LAO Analysis of the 1997-98 Budget Bill
General Government Crosscutting Issues

  1. The State's Audit Programs
    1. Background
      1. Resources Dedicated to the Audit Function
      2. BOE and FTB Audit Programs
    2. Concerns About Audit Program And Budget Requests
      1. Other Costs Reduce Claimed Rate of Return
      2. Total Revenues Should Be Discounted
      3. Opportunities for Efficiencies In Lieu of Audit Augmentation
      4. Audit Presence
    3. Legislature Needs More Information
  2. Overview of Employee Compensation Issues
    1. Employee Pay/Benefit Increases
      1. New Collective Bargaining Agreements Still Under Negotiation
      2. Strengthen Legislature's Collective Bargaining Oversight

The State's Audit Programs

We recommend that the Legislature not approve $18.9 million and 145 positions for the Board of Equalization (BOE) and Franchise Tax Board (FTB) that are requested, for the most part, on the basis of potential revenue benefits or losses because the Legislature does not have sufficient information to review the validity of the methodology used by BOE and FTB to make revenue impact calculations. We further recommend that BOE and FTB submit a report to the Legislature, evaluating the revenue impact of previous audit program augmentations.

As summarized in Figure 2, the budget proposes several augmentations--totaling $18.9 million ($16.8 million General Fund) and 145 positions--for Board of Equalization (BOE) and Franchise Tax Board (FTB). Although none of these requests are directly related to the boards' audit programs, both boards justify the augmentations on the basis that there will be a potential negative revenue impact due to foregone audit activity--to the tune of $128 million--if these requests are disallowed.

While some or all of the augmentations may have merit on a workload basis, we have several concerns about the boards justifying expansion of non-audit related programs on the basis of revenue impact. Furthermore, we believe the Legislature needs more information on the effectiveness of the boards' audit programs before it can evaluate the budget-year (and any future) augmentation requests. Specifically, the Legislature needs more information on the cost of generating and collecting revenues for the state before it can determine that there is a direct revenue benefit to each proposed non-audit related augmentation. We would note that both boards have been responsive to our initial requests for audit program information and have indicated that they are prepared to respond to additional legislative inquiries.
Figure 2
Augmentation Requests Justified on a Revenue Basis 1997-98
(Dollars in Thousands)
Expenditures Requested Positions Requested Claimed Revenue Loss a
Board of Equalization

Budget Change Proposals (Item 0860-001-0001)

Merit salary adjustments $3,300 -- $16,300
Settlement Program workload growth 670 12 $3,350
Cigarette and Tobacco Tax Enforcement Program workload growth 772 9 $4,600
Subtotals ($4,742) (21) ($24,250)
Franchise Tax Board

Budget Change Proposals (Item 1730-001-0001)

Merit salary adjustments $7,000 -- $65,300
Settlement Program workload growth 1,900 26 $12,200
Return processing workload growth 5,300 98 $26,300
Subtotals ($14,200) (124) $103,800
Totals $18,942 145 $128,050
a If change not funded.


Resources Dedicated to the Audit Function

California's two major tax agencies--BOE and FTB--expect to spend about $490 million from the General Fund in 1997-98 to collect $47 billion in General Fund revenues from the state's three major taxes--the Personal Income Tax, the Sales and Use Tax, and the Bank and Corporation Tax. Of the $490 million total, approximately $300 million will be spent on audit activities and about $90 million on collection activities.

In recent years, both boards have justified most augmentation requests--whether they were for new tax programs, workload adjustments to existing programs, salary and operating expense increases (such as merit salary adjustments and the purchase of modular furniture and information technology), or so-called revenue enhancement programs--on the basis of revenue impact. As mentioned above, we have several questions about the validity of this justification and the following discussion raises some issues we believe the Legislature should be aware of when evaluating augmentation requests for the BOE and FTB.

Auditors Added. Since 1992-93, the Legislature has added, at a cost of $18.3 million, a total of 440 permanent auditor positions to both boards. Figure 3 shows the number of auditors added to each board by fiscal year. In addition to these auditor positions, clerical and paraprofessional staff have been added to both boards as audit support positions.

