreements attempting to govern AI ownership when the nonowning entity doesn’t understand the target product. The panelists discussed Gatti’s concern, with Kennedy concluding, “[Companies] can act overly cautious, but the company that does not embrace this technology will [fall behind].”
What IP Issues Keep You Awake at Night?
Gatti asked the panel for closing remarks and posed the question, “What keeps you up at night [in relation to IP]?” Kennedy confided that attorneys and clients who ignore jurisdictional specifics in IP protection causes him the most concern. For example, different jurisdictions govern the use of virtual assistants differently, and ignoring the target locale’s laws could have negative impacts on common law ownership and formal agreements. Lashway was concerned by companies who are lagging behind in the protection of expensive assets they are building. He posed the question, “Have you taken the necessary measures to protect your lowercase ip and your uppercase IP?” This distinction between lowercase ip and uppercase IP was mentioned throughout the panel, with lowercase ip referring to common law and less “concrete” forms of IP protection, and uppercase IP referencing formal patent and trademark registrations.
Final Questions
When the opportunity for questions arose, I asked the panel for clarification on difficulties in determining IP ownership in employment scenarios as opposed to independent contractor relationships. The panel referred to their discussion on jurisdictional differences, such as employment agreements in Canada being more common than they are in the United States. The panel recommended advising clients that if IP protection is important to their model, they should incorporate a standard form agreement when onboarding across the board.
Artificial intelligence and digital tools are rapidly reshaping the legal landscape, but they do not eliminate the need for lawyers to comply with longstanding professional rules. The CLE program The Great Tech Quest of 2025: Ethical Considerations in AI, Deepfakes, Social Media, Cybersecurity, and Virtual Lawyering at the ABA Business Law Section (“BLS”) 2025 Fall Meeting delivered a timely and thought-provoking exploration into the ethical, practical, and technological challenges facing today’s legal professionals.
The discussion, moderated by Jasmine Smith, Chair of the BLS Professional Responsibility Committee and Partner at Robinson Gray Stepp Laffitte, featured helpful insights from Amy Richardson, Partner at HWG LLP and Professor at Duke Law School, and Jon Garon, Associate Dean for Technology and Innovation at Nova Southeastern University’s Shepherd Broad College of Law. Exploring topics from deepfakes to cybersecurity, the panel reviewed the various ethical obligations that apply to lawyers in different technological contexts, including core themes of competence and client confidentiality.
Hyperdiligence in the Age of AI and Deepfakes
Lawyers need to be “hyperdiligent” that the information they receive is accurate and correct, particularly with the proliferation of deepfakes and other synthetic media, which are often used in schemes like falsified Zoom calls and elder fraud. According to Garon, almost $5 billion in elder fraud occurred in 2024 (for more information, see another CLE program from the 2025 Fall Meeting, Nana and Poppa Go High Tech: Digital Assets, Online Communities, and the Legal and Business Services Essential for an Aging Population). Manipulated visuals can have a profound psychological impact, even influencing jury perception. Garon explained, “When somebody sees a falsified visual image, about 85% of the time in their recall, they will remember the image without necessarily remembering the information that told them it was fraudulent.” Given these risks, “as fiduciaries, we need to be hyperdiligent for our clients, for our processes, and for our internal procedures,” added Garon. This means precautions such as internal training, requiring two-factor authentication with every sign-in to protect data, and creating code words for financial transactions.
Lawyers also have an affirmative duty to make sure their clients do not misuse synthetic media to perpetrate fraud. If manipulated content is used in legal proceedings, lawyers must alert the court and opposing counsel, mitigate harm, and investigate misconduct. If a deceptive video of a client or key witness has been shared, for example, Garon suggested going to the U.S. Copyright Office with the original deposition and leveraging the notice and takedown provisions of the Copyright Act to get the video removed from the relevant platforms.
