Legislative Analysts Office, September 2002

California Spending Plan 2002-03

Chapter 3

Revenue-Related Provisions

In enacting the 2002-03 Budget Act, the Legislature adopted a number of provisions to significantly augment General Fund resources. These provisions will result in estimated additional General Fund resources in 2002-03 of approximately $10 billion. This total includes $4.5 billion from tobacco securitization, $2.9 billion from tax-related changes, and $2.6 billion from loans and transfers.

Tobacco Securitization

The single largest action taken to increase 2002-03 revenues ($4.5 billion) involves selling to investors the state's rights to its flow of tobacco settlement revenues (TSRs) over roughly the next 25 years. Under the provisions of the 1998 Master Settlement Agreement between certain large tobacco companies and various states, California will receive TSRs annually in perpetuity, including an estimated $10-plus billion during this 25-year period. The budget plan essentially converts this future TSR stream into an upfront payment in the current year. In return, those investors who pay the $4.5 billion will be repaid over time, with interest, from the TSRs when they are actually received. According to current estimates this will take roughly 25 years. The tobacco securitization program is the largest form of borrowing in the 2002-03 budget package.

Tax-Related Provisions

The $2.9 billion in tax-related changes include the suspension of various personal income tax (PIT) and corporation tax (CT) deductions and credits, various revenue accelerations, conformity to the federal tax treatment of certain items, and certain tax compliance and enforcement measures. These measures are summarized in Figure 1 (see page 22) and discussed in detail below.

No Major Tax Increases Were Adopted

As noted in "Chapters 1 and 2", the Legislature and Governor considered but eventually did not adopt various proposals for major tax increases as a means of helping to address the budget problem. These proposals included: (1) increased income tax rates for high-income taxpayers, (2) cigarette and other tobacco-related tax rate increases, and (3) increasing the vehicle license fee.

Tax-Related Suspensions

The single largest tax-related provision involves suspending the net operating loss (NOL) deduction for businesses for a two-year period. In addition, the budget suspends the teacher tax credit for one year and the natural heritage tax credit for one year. Specifically, with respect to the largest two provisions:

NOL Suspension. Prior to the budget agreement, businesses were allowed to deduct from their income in a given year a specified portion of their NOLs incurred in earlier years under both the personal and corporate income taxes. Specifically, the law provided that the percentage of NOLs that could be used as an offset when calculating taxable income in future years was 60 percent in 2002 and 2003, and 65 percent in 2004 and thereafter. In contrast, the budget agreement suspends the use of these NOLs as an income offset during tax years 2002 and 2003. This will result in additional General Fund revenues of $1.2 billion in 2002-03 and $800 million in 2003-04. In exchange, the agreement also extends the maximum NOL carry-forward period for an additional two years, so that taxpayers affected by the suspension will have the same number of total years as formerly to use their NOLs. In addition, beginning with tax year 2004, businesses will be allowed to carry forward 100 percent (instead of only 65 percent) of their NOLs for a ten-year period (with this 100 percent provision thus first affecting NOLs incurred in 2004 and claimed in 2005 or thereafter). These changes will result in significant annual General Fund revenue losses beginning in 2004-05 in the low hundreds of millions of dollars.

Teacher Tax Credit. Current law provides credentialed teachers with an annual tax credit against their PIT liabilities ranging from $250 to $1,500, depending upon their years of teaching service. The credit is limited to 50 percent of teaching-related income. The budget agreement suspends this credit for the 2002 tax year, resulting in additional revenues for 2002-03 of $170 million.

Tax-Related Revenue Accelerations

The budget provides for increased withholding on bonus and stock-option income, and expanded withholding on real estate sales. The main effect of these changes will be to accelerate revenues, although some increase in compliance also will likely result.

• Withholding on Stock Options and Bonus Income. Currently, withholding on stock options and bonus income occurs at the rate of 6 percent. The budget agreement increases this rate of withholding to 9.3 percent, resulting in a one-time revenue acceleration of $400 million in 2002-03.

• Withholding on Real Estate Sales. Under current law, nonresidents of the state are required to withhold for tax purposes 3.5 percent of the purchase price of commercial property. The budget agreement would expand the withholding requirement on commercial sales to state residents, resulting in a one-time revenue of $225 million for 2002-03.

Federal Tax Conformity

Measures adopted to conform state tax law to federal tax law involving income tax treatment include those relating to bank bad debt. They also include a number of proposals contained in the Governor's January budget proposal and later adopted by the Legislature as part of the retirement conformity package (the bills involved are Chapter 35, Statutes of 2002 [AB 1122, Corbett] and Chapter 34, Statutes of 2002 [SB 657, Scott]. Specifically:

• Bank Bad Debt. Prior to the budget agreement, the law allowed large banks, when computing their taxable income, to deduct amounts set aside as reserves against losses from bad loans. The budget agreement would alter that treatment to conform to existing federal law and allow the bad loan income deduction only if and when loans become nonperforming. In addition, under the agreement, 50 percent of existing bank loss reserves are to be declared as income during the 2002 tax year. This measure will result in one-time revenues of $285 million in 2002-03.

• Retirement Programs and Other Conformity. The Legislature previously approved legislation that conforms California law to federal tax law regarding pension plans, individual retirement accounts (IRAs), and 401k plans. Although these retirement provisions result in annual revenue losses, other conformity items incorporated in the bills (the largest item being the increase in required estimated tax payments from 80 percent to 90 percent of the final tax liability) would result in revenue increases. The net effect of these bills accounts for the vast majority of the $188 million increase in 2002-03 revenues.

Tax Compliance, Enforcement, and Administration

The budget agreement approved numerous proposals to increase tax compliance, adopted certain tax enforcement-related provisions, and adjusted downward the interest rate the state pays on tax overpayments. The most significant of these measures are:

• Waiver of Penalties and Interest. The largest single revenue source among these measures is the authority to waive penalties and interest on certain delinquent accounts. The waiver would provide an incentive for the payment of these accounts, which would be expected to result in additional PIT, CT, and sales and use tax revenues in 2002-03 of $145 million.

• Settlement, Audit, and Protest Activities. Enhancing the settlement program used to resolve tax disputes, increased auditing capabilities, and addressing protest program priorities is estimated to result in additional 2002-03 revenues of $212 million.

Loans and Transfers

As summarized in Figure 2, the budget package includes $2.6 billion of loans and transfers from special funds to help address the General Fund imbalance.

The single largest component involves a $1 billion transportation-related loan from the Traffic Congestion Relief Account. Other significant components of at least $100 million include a transfer from the Public Utilities Commission's High-Cost Fund B (related to telephone service), and loans from the Beverage Container Recycling Fund, Renewable Resources Trust Fund, and Vehicle Inspection and Repair Fund.

The various loans and transfers shown in Figure 2, while contributors to addressing the 2002-03 budget shortfall, will impose costs in future years to the extent that they have to be repaid. Their repayment requirements vary depending on the specific loan or transfer involved. For example, repayment to the Traffic Congestion Relief Account is scheduled to be $500 million in 2003-04 and $650 million in 2004-05. In addition, because these loans and transfers are largely one-time in nature, they will not be available as solutions for addressing the anticipated 2003-04 budget imbalance.

Continue to California Spending Plan 2002-03 Chapter 4

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