LAO 2006-07 Budget Analysis: General Government

Analysis of the 2006-07 Budget Bill

Legislative Analyst's Office
February 2006

Franchise Tax Board (1730)

The Franchise Tax Board (FTB) is one of the state’s two major tax collection agencies. The FTB’s primary responsibility is to administer-with the assistance of the Employment Development Department (EDD)-California’s personal income tax (PIT) and corporation tax (CT) programs. The FTB also administers the Homeowners’ and Renters’ Assistance Programs, the Political Reform Act audit program, and the Child and Dependent Care Expense Credit. In addition, the FTB administers several non-tax-related programs, including the collection of child support payments 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 (BOE), and the State Controller. An executive officer, appointed by the board, administers the daily operations and functions of the FTB.

The Governor’s budget proposes $662 million ($499 million General Fund) and 5,160 positions in support of FTB’s operations. Compared to the current-year budget, this represents a decrease of $35 million (3.6 percent) and a General Fund decrease of $15 million.

The decrease in total funding is due almost entirely to reduced support for the California Child Support Automation System (CCSAS). This program is funded largely through reimbursements from other departments, but also receives General Fund support. The CCSAS funding is reduced by $10.2 million in General Fund support. This system is being phased in over a number of years and is expected to receive declining General Fund support over the next several years. Elsewhere in this analysis, we discuss the past performance and current status of CCSAS and related child support collection activities (see “Health and Social Services” chapter).

The budget proposes increases for the ongoing activities associated with court-ordered debt collection programs ($3.8 million in special funds) and retention of outside legal counsel ($700,000 from the General Fund). These increases are partially offset by decreases due to one-time cost reductions, expiring programs, and unallocated reductions in state operations.

Review of Two Tax Credits

There are a number of special tax credits that are administered by the FTB. Below we discuss two of these programs that have significant fiscal-and policy-issues associated with them.

Child and Dependent Care Expense Credit

We recommend that the Franchise Tax Board (FTB) report at budget hearings regarding the impacts of shifting the focus of its fraud detection activities for the child and dependent care expense credit. We also recommend that the Legislature direct FTB to require additional documentation in order for taxpayers to qualify for this tax credit and to report at budget hearings on the costs and revenues associated with documentation options.

Background Regarding the Program. Since January 1, 2000, California has made available to taxpayers with children or other dependents a child and dependent care expense credit (CDCEC) equal to a percentage of their expenses associated with the care of such individuals. The purpose of the credit is to partially defray expenses incurred by taxpayers who must care for children or other dependents so that the taxpayer can be employed or seek employment.

The credit is available for direct expenses associated with such care-up to $3,000 for one child or dependent and up to $6,000 for two or more children or dependents. The California credit is calculated as a percentage of the similar federal credit. The percentage allowed under the California program decreases as taxpayer adjusted gross income (AGI) increases. Thus, for taxpayers with AGIs of $40,000 or less, the credit percentage is 50 percent of the federal credit; for taxpayers with annual AGIs of $40,000 to $70,000, the credit is 43 percent of the federal credit; and for taxpayers with AGIs of $70,000 to $100,000, the credit is 34 percent of the federal credit. (The credit is not available to taxpayers with annual AGIs in excess of $100,000.)

The maximum available credit for families with at least two children or dependents ranges from $1,050 for lower-income taxpayers to $408 for those with incomes of between $70,000 and $100,000. Unlike the federal credit, the California credit is refundable. Thus, taxpayers without a tax liability can claim the credit and get a tax refund. The refundable portion of the tax credit constitutes about 75 percent of the total revenue impact to the state.

Use of the CDCEC. Figure 1 shows the use of the credit since its inception in 2000 through 2004 (the last year for which data are available). As shown, the revenue loss attributed to the credit grew in the first four years following its introduction, exceeding $200 million in 2003, before tapering off in 2004 to $183 million. This pattern is generally mirrored with respect to the actual number of taxpayers claiming the credit. (Some of the 2004 reduction was due to new fraud detection efforts put in place by FTB). The average claim during the period shown increased from $282 in 2000 to $306 in 2004.