When using tools like artificial intelligence (“AI”), particularly in litigation and client representation, lawyers should understand the information that is being shared with a tool or application, review the attendant privacy statements, be familiar with device privacy settings to protect confidential client information, and consider who is alerted when accessing information on various platforms. In certain instances, informed client consent may be necessary, such as where a lawyer decides to use generative AI to summarize a video deposition.
Lawyers’ Online Conduct
As more law firms and lawyers use social media platforms like LinkedIn and TikTok for marketing, networking, client interaction, and diligence, Smith cautioned that lawyers must remain vigilant about confidentiality and the accuracy of information shared online. Garon pointed out that online content not only implicates legal professional ethical obligations but also Federal Trade Commission rules and state laws on unfair and deceptive trade practice.
Before posting on social media, get informed consent if the post contains information that could breach client confidentiality, even if couched in hypotheticals or revealing a client’s identity. Smith clarified, “If someone can deduce what you’re talking about, you may need informed consent.” Lawyers should also be careful about posting workplace videos and photos to avoid inadvertently disclosing confidential information in the background (e.g., documents on a desk, text on a computer screen). “If in doubt, don’t post,” she said.
When promoting legal services or achievements online, lawyers should ensure claims are accurate and not misleading. For example, a claim of a 100 percent win rate without context (such as the calculation being based on a single case) would be misleading. Richardson recommended using appropriate disclaimers. This obligation applies even when a lawyer uses another person or tool to create the content. Garon reminded the audience that “use of a tool is no different than use of an agent to create misinformation.” Lawyers therefore should critically review the accuracy of any AI-generated content, as well as third-party endorsements such as recommendations and testimonials posted on a law firm site or LinkedIn, and remove any claims that are inaccurate or misleading,
Virtual Lawyering
While remote work is increasingly accepted, lawyers must avoid holding themselves out as licensed in jurisdictions where they are not admitted. This prohibition extends beyond simply maintaining a physical office in a place where lawyer is not licensed to practice; it also includes having continuous and systematic contact with that jurisdiction and creating a recurrent impact there, or holding oneself out as being licensed to practice in that jurisdiction. Exceptions include in-house lawyers or lawyers who provide services authorized by federal law (e.g., the U.S. Patent and Trademark Office, immigration court). State rules governing the practice of law can vary, so Richardson recommended that lawyers comply with local rules and refer to the opinions of the jurisdiction in which they physically sit (not barred) or where the client is located (particularly during use of cloud-based communication tools). She reminded the audience that the obligations of competence, confidentiality, client communication, and staff supervision still apply with remote work. And in cases of uncertainty, Richardson recommended that lawyers call the legal ethics hotline in the state where they sit.
Practicing Cyber Hygiene
Cyber hygiene is paramount when using digital tools. Yet, according to Garon, a 2023 ABA report revealed that only 80 percent of law firms had technology policies and less than 50 percent of firms had implemented email encryption. As a result, Garon urged lawyers to take steps to secure data, including adopting robust data security policies, continuous training, encryption, “least privilege” access, as well as vetting cloud service providers for Health Insurance Portability and Accountability Act (“HIPAA”) data security standards. “Very few firms can afford the consequences of a massive data breach or ransomware attack,” he said.
Finally, the panel warned that free AI services are inappropriate for sharing confidential information and that lawyers must understand both technical and administrative safeguards for these tools. “If you’re not paying for the product, you are the product,” Garon said.
Conclusion
This session underscored the need for legal professionals to adapt to technological change while upholding existing ethical standards. As Garon stated, “Incorporating technology into the practice of law doesn’t change the ethics of the practice.” Looking ahead, the legal profession must continue to evolve, balancing innovation with the responsibility of maintaining the highest standard of conduct and integrity in a digital age.
The recent bankruptcy filing of Tricolor Auto Acceptance, LLC (“Tricolor”) highlights collateral-related risks for lenders, providing an opportunity for banks and whole loan purchasers to assess their practices and controls to mitigate risk.
