Analysis of the 2006-07 Budget Bill Legislative Analyst's Office February 2006

Board of Equalization (0860)

The Board of Equalization (BOE) is one of California’s two major tax collection and administration agencies. In terms of its responsibilities, BOE: (1) collects state and local sales and use taxes (SUT) 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 certain tax proceeds to local jurisdictions; (3) oversees the administration of the property tax by county assessors; and (4) assesses certain utilities and railroad property. The board is also the final administrative appellate body for personal income and corporation taxes, which the Franchise Tax Board (FTB) administers. The BOE is governed by a constitutionally established board-consisting of four members elected by district and the State Controller.

The 2006-07 Governor’s Budget proposes $371 million in support of BOE operations, of which $213 million is from the General Fund with most of the remainder consisting of reimbursements from local governments. The proposed level of support represents an overall decrease in funding of $8 million from the 2005-06 level and a net decrease of $10 million from the General Fund. The number of personnel years for the BOE is budgeted to increase slightly from 3,795 to 3,803.

Allocation of Sales and Use Tax Administrative Costs

We recommend the enactment of legislation implementing a new simplified methodology for allocating administrative costs associated with the sales and use tax (SUT) on behalf of various taxing entities. We further recommend that the Legislature consider statutory changes that would allow for allocating administrative costs to all tax programs within the SUT. (Reduce Item 0860-001-0001 by $6 million and increase reimbursements by an identical amount.)

State and Local Sales and Use Taxes

Sales and Use Tax Background. The sales and use tax (SUT) is levied by a number of different entities in the state. The basic state-wide rate is 7.25 percent consisting of: 5 percent General Fund, 0.5 percent Local Revenue Fund, 0.5 percent Local Public Safety Fund, and 1.25 percent uniform local rate (known as the Bradley Burns tax). In addition, in some geographic areas, optional rates approved by local voters are levied by special taxing jurisdictions (STJs). (See P&I, Part II, “Perspectives on State Revenues” for additional background information about the SUT.)

The BOE administers the SUT at a cost of almost $300 million annually and allocates its costs among the state General Fund and special funds, and all uniform and STJ funds. The administrative process encompasses (1) registration of taxpayers, (2) processing of tax returns and payments, (3) auditing of taxpayers, and (4) collection of delinquent taxes. Under current law, the BOE allocates its administrative costs among most of the tax components. The BOE allocates costs among the General Fund, the local uniform tax, and the STJs; however, no administrative costs are currently allocated to the Local Revenue Fund or the Local Public Safety Fund.

Special Taxing Jurisdictions Are Growing in Importance. Under current law, voters within local government jurisdictions-cities, counties and special districts-can approve special SUT rates that are imposed as an additional tax within the boundaries of a specific geographic area or STJ. The first such special tax rate was imposed by voters in the San Francisco Bay Area in 1970 as a means of providing funding support for the Bay Area Rapid Transit District.

Since that time, the number of STJs has grown rapidly, with 64 jurisdictions now levying an additional tax. In addition, a number of STJs are expected to come on line in the future. For example, there will be a net increase of six STJs beginning on July 1, 2006, and more are being considered for inclusion on the June 2006 and November 2006 ballots. The additional taxes levied by the STJs range from 1 percent by the City of Trinidad in Humboldt County to 0.1 percent for the Fresno Country Zoo Authority. However, most STJs add a rate of 0.5 percent to the existing statewide uniform rate of 7.25 percent. Under agreements made with each of the STJs, the BOE is responsible for administering the application and collection of the tax in each of the special jurisdictions.

Allocation of Administrative Costs

Current Cost Allocation. The BOE charges the General Fund, local governments, and local jurisdictions a fee for administering the local tax programs on their behalf based on current law. Current law requires the use of a “cost-allocation model” that is based on recommendations made in 1992 and 1996 reports by the Office of the Auditor General (now the Bureau of State Audits). In general, these recommendations centered on attributing costs associated with administering the taxes to the actual workload that such taxes impose on the agency. In addition, Chapter 865, Statutes of 1998 (AB 836, Sweeny) and Chapter 865, Statutes of 1999 (SB 1302, Senate Committee on Revenue and Taxation), required that such administrative fees be capped at a specified proportion of revenues.