Figure 1

History of CDCECa Claims

Tax Year

Number of

Amount of Credit Claimed (in millions)

Average Credit Claimed


























a  Child and dependent care expense credit.

Average claim over the period shown.


The use of the CDCEC by income class in 2003 (the most recent year for which such data are available) is shown in Figure 2. About 42 percent of the total taxpayers claiming the credit earn between $50,000 and $100,000. Taxpayers earning between $20,000 and $50,000 account for an additional 45 percent of the total. (As a reference point, the median household income in California is about $57,000.) These percentages regarding use of the credit by income class have remained relatively stable since the credit was established.


Figure 2

Use of CDCECa by Income Class in Tax Year 2003


Share of Total


Adjusted Gross Income

Number of Claims

Amount of Claims

Amount of Refunds

Average Claim Amount






















a  Child and dependent care expense credit.


While the amount of credit claimed grew by 17 percent between 2000 and 2003, the portion of the program representing refundable credits (as opposed to credits used only to reduce tax liabilities) expanded dramatically. The refundable portion of the credit grew by over 51 percent during the same period of time, and now constitutes 74 percent of the total. As shown in Figure 2, almost two-thirds of the refundable portion went to households in the $20,000-to-$50,000 AGI category. The average refundable credit has increased from $292 to $381 during this period.

Fraud Is a Growing Problem. According to the FTB, the increase in the refundable portion of the CDCEC has coincided with an increase in the amount of fraudulent claims. Although the actual amount of fraud is unknown, the FTB indicates that the dollar amount of fraudulent claims detected increased from less than $1 million in 2001 to close to an estimated $12 million in 2004. Similarly, the average amount of fraud per fraudulent return increased from $425 to $588 during the period. The FTB estimates there will be a total of $51 million in fraudulent claims over the next three years-an annual average of $17 million.

In 2005-06, the FTB is devoting 43 personnel-years (PYs) to the administration of the CDCEC. Most of these resources (33 PYs) are devoted to fraud detection. This more than doubles the staffing for fraud detection deployed by the department in 2004-05. The FTB also indicates that its fraud efforts for the 2005 tax year are focused on taxpayers earning less than $20,000. This segment of claimants has been the focus of the FTB fraud efforts due to the difficulty in collecting remittances from lower-income taxpayers in the event that an erroneous refundable credit payment is made.

While virtually all the CDCEC claims from lower-income taxpayers ($20,000 AGI or lower) are for the refundable part of the credit, most of the revenue losses associated with the refundable portion of the credit are generated by taxpayers in the $20,000-to-$50,000 AGI category. It should also be noted that while the refundable portion represents the majority of the total amount of the credit, whether the credit amount is refunded or serves to reduce tax liabilities is immaterial from the state’s revenue perspective.

The ability of taxpayers to file fraudulent returns may be in part due to the lack of independent third party reporting of actual expenses undertaken by the taxpayer. For example, to file a claim, the taxpayer fills out the FTB credit form, but supporting documentation (such as copies of birth certificates, social security numbers, or notarized statements from the care provider) is only requested when deemed warranted by the tax agency.

There are, however, additional requirements that could be imposed on claimants to address fraud concerns. These include:

In addition, taxpayers who file fraudulent returns could be disqualified from claiming the credit for an extensive period of time in the future.

Legislative Analyst’s Office (LAO) Recommendations. In view of the fraud problems that have been associated with the CDCEC, we recommend that the Legislature direct FTB to:

Enterprise Zone Costs Expanding

We recommend that the Franchise Tax Board report at budget hearings regarding (1) the current level of audit activity of enterprise zone tax credit claims, (2) the level of anticipated audit-related workload activities in the future, and (3) the adequacy of current audit resources available for carrying out these activities.