Tricolor Situation Overview
Tricolor, founded in 2007, is a “buy here, pay here” (“BHPH”) subprime auto finance company. This means that it is both an auto dealer and an auto finance company, offering in-house financing directly to its customers. Tricolor is also a Community Development Financial Institution (“CDFI”).[1] Tricolor, which is a subsidiary of Tricolor Holdings LLC, operates over sixty dealerships, the majority of which are located in Texas and California. Subprime customers visit their locations, find a car that suits their budget, and obtain financing on the spot through Tricolor.
Over the past five years, Tricolor has been among the fastest-growing auto lenders in the United States, quadrupling in size. Earlier this year it closed two term securitization transactions, the most recent of which was Tricolor Auto Receivables Trust 2025-2.[2] However, in mid-September, Tricolor’s rapid growth came to a halt when reports surfaced that warehouse lenders had uncovered alleged fraudulent activity, including double-pledging of collateral.[3] Shortly after those reports were published, Tricolor filed for chapter 7 bankruptcy.[4]
Because Tricolor operates as both a BHPH and a CDFI, its auto loan portfolio has features that differ from those of a typical subprime auto finance company. These unique characteristics should be considered when evaluating the lessons to be learned and applying safeguards to similar transactions.
While the facts and circumstances of the Tricolor case are still developing, industry participants across myriad asset classes (including consumer loans, mortgage loans, and esoteric assets) and types of transactions (including whole loan trades, warehouse financings, and securitizations) have renewed their focus on four key areas: (i) improved due diligence, (ii) updating credit agreement provisions related to pledged assets, (iii) revisiting who maintains custody of pledged assets and ensuring better control over cash flows, and (iv) evaluating the treatment of structured finance transactions under the Uniform Commercial Code (“UCC”) and in bankruptcy.
Each area is addressed below, with suggestions for enhanced practices and controls, and with callouts for considerations that may be specific to one asset class or transaction type as opposed to others. However, it is important to note that no set of controls can completely eliminate the risks inherent in third-party relationships, particularly the risk of fraud.
Due Diligence
Due diligence is the single most important step that banks and whole loan purchasers can take to protect themselves against fraud or mistake by originators and servicers. Because every company operates differently, there is no “one-size-fits-all” diligence protocol or checklist. The scope and focus of diligence should be tailored to the company and the asset class, including any aspects of its business model that are unusual or high risk, giving due consideration to the regulatory landscape and the mechanics of enforcement against the specific asset type. Given Tricolor’s unique business model as a BHPH and CDFI, lenders must carefully tailor the due diligence, focusing on how its customer base was likely more deeply subprime than usual and collateral risks inherent to BHPH companies.
In general, key areas for proper due diligence include all of the following:
Assess the company’s culture of compliance. In addition to public record searches for consumer complaints, licensing issues, regulatory enforcement actions, and lawsuits, consider on- site meetings and interviews with management, as well as a review of compliance policies, procedures, internal controls, and related training materials, to ensure alignment with regulatory requirements. Do not only include current documents, but consider how things may have recently been updated or changed. Particularly when the asset class involves subprime loans, review of each of these points at regular intervals (e.g., every six months or annually) may be appropriate.
Understand bank-fintech partnerships. If the warehouse loans are tied into a bank-fintech partnership, enhanced due diligence is appropriate. In addition to examining the overall culture of compliance, it is recommended to review the program agreement between the bank and the fintech, paying special attention to how involved the bank is in reviewing customer-facing materials, establishing the credit policy, and reviewing consumer complaints.
Consider independent reviews or consultants. Engaging third-party specialists can provide objective insights and detect red flags that internal teams may miss. Firms are often engaged by the company to conduct targeted reviews of loan files; lender and portfolio-level due diligence; review of servicing practices; operational assessments, including IT systems and data security controls; cash flow and liquidity analysis; and vendor oversight audits. Ideally, the reports from these reviews can be evaluated and the company can provide updates regarding improvements stemming from the reviews.
