Over the last decade, California has struggled with substantial and persistent budget deficits. The Great Recession placed a tremendous strain on an already structurally-imbalanced state budget. Early in the decade, short-lived spikes in revenues were repeatedly used to justify permanent spending increases. The state has spent the last ten years cobbling together a broad range of one-time solutions, including special fund borrowing, accounting maneuvers, spending reductions, revenue accelerations, and tax increases, with the hope that the economy would recover.
In both the 2008-09 and the 2009-10 Budget Acts, the Legislature adopted a variety of corporation tax-related “solutions” that increased corporation tax revenues during those two fiscal years. Specifically, the Legislature suspended the use of net operating losses (NOLs), accelerated estimated tax payments, and limited the use of business tax credits (most notably the Research and Development Credit).
In exchange for these “revenue raisers,” the Legislature also established economic incentives (Movie and Television Production Tax Credit; New Hire Tax Credit; New Home Purchase Credit; Elective Apportionment Formula; and Credit Sharing within a Unitary Group) that decreased corporate tax revenues but were intended to stimulate the economy, or at least soften the impact of the recession.
For many in the ruling party, the work of increasing taxes and state spending is never complete. Despite increased state tax revenues from an improving economy and Proposition 30 tax increases, Democrats are looking for reasons to increase taxes on businesses.
Democrats and their many tax consumer groups argue that businesses aren’t paying their “fair share” of taxes. They point to data that seemingly shows that corporate tax revenue collections both as a percentage of General Fund revenues and in actual revenues collected have decreased over the last 5 years. But, they’ll do their best to deflect blame for their decisions to manipulate business tax policies for short-term revenue increases which are a direct cause of today’s corporate tax collections.
Instead of accusing businesses of not paying their “fair share” of taxes, reinforcing California’s hostility towards businesses, Democrats should embrace their past budget decisions. When the data is placed in its proper context it will show that the decisions made by the Legislature are responsible, in part, for both a spike in corporate tax collections in 2006-07 and 2007-08 and depressed collections over the last five years. It is in this context, that we should evaluate the out-year impacts of those decisions, which we are feeling now.
Corporate Tax Revenue Collections
The vast majority of California corporate income tax revenue is paid by large multistate and multinational corporations that apportion (allocate) a share of their profits to California for purposes of determining their state tax liability.1 Nationally, while corporate profits have returned to their pre-recession levels, taxable corporate profits apportioned to California have not.
California corporate tax revenues fluctuate year to year, in terms of actual state collections and as a percentage of the state General Fund. As noted in the chart below, there was a spike of corporate tax revenues in 2007-08 totaling nearly $12 billion. Revenues then decreased thereafter through 2011-12 ending with $7.2 billion in total state corporate tax revenues (depicted by the blue bars). Tax revenues begin to rebound in 2013‑14 and according to the LAO, are estimated to increase by approximately six percent annually through 2019-20.
As a percentage of state General Fund revenues, corporate tax collections have fluctuated over the last 20 years with corporate tax collections reaching a peak in 2007-08 accounting for nearly 12 percent of General Fund revenues. In 2012-13 corporate tax collections moved closer to eight percent of General Fund revenues. The chart below reflects legislative actions in 2008-09 and 2009-10 that propped up spending in those years by shifting revenues from future years.
The LAO projects that notwithstanding the difficulties in estimating future corporate tax receipts due to the significant impacts of business tax changes made in recent years, corporate tax collections will continue to grow over time reaching approximately 10 percent of General Fund revenues in 2019-20.
What’s behind the decline?
The Budget Acts of 2008-09 and 2009-10 included a variety of corporation tax-related “solutions” that increased corporation tax revenues during those two fiscal years and provided numerous economic incentives to businesses. The Franchise Tax Board, Legislative Analyst, and Department of Finance have all indicated that the out year impact of these decisions may be playing a significant role in the current decline of corporate income tax revenues. Additional detail on each of these actions is provided below.
Net Operating Losses
For the 2008 through 2011 taxable years, the Legislature suspended the use of NOLs (except for a small business exemption), which effectively increased corporate tax collections during those years.2 Corporations were allowed to accumulate NOLs, but were prohibited from offsetting profits until after 2011. The Legislature also added a two-year carry-back provision that allows taxpayers to carry losses back up to two years. Now that corporations are again allowed to offset their taxable liabilities with use of NOLs, the data shows a decrease in corporate tax revenues collected, as was expected at the time this change was enacted.
The recession generated a significant amount of NOLs that can now be used to offset taxable income. According to the Franchise Tax Board, at the end of 2000, there was $102 billion of outstanding or accumulated NOLs. At the end of 2012, that number is estimated to have increased to nearly $647 billion.3 Most of the accumulated NOLs, approximately $319.8 billion or 49% of them were generated during the Great Recession, between 2008 and 2011.
