Analysis of the 2007-08 Budget Bill: General Government

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 corporation tax (CT) programs and—with the assistance of the Employment Development Department—California’s personal income tax (PIT). The FTB also administers the Homeowners’ and Renters’ Assistance Programs. In addition, FTB administers several nontax-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, and the State Controller. An executive officer, appointed by the board, administers the daily operations and functions of FTB.

The Governor’s budget proposes $623 million ($518 million General Fund) and 5,175 positions in support of FTB’s operations. Compared to the current-year budget, this represents a decrease of $140 million (18.3 percent) and a General Fund decrease of $44 million. The decrease from the General Fund is due almost entirely to reduced support of $39.2 million for the California Child Support Automation System.

The budget proposes increases for several initiatives to close the state’s tax gap ($19.6 million General Fund), ongoing activities associated with court-ordered debt collection programs ($2 million in special funds), investment in e-commerce portal infrastructure ($1.5 million General Fund), additional legal support for abusive tax shelter workloads ($1.3 million General Fund), and a telephone customer service augmentation ($1.3 million General Fund). These increases are partially offset by decreases due to one-time cost reductions, expiring programs, and lease-revenue bond debt-service adjustments.

Narrowing the Tax Gap


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 voluntarily 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 the PIT and CT at $6.5 billion annually.

Multipronged but Targeted Enforcement Approach Needed. The FTB and federal officials indicate that the tax gap is most associated with certain types of activities, taxpayers, and occupations—suggesting that particular targeted efforts should be made to best address the gap and limit the associated revenue losses. More than two-thirds of the gap results from underreporting of income (such as failure to report “off-the-books” income), while the remainder of the gap can be attributed to 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 certain other income) and the absence of third-party reporting (two major categories of such reporting include interest and dividends paid by financial organizations).

Recent Pilot Programs. The FTB has been pursuing various areas of tax noncompliance. For example, as part of the 2005-06 Budget Act, the Legislature approved six two-year pilot programs (at a cost of $13.6 million and 175.5 positions), which expanded FTB’s ongoing efforts in the following areas: (1) detecting preparers filing fraudulent returns with fictitious refundable credits, (2) developing additional information to detect PIT nonfilers, (3) conducting underground economy criminal investigations, (4) pursuing audit cases down to a four-to-one benefit-cost ratio (BCR), (5) targeting collection enforcement activities down to a three-to-one BCR, and (6) engaging in discovery audit activities to enhance the department’s ability to detect underreporters. The pilot programs were successful at bringing in $56.3 million of additional General Fund revenue in 2005-06, an increase of $4.5 million over the original estimates. The 2007-08 budget proposes to make these pilot programs permanent. The FTB projects that these programs will produce $64.7 million in revenue at a cost of $13.6 million and 180.5 positions in 2007-08. The BCRs for these continuing initiatives are shown in Figure 1.


Figure 1

Tax Gap: Continuing Initiatives


Average Benefit/ Cost Ratioa

Detection of preparers filing fraudulent returns


Additional information sources to identify nonfilers


Underground economy criminal investigations


Audit staff augmentation


Collections staff augmentation


Discovery audit activities



a  When programs are fully implemented.


Governor’s 2007-08 Proposal

The administration proposes four new tax gap initiatives for the budget year. These proposals would add 49.5 positions, at a General Fund cost of $6 million. As Figure 2 shows, the four new initiatives are projected to generate $12.8 million in additional revenue in 2007-08, tripling to almost $40 million by 2009-10.


Figure 2

Tax Gap: New Initiatives

(Dollars in Thousands)



2007‑08 Costs



Average Benefit/
Cost Ratio 2009‑10








Independent contractors








Corporate nonfilers








Out-of-state tax avoidance























The four programs would:

Recommend Reallocation of Tax Gap Efforts

We recommend that the Legislature redirect some proposed budget-year spending on tax gap enforcement activities in order to increase their payoff in terms of General Fund revenues.

Given the large tax gap, we believe the administration’s proposal to commit additional resources toward this problem is appropriate. It is, however, important to invest state resources where returns are greatest. Below, we identify areas in both the continuing and new tax gap programs where the state could get a bigger revenue bang for its enforcement buck.