Consider engaging third parties for ongoing review. Third-party firms may also include verification agents, valuation agents, and hot backup servicing arrangements. A verification agent independently confirms the existence of each asset and the related documentation. A valuation agent provides an independent assessment of the value of the assets, ensuring true and accurate marking as opposed to inflation of value. A hot backup servicer (especially when the primary servicer is an affiliate of the originator) provides a real-time alternative to the entity closest to the assets on a day-to-day basis. In the aggregate, these protections provide operational comfort about the integrity of the assets while deterring double pledging.
Conduct lien searches and collateral verification. Fraud often centers on misrepresentation of collateral, making the following steps essential: (i) lien searches to identify other secured creditors of the company who have perfected their security interests and to confirm details about the pledged collateral;[5] (ii) double-pledging controls, including reconciliation of pledged assets across facilities; (iii) electronic chattel paper controls, ensuring systems meet UCC requirements for control and include complete audit trails; and (iv) review of custody practices for both physical and electronic loan files.
The Interagency Guidance on Third-Party Risk Relationships: Risk Management[6] provides further detail on due diligence procedures. Although the guidance addresses banks’ reliance on third-party providers of products and services, it highlights critical areas such as (i) business strategies and goals, (ii) legal and regulatory compliance, (iii) financial condition, (iv) business experience, (v) qualifications and backgrounds of key personnel, (vi) risk management, (vii) information management and security, (viii) incident reporting, (ix) physical security, (x) reliance of subcontractors, (xi) insurance coverage, and (xii) contractual arrangements with other parties.[7]
Contract Provisions
The contracts governing asset purchases by a special purpose entity (“SPE”) and the pledge of those assets to a lender, trustee, or other secured party are essential to mitigating risk. These agreements generally address four core elements relating to the collateral, including (i) representations and warranties, (ii) covenants, (iii) repurchase and indemnification remedies, and (iv) audit and inspection rights.
Representations and Warranties. For common asset types, there is a well-developed and relatively market-standard set of representation and warranties. The Rule 17g-7(N) reports published by rating agencies for rated ABS are a good source for benchmark representations and warranties for various asset types.[8]
For example, a whole loan trade, warehouse financing, or securitization of auto loans will typically contain the following representations or warranties, or some variation thereof, which help to establish chain of title, the creation and perfection of first-priority perfected security interests, and the physical location of the collateral:
Each receivable (i) was originated in the United States by a dealer for the retail sale of a financed vehicle in the ordinary course of such dealer’s business and has been fully executed by the parties thereto and (ii) was purchased by the seller from a dealer and was validly assigned by such dealer to the seller.
Immediately before the sale under the purchase agreement, the seller had good title to each receivable free and clear of any lien other than permitted liens and, immediately upon the sale under the purchase agreement, the purchaser will have good title to each receivable, free and clear of any lien other than permitted liens.
There is only one original executed copy of each receivable.
The receivables constitute “chattel paper” (including “tangible chattel paper” and “electronic chattel paper”) “accounts,” “instruments,” or “general intangibles” within the meaning of applicable UCC.
Other than the security interest granted to the indenture trustee under the indenture, the issuing entity has not pledged, assigned, sold, granted a security interest in, or otherwise conveyed any of the receivables. The issuing entity has not authorized the filing of, nor is the issuing entity aware of, any financing statements against the seller, the depositor, or the issuing entity that include a description of collateral covering the receivables other than the financing statements relating to the security interests granted to the depositor, the issuing entity, and the indenture trustee under the basic documents or any financing statement that has been terminated. The issuing entity is not aware of any judgment or tax lien filings against the seller, the depositor, or the issuing entity.
The custodian has in its possession or with other third-party vendors all original copies of the receivable files and other documents that constitute or evidence the receivables. The receivable files and other documents that constitute or evidence the receivables do not have any marks or notations indicating that they have been pledged, assigned, or otherwise conveyed to any person other than the depositor. All financing statements filed or to be filed against the issuing entity in favor of the indenture trustee in connection herewith describing the receivables contain a statement to the following effect: “A purchase of or security interest in any collateral described in this financing statement will violate the rights of the indenture trustee.”
