Evaluating Tax Policy Changes in the Governor's Budget

The Governor’s budget includes a number of proposed tax policy changes. This post provides our assessment of those proposals. In summary:

• Reject Limit on Net Operating Loss Deductions. The Governor’s Budget proposes to limit the use of net operating loss deductions to 80 percent of a business’ taxable income in a particular year. Doing so would result in a less equitable tax system and would not offer meaningful administrative efficiencies. We recommend rejecting the proposed change.
• Approve Elimination of Tax Expenditures for Fossil Fuel Production. The Governor’s budget proposes eliminating three special tax rules for fossil fuel producers. We see no clear policy rationale for continuing these special rules. Eliminating the rules would move the state to a tax system with more consistent treatment across businesses. We recommend approving the Governor’s proposal.
• Approve Conformity on Tax Deductions for Open Space and Historic Preservation. The Governor’s budget proposes for the state to conform to a recent federal law change related to charitable conservation easements. Conforming to federal law would help curb potential misuses of tax deductions and could streamline state tax administration. We recommend approving the Governor’s proposal.
• Consider Bad Debt Proposal as a Budget Solution. The Governor’s budget proposes to eliminate lenders’ ability to claim tax deductions or refunds for sales tax payments made with bad debt. This proposal’s policy merits are ambiguous, but it would raise an estimated $50 million of ongoing General Fund revenue and $60 million of ongoing revenue to support various local programs. Given the state’s budget condition, the proposal warrants serious consideration.

Collectively, the tax policy changes proposed by the Governor would help address the state’s budget problem by raising about $400 million in new revenue. In light of the magnitude of the state’s budget problem, using revenue solutions to close the deficit is reasonable. In addition to evaluating the Governor’s revenue proposals, we suggest the Legislature explore changes to tax expenditures with questionable justifications. We offer some options for the Legislature to consider at the end of this post. For any policy changes that would raise revenue, it is important the Legislature keep in mind that a portion of new General Fund revenue would need to be allocated to schools. As such, the improvement to the state’s bottom line would be roughly 60 percent of the total amount of revenue raised.

Limiting Net Operating Loss Deductions

Background

Net Operating Loss Deductions Smooth Business Profits and Losses Over Time. Many businesses experience losses in some years. These businesses are allowed to carry forward these net operating losses (NOL) and deduct them from their taxable income in future years. NOL deductions allow businesses to smooth profits and losses over time for tax purposes. NOL deductions can be carried forward for up to 20 years.

Governor’s Proposal

Limit Use of NOLs to 80 Percent of Taxable Income. The Governor’s Budget proposes to limit the use of NOL deductions to 80 percent of a business’ taxable income in a particular year. Currently, if a business has enough NOL deductions, they can offset 100 percent of their taxable income, resulting in a tax payment of only $800. (Even when they have no taxable income, corporations are required to pay a minimum franchise tax of $800.)

Revenue Estimate. The administration estimates this change would increase revenues by $300 million 2024-25 and $200 million each year thereafter.

Comments

NOL Deductions Provide More Equitable Treatment of Taxpayers. The smoothing of profits and losses via NOL deductions results in businesses with similar profits over time paying similar taxes. Without this smoothing, businesses that have large swings in profits and losses from year to year pay more taxes than businesses with similar but more stable profits. Some businesses are more prone to large swings because they are in riskier or more innovative industries. For example, profits of businesses in the technology, motion picture, transportation, and real estate sectors tend to fluctuate more than other sectors. NOL deductions allow for a more equitable treatment of these types of businesses. As such, limiting NOL deductions, as the Governor proposes, would lead to a less equitable tax system. In effect, the Governor’s proposal would levy a tax increase focused on riskier or more innovative business activity. This, in turn, could discourage business owners from making investments that, while riskier, sometimes emerge highly successful.

Not Meaningful Conformity to Federal Law. The administration has framed their proposal as conformity to recent changes in federal tax law. In general, conformity is good because it streamlines the tax filing process for taxpayers and tax agencies. The Governor’s proposal, however, would not offer these streamlining benefits because it differs from federal law in key ways. First, federal law applies the 80 percent limit only to losses experienced after 2017, whereas the Governor proposes to apply the limit to losses from all prior years. Second, federal law allows NOLs to be carried forward indefinitely, whereas California would maintain its 20 year limit. Because of these and other differences, taxpayers and tax administrators would still need to track their NOLs separately for federal and state purposes. No meaningful streamlining would be achieved.

