The May Revision proposes to temporarily increase corporation tax revenues by limiting the use of business tax credits and net operating loss deductions. We think the proposal to limit use of tax credits is worth serious consideration. On the other hand, the proposal to limit net operating loss deductions raises concerns. In response, we suggest the Legislature consider alternative ways to raise revenue should it wish to pursue revenue solutions.
Background
Business Tax Credits Aim to Encourage Certain Economic Activity. Tax credits allow businesses to reduce their tax bill when they do certain activities—such as hiring certain workers and conducting research—that state policies aim to encourage. Business tax credits essentially are spending programs carried out through the state’s tax system. Examples include the research and development credit, the California Competes credit, and the film and television credit. The research and development credit is the state’s single largest business credit, reducing revenue by around $2 billion each year.
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.
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.
May Revision Proposal
Suspend Business Credits and NOL Deductions. The May Revisions proposes to not allow businesses to use tax credits to reduce their taxes by more than $5 million for tax years 2025, 2026, and 2027. This would not apply to the low-income housing tax credit. Similarly, businesses with $1 million or more in income would not be allowed to use NOL deductions in 2025, 2026, and 2027. The May Revision also pulls back a separate January proposal to limit NOL deductions, which we discussed here.
Raises Several Billion Dollars Per Year, Primarily in the Out Years. The administration estimates suspending business credits and NOL deductions would increase corporation tax revenues $900 million in 2024-25, $5.5 billion in 2025-26, $5.9 billion in 2026-27, and $3.6 billion in 2027-28.
Suspensions Would Not Occur If Tax Collections Beat Expectations. The proposal includes language to stop the suspensions from taking effect if total collections from income, corporation, and sales taxes beat budget assumptions by three percent or more across May 2024 to April 2025.
LAO Comments
Suspending Credits Worth Consideration. Business tax credits can and should be evaluated as spending programs. From this perspective, it seems difficult to justify maintaining business credits in full at a time when meaningful spending reductions are being considered in other areas of the budget. While promoting private research or maintaining Hollywood’s centrality in the film industry may be worthwhile goals in general, it is not clear they are core state responsibilities which should be prioritized in the current budget environment. Further, some credits, such as the research and development credit, are awarded with limited legislative oversight. If, analogously, a proposal was before the Legislature to spend over $1 billion on research grants with fairly limited information about the recipients or the specific activities to be funded, it would be difficult to justify adopting it at the moment.
Suspension of Net Operating Loss Deductions Raises Concerns. While the suspension of NOL deductions has been a go to budget solution for decades, the frequency with which this approach has been used is now starting to raise questions. Should the Governor’s proposal take effect, the state will have disallowed NOL deductions in nearly half of years between 2008 and 2027. At this rate, it seems reasonable to ask whether suspensions have begun to meaningfully undermine the purpose of allowing NOL deductions in the first place. Unlike tax credits, which are ancillary to the state’s tax system, NOL deductions are a more fundamental element aimed at ensuring taxes are levied fairly and equitably. It is not clear that the equitable treatment of taxpayers should vary with the ups and downs of the economic cycle.
Consider Alternatives. Given our concerns with suspending NOL deductions, we suggest the Legislature consider alternative ways to raise revenues should it wish to pursue revenue solutions. As we discussed in an earlier publication, one place to look for alternatives is the scaling back of other tax expenditures, including those under the personal income tax. Another option is a temporary corporation tax rate increase. Pairing a suspension of business credits with a temporary rate increase of 1.5 percentage points (from 8.84 to 10.34) would raise a roughly similar amount of revenue as the Governor’s proposal. Such an approach could even be combined with future temporary rate reductions, which would allow business to recoup some of their temporary tax payments in future years. This would mirror one of the beneficial aspects of NOL suspensions, which is that businesses often can defer the disallowed NOL deductions to future years and reduce their future taxes.