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

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.

Background

Resources Dedicated to the Audit Function

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

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

• Information on the total direct and indirect costs of generating and collecting additional revenues for the state.
• The current value of revenues identified through audit.
• Opportunities for efficiency improvements in lieu of augmentations.
• The appropriate level of auditing taxpayers.

Other Costs Reduce Claimed Rate of Return

• Overhead expenses (such as taxpayer information services and call centers, taxpayer protest settlements and hearings, and administrative support).
• Collections operations.
• Information technology projects.

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

Opportunities for Efficiencies In Lieu of Audit Augmentation

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

• The Appropriate Level of Taxpayer Compliance. One of the main purposes of auditing--irrespective of the fiscal benefit to the state--is to ensure that all taxpayers are reporting and paying their legal obligations. In considering audit requests, the Legislature has to determine the appropriate level of "equity" it wants in taxpayer compliance.
• Harassment Issue. The Legislature also has to consider the possible consequences of audit presence. Taxpayers can feel they are being harassed by the state.

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

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.

In this overview we discuss the following compensation issues:

• The administration's decision not to propose new pay or benefit increases in the budget (except for higher education).

• Collective bargaining agreements may again not be settled by the beginning of the budget year.

• Legislative oversight of state employee collective bargaining agreements.

Employee Pay/Benefit Increases

New Collective Bargaining Agreements Still Under Negotiation

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

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:

• Review the administration's MOU proposals (including final text and complete fiscal estimates) in the budget hearings and adopt, as appropriate, in the annual budget act. Any MOU that is not available in time for in-depth review during budget hearings should be referred to the budget committees and adopted, as appropriate, as an amendment to the budget act.
• Require a minimum time period between the submittal of the proposed MOUs to the Legislature and hearings on the proposal. This would give the Legislature sufficient time to study the MOUs to ensure that the fiscal and policy implications of the proposals are fully understood. Given the importance of these agreements, we suggest a 30-day review period.