LAO Revenue–Raising Proposals

What Tax Expenditure Programs Could Be Modified or Eliminated to Help Address the State’s Fiscal Situation?

Summary

The Governor’s budget includes almost no new revenue–raising proposals. Given the magnitude of the budget problem, we examine the state’s existing tax structure in the same way as the spending side—with an eye towards reducing inefficient or ineffective provisions. Accordingly, we have examined the state’s numerous tax expenditure programs and recommended that several of them be eliminated or modified. Adoption of our recommended changes would increase state General Fund revenues by $2.7 billion in 2008–09.

The Governor has also proposed a change in the way the state accrues certain tax revenues, which results in a one–time budgetary solution of $2 billion in 2008–09. We examine the administration’s proposal, noting issues about both the basis for doing the additional accrual and the potential amount which could be properly accrued. As a result of these concerns, we do not include this proposal in our alternative budget plan.

The Governor proposes to balance the 2008–09 General Fund budget primarily with expenditure savings—current–year reductions and significant budget–year, across–the–board reductions to virtually all state programs. Two other large solutions—the selling of remaining economic recovery bonds and an accrual accounting change—increase 2008–09 revenues even though California residents would make no additional payments to state government.

There are, in fact, only a handful of provisions in the Governor’s budget–balancing package that increase payments to the state:

• Vessels/Recreational Vehicles/Aircraft. The Governor proposes to reinstate the 12–month standard for applying the use tax to out–of–state purchases of these goods, for an annual revenue increase of $21 million.
• Enforcement. The budget adds personnel to the tax agencies to increase the amount of existing liabilities collected from taxpayers, for a 2008–09 gain of $150 million.
• Insurance Surcharge. The administration proposes to levy a surcharge on all homeowner policies to provide enhanced state firefighting capabilities, with the General Fund benefiting about $45 million each year.
• Fees. The budget also assumes some fee increases—at the state universities and registration fees—but these are not counted as budget solutions. (In our alternative plan, we discuss a number of potential fee increases and how they can be used to address the state’s fiscal problem by offsetting General Fund spending.)

Thus, the Governor’s plan has no significant proposals that increase tax liabilities on state residents.

As we have said in the past, we believe that to successfully address a budget problem of the magnitude the state now faces, it is important to cast the net broadly for solutions. This is especially so recognizing that in good budget times the state both reduced taxes and fees and increased spending commitments. In this section, we discuss proposals that look at the revenue side of the budget. In so doing, we have applied the same approach as with direct spending programs—that is, we have examined tax–related provisions referred to as tax expenditure programs (TEPs)—and recommended changes to those that are not achieving their stated purposes or are of a lower priority. These TEPs are special provisions in law—such as exemptions, deductions, and credits—that attempt to encourage certain behavior or that target relief to specific groups of people or businesses.

The Legislature could, of course, also consider raising monies by increasing the rates on any of its major taxes. For example, a 0.25 percentage rate increase in the sales tax rate would generate about $1.5 billion annually and a 1 percent increase in the corporation tax rate would also raise about $1.5 billion each year. Increasing tax rates, however, can negatively affect taxpayer work and investment decisions at the margin. We have chosen instead to focus on TEPs, which while they do increase payments for particular groups of taxpayers, do not have the same impact on work and investment decisions.

Figure 1 lists the 12 TEPs that we recommend be modified. In the sections that follow, we provide for each program: (1) background on the TEP, (2) our proposed change to the provision, and (3) the rationale for our proposal. We would note that there are many other TEPs that are worthy of modification that we have not included. In some cases this is because of difficult federal conformity issues—such as with the treatment of pension and health care expenditures by employers and employees. In other cases, it is because of timing issues. For example, changes to the mortgage interest deduction would likely have to be implemented over time, therefore not resulting in a significant fiscal impact until well into the future.

Following the write–ups on the individual TEPs, we also include a discussion of the Governor’s proposal regarding the accrual of certain personal and corporate income tax payments.

Tax Expenditure Program Proposals

Reduce the Dependent Credit

Background. Current law provides taxpayers with a nonrefundable personal income tax (PIT) exemption credit for each dependent. In 2007, this credit, which is subject to a phase–out for high–income taxpayers, is $294. This compares to a personal exemption credit, also subject to a phase–out, of $94 for single taxpayers and $188 for couples. Before 1998, the dependent credit was the same as the personal exemption. The dependent credit exemption was increased in two steps by legislation adopted in 1997 and 1998.