Current Costing Model Is Complex. In an effort to comply with various statutory requirements, the BOE’s costing model has become increasingly complex and expensive to administer. As new STJs have been established, adjusting the model has become an expensive and resource-intensive undertaking. Gathering the data necessary to calculate workload requirements is now a sizeable task, while the data gathered through such efforts (including number of seller permits, number of returns, and hours worked) often are not particularly reflective of the actual workload involved. (Workload is difficult to quantify because the existing time reporting system does not track costs to the necessary level of detail.) As a result of the cap mechanism referred to above, the General Fund subsidizes certain STJs for administrative costs; for these STJs the link to actual costs is even more tenuous.

The complexity of the costing model has made its results increasingly difficult to explain to local agencies. This is especially true in situations where fees may increase as a result of workload changes, yet revenues to the particular STJ are actually decreasing. In fact, the ratio of administrative costs to revenue can vary widely depending upon circumstances. In addition, it is difficult to estimate with any precision the likely fees for new STJs that come on line.

Alternative Fee Structures. As part of the 2004-05 Budget Act, the Legislature required that BOE report by December 1, 2004 regarding alternative methodologies by which to allocate administrative costs associated with the state and local SUT. In consultation with the Department of Finance, STJ representatives, and the Legislative Analyst’s Office (LAO), the BOE developed several alternatives that attempted to address the overall goals and features shown in Figure 1.

Of the alternatives developed by BOE, we believe its “modified revenue” model best meets the criteria listed in Figure 1. Basically, the model identifies four key types of workload, and uses-for three of the workloads-revenue-related “proxies” as a way of allocating costs to the different funds/jurisdictions. The workloads and cost allocation methods are:

• Registration. Allocated based on total revenue actually received through the normal returns process.

• Return Processing. Allocated based on the number of return lines used in the filed tax returns.

• Audits. Allocated based on the tax change associated with audits of each of the taxes.

• Collections. Allocated based on revenue collected for the benefit of each of the SUT funding sources.

The approach described above would eliminate the current somewhat arbitrary cap on administrative costs as a percent of revenue. Additionally, it would ease the cost of administration for BOE and provide a much more transparent process for other taxing entities. Finally, the methodology proposed could easily incorporate additional STJs as they are approved by voters, and accommodate adjustments to the rate or base of existing tax components.

The modified revenue model for allocating costs would have differential effects on individual components of the SUT-including the state General Fund, uniform local taxes, and special taxes. In addition, substantial shifts might occur within the uniform local revenue components and the STJ component. Any shift in the existing distribution of costs is likely to bring objections from those who would end up paying more and support from those who would pay less. Nevertheless, we think that the proposed alternative is a more reasonable method through which to allocate costs than that currently used.

Local Revenue Components Not Assessed for Costs. The BOE does not believe that it has the authority under current law to assess either the Local Revenue Fund or the Local Public Safety Fund for a share of SUT-related administrative costs. As a result, the apportioned costs associated with these two funds are shared by the General Fund and the local entities.

LAO Recommendations

In view of the issues associated with the current costing methodology, we recommend the enactment of legislation implementing a simplified methodology that will nevertheless reasonably approximate the workload associated with each of the SUT’s major funding sources. Under the modified revenue proposal described above, the share borne by the state General Fund and the STJs would drop slightly, while the share borne by the uniform local tax would increase somewhat. These changes are shown in Figure 2. The reduction in the proportion of costs borne by the General Fund (from 72 percent to 70 percent) would translate to a General Fund savings of $6 million.

