With billions at stake, law now requires new look at tax breaks

Tax loopholes are the invisible pieces of the California budget, drawing scant attention from either Republican Gov. Arnold Schwarzenegger or the Democrat-controlled Legislature. But this year, for the first time, the administration must start detailing some $28 billion in tax breaks–who benefits, how much the state loses and why they were passed in the first place.

The tax breaks are known as “tax expenditures” in the Capitol and they are angrily denounced or lavishly praised–depending on the taxpayer. They were not apparent Wednesday as Gov. Arnold Schwarzenegger unveiled his 2007-08, $143 billion budget plan, nor were they discussed by the governor in his scripted remarks. But they are there nonetheless. “It’s the hidden money,” said one Capitol staffer, a Democrat.

“‘Loophole’ is a pejorative term, and a loophole to one may be somebody else’s incentive to create more jobs,” said Ron Roach of the California Taxpayers Association. “Let’s give the same scrutiny to the spending lobby–the public-employee unions, local government, the education community.”

The new chairperson of the Senate Revenue and Taxation Committee, Sen. Jenny Oropeza of Long Beach, doesn’t see it that way. She already has targeted two loopholes: a break for yacht buyers and a $400 million a year break for limited-liability corporations. Assemblyman John Laird, D-Santa Cruz, the new chairman of the Assembly Budget Committee, said similar targets were being developed on the Assembly side.

“Essentially, people who could afford these luxury items got a free ride,” Oropeza said, referring to the yacht exclusion. “This critical provision is due to expire this year, and I hope my Republican colleagues will join me to end this preferential treatment.”

But however they are described, the tax breaks are a classic example of pocket-book policy. They were not targeted in Gov. Arnold Schwarzenegger’s newly released budget, which promises a zero operating deficit. But they affect an array of constituencies–farmers, homeowners, employers, insurers, students, newspapers, researchers, investors, computer programmers, advertisers, developers, Hollywood production companies, and on and on.

The lion’s share for the tax breaks, $22.4 billion worth, are linked to the personal-income tax. More than half that amount stems from three write-offs totaling nearly $13 billion–the $4.48 billion home-mortgage interest deduction, the $4.45 billion exclusion of employer-pension contributions and the $3.98 billion break from capital gains on the sale of a principal residence. Other income-tax write-offs, less well known, include a $16 million housing break for the clergy, a $105 million write-off in employer contributions to life insurance, the $34 million student-interest deduction and the $15 million National heritage preservation tax credit.

Corporate write-offs totaling $6 billion include nearly $4 billion for Subchapter S corporations–a corporation with 75 or fewer shareholders that is taxed as a partnership instead of a corporation–and some $650 million for research and development, or R&D. Tax-loophole critics see the R&D as particularly onerous because it rewards companies for activity that they would do anyway, researching and developing new products or strategies. “No pharmaceutical company, no high-tech company, can rest on its laurels. It has to innovate to survive,” said Jean Ross of the California Budget Project. “You could argue that the research- and development-tax credit simply rewards companies for their existing behavior.”

As the state wrestles with a $5.5 billion budget shortage, there is interest among lawmakers to ratchet back at least some of the loopholes. Staffers in both houses say they are being peppered with inquiries from legislators about the tax breaks, but that detailed information about the issue is sparse. For 35 years, the Department of Finance, the budget-writing arm of the governor’s office, has listed the tax expenditures, including the existing ones and those that have been eliminated or changed over time (the latest report is at http://www.dof.ca.gov/HTML/FS_DATA/TAX/Tax_Expenditure_Rpt_06-07.pdf).

But critics, such as Sen. Mark Ridley-Thomas, D-Los Angeles, say those reports are terse and lacking in perspective, offering the amount and type of the tax break, but little context or nuance. While in the Assembly, Ridley-Thomas authored two bills to force greater disclosure of the tax expenditures.

Schwarzenegger vetoed both bills, saying they were “redundant and unnecessary.” Other Democratic lawmakers, such as Mike Machado and Carole Migden, pushed for–and received–major disclosure reports, and studies were completed by the Franchise Tax Board, the Legislative Analyst’s Office, and administration and tax activists such as Leonard Goldberg of the California Tax Reform Association.
“There is no political will,” Goldberg said.

But in the end, little was done to deal with the tax breaks.

But in AB 1809, the trailer bill to the 2006-07 budget, Schwarzenegger approved what appears to be a major expansion of the loophole-reporting requirement. It received little attention at the time, but budget observers say the new law is likely to have a significant impact on state fiscal policy.

The law orders the Finance Department to issue its annual report beginning in September of 2007, and to include “a comprehensive list of tax expenditures (such as credits, exclusions or deductions)” greater than $5 million. The data, among other things, will include “any available expression of legislative intent” about the tax break, the number of taxpayers affected, a three-year estimate of the money loss to the state, a description of the interests that benefit from the tax break and whether there is a comparable tax break at the federal level.

Some observers of the budget, such as Ross, believe the new reporting
requirement is good, but that more disclosure would be valuable.

For example, an existing tax break for child care and the level of funding proposed for the same item could be listed side by side in budget-subcommittee agendas in both houses, thus allowing lawmakers to see, at a glance, the full impact of their decision-making. Similar data could be made available to the two-house conference committee that actually writes the budget before it is sent to lawmakers for the final vote.

Politically, the tax breaks are harder to rescind than they are to approve. That’s because tax expenditures can be approved with a simple majority vote, but only can be repealed by a two-thirds majority. Democrats have simple majorities in both houses, but lack the two-thirds majorities to approve a budget or rescind a tax break. That means both Democratic and Republican votes are needed to repeal tax expenditures–no mean feat.

“It’s what I call the ‘Roach Motel’ effect,” said Goldberg. “It takes a two-thirds to get rid of the tax expenditure, so once they crawl in, they don’t crawl out.”