Continuing Initiatives. With regard to the continuing initiatives, several programs that are funded would produce BCRs at or below 5:1, including (1) expansion of underground economy criminal investigations, and (2) augmentations to collections staff. We recommend instead that $3 million allocated to these programs be redirected to the identification of nonfilers. The FTB indicates this initiative will have a BCR of 11.5:1 when fully implemented. (We do not recommend shifting resources away from the discovery audit program because investment in this program can improve audit selection.)

New Initiatives. Similarly, revenues associated with proposed investigations are based on increased voluntary compliance due to media coverage of these cases. As such, these revenues are much more speculative than revenues expected from other programs. Consequently, we recommend that $600,000 be redirected from the investigations staffing to the program targeting corporate nonfilers.

We also recommend two other changes to the budget’s new proposals. First, the request reflects a shift in approach towards what FTB describes as “softer” tax gap efforts—including a focus on taxpayer education and direct outreach activities. While we agree that taxpayer education is important, we believe that tax gap efforts should be principally enforcement based. Accordingly, we recommend that the resources proposed for some of the new initiatives be reallocated to achieve greater benefit to the state’s General Fund. Specifically, the initiative targeting independent contractors would expend roughly one-half of the resources on education and outreach. We recommend instead that these types of expenses be limited to no more than 25 percent of the staffing request.

Second, the administration’s initiative targeting out-of-state tax avoidance includes a feature which would forego penalties even if an audit is completed and noncompliance identified. Penalties are assessed to both serve as a deterrent of future noncompliance and to recoup some of the audit costs from those noncompliant taxpayers. As such, we recommend that the board continue to assess the appropriate penalties when noncompliance is uncovered as a result of an audit.

Figure 3 shows our recommended allocation of resources among tax gap programs as compared to the administration’s proposal.


Figure 3

LAO Recommended Adjustments to Tax Gap Proposalsa

(Dollars in Thousands)


Governor's Budget















Additional information sources to
identify nonfilers






Underground economy criminal






Collections staff augmentation












Independent contractorsb






Corporate nonfilers



















a  Only those initiatives where we recommend changes are shown.

b  While there is no dollar difference, LAO's proposal would redirect more funding to audit activity and less to education and outreach.


Impact of LAO Recommendations. If the Legislature adopted our recommended changes to the proposed tax gap initiatives, the board would still be spending the same overall amount on these activities as proposed in the budget. We believe, however, that our approach would generate considerably more revenue to the General Fund, potentially in the tens of millions of dollars annually.

E-Services Save Time and Money

We recommend that the Franchise Tax Board’s (FTB’s) budget be reduced to account for savings associated with increased use of business entity electronic return processing, electronic remittance processing, and associated reductions in the amount of paper printing and mailings. (Reduce Item 1730-001-0001 by $500,000.)

The FTB has made considerable strides in electronic remittance and return processing. 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 staff hour. By comparison, only 62 paper remittances are processed per staff hour. This cost differential should translate 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 as society becomes increasingly computer oriented. The department reports that it expects 9 percent annual growth in electronic remittances through 2008, and 4 percent to 7 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 budget has been reduced almost every year since 2001-02. These annual reductions ranged from $400,000 to about $1 million.

The 2007-08 budget includes savings of $298,000 due to increased PIT electronic filing. However, no budget reductions were proposed related to increased electronic remittance processing or reductions in mailed and printed tax forms and booklets due to more use of online forms and other information. The board is also expanding the Business Entities E-File (BEEF) system, but did not account for any savings associated with increased electronic filing of BEEF returns.

LAO Recommendation. Based on information provided by the department, we recommend that the Legislature reduce FTB’s budget by $500,000 for 2007-08 to account for savings associated with increased use of business-entity electronic return processing, electronic remittance processing, and associated reductions in the amount of paper printing and mailings.

Customer Service Level Deficiency Is Seasonal

We recommend that the Legislature reduce the augmentation for the Franchise Tax Board’s Contact Centers by $724,000 (General Fund) because it does not provide adequate justification for the higher permanent staffing level. (Reduce Item 1730-001-0001 by $724,000.)

