LAO Contacts

May 20, 2020

The 2020-21 May Revision

Revenue Proposals in the 2020‑21
May Revision

The May Revision includes a number of revenue-related proposals, including the continuation of three proposals from the January budget. This post describes these proposals and offers our initial comments and recommendations. (As we learn more about the Governor’s proposals in the coming days and weeks, we may update this post.) We also offer alternative revenue options that the Legislature could consider in addressing the current sizable budget problem. These alternatives focus on policy changes that would (1) eliminate or modify tax expenditures that have a questionable policy rationale and/or (2) improve conformity with federal tax law. Figure 1 below summarizes the Governor’s proposals and our alternatives.

Figure 1

Summary of Governor’s Revenue Proposals and LAO Alternatives

(In Millions)



DOF Estimate

LAO Estimate

DOF Estimate

LAO Estimate

Governor’s Proposals

Suspend net operating loss deductions


$1,200 to $1,500


$850 to $1,100

Limit business credits


1,300 to 1,600


1,000 to 1,300

Interaction between NOL suspensions and credit limits


400 to 500


300 to 400

Used car dealers remit sales tax with vehicle registration



Estimated market value to calculate use tax on vehicles



Expand first‑year exemption from minimum franchise tax



Extend sales tax exemption for diaper and menstrual products


LAO Alternatives

Mortgage interest deduction conformity



Eliminate mortgage interest deduction for second homes



Local tax deduction conformity



Eliminate step‑up on inherited assets



Eliminate first‑year exemption from minimum franchise tax



Eliminate sales tax exemption for magazine subscriptions



DOF = Department of Finance and NOL = net operating loss.

Governor’s Revenue Proposals

Suspend Net Operating Loss (NOL) Deductions. Under the Governor’s proposal, corporations that have net income over $1 million (which the administration terms “medium and large” corporations) would not be allowed to use NOLs to reduce their taxes for 2020, 2021, and 2022. When a corporation’s expenses exceed its revenue in a year, it generates a NOL equal to the amount by which its expenses exceed its revenues. The corporation can then deduct the NOL from its taxable income the following year, reducing its taxes in that year. Corporations may carry forward unused NOLs for up to 20 years. In 2018, about 22,000 corporations—roughly 2 percent—had net income over $1 million. Not all of these had NOLs. The administration estimates that suspending NOLs would increase revenues in 2020‑21 by $1.8 billion.

Limit Business Credits. Under the Governor’s proposal, businesses would not be able to claim more than $5 million in tax credits per year in 2020, 2021, and 2022. Corporations may earn credits if they take actions the state wants to encourage, such as spending money on research and development. Tax credits reduce a business’s tax bill directly, on a dollar-for-dollar basis. If a corporation has earned more credits in a year than it can use, it can carry a credit forward to a future year. The Department of Finance estimates that limiting credits as it proposes would increase revenues in 2020‑21 by $2 billion.

Interaction Between Suspending NOLs and Limiting Credits. Some corporations have both NOLs and credits. If the state restricts the use of one, such corporations will increase the use of the other. For this reason, placing limits on both NOLs and credits results in a larger revenue effect than limiting just one or the other. The administration estimates that this interaction would increase revenues by an additional $0.6 billion.

Change Timing of Sales Tax Payment by Used Car Dealers. Currently, used car dealers must pay registration fees to the Department of Motor Vehicles (DMV) soon after they sell vehicles. They also must pay sales taxes by submitting periodic tax returns to the California Department of Tax and Fee Administration, as most retailers do. Under the Governor’s proposal, they would instead pay sales taxes along with their registration fees to DMV starting January 1, 2021. The administration anticipates this will improve sales tax compliance among used car dealers. As a result, they estimate that this proposal would raise $12 million General Fund in 2020‑21 and $24 million General Fund in 2021‑22.

Use Estimated Market Value to Calculate Use Tax on Vehicles. When people buy vehicles from other individuals (known as “private parties”), they owe use tax (similar to sales tax). Currently, the amount of use tax is based directly on the sale price that the buyer reports to DMV. The Governor proposes a new system for calculating the use tax on these purchases starting January 1, 2021. Under the proposal, the price used to calculate the use tax would be the higher of: (1) the reported sale price or (2) 80 percent of the estimated market value of the vehicle. Vehicle buyers could pay use tax on sale prices lower than 80 percent of the estimated market value only if they provide DMV with a certified appraisal valuing the vehicle at the lower amount within 20 days of purchase. The administration estimates that this proposal would raise $30 million General Fund in 2020‑21 and $61 million General Fund in 2021‑22.

