The May Revision proposes to permanently place a limit on the amount of business credits that can be claimed against a corporation’s tax liability. This proposal presents a reasonable option to increase corporation tax revenues and, given the state’s structural budget challenges, warrants consideration. However, we also note some tradeoffs associated with a permanent limitation and identify several issues the Legislature may wish to consider regarding both the long-run effects of the proposal and the structure of the research and development (R&D) credit going forward.
Background
Business Tax Credits Reduce Tax Liability to Encourage Specific Activities. California allows corporations to claim a variety of tax credits that reduce tax liability on a dollar-for-dollar basis. These credits are generally intended to encourage behavior that generates economic or social benefits beyond those accruing to the taxpayer, such as research and development (R&D), low-income housing, and job creation. Unlike deductions, which reduce taxable income, credits directly offset taxes owed and therefore can substantially reduce, or in some cases practically eliminate, a corporation’s tax liability. Most business credits are nonrefundable, meaning a taxpayer can only claim credits up to the amount of the tax liability. The credits, however, may be carried forward to future years if they exceed the current-year tax liability. As a result, corporations that consistently earn large amounts of credits can accumulate substantial balances of unused credits over time.
Majority of Credits Claimed by Larger Corporations for R&D Activities. Although California has numerous business tax credits, the R&D credit accounts for the overwhelming majority of business credit usage and carryforward balances. R&D credit claims are also highly concentrated among a relatively small number of large corporations, particularly firms in technology and other research-intensive industries. Tax data indicates that a limited number of corporations can offset a large share of their corporate tax liability through accumulated credits. This concentration partly reflects the structure of the research credit itself, which rewards qualified research expenditures above a calculated baseline amount and allows unused credits to be carried forward indefinitely. As a result, some corporations can accumulate large credit balances that substantially reduce or defer corporation tax liability over extended periods of time.
Previous Credit Limitations Primarily Served as Temporary Budget Tools. California has enacted several temporary limitations on the use of business tax credits during periods of fiscal stress. During the Great Recession, the state limited taxpayers with at least $500,000 in net business income to using business tax credits to offset no more than 50 percent of their tax liability in 2008 and 2009. In response to budget pressures associated with the COVID-19 pandemic, the state imposed a temporary $5 million annual limitation on the use of business tax credits for tax years 2020 and 2021. Most recently, the state enacted another temporary $5 million annual limitation for tax years 2024 through 2026. These policies generally raised revenue by delaying the use of credits rather than eliminating them outright, as unused credits could typically be carried forward to future tax years.
May Revision Proposal
Limit Annual Credit Use for Corporate Taxpayers. The administration proposes to permanently limit the amount of business tax credits that a corporation can claim each year. Beginning in tax year 2027, corporate taxpayers can claim a maximum of $5 million or 50 percent of their pre-credit tax liability, whichever is greater. Recent data on tax collections indicate this would affect fewer than 100 corporate taxpayers in California, since the limit does not affect taxpayers with less than $5 million in credits.
Raises Revenues by A Couple of Billion Dollars. The May Revision assumes that this proposal would raise $850 million in 2026-27, since the cap would only apply to part of the fiscal year, and $1.7-1.8 billion annually between 2027-28 and 2029-30.
Exemptions for Certain Credits. The proposed limit only applies to business tax credits and thus does not impact credits related to payment of the Pass-Through Entity Elective Tax (PTET). Additionally, this limit does not impact the ability of taxpayers to claim refundable tax credits, notably those associated with (1) the current credit limitation in effect for tax years 2024-2026 and (2) elections to make credits awarded through the film tax credit refundable.
Comments
Proposal Can Generally Be Viewed as Reduction in Generosity of R&D Credit. Although the proposal would apply broadly to business tax credits, the R&D credit likely accounts for most of the proposal’s fiscal effect. Placing a permanent limitation on R&D credit claims could reduce the effective value of newly generated R&D credits for corporations that consistently earn large amounts of credits. Many of these corporations already accumulate credits faster than they can be used. Repeated temporary limitations likely have contributed to this accumulation of unused credits. A permanent limitation would make it even less likely some corporations can use all their R&D credits, potentially weakening their incentive to carry out qualified R&D activities.
R&D Credit Should Be Evaluated as a Spending Program. Business tax credits can and should be evaluated as spending programs. From that perspective, the state is spending around $3.5 billion per year to support private research activities while receiving limited information about the recipients and the specific activities that are funded. Studies offer some evidence that suggests that businesses increase research activities in response to this funding, but the extent of this response is very uncertain. Given the state’s ongoing structural budget challenges, it is reasonable to weigh the value of this uncertain incentive for private research against other types of state spending.
Credit Limit Versus Structural Reforms to R&D Credit. Limiting annual credit claims is one option to reduce the cost of the R&D credit. Another option is to make structural changes to the R&D credit itself. These differing approaches present tradeoffs:
- Credit Limit Provides More Immediate Revenue Gains. Because changes to the underlying credit structure, such as modifications to baseline calculations or credit rates, would primarily affect the generation of future credits, they would likely yield more gradual fiscal effects. The administration’s proposal, in contrast, appears more directly targeted toward near-term revenue gains and, by limiting the extent to which large credit balances can offset liability, ensures that certain large corporations incur a minimum level of corporation tax liability each year.
- Structural Changes Could Be More Targeted. The Legislature could consider changes to the structure of the R&D credit to more appropriately target incremental research activity. For example, the Legislature could consider modifications to the calculation of the credit’s baseline amount or other changes intended to more closely tie credit generation to recent increases in research activity. Such changes may be more likely to preserve incentives for businesses to increase R&D activities but would yield limited near-term revenue gains.
Structural changes could complement the May Revision proposal by slowing the rate at which businesses earn credits in the future. Pairing credit limits with structural changes to the credit could help reduce the extent to which the limits are binding in the future, potentially preserving more of the incentive effect of the credit.
Broad Application of Limitation Could Affect Other Legislative Priorities. Although the proposal would primarily affect large users of the R&D credit, the limitation would apply broadly to business tax credits. To the extent the limits restrict the ability of businesses to make timely use these other credits, it could reduce the value they assign to them. As a result, the proposal could modestly reduce the effectiveness of other credit programs that the Legislature has prioritized for economic development and other policy purposes. For example, the low-income housing tax credit is intended to encourage affordable housing construction, an area the Legislature has identified as a major policy priority. Similarly, California Competes credits have demonstrated value as a tool to encourage economic development projects and investments. Future large awards of California Competes credits could become subject to the limitation. Moreover, firms receiving large California Competes awards may already have substantial accumulated business credits from other programs, particularly the R&D credit, potentially further reducing the value or timing of these incentives.
Excluding Net Operating Losses Deductions An Improvement Over Prior Temporary Limitations. Previous temporary credit limitations often were paired with suspensions of net operating loss (NOL) deductions for medium and large businesses. Our office previously commented that these limitations risked undermining the purpose of NOL deductions, which are intended to reduce disparities in tax treatment between businesses with stable profits and businesses with more volatile income patterns. By excluding NOL limitations, the May Revision proposal avoids these concerns.
Other Options to Raise Corporation Tax Revenue. In March, our office published a report evaluating various options for raising and lower taxes. Two of those options likely would raise a similar amount of corporation tax revenue as the Governor’s proposal:
- Increasing the corporation tax rate by 2 percentage points.
- Eliminating the water’s edge election.
To the extent the primary goal is to raise revenue, these options should be considered reasonable alternatives to the May Revision proposal. Our March report summarizes some of the key trade-offs between these types of corporation tax increases and other options for raising revenue.