California Policy on NOLs Would Be Among the Most Limiting in the Country. The majority of other states limit NOL deductions to 80 percent of taxable income. They do so, however, as part of full conformity to federal law, including applying the limit only to losses after 2017 and allowing NOLs to be carried forward indefinitely. By limiting NOL deductions to 80 percent while not conforming to other federal changes that broadened the use of NOLs, the Governor’s proposal would result in California having one of the most restrictive policies in the country.

Recommendation

Reject Governor’s Proposal. Limiting NOL deductions as the Governor proposes would result in a less equitable tax system and would not offer meaningful administrative efficiencies. As such, we recommend rejecting the proposed change. Rejecting this proposal would necessitate an additional $300 million in budget solutions for 2024-25. As a starting point, we suggest exploring changes to the tax expenditures we discuss in the final section of this post.

Eliminating Tax Expenditures for Fossil Fuel Production

Background

California Provides Some Special Tax Rules for Oil and Gas Producers. California law provides special tax rules for certain businesses—or rules different from the general rules that apply to most other businesses—sometimes known as “tax expenditures.” These are often intended to achieve some specific policy goal. A few of these special tax rules apply specifically to businesses that extract natural resources. These rules dictate when and how much businesses can deduct certain costs when calculating their taxable income. They include:

• Percentage Depletion. Businesses can deduct costs associated with using up a resource. Percentage depletion allows businesses extracting natural resources—including oil, gas, coal, sand, gravel, and lithium—to annually deduct a set percentage of gross income generated from the sale of the resource. Most notably in California, “independent” oil and gas producers—or producers that do not have a major refining or retailing business—may deduct 15 percent of gross income up to 1,000 barrels of average daily production per property. In many cases, this provides a larger cost deduction than is allowed for the depletion of other kinds of resources.
• Accelerated Intangible Drilling Cost Expensing. State law allows oil and gas producers to immediately deduct “intangible drilling costs” (IDCs) for wells. (This provision does not currently apply to businesses drilling geothermal wells.) IDCs are expenses related to drilling or modifying a well, excluding equipment that has a salvageable value. Examples of IDCs include survey work, ground clearing, drainage, and repair costs. Independent producers can immediately deduct 100 percent of IDCs and integrated producers can deduct 70 percent of these costs immediately with the remaining 30 percent spread out over the next 5 years. By comparison, for most other capital investments that are expected to provide benefits over a long period of time, the costs are deducted over the useful life of the investment. 
• Enhanced Oil Recovery (EOR) Costs Credit. State law allows independent oil producers to claim a nonrefundable tax credit up to 5 percent of EOR costs. EOR is a process whereby steam, gas, or chemicals are injected into a reservoir to extract oil that is difficult to obtain using more conventional extraction methods. This credit is only available if oil prices in the prior year are below an inflation-adjusted threshold price ($56 per barrel in 2023).

All three of these rules conform to, or are similar to, federal tax rules that were established decades ago with a general goal of encouraging domestic energy production.

Oil Production in California Has Been Declining Over the Last Few Decades. Currently, California produces about 2 percent of total U.S. crude oil, which is about 0.3 percent of global crude oil. (It produces much smaller share of natural gas.) As shown in Figure 1, over the last several decades, oil extraction has been declining at a rate of about 2 percent to 3 percent per year. California’s current level of oil extraction represents a 66 percent decline from when it peaked in 1985. These declining trends—which are expected to continue in the coming decades—result from a variety of factors including the age of California’s oil fields.

Oil and Gas Production Emits 3 Percent of State Greenhouse Gases (GHGs). California has established ambitious GHG reduction goals, including reducing emissions by at least 40 percent by 2030 and 85 percent by 2045. Oil and gas production generate about 13 million metric tons of annual emissions, or 3 percent of total statewide emissions.

Governor’s Proposal

Eliminate Percentage Depletion for Oil, Gas, and Coal. The Governor’s budget proposes to eliminate percentage depletion for oil, gas, coal, and oil shale. Percentage depletion would remain for other minerals, such as sand, gravel, gold, and lithium. The administration estimates that this proposal would generate $15 million General Fund in 2024-25 and $10 million ongoing.