Similar representation and warranty packages that are tailored to the particular asset type are also included in whole loan trades, warehouse financings, and securitizations of other consumer, mortgage, and esoteric assets.
Covenants. In addition to representations and warranties, transaction documents typically include affirmative (positive) and negative covenants that apply throughout the life of the transaction. Each key or material representation is generally paired with a corresponding covenant, ensuring that the stated condition remains true throughout the life of the transaction (e.g., a representation confirming perfection would be paired with a covenant requiring maintenance of perfection).
Special Purpose Covenants. In addition to the standard set of affirmative and negative covenants, financial transactions may also include special purpose covenants that are designed to keep a subsidiary legally separate from its parent. The covenants include things the company must do (e.g., maintaining separate books and records, holding itself out as a separate entity, and maintaining adequate capital) as well as things the company must not do (e.g., commingling of assets, guaranteeing the debt of others, or dissolving without the consent of an independent manager). The covenants in the aggregate are a conglomerate of bankruptcy case law, which wards against the special purpose entity being consolidated into the estate of its parent such that there is legal isolation between the assets of the company and the creditors of its parent.
Indemnities, Repurchases, and Other Remedies. When a representation, warranty, or covenant is breached, the affected party typically has notice and cure rights and, if uncured, specified remedies (e.g., indemnification, repurchase or substitution of affected assets, servicing transfer, or declaration of an event of default). Note that the representation, warranty, and covenants described above, as well as the corresponding remedies for their breach, are generally well suited to deal with the occasional breach with respect to a modest portion of the asset pool. The protections are less reliable in the case of fraud or pervasive breach, particularly where the originator or servicer is in financial distress or is otherwise unable or unwilling to satisfy its repurchase and indemnification obligations.
Note also that indemnification and repurchase obligations are unsecured corporate credit obligations of the seller or servicer. If the seller or servicer is in bankruptcy, indemnity/repurchase claims are subject to the automatic stay (and will generally be treated as unsecured claims in any bankruptcy case).
However, an important exception to the automatic stay arises in the warehouse finance context with respect to mortgage loans. The bankruptcy safe harbor protects certain participants in certain financial contracts backed by mortgage loans. In the repo context, the Bankruptcy Code permits creditors/repo buyers to terminate the financial contract, accelerate the related debt, and liquidate the related assets notwithstanding the bankruptcy of the repo seller and the automatic stay.[9] Such actions may not be stayed or otherwise avoided by any other provision of the Bankruptcy Code.[10] It is critical to engage skilled legal counsel to structure transactions to take full advantage of the bankruptcy safe harbor to the extent the related asset and deal participants are eligible for such protection.
Audit and Inspection Rights. Robust audit rights are a primary control for validating collateral quality, confirming continuing perfection and priority, and detecting emerging operational or fraud risks. In addition to baseline access and inspection rights, parties should push for more frequent, risk-calibrated audits—particularly in the first twelve to eighteen months of a new counterparty relationship or upon performance drift. Key elements to address are (i) broader scope and access, including unannounced visits; (ii) increased frequency and triggers; and (iii) clear logistics and cost-sharing arrangements.
Custody of Assets
Not all warehouse lending facilities or term ABS deals utilize a third-party custodian. In some cases, rating agencies, investors, and lenders may permit a well-established or highly rated seller/servicer to act as custodian of the securitized assets. In the mortgage loan repo context, however, it is market-standard to engage a third-party custodian at the start of the transaction. The triparty custodial arrangement requires a check-in process for the contents of the mortgage file, the delivery of an exception report with respect to any missing items in each mortgage file, and a checkout process for certain discrete reasons, including servicing of the loan and the review of such files by potential takeout investors. These arrangements often require any released mortgage files (including the negotiable instruments evidencing the obligation to pay) to be returned well within the date the UCC would deem the lender’s perfection by possession to be terminated.[11] The use of a third-party custodian is another critical lender protection in the mortgage repo market that should be maintained.