Origins of Enterprise Zone Incentives. Since the 1980s, the state has made available to expanding or relocating businesses in certain areas of the state a number of special tax programs. These tax incentives are available to businesses operating in particular areas of the state that have been designated as:

While the exact characteristics of these designated areas vary somewhat, in general, they were selected due to the challenging socio-economic characteristics that prevailed at the time of their establishment. The EZs were established in 1984, the MEAs and TTAs in 1988, and the LAMBRAs in 1993. Until the program expired, the state also had Los Angeles Revitalization Zone designated areas as well.

The tax incentives that are available vary somewhat depending upon zone designation, but the types of benefits that are generally available to businesses include: (1) hiring credits for a certain percentage of wages paid to employees, (2) sales and use tax credits for certain capital expenditures, (3) accelerated depreciation of purchased equipment, (4) a longer carryover of net operating business losses (NOLs), and (5) deduction of interest paid to lenders that extend credit to zone businesses.

The goals of the various tax incentives are to increase private investment in particular designated areas. In attracting or stimulating such additional investment, the programs are intended to generate additional economic activity through the creation of new employment opportunities. The programs are also intended to create incentives for businesses to hire hard-to-employ individuals who might otherwise be unemployed.

The principal program among those described above is the EZ designation (the other designations indicated are relatively few in number and have a minor fiscal impact on the state). There are currently 42 separate EZs with 56 separate locations in California. In 2006, 18 of these EZs will expire unless their designated status is renewed. Another 13 expire in 2007 and 2008. The remaining 11 expire between 2009 and 2012.

Usage of Programs Has Expanded. The use of the various incentive programs has expanded substantially since they were first started. Ten years ago, the total tax incentives claimed for all programs were in the low tens of millions of dollars; however, by tax year 2003, the direct revenue loss to the state had grown to $318 million. In terms of direct revenue losses, this makes this type of business-oriented tax incentive the state’s largest after the research and development tax credit.

About 70 percent of the credits that are claimed are by taxpayers filing under the CT, with the remainder claimed by businesses filing under the PIT. This later group consists of Subchapter S corporations, sole proprietorships, and limited liability corporations. Most of the credits awarded have been allowed pursuant to the EZs-about $282 million of the $318 million total. Of the EZ-related credits-93 percent were related to the hiring and sales tax credits. The growth of these hiring and sales tax credits-in terms of revenue effects-has been substantial, as shown in Figure 3. The number of employees reported on tax returns has increased from 24,190 in 1999 to 75,150 in 2003.

Geographic Tax Incentives May Not Be Effective. Research findings regarding the impacts of geographic tax incentives-such as the EZ credits-in general are rather mixed. Overall, the dominant strain of research indicates that the response of businesses to tax incentives of this type is likely to be rather small, and the programs result in significant revenue losses relative to the benefits received. Most research indicates that these types of incentives have little impact on the overall level of economic activity or employment.

However, the research also indicates that geographically based tax incentives-while unlikely to affect overall economic growth in the state-can have an impact on the distribution of economic activity across the state. Such influence on the location of economic activity is likely to be strongest within a metropolitan area, with the impact declining as the size of the area increases. These issues are discussed further in our December 2003 report entitled, An Overview of California’s Enterprise Zone Hiring Credit.

Administrative Problems Have Surfaced. With respect to the EZ hiring credit tax incentive program, significant administrative problems have surfaced. Many of these issues are a result of the unusual blend of state, local, and private entities that administer this program. For this credit, businesses can claim up to 50 percent of wages paid to an eligible individual. In order for businesses to claim a credit, the individual employees (for whom the credit is claimed) must meet certain criteria and provide documentation regarding their eligibility. Eligible individuals are then issued a voucher, which is presented to employers, thereby allowing the employers to claim the tax credit.

The hiring credit aspect of the EZ program relies on local administrators of the zones to carry out major functions associated with the program, including establishing and maintaining eligibility standards for employees. Administrators have relied upon interpretations of statute for guidance regarding the type of documentation necessary to establish employee eligibility. The result has been rather wide variations as to what documentation is sufficient. Some EZs have granted eligibility for certain individuals who would have been (or have been) denied by other jurisdictions. These ambiguities also have led some EZs to give vouchers to individuals who work in a different jurisdiction than the one in which the voucher was issued. A recent directive issued by the Department of Housing and Community Development (HCD) has reduced-but not eliminated-this latter practice.