Eliminate Accelerated IDC Expensing for Oil and Gas Wells. The Governor’s budget proposes to eliminate accelerated IDC expensing for oil and gas wells. The administration estimates that this proposal would generate $7 million in 2024-25 and the next 3 years. Since this proposal shifts some tax collections from later years into earlier years, the annual savings likely would be somewhat lower in the following years.

Eliminate EOR Credit. The Governor’s budget proposes to eliminate the EOR cost credit. The administration does not assume any fiscal effect associated with this proposal over the next few years since crude oil prices are expected to remain above the price threshold used to determine when businesses can claim the credit.

Comments

Proposals Generally Make Oil and Gas Industry Tax Rules More Consistent Across Businesses. One key principle of effective tax policy is consistency across businesses, including consistency between different businesses within an industry and across different industries. Consistent rules make it more likely that investments are allocated to the most productive uses. As we describe below, the Governor’s proposals generally move the state towards a more consistent tax structure.

• Percentage Depletion. First, within the oil and gas industry, eliminating percentage depletion would make independent producers subject to the same depletion rules as integrated producers. Second, moving to cost depletion would treat the oil and gas industry in a similar manner to other businesses. More generally, moving to cost depletion ties the deductions more closely to the underlying cost paid for the resource. Percentage depletion, in contrast, can allow resource owners to claim deductions that total more than the cost of the investment.
• IDC Expensing. First, independent producers would be subject to the same rules for IDCs as integrated producers. Second, rules for oil and gas companies would have the same IDC rules as geothermal companies. Third, the rules for intangible costs would be treated similarly to investments in tangible assets, such as equipment with salvageable value.
• EOR Credit. The EOR cost credit gives preferential tax treatment to oil producers that does not generally apply to other industries. Furthermore, this preferential treatment only goes to EOR methods, but not primary or secondary extraction processes.

Special Tax Rules Would Remain for Some Types of Natural Resource Extraction. The Governor’s proposal leaves some special tax rules in place for certain types of natural resource extraction. Most notably, percentage depletion would remain for companies that extract other resources, such sand, gravel, gold, and lithium.

No Clear Policy Rationale for Continuing Special Rules for Fossil Fuel Producers. Special tax provisions are often adopted to achieve a specific public policy goal, such as promoting innovation or environmental improvements. When these special tax rules for fossil fuel producers were originally adopted decades ago, the goal was to encourage more in-state production. However, this no longer appears to be a statewide policy goal. Rather, many state policies are now aimed at a transitioning away from fossil fuel production. For example, the state has various planning efforts around transitioning away from fossil fuels, including a Scoping Plan for reducing statewide emissions and a Transportation Fuels Transition Plan (under development) required by Chapter 1 Extraordinary Session of 2023 (SBX1-2, Skinner). Further, the Legislature has allocated money to programs to help prepare for a decline in fossil fuel production. For example, the 2022-23 budget included $40 million General Fund to help workers who are impacted by a transition from oil and gas production towards renewable energy.

Effects on Oil Production and Greenhouse Gases Are Likely Minor. Over the long-run, these proposals would result in slightly lower in-state oil production—likely no more than a couple percent decline. As context, if historical trends continue, California oil production will naturally decline by about 30 percent over the next 10 years.

The net effect on GHGs would likely be even smaller. The direct effect on emissions from oil and gas would be no more than a couple percent over the long run (a few hundred thousand tons per year), similar to the drop in oil production. This amount is less than 0.5 percent of statewide GHG emissions. Furthermore, some or all of these direct reductions will likely be offset by other indirect effects that increase emissions. First, most of the reduced oil production in California would be offset by an increase in oil production in other parts of the world. Second, under the state’s cap-and-trade program, a reduction in emissions from oil and gas production could free-up more allowances for other in-state emitters to use, thereby having no net effect on statewide emissions.

Recommendation

Approve Proposals to Eliminate Special Tax Rules for Fossil Fuel Producers. These changes would generally make the state’s tax rules more consistent. In addition, they would generate roughly $20 million in state tax revenue over the next few years, which could help address the state’s budget problem. In our view, these two factors represent the strongest justifications for adopting these proposals. Any environmental benefits would likely be relatively minor.

Consider Eliminating Special Tax Rules for Other Resources. The Governor’s proposal would leave percentage depletion rules in place for some resources, such as sand, gravel, gold, and lithium. The Legislature might want to consider eliminating percentage depletion for these other resources. Eliminating these provisions would likely have only a minor fiscal effect, but would further promote a consistent tax system between businesses. When considering whether to keep any of these special tax rules, the Legislature might want to consider (1) whether there is a clear statewide policy interest in promoting resource extraction and (2) if such a statewide policy interest exists, whether special tax rules are the most effective policy tool to achieve such goals.

