Legislative Analyst's Office
Analysis of the 2002-03 Budget Bill
The Franchise Tax Board (FTB) is one of the state's two major tax collection agencies. The FTB's primary responsibility is to administer California's Personal Income Tax and Bank and Corporation Tax laws. The FTB also administers the Homeowners' and Renters' Assistance Program (HRA), the Political Reform Act audit program, and the Household and Dependent Care Expense Credit (HDCEC) program. In addition, FTB administers several nontax programs, including collection of child-support and other court-ordered payments. The FTB is governed by a three-member board, consisting of the Director of Finance, the Chair of the Board of Equalization, and the State Controller. An executive officer, appointed by the board, administers the daily operations and functions of FTB.
The Governor's budget proposes $437 million ($398 million General Fund) and 5,888 positions in support of FTB's operations. The total amount of support is approximately the same as the department received in the current year, with a slight increase ($1.5 million) in General Fund support. The largest areas of reductions in the budget are associated with (1) savings from the electronic filing of tax returns, (2) savings in the Integrated Nonfiler Compliance project, and (3) staffing reductions, especially affecting customer service. On the other hand, the budget proposes substantial increases in staffing in its audit and compliance programs.
We withhold recommendation on the administration's request for an augmentation of $4.6 million to increase its Bank and Corporation Tax auditing activities, pending receipt of additional information regarding the feasibility of hiring and training the proposed staff on a timely basis. In addition, we recommend that a proposed shift of existing staff from audits with longer-range benefits to audits with more immediate revenue impacts be limited to a two-year period, so as to preserve the overall effectiveness of the audit program.
FTB's Audit Activities. The audit division of FTB is designed to encourage compliance with the state's tax laws by administering the audit function in an equitable and responsible manner. For purposes of administering the audit program, the benefits (revenues) are compared to the costs involved for a particular type of case, in order to calculate a benefit-cost ratio. Audit cases are then ranked according to this ratio, with the FTB typically seeking funding for all cases with a benefit-cost ratio of 5:1 or greater (based on the net proposed tax assessment).
FTB Proposal. The FTB's budget-year proposal includes an additional $4.6 million for more audit activities with respect to BCT taxpayers. The department expects this additional cost to result in a revenue gain of $52 million in the budget year as a result of the increased auditing activities.
The board's proposal involves hiring new staff in the eastern regional office of FTB, as well as shifting resources within the audit program. The proposal would shift resources from audits with longer-term revenue benefits to audits with more immediate revenue impacts. The first category of audits--which FTB calls discovery and claims audits--is designed to identify issues associated with tax reporting, new tax law implementation, emerging audit trends, and tax overpayments. These audits result in longer-term benefits by assuring continued effectiveness of the audit program and protecting existing revenues. The board indicates that the budget proposal would allow staff currently working on these discovery and claims audits with benefit-cost ratios of below 5:1 to shift to audits that are expected to have immediate revenue impacts of above 5:1.
Issues Exist Regarding Hiring, Training, and Retention. The FTB has discounted its estimate of revenues to be generated by the proposed new staff to account for training and "learning curve" issues associated with the first year of employment. We are concerned, however, that additional training may also be required for those audit staff being shifted from discovery and claims audits to audits with near-term revenue effects and, as a result, the revenues from this aspect of the proposal may be overstated.
In addition, with respect to the shift in auditors, the discovery and claims audits of the FTB provide important information regarding emerging trends that can have implications for how audit activities should most appropriately be managed. Consequently, a permanent shift of resources away from this program component could affect the future overall effectiveness of the audit program and, ultimately, tax compliance.
Finally, reports issued in 1999 by the Bureau of State Audits regarding the audit activities of the FTB and the Board of Equalization suggested difficulties associated with the hiring and retention of auditors. This was cited as one reason for the failure of previous augmentations to generate the expected revenues. Given that FTB currently has some unfilled audit positions, the availability of a qualified labor force is of some concern.
LAO Recommendations. We concur in FTB's efforts to devote the appropriate resources to audit activities that are expected to result in revenue generation in the budget year. Nevertheless, we recommend the following regarding the FTB proposal:
We recommend that the Legislature augment the budget in order to expand settlement activities that could generate increased General Fund revenues of $14.1 million. (Augment Item 1730-001-0001 by $520,000 and recognize additional General Fund revenues of $14.1 million.)
