Analysis of the 2008-09 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 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 FTB.

The Governor’s budget proposes $650 million ($554 million General Fund) and 5,348 personnel–years (PYs) in support of FTB’s operations. Compared to the current–year budget, this represents a decrease of $45 million (6.5 percent) in total funding, but a General Fund increase of $19 million. The budget proposes increases for several measures to close the state’s tax gap ($16 million General Fund), continued implementation of the Child Support Automation System project ($7.9 million General Fund), ongoing activities associated with expansion of the court–ordered debt collection programs ($3.9 million in special funds), and various information technology improvements ($1.6 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.

Additional Revenues From Closing the Tax Gap

Administration’s Revenues Scored Too Low

We recommend the Legislature score additional General Fund revenues of $100,000 in 2008–09 and $2.1 million in 2009–10 due to technical miscalculations in the administration’s tax gap budget proposal.

Background. There is a significant 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. 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).

Governor’s Proposals. The administration requests funding of $16 million from the General Fund and 197 positions for 2008–09 to develop additional tax gap initiatives. Specifically the proposals would:

• Fund a variety of efforts to increase tax compliance ($9.9 million and 132 PYs).
• Provide additional audit resources ($4 million and 35 PYs).
• Increase fraud prevention efforts in the areas of claims for the child dependent care credit and W–2 fraud ($2.4 million and 30 PYs).
• Fund a compliance behavior study on the effect of FTB’s various compliance activities on taxpayer behavior ($100,000).

The administration estimates that the proposal would generate General Fund revenues of $93 million in 2008–09 and $164 million in 2009–10.

Revenue Estimate Is Understated. Due to technical miscalculations, the administration’s revenue estimate does not account for all revenues generated by the proposed fraud prevention efforts. Based on our review, we recommend the Legislature score an additional $100,000 in General Fund revenues in 2008–09 and an additional $2.1 million in General Fund revenues in 2009–10, and annually thereafter.

Recommend Additional Efforts

We recommend that the Legislature appropriate an additional $3.9 million to the Franchise Tax Board to fund four additional tax gap enforcement efforts. These efforts would generate an additional $58 million in 2008–09 General Fund revenues. (Augment Item 1730–001–0001 by $3.9 million.)

Recommend Additional Tax Gap Efforts. In addition to the PIT gap initiatives identified by the administration, we recommend the Legislature provide an additional $3.9 million of General Fund support for four additional PIT gap initiatives. We describe each of these proposals below. In total, we estimate that these proposals would provide more than $50 million in additional General Fund revenues annually, as summarized in Figure 1. In the BOE write up in this chapter (Item 0860), we recommend a $5 million General Fund reduction to the administration’s tax gap proposal. Combined between the two tax agencies, therefore, we recommend spending slightly less than the administration—yet with the benefit of tens of millions of additional dollars in revenues.

Increased Number of Revenue Agent’s Reports. The Internal Revenue Service (IRS) has recently dedicated additional resources targeted toward high–income taxpayers, particularly those that work for themselves and do not have an employer that withholds income taxes. Compared to 2006, the IRS in 2007 audited 14 percent more taxpayers with incomes of $100,000 or more, 29 percent more taxpayers with incomes of $200,000 or more, and 84 percent more taxpayers with incomes of $1 million or more. The IRS plans to further increase the number of these audits in 2008. The computation of a taxpayer’s state PIT liability generally begins with federal taxable income (subject to state–specific adjustments). The adjustments to federal taxable income that result from the increased federal audits, therefore, will almost always result in additional state PIT liability. When an adjustment to a filed federal income tax return is proposed as a result of an IRS examination and audit, the notice of the proposed adjustment is called a Revenue Agent’s Report (RAR). All RARs are automatically shared with FTB. We recommend that the Legislature provide additional resources to FTB in order to focus on the additional RARs generated by the federal audits. An investment of $2.5 million would generate an additional $40 million in General Fund revenues in 2008–09, and annually thereafter.

RAR Backlog. The FTB also has a backlog of previously issued RARs. By providing additional resources for overtime pay, approximately $6 million in General Fund audit revenues could be accelerated to the budget year on a one–time basis. The proposal would have a General Fund cost of approximately $200,000 in 2008–09.

Additional Out–of–State Audit Workload. The FTB’s out–of–state offices currently have audit workloads that are not being addressed. By allocating additional resources for auditors in FTB’s field offices, these audits could be completed. The proposal would have a cost of approximately $1.1 million in 2008–09, and would raise an additional $10 million in General Fund revenues in 2008–09, and annually thereafter.

Modify Group Income Tax Return Provisions. Currently, California allows certain nonresidents who receive income from a pass–through entity (partnerships or S corporations) that derives income from California sources or is doing business in California to elect to have the pass–through entity file a group nonresident return on their behalf. The rationale for this practice is to make filing state returns more convenient. To take advantage of this filing procedure under current law, individuals must (1) be full–year nonresidents of California and (2) not have California taxable income in excess of $1 million. We recommend that the Legislature amend current law to expand who can file a group nonresident return. Primarily, this would involve authorizing individuals with more than $1 million in California taxable income to file a group return. By authorizing a pass–though entity to submit a return, more nonresidents who are not currently filing returns should begin to file via a group return. In addition to increasing General Fund revenues, this proposal would increase revenues to the Mental Health Fund (Proposition 63) from those individuals with more than $1 million in taxable income. The proposal would have a one–time General Fund cost of $101,000 in 2008–09 and would provide additional revenues of $6 million ($2 million General Fund) in 2008–09, increasing to $13 million ($6 million General Fund) in 2009–10, and annually thereafter.