We further recommend that the Legislature consider legislation allowing for the assessment of administrative costs that are attributable to administering the Local Revenue Fund and the Local Public Safety Fund. Enactment of this recommendation would result in additional General Fund savings of $30 million.

Sales and Use Tax Gap

To date, the Board of Equalization’s efforts in closing the tax gap in sales and use taxes have been limited. We recommend that the department provide information at budget hearings regarding additional proposals for curtailing tax noncompliance.

What Is the Tax Gap?

At both the state and federal levels, much concern has been raised regarding the “tax gap”-that is, the difference between what is legally owed by taxpayers and what is actually remitted to the government. The tax gap has long been in evidence, but officials are concerned that not only is the tax gap persisting, but it also is growing in size relative to the underlying tax base. The tax gap is further examined in our report entitled, California’s Tax Gap (February 2005). The Legislature expressed its concern in the 2005-06 Budget Act regarding this issue by requiring the BOE to prepare a report about the SUT gap.

How Big Is the Tax Gap?

Estimating the size of the tax gap is, by its very nature, a difficult exercise. However, through various indirect means federal and state officials have managed to estimate the gap’s overall level of magnitude. At the federal level, the tax gap associated with income taxes is over $300 billion. For California, the nonpayment of personal income taxes (PIT) and corporation taxes (CT) is estimated to be $6.5 billion, or about 8 percent of General Fund revenues. Regarding SUT, studies by other states and multistate organizations suggest that California’s tax gap for this tax is between $1 billion and $3 billion. As shown in Figure 3, BOE estimates the gap to be about $1.5 billion, equal to 3.5 percent of total state and local revenues raised by the tax.

Components of the Sales and Use Tax Gap

Much less is known regarding the characteristics of the SUT gap, than those of the PIT or the CT gaps. This is due largely to the fact that there is significantly more documentation filed by taxpayers and independent third parties as part of administering the income tax programs.

The SUT has both a sales tax component (collected by sellers of consumed items sold in the state) and a use tax component (levied on goods purchased outside of the state but consumed in California). To the extent that sales tax noncompliance occurs, this typically relates to understatements regarding the amount of taxable sales actually made. For example, a seller may not obtain the required seller’s permit or simply not file a sales tax return as required. In other cases, a seller may understate actual sales made through a cash transaction. In still other situations, a business may obtain a fraudulent reseller’s certificate and purchase items for its own use on a tax-free basis.

The majority of SUT gap, however, is attributable to the use tax component (as opposed to the sales tax component). The use tax is required to be remitted by individuals and businesses that have purchased items outside of the state, but are consumed in California. The three main areas of use tax noncompliance are:

• Use Tax Remittance by California Business Consumers. Business purchasers of equipment and supplies are required to pay sales tax on in-state purchases and use tax on out-of-state purchases (if the items are not for resale). The lack of payment of the use tax can often occur due to ignorance of the tax law, a misunderstanding of the obligations to remit such a tax, or intentional noncompliance. This type of noncompliance occurs most frequently among businesses that are not registered sellers in California, such as legal, health, and business services.

• Use Tax Remittance by California Household Consumers. This area represents another large component of the use tax gap. Noncompliance in this area is due to ignorance of the requirement to remit the use tax associated with out-of-state purchases (including Internet or catalog sales), and to the difficulty of collecting the tax without creating onerous compliance burdens.

• Use Tax Collection by Non-California Sellers. The final main area of use tax noncompliance relates to certain businesses located outside of California. Their obligation to collect the use tax is based on the state’s determination that they have nexus-or presence-with California. Determination of nexus could be based on one of several factors, including (1) a warehouse in California, (2) employees based in California, or (3) an agent based in California. Noncompliance by these businesses may be due to a lack of awareness of the requirements of the law, a misapplication of the law, or an outright flouting of the tax law in order to lower consumer prices and thereby increase sales.