The use of a third-party custodian provides several important benefits, including (i) supporting and evidencing perfection (by possession or control, as applicable), (ii) preventing double-pledging and loss of collateral, and (iii) operationalizing clear release/return mechanics. This is particularly critical for transactions secured by tangible chattel paper, electronic chattel paper, instruments, and/or mortgage notes, where perfection by possession or control has priority over perfection by UCC filing alone.
It is important to remember that the use of third-party custodian does not eliminate all collateral-related risks, particularly the risk of fraud. Indeed, a third-party custody agreement will typically provide that the custodian makes no representations as to the validity, legality, perfection, priority, enforceability, recordability, ownership, title, sufficiency, due authorization, or genuineness of any of the documents contained in any receivable file or of any of the contracts.
Control of Cash Flow
One other important lender protection found in the warehouse financing space is the control of cash flow. This is typically achieved through a triparty servicing arrangement, where the servicer acknowledges that the financed assets are now subject to the security interest of the warehouse lender and agrees to service such assets on behalf of the lender and other secured parties, particularly upon the occurrence of an event of default under the related credit agreement. Under this arrangement, all income generated by the assets is swept by the servicer into a controlled account after receipt and identification by the servicer. This construct minimizes the risk of “leakage,” meaning cash flowing outside the priority of payments in the credit arrangement (which is often called a waterfall). The involvement of the third-party servicer also wards against the risk of double-pledging, since the servicer’s acknowledgment and cash sweep mechanics make it clear that the income belongs to that particular lender, making it difficult for the borrower to double-pledge the assets to any other lender.
The Tricolor Bankruptcy Proceeding, and Risks and Protections for the Lenders
Chapter 7 Bankruptcy. Tricolor’s chapter 7 petition will result in a liquidation of the business. It is highly unusual for a case of this size and scope to file for a chapter 7 liquidation. Typically, large companies will file for protection under chapter 11 of the Bankruptcy Code, which permits reorganization and typically keeps the current directors and officers in place to run the company during the bankruptcy.
Secured Creditor Claims in Bankruptcy. Under section 506 of the Bankruptcy Code, secured creditors are granted an allowed secured claim equal to the value of the collateral. The secured creditor may also have an unsecured deficiency claim equal to the amount of the claim that is in excess of the value of the collateral, to the extent that the collateral is worth less than the amount of the claim.
To determine the value of the collateral and the security of a claim, the Bankruptcy Code authorizes debtors (and trustees) to value the collateral.[12] If the value of the collateral exceeds the claim amount, then the secured creditor may be entitled to receive unmatured interest or any fees or charges that otherwise would have been payable to that creditor.[13] If the value of the collateral is less than the claim amount, then secured creditors are entitled to receive an unsecured claim for any shortfall in value. Unsecured claims generally receive less than secured claims in bankruptcy cases.
However, the Bankruptcy Code affords secured creditors protections during the pendency of Tricolor’s chapter 7 case. Under section 363(e), secured creditors are also entitled to adequate protection of “any interest in property used, sold, or leased . . . by the trustee.” Adequate protection protects secured creditors from a diminution in the value of their collateral during the bankruptcy—thus protecting secured creditors’ property rights during the pendency of the case. Adequate protection generally includes periodic cash payments to the secured creditor and the grant of replacement liens to compensate for any diminution in value of the collateral.[14]
Risks for Secured Creditors in Bankruptcy. Given the allegations concerning Tricolor’s prepetition conduct and the precipitous decline of its business over the summer, a trustee may be incentivized to pursue litigation claims to maximize value for the estate, including:
Fraudulent Transfer Claims: The trustee may pursue claims for fraudulent transfer. There are two types of fraudulent transfer claims available to trustees for recovery. In most jurisdictions, there is a four-year look-back period to potentially unwind prepetition transactions.