These augmentations increased BOE and FTB audit staff by 25 percent and 56 percent, respectively, over 1991-92 levels. The Legislature approved these additional auditors on the premise that there would be at least a 5 to 1 benefit/cost ratio (rate of return) for tax auditing activity (a $5 incremental gain in tax revenue for every $1 spent on direct audit costs).
Figure 3
Changes in Auditor Positions

1992-93 Through 1996-97

1992-93 1993-94 1994-95 1995-96 1996-97 Total
Board of Equalization 256 79 -60 a 26 -28 a 273
Franchise Tax Board 50 24 76 16 1 167
Totals 306 103 16 42 -27 440
a Expiration of limited-term positions added in 1992-93 and 1993-94.

BOE and FTB Audit Programs

The state's audit programs are designed to identify, on a priority basis, taxpayers who have not reported or have under-reported taxable income. Both boards conduct targeted audits as new areas of noncompliance are identified. Based on board priorities for tax compliance, certain accounts receive 100 percent audit coverage over the three-year audit cycle, while other types of accounts can receive, less than 2 percent coverage over the audit cycle. The boards have a total of over 1,800 auditor positions authorized for the current year--1,351 for BOE and 466 for FTB--representing about one-fifth of the combined total staffing levels of both boards. Together, both boards plan to conduct over 800,000 audits in the current year.

In general, there are two types of audit workloads--desk audits and the more expensive field audits. Desk audits generally can be conducted by clerical or paraprofessional staff through telephone and written correspondence from board headquarters. According to FTB, 99.5  percent of its audits are desk audits. Information on the distribution of BOE audit workload by type was not available at the time this analysis was written.

Field audits usually require district office auditors to audit on site. In support of their field audit programs, both boards maintain several field offices (16 offices for FTB and 27 offices for BOE). In addition, both boards maintain out-of-state field offices in the New York, Chicago, and Houston areas, with a total of 316 staff (141 positions in FTB's four offices and 175 positions in BOE's three offices) for auditing of multistate accounts.

Concerns About Audit Program And Budget Requests

In evaluating the state's audit programs and the budget-year augmentation requests for BOE and FTB, we believe there are several issues the Legislature should consider. They include:

Other Costs Reduce Claimed Rate of Return

In addition to the direct costs of audit activities, such as auditor salaries and field office operating expenses, there are several other indirect program and administrative costs associated with conducting audits. For example, both boards devote significant resources to the related audit support functions of:

As discussed below, these costs are not always included in the calculation of the benefit to cost ratio.

Overhead Expenses. According to both boards, the workload associated with taxpayer inquiries, protests, settlements, appeals, litigation, and delinquent collections has increased in proportion to the number of audits conducted. For example, both boards report a significant increase in the volume of (1) calls coming into their toll-free (800 number) telephone lines and (2) audit protests and appeals. As a result, the actual costs of collecting additional revenue continue to increase. (When a taxpayer chooses to appeal an audit decision, the boards can take one of two actions--settle the dispute through the state's tax dispute settlement program or proceed with formal protest and appeals hearings.) For example, both BOE and FTB have submitted requests totaling $2.6 million for 38 additional positions in the budget year to handle settlement program workload growth. It is unclear which of the above overhead expenses, if any, are included in the benefit/cost ratio.

Collection Operations. Collection activities, which usually involve filing liens on wage and bank accounts, are another cost component of the total effort by both boards to generate revenue for the state. In general, both boards are able to use automated processes to initiate collection activities against delinquent accounts. A small portion of delinquent accounts (less than 5 percent) are contracted to private vendors for collection. In our view, the full cost of any activity related to collecting tax amounts identified through audit should be considered as part of the overall and true cost of generating revenue for the state.

With regard to collection costs, the BOE has indicated that, due to deficiencies in its information management systems, it cannot identify (1) the costs of collecting additional revenues identified through audit or (2) the amount of revenue collected through audit findings. The FTB also indicated that it does not track actual revenue collected due to audit activity. Thus, currently, it is not possible for the Legislature to know what the true rate of return is on audit activity.

