California: State Auditor studies how to get the most out of corporate tax breaks
In fiscal year 2013-14, corporate income taxes contributed about 8 percent to California’s General Fund, or $8.5 billion, and were the third largest source of revenue. The first and second largest revenue sources were personal income taxes, at about 65 percent, or $66.2 billion, and sales and use taxes, at about 22 percent, or $22.2 billion, respectively.
The California State Auditor released its findings last week, in response to a request by the Joint Legislative Audit Committee (Committee) to assess the benefits and cost-effectiveness of certain corporate tax breaks. In its April 2016 Corporate Income Tax Expenditures (Report), the Auditor found that regular evaluation of corporate income tax expenditures would improve their efficiency and effectiveness. These tax expenditures, which are defined as tax benefits for qualifying corporations, consist of tax exemptions, deductions, credits, and exclusions, and cost the state more than $5 billion in forgone revenues for fiscal year 201213.
For its Report, the Auditor studied six tax expenditure programs. These were selected because they have (1) the highest forgone revenue and are at least partially unique to California; (2) at least three years of tax data were available; and (3) the Legislature has not yet repealed or allowed them to sunset.
The Report contains a table showing each program and the foregone revenue associated with it in fiscal year 2012-13:
|TAX EXPENDITURE PROGRAM and DESCRIPTION||PURPOSE||FOREGONE REVENUE IN FISCAL 2012-13 IN MILLIONS|
|Subchapter S corporation election:
Offers businesses an alternative to the standard Subchapter C corporation filing status
|To simplify the tax preparation process by conforming with federal legislation, and to allow state businesses to be competitive with those located elsewhere.||$220|
|Water’s edge election:
Allows multinational corporations to limit their taxable base to income derived from sources within the U.S.—which excludes earnings or losses from foreign portions of their business.
|To provide corporations an option not to be subject to tax on their worldwide income.||$700|
|Low income housing credit:
Provides funding for developers that rehabilitate existing housing or construct new projects to construct low-income housing in California. The state credit generally requires developers to use it in conjunction with a federal lowincome housing credit.
|To fund low-income housing that would otherwise not be economically viable.||$50|
|Film and television credit:
Encourages film and television production in California by providing credits to production companies seeking to film in the State.
|To increase production spending, jobs, and tax revenues in the State.||$100|
|Research and Development Credit (R&D): Allows corporations to claim a portion of their R&D expenses as a credit, which reduces their tax liability, based on the amount they spent on R&D conducted in California.||To increase R&D activity in California.||$1,500|
|Minimum franchise tax exemption:
Exempts every corporation that incorporates or qualifies to do business in California on or after January 1, 2000, from paying the minimum franchise tax for its first taxable year. Although some entities that are deemed tax-exempt can claim this exemption, like churches and nonprofits, only corporations doing so are included in this study.
|To encourage new businesses to incorporate in California.||$45|
According to the Report, the subchapter S corporation election is the only program that “appears to be achieving its purpose.”
The Auditor determined that three of the programs, the water’s edge election, the low-income housing credit, and the film and television credit “appear to be achieving their purposes, but could be improved.”
For the remaining two programs, the R&D credit and the minimum franchise tax exemption, the Auditor found that “a lack of oversight or evaluation has resulted in insufficient evidence to determine if they are fulfilling their purposes.”
Benchmarking to improve California’s programs
As part of the audit, the Auditor studied how other states oversee their tax expenditures, and identified certain best practices that California does not currently follow. The Report recommends adapting the following oversight practices from Vermont, Washington, Oregon, and Maryland:
- Clearly define and periodically update measurable policy objectives.
In Vermont in 2014, lawmakers adopted legislation that requires all new tax credit bills to include specific goals, purposes, and objectives, and detailed performance indicators that measure whether the tax credit meets its goals, purposes, and objectives. However, the Report noted that this requirement is limited only to tax credits and is not always followed.
- Establish performance measures to help monitor the effectiveness of all tax expenditures.
Washington lawmakers passed a bill in 2013 that requires every new tax expenditure bill to include a performance statement that specifies a legislative purpose and performance metrics to allow the legislature to measure its effectiveness.
- Require comprehensive, systematic evaluations of all tax expenditures by a state entity with the necessary resources for analysis.
Also in Washington, pursuant to a 2006 law, that state’s Joint Legislative Audit and Review Committee now evaluates some tax expenditures over a 10-year schedule that the Citizens Commission for Performance Measurement of Tax Preferences developed.
- Establish sunset dates for tax expenditures to encourage reviews.
In 2009, Oregon lawmakers passed a bill that assigned sunset dates to many tax credits, and designated a default sunset date of six years after the effective date of new tax credits, unless stated otherwise.
- Develop policy-relevant conclusions and recommendations to continue, modify, or repeal each tax expenditure, and connect results to the policymaking process.
In 2012, Maryland established a legislative evaluation committee that is responsible for assessing tax incentives and recommending whether they should be continued, modified, or ended. One example is the review of Maryland’s Enterprise Zone tax credit, which found that it was not effective in creating jobs for zone residents who are chronically unemployed or live in poverty, and recommended that changes be made to better meet the needs of unemployed job seekers in the enterprise zone.
The Report concluded that by consistently following these best practices, existing tax expenditures could be improved while simultaneously reducing the risk of creating new ineffective incentives.