Proposal. Make the dependent credit the same dollar amount as the personal exemption credit. Revenue gain of $1.3 billion 2008–09 and $1.1 billion in 2009–10.

Rationale. Exemption credits are usually justified on the grounds that people who raise children or care for others incur extra expenses and therefore have less disposable income from which to pay taxes. There is, however, no consensus as to the “right” amount of such a credit. As noted above, prior to 1998, the state’s exemption credit was set at the same level as the personal credit. Our proposal would reinstate that linkage.

Currently, over 80 percent of the benefits of the credit in excess of the personal exemption amount goes to taxpayers with incomes over $50,000, and about 30 percent to those with incomes over $100,000.

Eliminate the Senior Credit

Background. California grants a special PIT exemption credit, equal to $94 in 2007, for persons aged 65 or over. The credit is in addition to the regular personal exemption credit available to seniors. The credit is not refundable.

Proposal. Eliminate the senior credit. Revenue gain of $125 million in 2008–09 and $130 million in 2009–10.

Rationale. The origin of the senior credit appears to have been related to concerns about the income level of seniors. It is not clear, however, why seniors should receive more favorable treatment than other taxpayers with the same income. California already provides special treatment to seniors by excluding social security income from its calculation of taxable income, saving seniors approximately $1.5 billion per year. Because of this treatment, combined with the state’s relatively high income tax threshold, many seniors do not owe any California income tax. In fact, the senior credit provides a benefit to only about 30 percent of California’s seniors. We believe that because other features of the California tax code provide relief to seniors who need it, the additional senior credit is unnecessary.

Eliminate Partial Exclusion of Capital Gains on Small Business Stock

Background. California excludes from the taxable income of personal income taxpayers 50 percent of the capital gains earned on the qualified sale of small business stock. The exclusion is generally similar to the one offered at the federal level, except that the California exclusion requires that minimum portions of the corporation’s payroll and assets be located in California. The exclusion is only available for stock that was acquired upon its original issuance and has been held for at least five years. For a married couple filing jointly, the exclusion is limited to the greater of $10 million or ten times the stock’s basis. For single taxpayers and married taxpayers filing separately, the limit is smaller.

Proposal. Eliminate the partial exclusion of capital gains on small business stock. Revenue gain of approximately $55 million each in 2008–09 and 2009–10.

Rationale. As described in our March 1999 report on this exclusion, The Partial Capital Gains Exclusion for Qualifying Small Business Stock, this program is intended to reduce the cost of financial capital for qualified small businesses. This report noted, however, that the extent to which the program actually expands the amount of financial capital available to the small business community, and how its benefits are shared, is unknown. It is also unclear why owners of small corporate enterprises should receive more favorable tax treatment than other types of small businesses.

Limit Net Operating Loss Deductions

Background. California allows businesses who experience net operating losses (NOLs) to “carry them forward” on their books and deduct them in future years when their incomes are positive, thereby reducing their tax liabilities in those years. For California purposes, NOLs may be carried forward for up to ten years, and the oldest NOLs must be used first. At the federal level, NOLs may generally be carried back 2 years and carried forward up to 20 years. Most taxpayers that incur NOLs are not able to use them in the following tax year. Since the state started allowing NOLs, only about one–fifth of those incurred have ever been deducted.

Proposal. Limit NOL deductions to 50 percent of a taxpayer’s net income in a given year. Revenue gain of $330 million in 2008–09 and $410 million in 2009–10.

Rationale. The principle of permitting NOL deductions has the most obvious merit in the case of businesses that have highly cyclical profits from one year to the next. For them, NOL deductions can enable their cyclical income to essentially be spread out over a multiyear time horizon, thereby not disadvantaging them in terms of the total taxes they pay over time compared to less–cyclical enterprises. Some people have questioned NOLs, however, as potentially subsidizing economically inefficient business activities and being inconsistent with the view that an annual tax accounting period is a generally appropriate period over which to measure taxable income. The NOLs also tend to complicate budgetary management, since accurately predicting NOL usage has proved very difficult. The NOL deductions have been suspended previously during times of budgetary stress. Limiting NOL deductions to 50 percent of tax liability would provide the benefits of (1) significant fiscal relief to the state, (2) mitigating the immediate loss to taxpayers by still allowing them to receive partial tax benefits currently, and (3) still allowing taxpayers to benefit in the future from the deductions they could not now claim.