Charitable Conservation Easements Conformity

Background

Charitable Conservation Easements. When a property owner gives up their right to develop certain land or buildings they are allowed a tax deduction equal to the market value of the property were it to be developed. A 2023 federal law change limited this deduction to 2.5 times the amount of the property owner’s original investment.

Governor’s Proposal

Conform to Federal Law. The Governor proposes to conform California law to the 2023 change. The administration estimates this will raise $55 million in 2024-25 and $25 million annually thereafter.

Comments

Federal Change Sought to Rein in Misuse of Conservation Easements. The 2023 federal law change was motivated by concerns about misuse of conservation easements by some taxpayers. The Internal Revenue Service had expressed concerns that some promoters were creating opportunities for taxpayers to claim charitable contribution deductions that were based on inflated property value appraisals. The 2023 change sought to curb those misuses.

Conformity Streamlines Tax Administration. As mentioned, state conformity with federal tax law generally is good because it streamlines the tax filing process for taxpayers and tax agencies. In this case, conformity should allow the Franchise Tax Board (FTB) to leverage federal data collection and enforcement efforts with respect to conservation easements.

Revenue Gains Highly Uncertain. Information on charitable conservation easements is very limited. As a result, the actual revenue gains associated with conformity could vary significantly from the administration’s estimate.

Recommendation

Approve Conformity with Federal Law. Conforming to federal law would help curb potential misuses of charitable conservation easements deductions and could streamline state tax administration. We recommend approving the Governor’s proposal.

Limiting Bad Debt Deduction

Background

Some Sales Tax Payments Made With “Bad Debt.” Oftentimes, a consumer will borrow money from a lender and then use that money to buy a taxable good, including the sales tax that applies to the purchase. The retailer then must remit the sales tax to the California Department of Tax and Fee Administration (CDTFA). Afterwards, if the borrower does not repay the debt within a certain period, the lender--often a credit card company, but sometimes another financial institution or the retailer itself--“charges off” the debt on its financial statements or income tax returns. In doing so, the lender declares it to be “bad debt” that is unlikely to be repaid.

Lenders May Claim Sales Tax Deductions or Refunds for Purchases Made with Bad Debt. Under current law, when a lender charges off bad debt that includes sales tax payments, they can get those sales tax payments back from the state. They have two ways to do this. The first way is to claim a deduction on one of the returns that lenders file quarterly with CDTFA. Alternatively, lenders may file a separate claim for a refund.

Governor’s Proposal

Limit Bad Debt Deductions and Refunds to Retailers Only. The Governor’s proposal would limit the types of lenders who could claim a sales tax deduction or refund for a purchase made with bad debt. Non-retailer lenders who charge off bad debts after December 31, 2024 could not claim deductions or refunds for the associated sales tax payments. Retailers would remain eligible to claim such deductions or refunds.

Revenue Estimate. In January, the administration estimated that the proposal would raise General Fund revenues by $25 million in 2024-25 and by $51 million in 2025-26 and ongoing. They estimated that revenues for other funds, which support various local programs, would increase by roughly $30 million in 2024-25 and $60 million in 2025-26 and ongoing.

Comments

Proposal Warrants Serious Consideration. We offer some comments on this proposal below. Overall, we do not see a compelling policy argument either for or against the proposal. This year, the condition of the General Fund could force the Legislature to consider some highly undesirable choices, so budget solutions whose policy merits are ambiguous warrant serious consideration.

Lenders Have Multiple Ways to Reduce Losses From Bad Debts. In addition to the sales tax deduction or refund, lenders have several ways to reduce the financial losses that they incur from bad debts. Even after a lender charges off a bad debt, they may continue to pursue repayment from the borrower through a collection agency or eventually through litigation. They also may deduct bad debts on their income taxes.

Current Law Encourages Risky Lending. The deduction or refund available under current law slightly reduces lenders’ losses from bad debts. As a result, it weakens their incentives to avoid lending money to borrowers who are relatively unlikely to repay the debt. Eliminating this subsidy could make lenders slightly less willing to offer credit to such consumers.