Settlement Activities. The FTB is authorized to conduct a voluntary settlement program with taxpayers in order to accelerate the resolution of specific tax disputes. The acceleration of tax disputes meets the department's efficiency objective by reducing otherwise lengthy and costly administrative and court litigation procedures in order to finalize assessments and claims. The FTB's settlement authority functions in a manner similar to that of an equivalent federal program.
Supplemental Report Is Late. Last year, the Legislature raised questions regarding tax assessment regulations and the implementation of deadlines with regard to the settlement program. The Legislature approved supplemental report language requiring the FTB to evaluate the current tax assessment protest process, including time frames for each phase of the process. This report was due to the Legislature by December 10, 2001, but has not yet been issued. Consequently, we have been unable to evaluate the FTB's progress in resolving settlement cases. In our discussions with FTB staff, however, they have indicated that they are completing the resolution of settlement cases in a timely manner and that cases totaling approximately $1.9 billion in value are expected to be settled by the end of the fiscal year.
Backlog Warrants Additional Staff. Based on our review, there is an existing inventory of approximately 180 cases that could be "worked down" in the next three to four years, assuming that staffing is sufficient to conduct this work. In our discussions with FTB, it indicated that four additional staff attorneys for the settlement program (at a cost of $520,000) would generate an additional $14.1 million in revenues in the budget year. This revenue estimate takes into account training costs for additional staff, lower productivity in the initial year, and the probable final resolution regarding any subsequent appeals.
LAO Recommendation. Given the state's current fiscal situation, we recommend that the Legislature provide funding for additional settlement activity by augmenting FTB's settlement program by $520,000. We recommend that the additional support for settlement activity occur for a period of two years, with renewal subject to legislative review.
We withhold recommendation on the administration's request for an augmentation of $6.2 million to increase personal income tax collection activities. We recommend that the Legislature require the board to report at budget hearings regarding the timing and feasibility of hiring additional staff.
FTB Collection Activities. Tax collection activities involve collections of accounts receivable that are established by the board's self-assessment, audit, settlement, and filing enforcement activities. An automated billing system, combined with central and field office collections staff, administers the collections activity. The automated billing system initiates the billing process and accounts for tax revenues collected from voluntary compliance. The board's collections staff conducts manual collection efforts to ensure that nonvoluntary taxpayers pay the appropriate amount of taxes. As with its audit activities, FTB typically seeks funding for collection activity that result in a benefit-cost ratio of 5:1 or higher.
FTB Proposal. The board seeks an additional $6.2 million and 78.8 personnel-years (PYs) for additional collection activity above the 5:1 benefit-cost ratio. The board indicates that this additional activity will result in $27.5 million in revenue in the budget year and $55 million on an ongoing basis. The additional workload identified by FTB is in the areas of: (1) system enhancements, which have allowed a more efficient means of determining the best possible account to be collected; (2) bankruptcy cases, which have been growing at a faster rate than projected; and (3) discretionary workload, consisting of a variety of miscellaneous cases.
Although the board's request appears reasonable, we are concerned about the likelihood of hiring qualified staff by the July 1, 2002 date indicated in the proposal. We therefore withhold recommendation regarding the increase in the FTB's budget to hire new staff pending additional information from the department.
We recommend that the administration's proposed reductions in customer service programs be adjusted to minimize the inconvenience to taxpayers. This adjustment would result in additional reductions in district office staff to fund an increase in call center activities. In addition, we recommend that the board investigate changes that would result in covering the costs of the tax practitioners' telephone hotline by establishing a fee for this service. (Redirect $800,000 within Item 1730-001-0001.)
Customer Service Program. The FTB maintains a program that provides information and assistance to taxpayers and professional tax practitioners. Taxpayers may receive assistance from FTB through four channels: (1) a centralized call center with automated and staffed responses, (2) written correspondence through the FTB central office, (3) walk-in accessibility through one of the 16 FTB field offices located throughout the state, and (4) Internet access through the department's web site.
The department's call center reaches the greatest number of taxpayers, serving approximately 2.7 million calls per year. Written correspondence is limited to approximately 200,000 inquiries, and use of the Internet is currently relatively limited. While district offices experience limited taxpayer contact, they provide an important resource to taxpayers with collections issues as well as participants in the HRA.
Tax practitioners, in contrast, have access to a higher level of tax expertise than do general taxpayers, through FTB's Tax Practitioner Support Team (TPST). This service offers free technical advice to attorneys, enrolled agents, and certified public accountants. The TPST program is staffed by customer service specialists and auditors.