Expand the First-Year Exemption From the Minimum Franchise Tax. The Governor proposes that new noncorporate businesses be exempt from paying the minimum franchise tax of $800 in their first year. Corporations, limited liability companies (LLCs), and many partnerships are required to annually pay a minimum franchise tax, regardless of their net income. However, under current law, new corporations do not have to pay the tax in their first year of business. This proposal would extend that exemption to LLCs and certain partnerships. The administration estimates that this would reduce revenues by $50 million in 2020‑21 and $100 million in 2021‑22 and out-years. This proposal was introduced in the Governor’s January budget.

Extend Sales Tax Exemption for Diaper and Menstrual Products. Under current law, the sales tax exemptions for menstrual products and children’s diapers will expire on January 1, 2022. The Governor proposes postponing this expiration date to July 1, 2023. We estimate that these exemptions reduce General Fund revenue by roughly $48 million annually. This proposal was introduced in the Governor’s January budget.

Extend Carryforward Period for Film Tax Credits. Corporations sometimes earn more credits in a year than they can use and are allowed to carry those credits forward to use in a future year. Under current law, motion picture production tax credits expire after six years. The Governor proposes to increase the carryforward period for film credits by three years. Extending film tax credits by three years would not begin to reduce revenue until 2022‑23 and the amount of lost revenue would depend on the tax circumstances of a small number of corporations. This proposal was introduced in the Governor’s January budget.

LAO Comments

NOL Suspensions and Credit Limits Are a Reasonable Starting Point for Deliberations. Should the Legislature wish to include revenue actions in its mix of solutions, the May Revision proposals are worth consideration. The state has suspended NOLs and limited business tax credits during prior recessions. These actions generally are considered somewhat less burdensome on taxpayers than other actions like increasing tax rates. This is because they largely would change only the timing of tax payments (causing payments to be made sooner than they otherwise would) but would not significantly increase the total amount of taxes businesses pay over the next several years. That being said, the proposed actions also have some drawbacks, as discussed below.

Revenues From NOL Suspensions and Credit Limits Would Be Difficult to Predict. We have found that predicting the revenue effects of corporation tax changes accurately is challenging. Changes to NOLs and credits are particularly challenging because they are concentrated with a relatively small number of corporations. Counting on a certain amount of revenues from these solutions to fix the budget problem is somewhat risky. Compounding this risk, our preliminary review suggests that the administration’s estimates for the revenue solutions may be too high. Whereas the administration estimates suspending NOLs and limiting credits as they propose would increase revenue by $4.4 billion in 2020‑21, we estimate that the revenue effect could be $2.9 billion to $3.6 billion. Our lower estimates are driven by our office’s lower expectations for taxable corporate income. Given lower taxable income, the amount of NOLs and credits corporations would use in the absence of the proposed limitations would also be lower.

Net Income Is an Imperfect Way to Identify a “Small Business.” In general, small businesses are difficult to identify based on simple, quantitative criteria. Commonly used definitions typically rely on the number of employees or annual revenue. However, such thresholds may not always reliably distinguish small businesses. Net income is an especially poor way to identify small businesses because many large businesses with high revenues also have a lot of expenses. An arbitrary threshold of $1 million would still allow many medium and large businesses to claim NOLs. Such a threshold also would create an artificial cutoff that could result in similar businesses being treated differently. For example, one business with income of $975,000 would be allowed to use NOLs while a very similar business with income just above $1 million would not.

Estimated Vehicle Value Proposal Likely Would Penalize Many Compliant Taxpayers. Data provided by the administration suggest there are substantial use tax compliance problems for private party vehicle sales. The Governor’s proposed solution, however, would place unreasonable burdens on taxpayers who already comply with the law. In particular, the proposal likely would require many compliant taxpayers either to overpay use tax or to incur the hassle and expense of obtaining a certified appraisal and submitting it to DMV. This problem would arise because the proposal does not adequately account for variation in legitimate sale prices. The estimates provided by standard vehicle guides depend crucially on information that DMV does not collect, such as the condition of the vehicle. Even if DMV collected more detailed information about vehicles, many legitimate sale prices still likely would fall below the 80 percent threshold. Research suggests that retail prices of identical goods tend to vary widely—even in the same geographic area and time period—with a substantial share falling below 80 percent of the average price.

First-Year Minimum Franchise Tax Exemption Is an Inefficient, Poorly Targeted Policy. We previously assessed the Governor’s proposal earlier this year in The 2020‑21 Budget: Expanding the Minimum Franchise Tax Exemption. In our report, we explain why we think that it lacks a strong policy justification and poorly targets small businesses.

Diaper Exemption Less Targeted Than Alternatives. As noted in our 2019 analysis, the diaper exemption provides a broad, but limited, benefit to parents. Alternative uses of the forgone revenue, such as child care slots, could provide more substantial assistance to families with the greatest financial needs.

