| Last Updated: | 3/6/2014 |
| Budget Issue: | Requirements for accelerated remittance of certain income tax estimated and withholding payments |
| Program: | Taxes |
| Finding or Recommendation: | Recommend, at some point in the future, repealing 2008 and 2009 laws that accelerated certain state receipts of personal income and corporate taxes. |
The "Wall of Debt." The Governor's "wall of debt" is a collection of selected state actions adopted in the past, primarily for short-term state budgetary benefit. It includes items that the state is obligated to undo or repay over time, such as the state's deficit financing bonds. The wall of debt, however, also includes budgetary maneuvers that the state can choose—but is never obligated—to reverse, including school payment delays, the one-day bookkeeping change for June state payrolls, and the cash-basis accounting method for certain Medi-Cal costs. (The wall of debt excludes various other state obligations, such as the state's large unfunded pension and retiree health liabilities.) As we have stated previously, the Governor's focus on paying down the wall of debt is commendable.
Tax Accelerations Excluded from the Wall of Debt. Excluded from the Governor's wall of debt list are state actions in 2008 and 2009 to require taxpayers to make certain personal income tax (PIT) and corporation tax (CT) payments earlier. These tax accelerations remain in place today and never have to be undone by the state. Like most of the wall of debt items, the tax accelerations were adopted mainly for short-term budget and cash flow benefit for the state. Instead of directly deferring state costs to later fiscal years, however, the tax accelerations caused some state revenues to be received in an earlier fiscal year than otherwise would have been the case. This nevertheless provided the state with short-term budget benefit during the economic crisis. While these particular accelerations caused the state to receive some revenues earlier, they did not change taxpayers' annual tax liabilities. We think of the tax accelerations as similar to the items in the Governor's wall of debt.
Recommend Repeal of Some Tax Accelerations in the Future. As described below, we think that some of the key tax accelerations should be repealed in the future, but not necessarily this year. Given the long list of state liabilities to be repaid, we suggest that the Legislature weigh the pros and cons of undoing the tax accelerations alongside the costs and benefits of undoing other items on the wall of debt, paying other state liabilities, building budget reserves, and implementing other legislative budget priorities.
Definitions. The discussion below relates principally to PIT and CT estimated payments and PIT withholding. Withholding, for purposes of this discussion, is the amount withheld for state taxes from individuals' pay checks and certain other bonus, option, and other payments. Businesses and primarily high-income individuals also make "quarterly" estimated payments on expected taxable income for which there is no withholding—such as business income and realized capital gains on sales of stock and other assets.
Prior Law. California law requires the Franchise Tax Board (FTB) to annually prepare and make available to the Employment Development Department (EDD) wage withholding tables. EDD—the state department that administers withholding and payroll taxes—distributes the tables to employers. In turn, each employer sees that its employees complete a Form W-4 (and related forms) for federal and California withholding. Based on the information on these forms, including filing status and dependent information, the employer uses the withholding schedule to determine the amount of state taxes to withhold and forward to EDD. Employees can request that additional amounts be withheld, or they can adjust their tax forms to cause less to be withheld in some cases. Prior to 2009, the law required FTB to calculate withholding table amounts estimated to be "substantially equivalent" to the amount of tax reasonably estimated to be due as a result of income subject to withholding. For example, for taxpayers earning substantially all of their income from regular monthly salaries subject to withholding, the pre-2009 law aimed at having these taxpayers pay about one-twelfth of their annual tax liability each month.
2009 Withholding Acceleration Legislation. A 2009 budget bill—Chapter 15, Statutes of 2009-10 Fourth Extraordinary Session (ABX4 17, Committee on Budget)—provided that for wages paid beginning in November 2009, the wage withholding tables would instead be calculated to produce an amount 10 percent above the amount of tax reasonably estimated to be due as a result of income subject to withholding. The text of the bill stated that this action "will significantly prevent underwithholding," referring to the possibility that individuals subject to wage withholding also have other sources of income for which no withholding or estimated payments are made. The bill was a budget-related bill to address the fiscal emergency that the Governor had already declared. According to Assembly and Senate floor analyses of the bill, the withholding change was estimated at the time to increase 2009-10 General Fund revenue collections by $1.7 billion. This was a small part of the approximately $60 billion of actions that the Legislature adopted in 2009 to attempt to bring the 2009-10 budget closer to balance.
As we explained in our Spending Plan summary of the 2009 budget plan (see page 19), as a result of the withholding change, "unless individual taxpayers make manual adjustments to their withholding, they will see larger income tax deductions from their monthly paychecks." We continued, "By paying more during the year...individuals will pay less in April 2010 to settle their 2009 taxes or they will receive larger refunds." In short, the withholding change did not increase the amount of annual tax liability for any taxpayer, but merely accelerated the state's receipt of taxes, which resulted in more revenues being received in 2009-10, as well as short-term improvements in the state's then-troubled cash-flow situation.