State Needs to Step In. The hiring credit associated with the EZ designation is a program that relies on state and local cooperation and coordination. As indicated previously, local governments and agencies provide direct day-to-day administrative support for the program. At the state level, FTB, EDD, and HCD are all involved in some aspects of the program. For example, EDD maintains much of the data regarding the eligibility status of prospective employees, while HCD provides general oversight of the EZs and conducts programmatic audits. The FTB is responsible for reviewing the tax returns of employers claiming the credit and for conducting any appropriate audit activity. Given the multiple agencies and levels of government, however, the roles, responsibilities, and authority of each of the parties have not always been completely or clearly defined.

In particular, in its compliance-related activities, FTB has uncovered situations where a claim for a tax credit may not be warranted due to ineligibility of either the employer, or the employee for whom the credit is claimed. For example, FTB has examined the documentation for certain employees and found that there were significant violations of eligibility requirements. However, FTB’s authority to continue such audits was challenged by an administrative appeal to BOE (the agency responsible for income tax appeals).

Some steps are being taken to address the administrative issues discussed above. Regulations are now in the process of being formulated and adopted by HCD-an action that might eliminate or reduce many of the ambiguities and uncertainties associated with the administration of the program. In addition, the Legislature is in the process of revisiting the program and considering statutory “fixes” to some of the problems associated with it. Finally, based on a recent BOE decision, FTB can now proceed with its auditing activities regarding the validity of the vouchers associated with some of the hiring credit claims.

This BOE decision will allow FTB to “go behind” the voucher and assess the adequacy of the documentation and validity of the claim. Given the level of tax credits claimed-as well as a substantial carryover of earned but unclaimed credits, the BOE decision could result in a significant increase in audit and other compliance-related activities by FTB. These would relate not only to employee eligibility, but also to the location of the employer, the proportion of employee activities carried out in the EZ, as well as other statutory requirements of the program.

LAO Recommendation. Given the magnitude of the revenue impacts of the EZ hiring credit, the administrative issues that have emerged, and the likelihood that the program will continue in some form, we recommend that the Legislature direct FTB to report at budget hearings regarding: (1) the current level of audit activity of tax credit claims, (2) the level of anticipated audit-related workload activities in the future, and (3) the adequacy of current audit resources available for funding these activities.

Other Tax Agency Issues

Tax Gap Continues

We recommend that the Franchise Tax Board report at budget hearings regarding (1) the status of its efforts to address the state’s tax gap with respect to the personal income tax and the corporation tax; (2) costs and revenues associated with a misdemeanor filing enforcement program, combined use tax and income tax audits, and investigations of questionable wage withholding; and (3) the status of the required report on independent contractor withholding that was due to the Legislature last year.

There is a substantial difference between the amount of taxes that are statutorily owed to the state and the taxes that are actually remitted by taxpayers. This difference between owed and remitted taxes is known as the “tax gap.” Using federal estimates and state sources of information, the FTB has pegged California’s tax gap associated with PIT and CT at $6.5 billion annually.

The FTB and federal officials indicate that the tax gap is associated with various types of activities, taxpayers, and occupations-suggesting that particular targeted efforts can be made to address the gap and limit the associated revenue losses. The gap results from underreporting of income (including claiming excess deductions from income), underpayment of taxes (including unwarranted claiming of tax credits), and nonfiling by those with California income. In terms of administrative issues, the existence of the tax gap is highly correlated to both the absence of tax withholding (such withholding currently occurs with respect to wages) and the absence of third-party reporting (such reporting occurs for interest and dividends paid). Expanding withholding and third-party reporting to other types of income or payments would help close the tax gap.

The FTB Has Made Progress. The FTB has independently pursued various areas of tax noncompliance. For example, as part of the 2005-06 Budget Act, the Legislature approved FTB programs to: (1) enhance the detection of preparers filing fraudulent returns, (2) target audits to areas of income underreporting, and (3) develop information to detect nonfilers.

