Summary
Results in Brief
Corporate income tax expenditures (tax expenditures), which are tax benefits for qualifying corporations, cost the State more than $5 billion in forgone tax revenue in fiscal year 2012–13, the most recent year that complete tax data were available. Tax expenditures are defined as exceptions to the normal tax structure that can have the same effect as government spending programs. They are intended to achieve a public policy purpose, such as to improve industry competitiveness, alter taxpayer behavior, or provide tax relief to spur economic growth. Tax expenditures include exemptions from certain taxes, deductions from taxable income, credits that reduce total tax liability, exclusions that do not tax certain income, and elections that allow a choice in how taxes are calculated. In each case, the State forgoes tax revenue that it would otherwise collect, which results in reduced funding available for government activities.
We reviewed how other states oversee their tax expenditures and identified some best practices that are not consistently followed in California. Adopting oversight methods used by other states would improve the effectiveness of the State’s current and future tax expenditures, providing the Legislature with more information and a better accounting of the effectiveness and impact of these tax expenditures. These practices include the use of clearly stated policy objectives to define the Legislature’s intent in enacting the tax expenditures, corresponding performance measures, sunset provisions to prompt legislative review and to create the ability to more easily modify or repeal them if needed, and an evaluation process that creates recommendations that tie back to the Legislature’s policymaking process. By consistently following these best practices, existing tax expenditures could be improved while simultaneously reducing the risk of creating new ineffective incentives.
We reviewed six of the largest California state‑only tax expenditures for the most recent three years for which complete tax data were available.1 We selected these tax expenditures from the Department of Finance’s tax expenditure reports and found that five of them required additional study to determine whether they were achieving their purposes or whether they could be improved to be more effective. In total, the six tax expenditures we reviewed cost the State more than $2.6 billion in forgone revenue for fiscal year 2012–13.
For two of the tax expenditures—the research and development (R&D) credit and the minimum franchise tax exemption (franchise exemption)—a lack of oversight or evaluation has resulted in insufficient evidence to determine if the two expenditures are fulfilling their purposes. The R&D credit allows corporations to claim a portion of their R&D expenses as a credit, thus reducing their tax liability. The franchise exemption waives the $800 minimum franchise tax imposed on all corporations during their first year of business. Economic literature provides conflicting evidence on the effectiveness of state‑level R&D credits for stimulating additional state R&D activity and on how well small state‑level tax reductions—like the franchise exemption—can affect such economic activity as business formation. Without appropriate evidence to confirm these tax expenditures’ effectiveness, it is not clear that the amount of forgone revenue associated with these two tax expenditures—$1.5 billion alone for the R&D credit in fiscal year 2012–13—is cost‑effective, or if these funds could be better allocated to fulfill the same or similar policy objectives.
Three other tax expenditures—the water’s edge election, the low‑income housing credit, and the film and television credit—appear to be achieving their purposes, but improvements would make them more effective. For example, the water’s edge election allows corporations to exclude from their reportable income what they derive from the foreign portions of their business, resulting in reduced international concern over California’s corporate taxation practices. However, it also may provide corporations with unintended benefits that reduce state revenue, such as allowing corporations to shield income in offshore tax havens. In addition, although the low‑income housing credit is subsidizing housing that would not otherwise be built, the Legislature could modify the credit to increase the number of new low‑income housing units without increasing the amount of the credit the State awards. Finally, although the film and television credit appears to be keeping some film and television production from moving to other states, some of its benefits may be going to corporations that would have filmed in the State without the credit.
Our review of the final tax expenditure—the Subchapter S corporation (S corporation) election, which offers businesses an alternative to the standard Subchapter C corporation filing status—found that the election appears to be achieving its purpose and does not need legislative changes to improve its effectiveness. Electing to incorporate as an S corporation allows businesses with fewer than 100 shareholders to receive limited liability protection with a lower tax rate than that of Subchapter C corporations.
Lastly, limiting corporate tax expenditures could allow the State to better control the amount of revenue it forgoes, but a limit is not always appropriate for each type of tax expenditure. State law already places an annual cap on the low‑income housing tax credit and on the film and television production credit. However, three of the four tax expenditures we reviewed that do not already have caps—the water’s edge and S corporation elections and the franchise exemption—do not appear to be appropriate candidates for annual caps. Although the Legislature could also cap the R&D credit, we believe that it would not be advisable to do so without first determining whether the credit in its current form is fulfilling its purpose of stimulating additional R&D spending within the State.
Recommendations
To increase oversight of existing and future corporate income tax expenditures, the Legislature should consider adopting best practices that other states use to evaluate their tax expenditures’ effectiveness.
The Legislature should consider commissioning studies to evaluate the cost‑effectiveness of the R&D credit and franchise exemption and whether these tax expenditures are meeting their policy objectives.
To improve their effectiveness, the Legislature should consider modifications to the water’s edge election and the low‑income housing credit. Specifically, it should include income from offshore tax havens within the State’s water’s edge election, and remove negative tax implications from the low‑income housing credit.
Agency Comments
We met with staff from the Franchise Tax Board (tax board) on March 10, 2016, to discuss our report's conclusions and provided the tax board a copy of the draft report on March 16, 2016. Since our report had no findings or recommendations directed to the tax board, we did not ask for a formal response to the audit. The tax board did provide some verbal comments that were technical in nature, and we considered those comments when preparing the final public report.
Footnotes
1We define state‑only tax expenditures as those that do not conform to an equivalent federal version.Go back to text