Limit the Research and Development Credit

Background. California allows taxpayers a nonrefundable income tax credit for qualified research and development (R&D) expenditures. The calculation of qualified expenditures is generally based on computations used for the federal R&D credit. The credit is available only for incremental expenditures above a baseline amount established in previous years. The credit rate is 15 percent for R&D spending undertaken by the taxpayer, and 24 percent for R&D activity paid for by corporations but undertaken by universities or charitable institutions. California also offers an election for an alternative calculation of the R&D credit based upon the Federal Alternative Incremental Credit. The state credit is generally awarded for expenditures that also qualify for the federal credit and in some cases may be larger than the federal credit. Any credits that cannot be used in a given year because a taxpayer lacks sufficient tax liabilities can be carried forward indefinitely for possible use in future years.

Proposal. Limit the amount of the credits that may be claimed in any one year to two–thirds of a taxpayer‘s liability. Any earned but unused credits could be carried forward for use in future years, as under current law. Revenue gain of $335 million in 2008–09 and $290 million in 2009–10.

Rationale. Economists suggest that some public subsidization of R&D spending makes sense because its level would otherwise be less than the “ideal” amount for society. This is partly because certain R&D activity has characteristics akin to a “public good” in terms of the substantial spillover benefits it can produce for society. These benefits can go well beyond those that accrue directly to the individual taxpayer actually making the expenditures. An example includes some of the electronic discoveries associated with the space program that have found applications over time in all kinds of other industries, such as medicine. However, the current program raises several concerns:

• Federal R&D incentives may already be inducing an optimal amount of R&D activity to occur without the need to provide additional state subsidies.
• The optimal state R&D credit rate, and the effects of the state credit on the total amount of R&D activity in the state, are unknown.
• In the case of those R&D projects that would have been undertaken even if the state did not offer its own credit on top of the federal credit, the state credit produces windfall benefits to select taxpayers but does contribute to the state’s goal of increasing total R&D spending.
• There are now more than $10 billion in unused state R&D credits being “carried–over” to future tax years by taxpayers. Such taxpayers having large carryovers can generally eliminate their California liabilities. For many such taxpayers, however, it seems unlikely that their current and future R&D spending decisions will be influenced by their ability to stockpile even more unused R&D credits.

Limiting the use of R&D credits to two–thirds of a firm’s liabilities, therefore, is likely to save substantial amounts of revenue for the state while having relatively little impact on the policy goal of supporting research activities. Our proposal would not affect the total amount of credits available to a company, as unused credits could still be carried forward to future years.

Additional analysis of the R&D credit can be found in our November 2003 report An Overview of California’s Research and Development Tax Credit. This report noted that arguments in favor of this credit include the possibility of societal spillover benefits, the desire to boost specific types of economic activity (such as in the biotech area), and possible benefits from improvements in the perception of the California business climate. The report found, however, that state–level credits likely are not as effective as federal credits at generating spillovers and that the appropriate level of state credits is unknown. The report ended up recommending that the Legislature consider reducing the credit or phasing it out over time, especially given the substantial direct revenue losses associated with the program and the state’s tight budgetary position at the time.

Phase Out Enterprise Zone Programs

Background. California offers several tax programs that provide benefits only to taxpayers affiliated with designated areas of the state. (These are typically blighted areas in need of economic redevelopment.) Tax programs for these areas include hiring credits, wage credits, credits for sales taxes paid on purchases of certain machinery, exclusions of interest earned on qualifying loans to businesses, and expensing of qualified business investments. Current law allows for the designation of 42 enterprise zones (EZs) as areas qualifying for these treatments. Zone designations are for 15 years, with some zones having received an additional five–year extension. More recently, Chapter 718, Statutes of 2006 (AB1550, Arambula), enabled roughly 20 EZs whose designations had expired to be redesignated as EZs for an additional 15 years. Thus, many EZs have now been in existence for more than 20 years.