Ongoing Effects of the Change. The withholding change remains in place today. The most recent estimates from the state’s tax agencies indicate that the change increased 2009-10 state revenues by $1.6 billion. While the law remains in place, the amount of revenue it accelerates in each subsequent fiscal year is roughly offset by the decreased April PIT payments (or higher refunds), according to recent estimates. Therefore, the net change for 2013-14 and 2014-15 revenues due to the law currently is estimated to be small: an under $100 million annual increase. These estimates from the state’s tax agencies generally assume that about 20 percent of taxpayers adjusted their withholding over time in response to the acceleration law. While the estimates seem reasonable, there is little hard data readily available to assess the accuracy of the 20 percent assumption.
Prior Law. Prior to 2009, CT taxpayers and certain PIT taxpayers generally were required to make four quarterly estimated payments of 25 percent of their estimated full-year tax liability. (In other words, prior to 2009, estimated payments for the four quarterly payments were required to be: 25%, 25%, 25%, and 25%, respectively.) Various exceptions to this general rule, including the annualized income installment method of calculating estimated payments (for those for whom income varies throughout the course of the year), have long applied and continue to apply today.
2008 Estimated Payment Acceleration Legislation. A 2008 budget-related bill—Chapter 1, Statutes of 2007-08 First Extraordinary Session (SBX1 28, Committee on Budget and Fiscal Review)—implemented a permanent change to increase the general rule for PIT and CT estimated payment requirements to 30 percent of the full-year requirement in April, 30 percent in June, 20 percent in September, and 20 percent for the final year-end payment due in either December or January. (In other words, SBX1 28 changed the estimated payment requirements to 30%, 30%, 20%, and 20%, respectively, for 2009.) According to our Spending Plan summary of the 2008 state budget package (see pages 16 and 17), the change was estimated to increase state revenues by $1.4 billion in 2008-09 (and smaller revenue increases thereafter)—a small part of the $24 billion of actions adopted to help bring the budget closer to balance that year.
2009 Estimated Payment Acceleration Legislation. The state again accelerated estimated payments in 2009 to help bring the state budget closer to balance. In 2009, ABX4 17 (discussed above) changed the general rule for estimated payment requirements to 30 percent of estimated annual tax liabilities in April, 40 percent in June, zero in September (provided that the taxpayer has already paid 70 percent of their annual estimated liability in prior payments), and 30 percent in the final estimated payment in December or January. (In other words, beginning in 2010, estimated payments for the four quarterly payments generally were required to be: 30%, 40%, 0%, and 30%, respectively.) The 2009 budget package assumed about $600 million in increased PIT and CT revenues in 2009-10 due to these changes, with smaller increases thereafter.
Summary of Changes to Law Since 2008. To put the two sets of changes in perspective, prior to 2008, the general rule (with some exceptions) was that taxpayers were required to make estimated payments equal to 50% of estimated annual tax liability in the first half of the year and payments equal to 50% of estimated liability in the second half of the year. Since 2010, however, the general rule (again, with some exceptions) has been that taxpayers are required to make estimated payments equal to 70% of estimated liability in the first half of the year and payments equal to 30% of estimated liability in the second half of the year.
Ongoing Effects of the Changes. The estimated payment changes remain in place today. Their main effect was to increase state revenues in 2008-09, 2009-10, and 2010-11. State tax officials now estimate that the changes increased state revenues by over $900 million in 2008-09, $1.2 billion in 2009-10, and over $300 million in 2010-11. While the laws remain in place, the amount of revenue they accelerate to each subsequent fiscal year is roughly offset by decreased payments on final returns (or higher refunds), according to current estimates. Therefore, the net revenue increase due to these changes for 2014-15 and the few fiscal years thereafter is currently estimated to be around $200 million per year.
Other Changes Related to Estimated Payments. The payment schedule changes described above are fairly simple to understand. The state essentially took actions to require earlier payments, and this brought more revenue into the fiscal year in question, thereby making it easier to balance the budget in that fiscal year. The state also adopted other tax changes during the economic crisis that served to accelerate revenues—particularly CT receipts—from future fiscal years but are much more complicated. For example, changes to CT net operating loss provisions in 2008-2010 increased revenues (and some taxpayers' liabilities) in those years, but decreased state revenues beginning in 2012-13. While these and other changes also accelerated state revenues in a sense, we do not focus on them in this discussion.