Bridging the Tax Gap

Existing Programs Are in Place. The BOE has initiated a number of programs designed to curtail specific activities that contribute to the tax gap. For example, the BOE conducts what it calls the “Form 1032 Nexus Program,” which provides leads (through audits of California businesses) on out-of-state businesses that should be collecting the state’s SUT due to their nexus with California. The BOE reports that this program is successful, raising about $6.5 million in 2004-05 on costs of about $0.5 million annually with a similar return expected in 2005-06.

In addition, through the state’s participation in the Multistate Tax Commission, it receives referrals regarding businesses that may have nexus with more than one state. The BOE can then pursue these leads to determine whether these companies are collecting the SUT on behalf of California. The BOE reports that this program is only marginally successful in generating revenues. Other efforts by BOE to date are limited and are likewise only marginally successful in increasing tax compliance.

At the direction of the Legislature, BOE prepared a report regarding the SUT tax gap. The report was to identify specific strategies and steps for reducing the tax gap, estimate revenues that would be produced by these strategies, the cost of implementing each approach, and recommend those actions that the board determined would be most cost-effective and feasible. The BOE identified three potential programs that would together generate annual revenues of about $50 million. In addition to the items addressed in the report, the BOE will report in its 2006-07 budget hearings on the findings of its pilot audit of the use of resale certificates.

Additional Programs Are Proposed. As part of the 2006-07 Governor’s Budget, additional measures are proposed to address the SUT tax gap. These programs were identified in BOE’s report discussed above. Specifically, the administration proposes the following tax gap programs:

• Retail Licensing Enforcement. This proposal targets businesses engaged in selling taxable items in California which do not have a seller’s permit and thus do not file tax returns with the BOE. (The BOE indicates that this component is the largest sales tax-related part of the SUT tax gap and accounts for uncollected revenues of $300 million annually.) The proposal would fund 14.5 two-year limited-term positions at a cost of $1.6 million ($1 million General Fund) in 2006-07, with a somewhat lower funding requirement ($1.5 million) for the second year. By identifying and registering entities which actively engage in business in California, the program will raise an estimated $12.6 million annually.

• Agricultural Inspection Station Tax Leads. This proposal targets property being transported into California without payment of the use tax component of the California SUT. The proposal would fund 16 two-year limited-term positions at a cost of $1.4 million ($800,000 General Fund) each in 2006-07 and 2007-08. Under an interagency agreement between BOE and the California Department of Food and Agriculture (CDFA), CDFA would collect documentation (for example, bills of lading) on behalf of BOE. Such documentation would provide the BOE with evidence regarding the associated business’s compliance with registration, filing, and tax remittance requirements. The program is estimated to generate $9 million in the first full year of operation.

But Should More Be Done? The BOE’s and administration’s tax gap-related efforts represent reasonable policy initiatives. However, the proposals put forth by the administration, while commendable-represent piecemeal approaches to specific tax gap-related activities. Additional proposals were approved by BOE but were not chosen for funding by the administration. One of these activities-so-called “discovery audits”-is an important component of an effective audit program and an effective means of addressing the tax gap through systematic changes in tax administration. Improving audit selection-through discovery audits or other improvements in audit selection methods-represent more fundamental approaches to dealing with noncompliance.

The FTB-the state’s tax agency responsible for administering income taxes-has long devoted resources to discovery audits, the objective of which is to get a better sense of potential and emerging areas of tax noncompliance. Unlike other states with large SUT programs, however, BOE devotes few resources to audit selection to help determine the highest return audits. In contrast, Arizona, with a substantially smaller population, has in the past delegated five staff specifically to audit selection.

We would also note that the BOE has identified use tax noncompliance by service industry businesses as a major contributor to the tax gap. For example, many professional offices and consulting firms use equipment and furniture purchased from out of state, but fail to pay the use tax owed to California on such items. As we indicated earlier, this may be due to either inadvertent or willful actions on the part of businesses. Despite the importance of this sector as a contributor to the tax gap, neither the BOE nor the administration has put forth a proposal to address it.