But Additional Steps Could Be Taken. Although some steps have been taken by FTB to reduce the tax gap, it remains a significant problem for the state. Not only does the continuation of the tax gap produce an ongoing revenue drain for the state, but continued or increased noncompliance can have a corrosive impact on the viability of the tax system itself. Although FTB is continuing its existing tax compliance efforts, the administration has proposed no new tax gap initiatives. In addition, the department has not provided the Legislature with the required supplemental report on withholding on payments to independent contractors that was due December 1, 2005. (The absence of withholding from, or adequate reporting of payments made to, independent contractors constitutes a significant portion of the tax gap.) The $200,000 appropriation for this study was vetoed by the administration, but the study requirement remains and FTB staff have identified aspects of the study that can be accomplished using existing resources.

There are additional steps that FTB could take that would enhance its tax compliance and enforcement efforts. Some of these measures-such as a combined use tax and income tax audit program, investigations of questionable wage withholding, and pursuing misdemeanor cases of noncompliance-could generate additional revenues in the short term. Other components-such as increased data collection, maximizing audit links to the state’s other tax agencies (BOE and EDD), and examining the expanded application of withholding-would generate additional revenues in the future.

LAO Recommendations. In view of the magnitude of the tax gap, and the importance of a fair and efficient tax collection system to the state, we recommend that the Legislature direct FTB to report on tax gap measures that it is currently considering and the performance of its existing efforts in this regard. In addition, it should report on the costs and revenues associated with a misdemeanor filing enforcement program, combined use tax and income tax audit program, and investigations of questionable wage withholding. We also recommend that FTB report on the status of its response to the legislatively required report on independent contractor withholding.

Electronic Filing Saves Time and Money

We recommend that the Franchise Tax Board’s (FTB’s) budget be reduced to account for savings associated with the increase in electronic return and remittance processing and the associated reduction in the number of paper submissions. We also recommend that the Legislature require FTB to report at budget hearings regarding (1) the discrepancy between forecast and likely e-filing savings in 2006-07 and (2) the status of the new electronic filing system for business entities. (Reduce Item 1730-001-0001 by $200,000.)

Previously, we have noted that some of the state’s tax agencies have made considerable strides in electronic remittance and return processing, including FTB. The costs associated with processing electronically filed returns and remittances are a fraction of the costs associated with paper documentation. For example, FTB has reported that about 4,800 electronic remittances are processed per each direct staff hour. By comparison, only 62 paper remittances are processed per direct staff hour. This cost differential translates directly into budget savings.

Information provided by FTB indicates ongoing growth in electronic filing of returns and remittances. This growth has occurred as a combined result of statutory mandates for tax practitioners as well as a “natural” migration from paper to electronic filing by individual and business taxpayers. The department reports that it expects 10 percent annual growth in electronic remittances through 2008, and 5 percent to 10 percent annual growth in electronic returns over the same period.

Reflecting the growth in electronic filings and remittances-and the large savings associated with the use of this technology-the department’s processing budget was reduced annually from 2001-02 through 2003-04. These reductions ranged from $400,000 to about $1 million. The 2005-06 budget was adjusted to account for continuing e-filing savings in 2004-05 and 2005-06.

No such budget reductions were proposed as part of the 2006-07 budget, although FTB indicates that its savings are expected to be over $200,000. (Based on our review, this savings amount does not appear to mesh with the level of e-filing anticipated by the department.) The FTB is also bringing on line the Business Entities E-File (‘BEEF’) system. Although the program was not started until January 2006, budgetary savings should materialize in the near future.

Based on information provided by the department, we recommend that the Legislature reduce FTB’s budget by $200,000 for 2006-07. We also recommend that the Legislature require the department to report at hearings regarding (1) the discrepancy between forecast and likely budget savings associated with increased e-filing in 2006-07, and (2) the status of the FTB’s BEEF program and the timing of additional budgetary savings.

Return to General Government Table of Contents, 2006-07 Budget Analysis