Proposal. Cancel the recent redesignations of EZs and deny future extensions for all other EZs. Revenue gain of about $100 million in 2008–09 and $120 million in 2009–10.

Rationale. Many studies of EZs question whether they are efficient or cost–effective tools for improving the economic conditions of the targeted areas. Our December 2003 report, An Overview of California’s Enterprise Zone Hiring Credit, concluded that EZ incentives have little, if any, impact on the creation of new economic activity or employment, but that they can be effective in shifting activity into the EZ that otherwise would have occurred elsewhere in the same geographic region. As noted above, many EZs have already been in effect for many years. It is not clear what additional benefits will be gained by extending the same incentives that have already been in place for as many as 20 years. Rather, other redevelopment policy tools could be more effective than extended use of EZ tax incentives.

Eliminate Exclusion for “Like–Kind” Out–of–State Property Exchanges

Background. California permits investors to exchange business or investment property for property of a like kind without paying any capital gains that might have accrued on the first property. A similar federal program also exists. Commonly referred to as Section 1031 exchanges, these nontaxed transactions can be repeated over time, with the tax on the accumulated capital gains from all transactions not assessed until the final property is eventually sold. These tax–free exchanges are allowed even when in–state property is exchanged for out–of–state property. Subsequent sales of out–of–state property, which ought to trigger deferred capital gains taxes, are rarely, if ever, reported to California. Such factors as the absence of a California estate tax, the stepped–up basis rule for real estate, and the ability to move assets into family trusts without property tax reassessments, also interact with these exchanges to enable many capital gains to go untaxed.

Proposal. Eliminate the income tax exclusion for capital gains on like–kind exchanges involving out–of–state commercial property. Revenue gain of approximately $25 million in 2008–09 and $50 million in 2009–10.

Rationale. Capital gains on real property transactions constitute the income earned from such activities and as such should be taxed, just like other types of income. It can be argued that these taxes should be deferred until the investment is ultimately liquidated. We see no justification, however, for allowing these gains to escape taxation completely. Given the administrative difficulty in taxing these gains once the exchange involves an out–of–state property, we recommend that existing law be amended to capture these gains.

Eliminate Exemptions for Industry–Specific Equipment

Background. California currently exempts equipment used in farming and timber harvesting (adopted in 2001), and post–production activity for television and films (adopted in 1998) from the state portion of the sales and use tax (SUT).

Proposal. Eliminate these partial SUT exemptions. Revenue gain of $143 million in 2008–09 and $146 million in 2009–10. Figure 2 shows the breakout of these amounts by type of equipment.

Rationale. In these situations, it is clear that the owner of the equipment is the final user of the product. As such, in California, the normal practice is that a final user of an item must pay the SUT at the time it is purchased. Therefore, for consistency in the application of the SUT law, these transactions would be subject to paying the full SUT rate. The arguments that have been offered for this type of exemption vary depending on the type of equipment involved. Regarding farming equipment, one argument is that in–state sellers of equipment have a competitive disadvantage relative to out–of–state sellers, who rarely face enforcement of the state’s use tax. In the case of post–production activity, the need to keep businesses from leaving California has been raised. As a general tax policy, however, we believe that all industries should be treated similarly, and it is not clear that these particular industries are more deserving of tax exemptions than a variety of other industries in the state.

Eliminate Certain Diesel Fuel Exemptions

Background. California currently exempts the excise tax portion of the price of diesel fuel from sales taxation. In addition, all diesel fuel used for farming activities is exempt from paying the SUT.

Proposal. Eliminate SUT exemption on diesel fuel excise taxes and for diesel fuel used in farming activities. Revenue gain of $73 million in 2008–09 and $75 million in 2009–10. A statutory change would be required to deposit these revenues in the General Fund. Figure 3 shows the breakout of these amounts by component.

Rationale. Both gasoline and diesel fuel are currently subject to fuel excise taxes. However, only gasoline is subject to sales tax on the excise tax portion of the price. This is because, previously, administrative complications prevented the collection of sales tax on the excise tax portion of diesel fuel. Now, however, due to the actions of past legislation changing the point where the excise tax is levied, this is no longer a valid concern. For this reason, there is no reason why diesel fuel should be treated differently than gasoline. In regards to the exemption for diesel fuel used in farming activities, one of the arguments offered in favor of this exemption is the need for California agriculture to be subsidized to help compete with interstate and international agricultural rivals, and to help farming remain economically viable in the face of increasing pressures to develop farm land for urban purposes. There are preferred options for dealing with these issues, however, including local land use policies.