LAO Recommendations

We recommend that the BOE report to the Legislature at budget hearings regarding potential additional tax gap programs, as shown in Figure 4. Specifically, BOE should identify policy issues along with an estimate of administrative costs and additional revenues for the following initiatives:

• Audit Selection Improvements. Reallocate existing resources to improve audit selection methodology.

• Discovery Audit Program. Initiate discovery audit program for the SUT in order to improve audit selection.

• Services Business Education. Design education program for certain service businesses regarding their use tax obligations.

• Targeted Use Tax Audits. Establish pilot program of targeted audits for selected service industries regarding use tax compliance.

• Business Personal Property Reporting Requirement. Expand the form and require businesses to file personal property forms with county assessors and BOE.

Electronic Technology Planning

We recommend that the Board of Equalization report at budget hearings regarding the status of efforts to convert existing registration, tax filings, and manual processing to electronic systems, including the agency’s medium- to long-term goals regarding this technology, together with estimates of related savings and costs.

The application of electronic technologies to tax administration has expanded rapidly over the last decade. As we indicated in our January 2005 report, Tax Agency Consolidation: Remittance and Return Processing, the Employment Development Department (EDD) and FTB have increasingly converted to electronic technologies in the filing of tax returns and remittances as well as the processing of this documentation.

The advantages of shifting to electronic remittances and returns are significant. From the taxpayers’ perspectives, using electronic filing can minimize record keeping requirements, increase filing accuracy, and reduce costs in the long term. From tax agencies’ perspectives, electronic technologies decrease processing time, reduce storage costs, minimize personnel requirements, improve data accuracy, and facilitate sharing of information for enforcement and compliance purposes.

Processing Costs Are Lower for Electronic Processing. The processing costs associated with electronic registration, returns, and remittances are far below those for paper documentation. For example, FTB estimates that 4,800 electronic remittances can be processed for each direct staff hour. For paper submissions, only 65 remittances can be processed for each direct staff hour. At EDD, just over 40 percent of the volume of remittances is by paper, but these remittances consume 80 percent of related staff time. Similarly, paper tax filings represent 50 percent of the total, but use 85 percent of processing-related resources. Additional savings typically occur because the electronic submissions of remittances and returns are more accurate than their paper counterparts.

Work on Electronic Technologies Should Continue. Although BOE has made some efforts in the electronic technologies and automation area, there are still substantial additional improvements that could be made. For instance, while the agency receives about 60 percent of total SUT payments through electronic funds transfer, electronic tax filings represent only a small share of total tax returns. The BOE implemented electronic filing for single-location taxpayers in September 2005. It plans to extend the e-filing technology to businesses with multiple locations in the future. In addition, in its report to the Legislature, “Field Office Operations,” the agency indicated that it is developing additional electronic interfaces through the Internet, including registration; petitions; and claims for refund, account balances, and account maintenance.

Our largest concerns with BOE’s plans center on the length of time that is projected for the various components to come “on line.” For example, extending e-filing to businesses with multiple locations is not expected until 2008. The additional components discussed above as part of field office operations are not planned for implementation until well after that date.

Investing in electronic technologies is likely to have substantial payoff over the medium- to long-term in terms of budgetary savings, due largely to reduced staffing requirements as well as the number of required field offices. In addition, the technology is likely to have significant benefits for coordination and information sharing among the tax agencies for enforcement and compliance purposes. Finally, a shift to electronic filing will simplify filing requirements and result in reduced costs for taxpayers.

While converting to electronic filing and processing would result in annual savings for the state in the medium- to long-term, it is also important to note that investing in electronic technologies would likely require up-front investment. Given the complexity of the issues associated with electronic filing and processing-as well as the budgetary impact-we recommend that BOE report at budget hearings regarding its near- and medium-term goals regarding this technology, including estimates of related savings and costs.