Background. The FTB provides taxpayers with several ways to access tax-related information. One such mechanism is its Taxpayer and Tax Practitioner Contact Center, which provides assistance to taxpayers with general information on tax laws, filing requirements, return preparation, forms requests, and other services. Calls to the Contact Center are first answered by the department’s Integrated Voice Response (IVR) system, which is an interactive system that uses prompts and keyed-in responses from the taxpayer to provide tax-related information and services. These include (1) providing refund status, payment, balance due, and other account information; (2) ordering forms; and (3) answering frequently asked tax-related questions. Prompts from the IVR system are available in both English and Spanish for both PIT and CT filers, and 100 percent of all calls are answered immediately by the IVR system. Taxpayers who indicate that they do not want to interact with the IVR system are then routed to personnel in the Contact Center. Several budget reductions in the past few years have reduced staffing levels in the center by roughly 80 positions (approximately 28 percent).

Governor’s Budget Proposes to Partially Restore Staffing Levels. This proposal requests funding of $1.3 million (General Fund) and 27 permanent positions to partially restore staffing levels in the Contact Center.

Governor’s Proposal Lacks Justification for Permanent Staffing. On a month-to-month basis, Contact Center personnel respond to 83 percent of all calls routed by IVR—excluding the high-volume call times of May through August. However, during these four high-volume months, the center responds to just 50 percent of callers. (The other half never actually speak with a live agent—some hang up while waiting for a live agent to become available, while others are not able to get in the queue for a live agent due to high-call volumes). We agree that additional support to the department in conjunction with these high-volume months would be appropriate. However, we find that the administration’s proposal to add 27 full-time staff overstates their need. Rather, to reduce wait times on calls and improve taxpayer access during the busy months, we recommend that the Legislature authorize the equivalent of 35 positions for the high-volume call period. (The board could use either permanent intermittent staff or temporary help during this time.) This approach would result in savings of $724,000 (General Fund) relative to the budget proposal.

Delete Augmentation of Legal Support for Abusive Tax Shelters

We recommend that the Legislature delete $1,330,000 and ten positions from the budget’s request to provide additional legal support for Abusive Tax Shelter workloads as the Franchise Tax Board has not adequately justified the staffing increase. (Reduce Item 1730-001-0001 by $1,330,000.)

Background. In recent years, the prevalence of illegal or “abusive” tax shelters (ATSs) has increased dramatically, resulting in substantial revenue losses in California. In an effort to curb ATS activity, the Legislature enacted Chapter 654, Statutes of 2003 (AB 1601, Frommer), and Chapter 656, Statutes of 2003 (SB 614, Cedillo). This legislation established a number of programs to penalize the use of ATSs and to discourage their further use. The statutes (1) provided for a limited amnesty for participants in certain ATSs through a Voluntary Compliance Initiative (VCI), (2) created new ATS-related penalties and reporting requirements, and (3) expanded the state’s ability to take legal action against ATS participants.

The VCI was implemented to provide taxpayers who participated in an ATS an opportunity to voluntarily amend their tax returns before harsher penalties became effective. To support the VCI, seven legal positions were dedicated to the department’s ATS task force. Subsequently, in 2006, FTB reclassified seven audit positions into seven legal-related positions, bringing total legal ATS resources to 14 positions.

Governor’s Budget Proposal. The budget requests an augmentation of $1.3 million (General Fund) and ten legal positions for the ATS program. The budget maintains that the positions are needed to assure that the state will generate the level of ATS-related audit revenues already assumed in the budget.

Concerns With the Proposal. As we have noted in the past, ATS transactions can be incredibly complex. As such, it is important for the board to have adequate legal support for its enforcement efforts. The budget request, however, would result in a more than tripling of ATS-related legal staff from the level authorized in the 2006-07 Budget Act. As noted above, the board doubled its ATS-related legal staff in the fall of 2006 by reclassifying seven auditors to attorneys. Given the short amount of time these additional resources have been in place, it is too soon to evaluate the benefits of these existing ATS legal positions—let alone assess the worth of ten additional positions. Therefore, we recommend the Legislature delete the proposed augmentations of ten positions, for a savings of $1,330,000 (General Fund). This would give FTB time to develop better information on the relative benefits of adding ATS-related legal staff versus other compliance positions (such as auditors).

Tax Agency Information and Data Exchange

As discussed in the “General Government” “Crosscutting Issues” section earlier, improved information and data exchange among the several state agencies that administer, collect, and enforce California’s taxes would benefit the state. In that section, we summarize the findings of a report we recently prepared on this topic at the request of the Legislature and with inputs from the tax agencies involved. We also recommend that the tax agencies, including FTB, report at budget hearings on what actions they have undertaken or are planning to undertake in conjunction with our report’s findings, and on other specified matters relating to tax-agency information and data exchange.

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