State is strapped, but tax breaks abound for powerful interests

Even as lawmakers grapple with deep budget cuts, generous tax breaks are costing the state billions of dollars, according to Senate investigators.


The Office of Oversight and Outcomes, created by Sen. Darrell Steinberg, D-Sacramento, looked at 10 tax breaks passed in the last two decades, determining what the state would have received had the provisions not been in effect.


According to the analysis, these breaks cost the state $6.3 billion more than originally projected, including $1.3 billion in the 2010-11 fiscal year alone.


The largest drain: California’s Research and Development Tax Credit, designed to subsidize innovation and keep California a competitive destination for R&D.  Despite doubts about its benefits, the credit has grown into one of the most generous in the nation. Corporations with revenue above $1 billion claimed the largest portion the of research and development credits in 2007 – $1.2 billion, or 84 percent.

The report found that the credit accounts for more than $1.4 billion in foregone revenue

in recent years, $953 million in 2010-11.

The runner up is what’s sometimes called the double-weighted sales factor, a way for corporations to allocate income between states. It is intended to encourage mobile firms to locate facilities and employees in California. But instead of creating windfall revenue, the sales factor seems to encourage businesses to maximize reported sales outside of the state, lowering their California tax liability.

The report notes that California represents 12 percent of the U.S. economy yet total sales reported on multi-state companies’ tax returns in California add up to only 5.4 percent of the national total in 2008, according to the Franchise Tax Board.

The sales factor is reported to have cost the state $230 million in 2010-11. The new optional single sales factor, in effect this year, is expected to cost the state even more.

According to the report, the remainder of the losses came from “minimum franchise tax exemption for new corporations, a sales tax exemption for fuel used by shipping companies, and sales tax exemptions for machinery and diesel fuel used in farming.”

A 2002 California Budget Project report found that two thirds of what is spent on economic development is in the form of tax breaks.

The state misses out on almost $50 billion a year because of forgone revenue from various tax breaks, referred to as “tax expenditures,” in the form of credits, exemptions, preferential tax rates deductions from gross income granted to businesses and individuals.

In trying to explain the cause of these overruns, the report notes that unlike other government spending programs, tax expenditures are not capped or reviewed by lawmakers when they write budgets. Exemptions are also often expanded well beyond their original scope by courts and tax boards.

Other potential factors include the three-year-old economic and demographic data used in state tax board estimates, and changes in taxpayer behavior taking advantage of existing breaks.

While the Department of Finance and the Franchise Tax Board publish annual reports on foregone revenue from tax expenditures, they do not compare expected and actual costs, and the reports are not used in the state’s budget making process.

The legislative intent of only 12 of the 82 tax expenditures were indentified in the Department of Finance’s 2009-2010 report. The purpose of the remaining 70 were “not specified”, making it difficult to determine if these expenditures are doing what they were meant to do.

In short, the state currently has no standard method for reviewing the efficacy of tax expenditures and deciding whether to continue them.

The Oversight office recommends a commission, similar to ones created in other states, to annually review tax expenditures, using dynamic modeling to help assess the effects of foregone revenue in reduced government spending or increased taxes for taxpayers.

Reports should include including original estimates alongside actual costs, so that policymakers can easily assess whether tax breaks are overshooting projections and which ones are worth eliminating.

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