Proposed Customer Service Changes Should Be Fine-Tuned. As a means of achieving General Fund savings, the budget proposes to reduce funding for the centralized call center by $800,000 and 21 PYs. If the Legislature agrees to a reduction in customer service, we believe cuts should be taken in a different area in order to reduce the inconvenience to taxpayers. In 2000-01, the call center received 2.9 million calls and answered 2.7 million. The proposed reduction will increase the percentage of calls that go unanswered as well as increase the waiting time per call. While the department is unable to provide us with an estimate of the magnitude of these changes, it is likely to reduce the effectiveness of this program. The budget-year reduction would come in addition to a 12 PY reduction in the current year.
Limit Public Service at District Offices. Currently, the most expensive means of taxpayer assistance is the public service activities that occur at the department's 16 field offices. In order to capitalize on the efficiencies of the call center, we recommend the department restrict or eliminate public service activities at certain field offices. For example, eliminating public service activities at 11 of its 16 offices (while still providing this service at its offices in Oakland, Los Angeles, Sacramento, San Diego, and Santa Ana) would reduce costs by at least $800,000. We recommend that this savings be redirected to the call center in order to maintain its current-year level of resources. It is our understanding that the great majority of assistance provided through the district offices can be addressed directly through the call center. We further recommend that this option be carried out on a two-year trial basis in order to monitor the effect on taxpayers and HRA participants, as well as on department costs.
Charge for Tax Practitioner Program. The board spends approximately $800,000 a year on the TPSP, which handles about 160,000 calls annually. We believe that the costs of this technical tax assistance program should be considered a "cost of doing business" for tax practitioners. Therefore, we recommend that the costs be borne, at least partially, by the professional tax business community as opposed to taxpayers in general. While a charge per call is not feasible without the board investing in more complex (and expensive) telephone infrastructure, an annual fee for a certain amount of use would be feasible, according to the department. We recommend the Legislature direct the department to explore this option and report its findings prior to budget hearings, including an estimate of an appropriate fee and a means by which to assess it.
We recommend that the budget proposal requiring e-filing for all tax practitioners filing 100 or more returns use a more reasonable savings estimate, and be expanded to require e-filing for those filing 50 or more returns. (Reduce Item 1730-001-0001 by $1 million.)
The budget proposes that professional tax preparers who file 100 or more tax returns be required to file these returns electronically. The savings from this requirement is estimated by FTB to range from $2.2 million to $3.4 million annually, based on an increase in e-filings of from 2.5 million to 4 million. This change would affect 10,000 of the approximately 40,000 tax professionals doing business in California. We believe that FTB's savings are underestimated since they are based on the lower bound estimate of the number of returns. If a mid-point were used, FTB would realize an additional $600,000 in savings.
In addition, we recommend that the e-filing requirement threshold be further reduced to include all those professional tax preparers who file 50 or more returns. The filing of 50 tax returns or more constitutes a significant business activity, and warrants an e-filing requirement. Assuming that this lower requirement would result in an increase in e-filings of roughly 500,000, we estimate additional savings of $440,000. Together, our estimate of the additional savngs from the administration's proposal and the savings from an expanded e-filing requirement total approximately $1 million.
We recommend that the Franchise Tax Board report prior to budget hearings regarding the actual and expected costs associated with administration and compliance activities for the Household and Dependent Care Expense Credit.
Pursuant to Chapter 114, Statutes of 2000 (AB 480, Ducheny), the Legislature approved the Household and Dependent Care Expense Credit (HDCEC) for tax years beginning in 2000 and thereafter. The program allows a refundable credit to be taken as a percent (varying with income level) of household and dependent care expenses incurred as necessary costs to sustain employment. The credit is based on a percentage of the federal nonrefundable credit known as the Child and Dependent Expenses credit, and is dependent on taxpayers' California adjusted gross income. The credit ranges from 63 percent of the federal credit for taxpayers with incomes of $40,000 or less, to 42 percent for those with income not exceeding $100,000. The credit is not available to those with incomes of greater than $100,000.
Program Administration. The FTB is budgeted $3.8 million for HDCEC program administration, fraud detection, prevention, and investigations in 2002-03. This amount is based on processing a level of claims assumed for the first year this credit was in effect. Actual experience has been much less than that originally projected amount. Thus, the board may be overbudgeted for the administrative costs of the program.
LAO Recommendation. Since the board now has access to more complete data, it should be able to provide a firmer estimate regarding its administrative costs. Therefore, we recommend that FTB report prior to budget hearings on HDCEC projected filings and associated workload.