Refunds Costly to Administer. Although lenders may claim deductions for bad debt on tax returns, they often opt to file separate claims for refunds. The administration estimates that CDTFA’s field auditors spend roughly 6,000 hours per year verifying these refund claims. (We estimate that these hours account for 0.4 percent of CDTFA’s field audit personnel.) These claims also generate substantial workload for other audit staff, though precise estimates of this workload are not available. The administration argues that this costly verification process is necessary because non-retailer lenders’ records generally do not document sales tax payments as thoroughly as retailers’ records. The administration further argues that these audit resources could be put to better use pursuing revenue-generating audits.

January Projections Do Not Reflect Timing of Refund Claims. Although the Governor’s proposal would make bad debt charged off after December 31, 2024 ineligible for deductions or refunds, lenders would have additional time—in many cases, up to three years—to claim deductions or refunds for the bad debt they charged off before that date. The administration’s January revenue estimate does not reflect the resulting delay in revenues that would be raised by the proposal. They plan to revise their May Revision estimate to address this issue.

Alternative Revenue Options

Collectively, the tax policy changes proposed by the Governor would help address the state’s budget problem by raising about $400 million in new revenue. In light of the magnitude of the state’s budget problem, using revenue solutions to close the deficit is reasonable. In addition to evaluating the Governor’s revenue proposals, we suggest the Legislature explore changes to tax expenditures with questionable justifications. Below we discuss four such tax expenditures. These proposed changes, especially the first two, would result in additional administrative costs for FTB. These costs likely would be minor relative to the revenues raised.

Eliminate Capital Gains Step-Up Basis on Inherited Assets. Net earnings from the sale of an asset are taxed as income, known as a capital gain. To determine a taxpayer’s capital gain when they sell an asset, the sale price of the asset is compared to its “basis,” what the taxpayer originally paid for the asset. Under current law, the basis of an inherited asset is “stepped up” from its original purchase price to the asset’s value when the heir received it. Historically, this “step-up” provision prevented inherited assets that had already been taxed once under an estate tax from being effectively taxed again after they are sold. This rationale is no longer valid as the state no longer has an estate tax. Ending the step-up basis prospectively for inheritances received after July 1, 2024 would increase revenues by a few hundred million dollars in 2024-25 and several hundred million dollars in 2025-26. Revenue gains would increase over time to about $5 billion per year.

Better Target the Mortgage Interest Deduction. Homeowners can reduce their taxable income by deducting the costs of their mortgage interest payments. California law allows taxpayers to deduct interest costs related to up to $1.1 million in mortgage debt. The mortgage interest deduction generally is an inefficient and inequitable way of achieving the policy’s primary goal: promoting homeownership. The vast majority of the $3.5 billion in statewide tax savings from the deduction go to higher income households who, for the most part, do not require assistance to afford a home. This is because taxpayers must be able to itemize their deductions to claim the mortgage interest deduction, something which is much more common among higher income taxpayers. One option to better target the mortgage interest deduction is to convert it to a tax credit, which would be available to a broader range of taxpayers. Such a conversion could be structured to also reduce the overall revenue loss to the state. For example, converting the mortgage interest deduction to a credit equal to two percent of mortgage interest paid on up to $1 million of debt likely would increase income tax revenue by $1 billion or more per year.

Eliminate Mortgage Interest Deduction for Second Homes. The mortgage interest deduction is not limited to interest paid on a taxpayer’s primary residence. Taxpayers also can deduct interest paid for vacation homes and other second homes, as long as they are not used to generate rental income. This policy provides little benefit in the way of promoting homeownership or improving housing affordability and primarily benefits higher-income taxpayers. Eliminating the mortgage interest deduction for second homes could increase income tax revenue by $100 million to $150 million per year.

Eliminate First-Year Minimum Franchise Tax Exemption. Many corporations have no net income in California, but are still required to pay a minimum franchise tax of $800. Other types of noncorporate businesses are not subject to the corporation tax, but also are required to pay a minimum franchise tax of $800. The minimum franchise tax ensures that all of these businesses pay a minimum amount for the right to conduct business here and for the benefits of limited liability protection, meaning their owners are not personally liable for the business’s debts. State law currently exempts new businesses from paying the minimum franchise tax in their first year. As we discussed here, the first-year exemption is an ineffective and poorly targeted means of helping small businesses—the stated objective of the policy. Eliminating the first-year exemption could increase corporation tax revenue by $100 million to $150 million per year.