First, under constructive fraud, the trustee may recover transfers made for less than fair consideration at a time when the debtor was insolvent. The trustee may pursue such actions to avoid payments to creditors, or to unwind certain aspects of the overall transaction (such as the liens securing any debts). However, the trustee may not recover from creditors that received the value for satisfaction of a prebankruptcy debt, provided that such creditors have acted in good faith and lacked knowledge of the voidability of the challenged transfer.[15]
Second, and potentially relevant here, the trustee may recover payments or transfers that were made with the intent to hinder, delay, or defraud creditors. These are known as “actual fraudulent transfers.” Defenses to actual fraudulent transfer claims include the lack of “badges of fraud” evidencing intent to defraud creditors.
Notably, nondebtors are typically protected from fraudulent transfer arguments with respect to settlement payments to financial institutions in connection with a securities contract.[16] The Bankruptcy Code also prevents the avoidance of any transfer made “in connection with a repurchase agreement” prior to the filing of a bankruptcy.[17] Moreover, if the creditors are parties to certain safe harbored contracts (such as repurchase agreements), then certain actions taken to accelerate, liquidate, or terminate a repurchase agreement may not be avoided under the avoidance provisions of the Bankruptcy Code as noted above.[18]
Preference Claims: Section 547 of the Bankruptcy Code also authorizes the trustee to avoid any payments made to a creditor within ninety days of the bankruptcy filing, if such payment enables the creditor to recover more than it would if the case were in chapter 7 or the payment had not been made. As a general rule, a prepetition transfer to a fully secured creditor will not be considered preferential, because the creditor would be paid in full in a hypothetical chapter 7 liquidation.[19]
Lien Avoidance: The trustee may also avoid any unperfected liens under section 544 of the Bankruptcy Code. Specifically, section 544(a) grants a bankruptcy trustee the powers of a hypothetical judgment lien creditor. The trustee may avoid any unperfected lien if, under applicable nonbankruptcy law, a hypothetical judgment lien creditor could have obtained a superior lien on any collateral subject to that unperfected lien.
Creditors therefore may potentially become targets of the chapter 7 trustee in its efforts to claw back value into the estate.
Conclusion
The Tricolor case has led to renewed focus on due diligence, credit agreement provisions related to pledged assets, the custody of pledged assets, control over cash flows, and the treatment of structured finance transactions under the UCC and in bankruptcy. Although the risk of fraud or mistakes cannot be fully eliminated, robust due diligence (upfront and ongoing), well-tailored contract provisions, and suitable asset custody and cash flow controls can reduce the probability of loss and mitigate any losses that do occur.
The authors thank Kathryn Borgeson, Christopher Dickson, Stuart Goldstein, Christopher McDermott, Lisa Pauquette, Hunter White, Thomas Curtin, James McDonnell, and Alexander Strom for their contributions to this article.
This article has been prepared for informational purposes only and does not constitute advertising or solicitation and should not be used or taken as legal advice.
See the S&P Presale Report for more information. Kelly R Luo & Sanjay Narine, Presale: Tricolor Auto Securitization Trust 2025-2, S&P Global (June 4, 2025). Tricolor has several other term asset-backed securities (“ABS”) transactions that remain outstanding. ↑
An independent third-party trustee has already been appointed to oversee the bankruptcy case. The chapter 7 trustee’s role will primarily be to liquidate assets to maximize value for creditors. Those assets can include claims against the debtor’s prior officers and directors, as well as against creditors and other parties for actions taking place in the run-up to bankruptcy. ↑
Note that lien searches will not be effective to identify a secured party who has perfected its security interest solely by possession (in the case of tangible chattel paper) or control (in the case of electronic chattel paper). ↑
Twenty days for instruments perfected by possession. U.C.C. §9-312(g). Note that there is not a parallel permission for a secured party in possession or control of chattel paper to relinquish it to the debtor for servicing; therefore, secured parties in possession or control of chattel paper will rely on filing perfection during any such release for servicing. ↑
See Official Comm. of Unsecured Creditors of 360Networks (USA) Inc. v. AAF-McQuay, Inc. (In re 360Networks (USA) Inc.), 327 B.R. 187, 190 (Bankr. S.D.N.Y. 2005). ↑
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