Legislative Analyst's Office

Analysis of the 2002-03 Budget Bill

Board of Equalization (0860)

The Board of Equalization (BOE) is one of California's two major tax collection agencies. In terms of its responsibilities, BOE: (1) collects state and local sales and use taxes, and a variety of business and excise taxes and fees, including those levied on gasoline, diesel fuel, cigarettes, and hazardous waste; (2) is responsible for allocating tax proceeds to the appropriate local jurisdiction; (3) oversees the administration of the property tax by county assessors; and (4) assesses railroad and specified utility property. The BOE is also the final administrative appellate body for personal income and corporation taxes that the Franchise Tax Board (FTB) administers, as well as for the taxes that BOE administers. The BOE is governed by a constitutionally established five-member board--four elected members and the State Controller.

The 2002-03 Governor's Budget proposes approximately $311 million in support of BOE operations, of which roughly $193 million is from the General Fund. This proposal represents a decrease of about 2.5 percent in total support, and about 3 percent in General Fund support, from estimated expenditures in the current year.

Audit Activities Deserve Annual Assessment

We recommend adoption of supplemental report language directing the Board of Equalization to report annually to the Legislature regarding its audit and related compliance activities.

BOE's Audit Activities. The BOE maintains an audit program whose mission is to ensure that businesses accurately report sales and use taxes (SUT) that are due to the state. The BOE audits approximately 3 percent of active registered sellers' accounts each year, concentrating on those considered most likely to be inaccurate in their tax reporting. The BOE's audit and compliance activities result in approximately 2 percent of the state's (General Fund only) SUT revenues--in excess of $450 million.

Audit Report Found Problems. In the early-to-mid 1990s, the Legislature approved an additional 250 auditing staff (200 in 1992-93 and 50 in 1995-96) to supplement BOE's existing auditing activities. According to a March 1999 Bureau of State Audits (BSA) report, the revenues raised from these additional auditing positions fell well short of BOE's estimates, for several reasons:

It is noteworthy that the BSA report did not point to a lack of "quality" accounts to audit as a significant reason for the shortfall in audit collections.

Recent Actions Affecting the Audit Program. The 1999-00 budget requested an additional 116 personnel years (PYs) to conduct BOE audit activities. These positions, however, were not approved by the Legislature. Then, in 2001-02, 50 PYs were shifted from the audit program to collections activity on a temporary basis. This was undertaken based on the expectation that the return from collection-related activities was higher than for audit-related activities. To date, the shift appears to have been successful in increasing overall revenues. It is currently anticipated that these positions will revert to audit activities beginning in 2003-04.

The result of these actions is that BOE has not received an increase in budgeted audit positions in recent years, and, in fact, has seen a diversion of resources to other activities. In addition, a systematic appraisal of the benefit-cost ratio of the BOE's audit and compliance activities has not been conducted since the BSA study released in March 1999, which in turn, was based on data from 1997-98.

Concerns Exist Regarding Audit Vacancies. The BOE has noted in its response to the BSA report that two of the major difficulties that it faces in its audit program are: (1) keeping its professional audit positions filled, and (2) the rapid turnover that exists in the program. According to the board, the inability to fill positions in the past has resulted in the hiring of support staff and less highly trained professionals to carry out the audit activities. In addition, the relatively high turnover has resulted in higher training costs than would occur with a more stable workforce.

LAO Recommendations. In the past, we have raised concerns with respect to the Legislature's lack of sufficient information to review the board's methodology for estimating the increased revenues from additional auditing. Although BOE's response to supplemental report language in November 1997 and the BSA audit provided valuable information to the Legislature, these were conducted several years ago, and no information is provided on a regular basis to the Legislature regarding these audit-related revenue issues. In addition, no recent formal reports have addressed the board's compliance activities.

Given the importance of audit and compliance activity, both for the integrity of the tax system as well as for revenue purposes, we recommend that the Legislature institute an annual reporting requirement regarding BOE's audit and compliance activities. The Legislature requires a similar report from the FTB. The purpose of the report would be to give the Legislature information necessary to evaluate the appropriate level of resources to devote to the audit and compliance activity by the BOE, and address the issue of vacancies in the audit and compliance programs. In addition, this report, coupled with the existing annual report from FTB, would help the Legislature determine the appropriate allocation of audit and compliance activity between the state's two main tax agencies.

We recommend that the Legislature adopt the following supplemental report language:

The Board of Equalization (BOE) shall provide to the Chair of the Joint Legislative Budget Committee and chairs of the fiscal committees of the Legislature by December 1 of each year, beginning December 1, 2002, a report containing the following information: (1) description of the methodological approach used to conduct its audit and compliance activities, including the work plan relating to these activities; (2) the number of hours and costs associated with direct audit and compliance activities, as well as supporting (overhead) activities; (3) the revenues associated with its audit and compliance activities; and (4) data regarding the revenue and cost impacts associated with any increase or decrease in resources devoted to audit and compliance activities. Items 2, 3, and 4 should include prior-year actual data, current-year estimated data, and budget-year projected data. This information shall also be provided to the Department of Finance, in a format it specifies, with submission of documents used to prepare the Governor's budget as well as when BOE makes a request to alter funding or personnel services for audit or compliance activities. Such information shall also be provided as a part of any budget change proposal submitted to the Legislature regarding resources for auditing or compliance activities.

Keep an Eye on Investigations

We recommend that the Board of Equalization monitor closely any adverse effect on General Fund revenues of shifting the focus of its investigations activity, so as to protect the sales and use taxes revenue stream, and report to the Legislature by December 1, 2002 on its findings.

The BOE's investigation activities involve responding to reports of tax fraud and evasion. For the budget year, the direct cost of staffing for the investigations division is approximately $3.3 million. The budget proposes a shift of funding for investigations from the General Fund to special funds in response to a shift in investigations from SUT to Cigarette and Tobacco Tax evasion. This funding shift is to occur for both the current year as well as the budget year. While this results in a reduction in General Fund costs of roughly $600,000 annually, we are concerned that General Fund revenues could suffer from this shift in resources. This could occur, for example, if the investigations division were unable to respond appropriately to compliance issues related to the SUT. We therefore recommend that the Legislature require that the board monitor shifts in investigations activity closely to protect the SUT revenue stream. Adoption of the following supplemental report language would be consistent with this recommendation:

The Board of Equalization shall provide to the Chair of the Joint Legislative Budget Committee and chairs of the fiscal committees of the Legislature by December 1, 2002, a report that contains the following information: (1) a description of the methodology and approach used in allocating investigations resources among the various tax programs; (2) actual or estimated data regarding the number of investigation cases, associated workload, and revenue impacts for each tax program for the prior, current, and budget years; and (3) data regarding additional investigations workload that is currently not funded.

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