Information Technology Projects. These are another example of direct and indirect costs that may not be fully included in the boards' rate of return calculations. In an attempt to automate various tax auditing and collection functions and reduce program costs, both boards have initiated several large-scale information technology projects--totaling at least $150 million. While early results indicate increased revenue generation from improved audit modeling programs and taxpayer information databases, some projects have experienced implementation delays and cost overruns. For example, projected revenue generation has not been realized as estimated because the largest projects at both the BOE and FTB--the Integrated Revenue Information System and the Bank and Corporation System Redesign--are behind schedule. It is not clear that BOE and FTB include those information technology implementation costs in the audit rate of return.

Conclusion. Our review of the BOE and FTB audit programs indicates that these cost elements (whether considered separately or in total) reduce the state's return on audit programs. For example, BOE indicates that the 1995-96 benefit/cost ratio for its sales and use tax program decreases from $5.45 to $3.80 when indirect costs related to taxpayer protests and administrative support are taken into consideration. More importantly, the $3.80 does not include collection costs. Consequently, we believe the 5 to 1 benefit/cost ratio overstates the true rate of return on state audit activity.

Total Revenues Should Be Discounted

The rate of return on audit activity also may be overstated because actual revenue collections lag behind audit activity by several years. That is, audit costs are incurred "up front," but the audit revenues come in over a period of years. To get a true rate of return for audit activity, the revenue to be collected should be discounted for the time it takes the boards to collect the monies due. Doing so has the effect of reducing the benefit/cost ratio by about 20 percent.

Opportunities for Efficiencies In Lieu of Audit Augmentation

As mentioned above, both BOE and FTB frequently claim that any reduction in their budgets will lead to a corresponding five-fold revenue loss. For example, as Figure 1 shows, the FTB is requesting $5.3 million and 98 positions for workload growth related to processing tax returns. The FTB justifies the need for this augmentation, in part, by stating that if the request is denied the board will redirect existing resources to this activity and there will be a revenue loss of $26.3 million. The underlying assumptions in this argument are that: (1) in lieu of reducing operating expenses and redirecting savings realized from efficiency improvements (such as automation), the board will be forced to redirect from audit activity and (2) all audit activity will, on average, produce $5 in revenue for every $1 spent.

As discussed above, we have several concerns about the validity of this claim because, here too, neither full indirect costs of audit nor direct costs of actual revenue collection from audit are considered in this calculation. Furthermore, the boards should be able to manage their operations in a more efficient manner in order to redirect costs in ways that do not affect revenues. For example, the BOE--on its own initiative--is reducing its baseline budget by $1.6 million and 32 positions in the budget year without identifying any projected revenue loss. In addition, the past automation efforts of both boards should improve operations and reduce costs.

Audit Presence

In approving resources for the state's audit programs, the Legislature needs to consider issues in addition to the revenue return on audit activities. For example:

Balancing taxpayers' desire for equity with their equally strong opposition to perceived harassment by tax agencies is an ongoing challenge for the Legislature and the boards.

Legislature Needs More Information

Based on the issues discussed above and our concerns that BOE and FTB are overstating the 5 to 1 rate of return on audit programs, we recommend that the Legislature receive and review additional information on the state's audit programs. To ensure that the Legislature has the information it needs to: (1) evaluate the effectiveness of the state's audit programs and (2) determine if the 5 to 1 methodology is valid, we recommend that BOE and FTB be required to submit a report by November 1, 1997, on the audit programs. We recommend, therefore, that the Legislature adopt the following supplemental report language:

The Board of Equalization and the Franchise Tax Board shall each provide the Legislature a report by November 1, 1997, on their audit programs. Each report shall, at a minimum, identify by fiscal year since 1992-93 (1) authorized, filled, and vacant auditor positions, (2) the classification of all authorized, filled, and vacant auditor position, (3) the number of supervisory auditor positions, (3) the approved and filled program assignment of all authorized auditor positions, (4) the revenue identified and collected through the audit activities of the filled auditor positions by types of audit, and (5) the total costs-- direct and indirect-- of identifying and collecting these revenues through audit.

