The Governor’s 2018‑19 budget proposal modifies and extends the California Competes tax credit. California Competes—an economic development incentive to attract or retain businesses considering a significant new investment in California—is a $200 million per year program that reduces taxpayers’ personal income tax or corporation tax. The state will not award new tax credits after this year unless the Legislature acts to extend the program.
Below, we first summarize how the program works and describe our concerns with it. (Our October 2017 Review of the California Competes Tax Credit report contains more detailed information concerning the program.) We then describe and assess the administration’s proposal to extend California Competes. Finally, we recommend that the Legislature reject the Governor’s California Competes tax credit proposal. (We offer suggestions for the Legislature to consider, however, if it wishes to extend the program.)
State’s Economic Development Programs Overhauled in 2013. The Legislature overhauled the state’s economic development incentive programs in 2013 by replacing the “Enterprise Zone” programs with three new tax provisions:
Manufacturer’s Sales Tax Exemption. A partial sales tax exemption for purchases of certain manufacturing equipment.
New Employment Credit. A tax credit for businesses located in certain specified areas for hiring qualified new employees.
California Competes. A program that awards tax credits to selected businesses that agree to meet multiyear hiring and investment targets. The credit is a financial incentive to attract or retain individual businesses that might not otherwise invest or remain here.
Businesses Apply for a Tax Credit. California Competes tax credits are awarded to businesses through a formal process administered by the Governor’s Office of Business and Economic Development (GO-Biz). Businesses wanting a tax credit must first apply. Applicants request a specific amount of California Competes tax credit and provide detailed information about their intended hiring and investment plans over a five-year period.
Evaluation and Selection. GO-Biz uses a two-stage evaluation process to identify the businesses that will receive a California Competes tax credit:
In the first stage, the applications are scored and ranked based only on (1) the amount of tax credit that the business requested and (2) the total dollar value of their proposed hiring and investments over five years. An applicant that requests a smaller tax credit—holding constant the proposed amount of hiring and investment—receives a higher score. Only the highest scoring applicants move on to the second stage.
In the second stage of the evaluation process, GO-Biz reviews all of the other information that the applicants provided. State law requires GO-Biz to base the amount of the tax credit award on 11 different factors, such as the extent of unemployment or poverty in the area where the project would be located and other state or local incentives available to the applicant. In addition, GO-Biz may also consider other factors in determining whether to award a tax credit—current law allows GO-Biz a significant amount of discretion.
Some Businesses Receive Preferences. Under current law, businesses that would expand in high-unemployment or high-poverty areas automatically pass the first stage of the evaluation process. (These areas have poverty or unemployment rates that are at least 150 percent of the statewide rates.) In addition, one-quarter of the tax credits are set aside for small businesses—defined as having less than $2 million in annual revenues. GO-Biz evaluates these small business applications separately from the rest.
Tax Credit Agreements Individually Negotiated. State law requires GO-Biz to negotiate a written agreement with those businesses it selects for a tax credit. GO-Biz negotiates specific annual investment and hiring commitments—called “agreement milestones”—that the business must meet in order to claim their credit. The total amount of tax credit over the five-year period typically is not negotiated. The agreements also include various, typically non-negotiable, contractual details—such as reporting requirements and the conditions under which the state may recapture a tax credit.
Agreements Approved by Oversight Committee. A five member California Competes Tax Credit Committee meets to approve or reject all of the negotiated tax credit agreements. The committee is comprised of the Director of GO-Biz, the State Treasurer, the Director of Finance, or their designated representatives; an appointee of the Senate Committee on Rules; and an appointee of the Speaker of the Assembly. As of November 2017, the committee has met 11 times and approved 865 written agreements.
Tax Agency Reviews Credit Claims. If a business meets their agreement milestones, they may notify GO-Biz and claim the tax credit when they file their income taxes. After the business files their tax return, the Franchise Tax Board (FTB) reviews the tax credit agreement and supporting information, such as documentation of equipment purchases and payroll records, to independently determine whether the business claimed the correct credit amount. FTB is not required to audit small business recipients, although they may do so at their discretion.
Modify and Extend California Competes. The administration proposes to extend California Competes for five years. Specifically, GO-Biz would be allowed to award new credits through 2022‑23 and credits could be claimed until January 1, 2030. In addition, the proposal would:
Reduce the amount of credits from $200 million per year to $180 million per year.
Eliminate the requirement that 25 percent of the total amount of available credits be awarded to small businesses. (The administration has a separate proposal to provide assistance to small businesses. We plan to review that proposal when more information is available.)
Specify that GO-Biz may consider the extent to which the credit will increase employment in the state when awarding tax credits.
Our office reviewed the California Competes tax credit program in October 2017. In this report, we concluded that the executive branch has made a good faith effort to implement California Competes. However, we have repeatedly found that discretionary tax incentive programs like California Competes are highly problematic. We discuss the specific problems with California Competes below.