Problematic to Continue Some of These Accelerations. The state implemented many undesirable budget actions during the economic crisis to keep its budget closer to balance. The Governor's wall of debt spotlights certain financial maneuvers of this type—mainly ones intended to generate short-term budget benefit, but which remain in law today. In our view, the withholding and estimated payment schedule accelerations discussed above should be considered as similar to the wall of debt items. The state is not obligated to undo these schedule accelerations, but they were adopted for short-term budget benefit and, in our view, have little or no independent policy rationale supporting them.
With regard to the withholding accelerations, prior law set withholding tables at amounts sufficient to cover estimated tax liabilities, and this made sense. It is true that some taxpayers receive income for which there is no withholding, but these taxpayers may be required to make estimated payments under separate provisions of law. For those taxpayers who do not go to the trouble of adjusting their W-4 forms, the withholding acceleration results in what may amount to a multimonth interest-free loan to the state, which can result in higher tax refunds the subsequent April.
With regard to the estimated payment accelerations, prior law that generally required equal quarterly payments also made sense. It is true that some estimated payers make smaller payments than required under the law, but, in some cases, penalties are available to address those taxpayers' non-compliance. As with the withholding acceleration, for some corporate and individual taxpayers, requiring more than 50% of annualized tax liabilities to be paid in the first half of the year can result in something that may amount to a multimonth interest-free loan to the state.
Suggest Repeal, But Not Necessarily Immediately. The state has a long list of wall of debt and other liability payments to make. It also needs to build reserves and address other budget priorities. We do not suggest that the tax schedule accelerations be undone immediately, but we do suggest that policy makers consider the accelerations for future repeal, just as they are considering payment of the other items on the Governor's wall of debt. We think that the rationale for undoing these accelerations is at least as strong as the rationale for repaying some of the wall of debt items.
Benefits to Undoing the Accelerations. If the estimated payment and withholding accelerations were repealed, the general rule for income tax payments would be that taxpayers remit payments to the state through the course of each year in line with the timing of their income. This strikes us as a reasonable public policy goal. With regard to estimated payments, in particular, repeal of these accelerations would make state requirements more consistent with federal requirements.
A key benefit to repealing these accelerations would be to keep a few billion dollars with individual and business taxpayers in the California economy for a few months longer than otherwise would be the case. Instead of having to make estimated and withholding payments on an accelerated basis, taxpayers could hold on to those funds longer and use them for household and business purposes—including, for some taxpayers, generating investment returns—during that period. Overall annual tax liabilities would not be directly affected by the repeals. Taxpayers, however, would be able to make some of their payments later than would be the case under current law.
Costs to Undoing the Accelerations. Just as the accelerations were instituted mainly to provide a one-time benefit to the state budget in a particular fiscal year, undoing them would result in a noticeable, one-time reduction to state revenues in that fiscal year. The exact amount of the revenue losses would depend on when the change was adopted and the details of the package. (We discuss potential costs below.) In the year when the revenue loss occurs, Proposition 98 guaranteed funding for schools could be lower due to the revenue change. In addition, as the state's recently adopted "net final payment" accrual methodology for Proposition 30 and 39 revenues is premised in part on the current estimated payment schedule, reducing the amount of required estimated payments in the first half of the calendar year could also reduce the amount of these tax revenues accrued to each fiscal year, resulting in additional one-time revenue and Proposition 98 impacts.
The tax accelerations also helped the state's once-troubled cash-flow situation in some months during the depths of the economic crisis. Similarly, undoing the tax accelerations could hurt the state's cash flow in some months, potentially requiring somewhat more annual cash-flow borrowing by the state's General Fund in some years. This could result in added state borrowing costs during those years of up to several million dollars.
In general, therefore, it would be easier for the state to undo the withholding and estimated payment accelerations in a strong revenue year, when it has some capacity to cover the resulting one-time revenue losses. Alternatively, these payment accelerations could be phased out over a multiyear period.
In addition to its effect on annual state revenues and cash flows, the process of repealing the accelerations also could affect the state’s revenue estimation process temporarily. In the year when the accelerations were repealed—and perhaps for a year or two thereafter—changing tax payment patterns could make it somewhat more difficult to track and forecast state revenues. Within a few years, tax payments would return to a more regular pattern.
How Much Might Repeal Reduce Revenues on a One-Time Basis? It is difficult for us to estimate precisely how much repeal would reduce revenues on a one-time basis. At the time it chooses to consider repealing the accelerations, the Legislature could request up-to-date estimates from FTB. The amount of revenue reductions would depend on when the change was adopted, how the economy was performing at the time, and other factors, as discussed below.
With regard to the estimated payment accelerations, these can be considered for their effects on PIT and CT revenues, respectively. We have made some very rough estimates below.
LAO analysis prepared by Jason Sisney, with contributions by Brian Weatherford and Justin Garosi.