Eliminate Exemption for Leasing of Films and Tapes

Background. California currently exempts from the SUT the leasing of motion picture and television films and tapes.

Proposal. Eliminate SUT exemption. Revenue gain of $65 million in 2008–09 and $70 million in 2009–10.

Rationale. Supporters of this program argue that it is needed to help maintain the profitability of the film industry in California and encourage production activities to stay in the state rather than relocate to other states and countries. We have two main concerns with the exemption. First, it is unclear why this industry is more deserving of such a subsidy than the many firms in other industries that also are mobile and can relocate elsewhere. Second, other lease transactions are generally subject to the SUT, so eliminating the exemption would make for a more consistent application of the tax.

Eliminate Exemption for Custom Computer Programs

Background. California currently exempts sales of custom computer programs from the SUT. These are programs not produced in mass but rather customized for the client to carry out specific types of applications.

Proposal. Eliminate SUT exemption and tax the sales value of custom computer programs. Revenue gain of $53 million in 2008–09 and $48 million in 2009–10 after adjusting for likely behavioral responses by taxpayers.

Rationale. The argument commonly made in favor of the exemption is that the value of such custom programs reflects largely the programming–related services provided to the purchaser. Thus, it concludes that since services are generally not subject to the SUT, neither should such custom programs. However, this argument could be applied to a wide variety of other items that are subject to the SUT, including “off–the–shelf” computer programs, books, musical recordings, and paintings. In fact, any physical item embodying a large amount of services might also arguably fit this criterion. Eliminating this exemption would therefore result in somewhat more consistency in the way the SUT is applied. As a general policy, special tax exemptions should not be given for specific industries or commodities.

Adopt One–Year Use Tax Standard on Selected Out–of State Purchases

Background. State law requires that a use tax be paid on goods purchased out–of–state for use in California. For purchases of vessels, vehicles, and aircraft, such items are deemed to be for use in the state if they are brought into California within 90 days of their purchase. Otherwise, no use tax is owed, even if they are permanently used here once the 90 days have passed. For a recent two–year period, California adopted a one–year standard for this purpose. In our statutorily required report Out–of State Purchases: California’s Taxation of Vessels, Vehicles, and Aircraft (April 2006), we found that the change increased state revenues, and the associated adverse economic impact was not particularly large, and recommended that the one–year criterion be made permanent. However, that law was not extended last year when it sunset.

Proposal. Reinstate the one–year standard for determining when items purchased out–of–state are subject to the use tax. This change is also proposed in the 2008–09 Governor’s Budget. Revenue gain of $21 million annually, beginning in 2008–09.

Rationale. Using a 90–day period is too short to reliably determine where an item such as a vessel, vehicle, or aircraft will actually be used on an ongoing basis. Evidence exists of the purchasers of items, such as expensive yachts, arranging to keep them out of state until the 90 days have passed, sometimes using the large use tax savings involved to help finance recreational stays in such places as the coast of Mexico until the qualifying period is up. Based on our review, the one–year period eliminated much of this tax–avoidance behavior.

Proposal to Accrue Estimated Tax Payments

The administration is proposing to make an accrual change that would result in a “paper shift” of $2 billion in tax revenues from 2009–10 back into 2008–09 to help balance the budget. This amount represents one–third of the September 2009 estimated tax payments projected to be made under the PIT and the Corporate Tax (CT). Under current law, these revenues would be counted in 2009–10 when they are received. The administration argues, however, that this $2 billion in taxes is really attributable to economic activity that will take place in June 2009, and thus deserves to be counted in 2008–09. The proposal would affect neither the amount of taxes paid nor when they are due, but only the year in which they are scored for budgetary purposes. For future years, the same accounting change would also apply. Thus, for 2009–10 the loss of revenues shifted from September 2009 to 2008–09 would be offset by revenues shifted into 2009–10 from September 2010. The practical result would be a one–time $2 billion increase in 2008–09 revenues, which is a significant solution in the Governor’s budget plan.