Some Awards Will Not Create Jobs Statewide. In our review of the program, we found that about 35 percent of the total number of awards—about 15 percent of the dollar value—were awarded to businesses in the ”non-tradable” sector of the state’s economy. Non-tradable businesses—in industries such as construction and healthcare, for example—generally must be located close to where their customers are. Local demand for non-tradable goods and services is generally based on location-specific factors. For example, the demand for plumbing services is driven by the number of households in an area. Awarding a tax credit to a plumbing business will not increase the number of households, and therefore will not increase the demand for plumbing. California Competes has awarded tax credits to at least seven plumbing businesses. As these businesses increase their employment, competing businesses employ fewer people than they otherwise would have. For this reason, awarding credits to businesses in the non-tradable sector does not create jobs statewide.
“Windfall Benefits” Limit Program’s Effectiveness. Many businesses that have received California Competes tax credits likely would have stayed, relocated, or expanded in California, even if they did not receive the tax credit. There are strong reasons to do so, including access to a skilled workforce, proximity to key suppliers, and the personal preferences of executives. When a taxpayer receives a tax credit for taking an action they would have taken anyway, the tax credit is a windfall benefit. Windfall benefits are an unavoidable problem with California Competes—both in the case of non-tradeable and tradeable businesses. (Businesses in the tradeable sector produce goods and services that can be readily consumed in a location far from where they are produced.)
Program Inadvertently Harms Some California Businesses. California Competes provides a substantial benefit to a relatively small number of the hundreds of thousands of businesses here. As such, it confers a competitive advantage to those businesses over their competitors by reducing their state tax burden significantly. This discrepancy harms equally deserving businesses that are unaware of California Competes or find it inconvenient to apply to the program.
Small Businesses Not Using All Available Credits. As described earlier, one-quarter of the available California Competes credits are set aside for small businesses. However, despite hundreds of applications and awards, the demand for tax credits from small businesses has been far less than the amount available. In 2016‑17, for example, GO‑Biz awarded only $30 million in tax credits to small businesses—about half of the reserved amount. To increase awareness of the program, GO-Biz has held workshops in more than 100 cities over the past three years. While this outreach may have increased awareness of the program and the number of applicants, the demand for this program from small business has remained relatively low.
Administration’s Proposal Does Not Fully Address Problems Inherent in California Competes. The administration’s proposal attempts to address some of the problems we raised about California Competes. For, example, it proposes to add the following language to current law regarding the factors GO-Biz may consider when awarding tax credits:
The extent to which the credit will influence the taxpayer’s ability or willingness, or both, to create jobs in this state that might not otherwise be created in this state by the taxpayer or any other taxpayer.
This language begins to address our concerns about windfall benefits, but the changes would not prevent windfall benefits or awards to businesses in the non-tradable sector of the economy. In addition, the changes would not prevent significant tax burden disparities among similarly situated taxpayers. To a large extent, these problems are inherent in and unavoidable for a program like California Competes.
Reject Governor’s Proposal to Extend California Competes. Given its largely unavoidable problems, we recommend that the Legislature reject the Governor’s proposal and allow California Competes to end. If the Legislature wants to provide some regulatory and/or tax relief to businesses, it could consider alternatives based on what it considers the most pressing competitive disadvantages for businesses in California with respect to their competitors in other states. If the concern is over high taxes generally, we suggest that the Legislature consider providing broad-based tax benefits to all California businesses. However, if the concern were over another factor, such as the high cost of residential housing or excessive regulation, we would suggest addressing those directly instead of through the tax code.
Ongoing California Competes Compliance Review. If the Legislature allows California Competes to end, GO-Biz will require funding through 2022‑23 to continue monitoring the existing California Competes tax credit agreements and, if necessary, to recapture any tax credits. The FTB may also need additional funding in future years, depending on their audits of California Competes tax credit claims.
Suggestions if Program Is Extended. If the Legislature chooses to extend California Competes, we have several suggestions to increase the effectiveness of the program while potentially reducing its problems.
Clarify Intent. If the program is extended, we suggest the Legislature add language to law that clearly expresses the intent of the program as a tool to attract and retain employers in California. We observe that some of the factors in law that GO-Biz considers in awarding tax credits create confusion about the intent of the program and allow GO-Biz to score non-tradable businesses highly in their evaluation process. For example, one of these factors is “the duration the taxpayer commits to remain in this state.” Businesses that would locate or remain in the state absent the tax credit could be scored highly on this factor despite the strong likelihood such an award would be a windfall benefit. We suggest narrowing these factors to only those most relevant to the program’s core mission: to help California compete against other states and countries to attract and retain businesses.
Narrowly Focus Program on Tradable Businesses. To maximize the statewide economic benefits of the extended program, we suggest restricting the program to businesses that primarily serve markets outside the state. For example, the Legislature could require applicants to provide GO-Biz information about how much of their income is from California sales. We also suggest strengthening the new language proposed by the administration. For example, the Legislature could require GO-Biz to consider the extent to which the credit would result in windfall benefits or would put other California businesses at an unfair disadvantage.
Adopt Proposed Modifications Regarding Small Business Set-Aside. The administration’s proposal to eliminate the set aside for small businesses is reasonable and we suggest the Legislature adopt the change.