LAO Recommendations on Governor’s Proposals

Consider Modified Version of NOL Suspension. To avoid the issues associated with creating an arbitrary income threshold to define medium and large businesses, the Legislature could consider a modified version of the proposal to suspend NOLs. Instead of limiting the suspension based on a corporation’s net income, the Legislature could limit the amount of NOL deductions a corporation could claim to a certain amount, such as $100,000. This approach would avoid creating an arbitrary income cutoff that could result in two similar businesses being treated differently. The approach also would allow most corporations to continue to claim all of their NOLs, while still focusing the cost of the suspension on higher income corporations. We estimate that limiting the NOL deduction to $100,000 per taxpayer would generate about $1.4 billion in 2020‑21—about the same as we estimate would be generated by the Governor’s NOL suspension proposal.

Reject Estimated Vehicle Value Proposal. Given the issues mentioned above and the Legislature’s limited time to develop an alternative, we recommend rejecting the Governor’s proposal to use estimated market value to calculate use tax on vehicles.

Reject Proposal to Expand First-Year Minimum Franchise Tax Exemption. Given the issues mentioned above, we recommend rejecting the Governor’s proposal to expand the first-year minimum franchise tax exemption to noncorporate businesses.

LAO Alternatives

Eliminating or Modifying Other Tax Expenditures Worth Consideration. In addition to the business tax provisions put forward by the Governor, we suggest the Legislature—should it wish to pursue revenue solutions—consider alternative revenue options. Below, we discuss a number of other options that could be worth consideration because they would (1) eliminate or modify tax expenditures that have a questionable policy rationale and/or (2) improve conformity with federal tax law, which facilitates tax compliance and enforcement (more detailed discussion of federal tax conformity issues can be found in our 2019 report).

Conform to Federal Changes to the Mortgage Interest Deduction. Personal income tax (PIT) filers can reduce their taxable income by deducting their costs for mortgage interest payments. California law allows taxpayers to deduct interest costs on up to $1.1 million in combined mortgage and home equity debt. In 2017, federal law changed to allow filers to deduct interest on only $750,000 of mortgage debt plus up to $100,000 of home equity debt used to improve the property. The change applies to loans made after December 15, 2017. California did not conform to these changes. The mortgage interest deduction generally is an inefficient and inequitable way of achieving the policy’s primary goal: promoting homeownership. The benefits from the deduction largely go to higher income taxpayers who, for the most part, do not require assistance to afford a home. Conforming with the 2017 federal changes would lessen these concerns somewhat. We estimate that conforming beginning July 1, 2020 would increase PIT revenue by about $200 million in 2020‑21, $400 million in 2021‑22, and increasing amounts over time.

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 PIT revenue by about $250 million per year.

Conform to Federal Limit on Local Tax Deductions. Taxpayers can deduct the amount of state and local taxes they pay (property taxes plus either sales or income taxes, but not both) from their federal taxable income. A 2017 federal law change capped this deduction at $10,000. California could conform to this change by similarly limiting the state deduction for local property tax payments at $10,000. Doing so would only affect a limited number of higher-income taxpayers. In 2018, the average property tax deduction was under $6,000 for filers with income under $200,000 and about $8,500 for those with income between $200,000 and $300,000. Conforming to the federal cap would increase PIT revenue by around $350 million per year.

Eliminate Capital Gains Basis Step-Up on Inherited Assets. Capitals gains from the sale of an asset are taxed as income. To determine a taxpayer’s capital gain when they sell an asset, the sale price of the asset is compared to its “basis,” typically the price 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. If the state were to eliminate the provision prospectively for inheritances of people who die after July 1, 2020, we estimate increased PIT revenue of about $120 million in 2020‑21, $450 million in 2021‑22, and $615 million in 2022‑23, with further increases in later years.

Eliminate First-Year Minimum Franchise Tax Exemption for Corporations. As mentioned previously, the first-year minimum franchise tax exemption is an ineffective and poorly targeted means of helping small businesses. Because of this, in addition to rejecting the Governor’s proposal to expand this policy, we suggest that the Legislature eliminate the existing exemption for corporations. Ending the exemption for corporations would increase General Fund revenues by around $60 million.

Eliminate Sales Tax Exemption for Magazine Subscriptions. Magazine subscriptions are exempt from sales tax. However, magazines sold at stores are taxed, as are subscriptions to daily newspapers. There is no clear rationale for this discrepancy. The soonest it would be practically feasible to repeal this exemption is October 1, 2020. We estimate that repealing this exemption on October 1, 2020 would raise roughly $9 million General Fund in 2020‑21 and $11 million General Fund in 2021‑22.