Does the Proposal Make Sense?

In evaluating the proposal there are two key questions to ask:

• First, is the proposal consistent with sound governmental accounting standards?
• Second, is the $2 billion accrual amount reasonable?

The Accounting Standards Issue

The Rules for Accruals. In order to determine how to allocate revenues between fiscal years, governments use what are referred to as “accrual” rules. In principle, these rules attempt to allocate revenues to the fiscal year in which the economic and financial activity giving rise to them occurs. Because it can be difficult to identify in all cases exactly what these transactions are on a month–to–month basis, simple “second best” accrual rules have been adopted for practical purposes. These rules govern the way in which tax payments are moved from the year when they are actually received to when the activity that produced them happened. Under current law, the general rule is that revenues can be accrued to a previous fiscal year if (1) the underlying activity to which they are attributable occurs prior to the end of that previous year and (2) the due date for the tax is within two months of the previous year’s end. The administration would change this rule by eliminating the two–month standard and replacing it with the requirements that the amount of any accrued revenues be (1) measurable and (2) received in time to pay current year–end liabilities.

Proposal Has Inherent Problems. We agree with the administration that some of the estimated tax payments received in September of a given year are due to economic and financial activity occurring in the preceding June. The question, however, is if this activity is measurable. For example:

• In the case of the CT, the tax is imposed on a year’s net taxable corporate profits, and requires a complicated calculation involving a firm’s income, expenses, credits, net operating loss deductions, alternative minimum tax, and various other items over an entire 12–month period. Many of the individual elements in the computation are not even calculated or identifiable on a monthly basis, such as those relating to products produced or costs incurred.
• In the case of the PIT, the individuals making estimated payments tend to be those having income other than normal wage and salary income subject to monthly withholding. Thus, most of the estimated payments relate to such income as business income, proprietor’s and partnership income, capital gains, stock options, investment income generally, and other types of income not subject to withholding. Given its nature, much of this income also can be difficult to estimate and/or keep track of on a monthly basis.

Given the above, we conclude that the “measurable” criterion may be difficult to meet.

Proposal Also Might Require Other Accounting Changes. Apart from the above problems, if the administration’s proposal is adopted, its principle should arguably be applied consistently to all types of payments, not just those estimated tax payments made in September. For example, each year, many taxpayers overpay their state income tax and receive refunds in the spring of a fiscal year. This means that some of the money included in estimated payments made in the prior April and June—and counted in the prior fiscal year—was higher than necessary. To apply the administration’s reasoning consistently, adjustments would also have to be made to reduce certain estimated payments, thereby lowering the amount of budgetary solution from this proposal. Various other adjustments—such as to final payments (revenues) and Medi–Cal (spending)—would have to be made in order for the proposal to be consistent in its implementation.

The Proposal’s Accrual Amount Is Overstated

Even if the Legislature decided to adopt the administration’s accrual proposal, we believe that assigning one–third of each September’s estimated payments to the previous fiscal year would be much too high a share. As a result, the administration’s estimated $2 billion revenue effect for the proposal is seriously overstated.

Few September Payments Are for June Income. There are two different ways that taxpayers may calculate estimated tax payments. Under one method, taxpayers track income on a monthly basis and make estimated payments quarterly based on the resulting liabilities. Under the other, much simpler method, taxpayers calculate an annual liability and make four, equal quarterly payments (generally in January, April, June, and September). The administration’s proposal assumes that most estimated payments are of the first type. If true, it would be appropriate to accrue a portion of September estimated payments back to June as there would be measurable evidence for income actually earned in that month. Data on estimated payments suggests, however, that most taxpayers make estimated payments based on the second method. As such, most income attributable to June is already being captured in the June 15 estimated payment, not the September 15 estimated payment. As a result, we estimate that, if the budget proposal were adopted, the appropriate amount to accrue would be in the hundreds of millions of dollars—not the $2 billion estimated by the administration.

Conclusion

We agree in principle with the administration that some portion of September 2009 revenues in 2008–09 is associated with June 2009 economic activity and therefore could be accrued to the budget year. However, there are serious concerns as to whether this potential accrual amount is based on a measurable underlying activity and as to the amount of the accrual. Given these concerns, we have not included the accrual proposal in our alternative budget plan laid out in this part of the document.