This information will give the Legislature the opportunity to evaluate the impact of the 440 auditor positions added to both boards since 1992-93. Until the Legislature has a better understanding of the true revenue generating capabilities of the state's audit programs, it cannot accurately evaluate augmentation requests that are justified on the basis of a 5 to 1 revenue impact.

Therefore, we recommend that the Legislature delete $18.9 million and 145 positions included in the budget for the boards as shown in Figure 1. As mentioned above, some or all of the requests may have merit. Therefore, if the boards can provide additional information that demonstrates that the augmentations are justified on a workload basis, legislative consideration of the proposed augmentations or other adjustments to their respective budgets may be warranted. (Reduce Item 0860-001-0001 by $4,742,000 and 21 positions; reduce Item 1730-001-0001 by $18,942,000 and 124 positions.

Overview of

Employee Compensation Issues

A major portion of state government expenditures is for compensation of state employees. The Governor's budget projects $12.4 billion for salary and wage expenditures for nearly 278,000 authorized personnel-years in 1997-98 (including $4.1 billion and 89,300 personnel-years in higher education). Including benefits (such as contributions to retirement and health insurance), estimated employee compensation expenditures exceed $15 billion for the budget year.

In this overview we discuss the following compensation issues:

Employee Pay/Benefit Increases

State employees (other than those in higher education) last received a general pay increase (3 percent) on January 1, 1995. The budget does not propose funds for new pay or benefit increases for these employees. In higher education, the Governor proposes a 4 percent increase to the baseline budgets of the University of California and the California State University (in keeping with the terms of the Governor's four-year "compact") but leaves it to the systems to allocate these funds among compensation and other purposes. Out of this increase, the systems propose to spend $155 million for salary and benefit increases. Figure 4 (see page 20) shows how this amount will be allocated.
Figure 4
Higher Education

Salary and Benefit Increases

1997-98 Governor's Budget

General Fund

(In Millions)
University of California
5 percent faculty salary increase,

effective 10/1/97

2 percent staff cost-of-living increase,

effective 10/1/97

Full-year cost of 1996-97 salary increases 15.2
Merit salary adjustments 34.1
Subtotal ($96.9)
California State University
Salary and benefit increases to be negotiated $55.0
Full-year cost of 1996-97 salary/benefit


Subtotal ($57.8)
Higher Education Total $154.7

New Collective Bargaining Agreements Still Under Negotiation

The Department of Personnel Administration should report to the budget committees during budget hearings on the administration's collective bargaining proposals and the status of negotiations.

The Department of Personnel Administration (DPA) began negotiations in 1995 with the 21 bargaining units representing rank-and-file state employees (other than higher education) for new Memoranda of Understandings (MOUs) governing compensation and other terms and conditions of employment. These MOUs are to replace MOUs that expired June 30, 1995. In 1995, the DPA reached agreement with only one of the 21 units, the highway patrol officers. This MOU expires, however, on June 30, 1997.

Under current law, the provisions of expired MOUs generally remain in effect pending adoption of replacement MOUs. Thus, unless the DPA can negotiate successfully with one or more of the 21 bargaining units before June 30, 1997, the state will begin another budget year with expired MOUs. In our analysis of the DPA budget, we recommend that the DPA report to the budget committees during budget hearings on the administration's collective bargaining proposals and the status of negotiations.

Strengthen Legislature's Collective Bargaining Oversight

We continue to recommend that the Legislature adopt policies to assure that the Legislature will have the opportunity to fully review proposed collective bargaining agreements.

In our overview of employee compensation issues in the Analysis of the 1995-96 Budget Bill, we discussed at some length the need to strengthen the Legislature's oversight of proposed collective bargaining agreements. In order to assure the Legislature has the opportunity to appropriately review new MOUs, we continue to recommend that the Legislature adopt the following policies:

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