Table 1 illustrates (1) the history of NOL accumulation, (2) the fiscal impact of suspending NOL deductions (2008-2011), and (3) how much additional NOLs corporations are anticipated to utilize in 2012.
(dollars in billions) Source: FTB
Utilization of Tax Credits
In 2008 the Legislature limited the use of business tax credits for two years and permanently permitted credit sharing within a unitary group.
Limitation of Business Tax Credits for Two Years: For the 2008 and 2009 taxable years, the Legislature dictated that the total of all tax credits allowable shall not reduce a corporation’s tax liability by more than 50 percent. The most notable business tax credit is the Research and Development (R&D) Credit, which the FTB valued at about $1.8 billion in 2011. That credit, however, was only valued at $1.2 billion and $993 million in 2008 and 2009, respectively.
Similar to what happened with NOLs, when this limitation expired, corporations would resume utilizing their R&D credits to offset their taxable liabilities. As expected, the broad use of these credits would have impacted General Fund revenues. It is important to note that while the state limited usage of the R&D Credit it did not limit the amount of credits that could be earned and accumulated during the suspension. As a result, earned, yet unused credits, continued to grow. FTB now estimates that by the end of 2012, corporations will have accumulated about $12.6 billion of credits for future use.
Credit Sharing within a Unitary Group: In a 2008 effort to increase credit utilization (in response to the increasing balance of unused credits), the Legislature also allowed corporations to “assign eligible credits to any eligible assignees.” In other words, a corporation is now allowed to assign unused credits to any affiliated corporations that are properly treated as a member of the same combined reporting group. As was the intent of the statute, increased credit utilization is having the effect of decreasing corporate tax revenues.
While the fiscal impacts of these two changes are less significant than the NOL suspension, they have an impact on corporate tax revenue collections. Table 1 (above) illustrates how 2008 and 2009 were impacted by these policies.
It is interesting to note that the Legislative Analyst’s Office is projecting much larger usage of these two offsets than the FTB and the Administration. Given the multitude of “unknowns” and complexity of forecasting this revenue source, this difference could result in significantly decreased corporate tax revenues when compared to the Governor's Budget.
(dollars in billions)
The LAO has consistently emphasized that recent business tax policy changes and the volatile economy have created some unprecedented forecasting challenges, of which, projecting the use of NOL deductions and R&D credit usage are just a few. Accordingly, it will take several years — and a period of policy stability — before everyone can feel comfortable with future projections of many elements of this tax.
Single Sales Factor Apportionment
Under existing law, multistate and multinational corporations must use a complex apportionment formula to determine how much of corporate profits must be apportioned to California for taxation purposes. From 1993 through 2010, all corporations that apportioned income to California did so using what was known as the “double weighted sales factor,” which weighted property and payroll at 25 percent each, but weighted California sales at 50 percent.
Beginning January 1, 2011 California allowed corporations to choose an alternative apportionment formula, known as the “single sales factor.” This formula allows corporations to apportion income to California based solely on sales in California (when compared to sales outside of the state). Immediately, corporations that had a large property and payroll footprint in California, but a relatively lower sales footprint in California, benefited from a decrease in tax liability (so-called “in-state” corporations).
Corporations with a relatively higher sales footprint than combined property and payroll, referred to as “out-of-state” corporations, continued doing business as they had for the previous 18 years under the double weighted sales factor apportionment formula. The intent was to reduce the tax liability “in-state” businesses and increase jobs and investments in California, but critics called it a giveaway.
Beginning in 2013, Proposition 39 (2010) mandated that all apportioning corporations must use the sales factor to apportion income to California (“mandatory single sales factor”). Eliminating the double weighted sales factor option was expected to increase taxes on so-called “out-of-state” businesses beginning January 1, 2013. Pre-election estimates anticipated nearly $1 billion in new state tax revenues from “out-of-state” businesses annually; instead the Governor is expecting to receive about $700 million annually.
According to the FTB, the most recent taxpayer data available suggests a smaller revenue gain primarily attributable to lower than expected reported sales factors for some large taxpayers. However, the complexity of the changes to the state’s apportionment formula and the numerous factors that determine taxpayers’ liabilities makes forecasting tax revenue collections difficult.
The bottom line is that the full impact of Proposition 39 changes to the state’s corporate tax apportionment formula will not be known until the FTB has received and has processed all 2013 corporate tax returns for both calendar year and fiscal year tax filers in the Spring or Summer 2016.
In addition to the recent legislative changes, the reduction of C-Corporations tax filings and the increase of S-Corporation filings are affecting state General Fund revenues.
S-Corporations versus C-Corporations
The FTB has indicated that declining C-Corporation tax filings, offset by increasing S‑Corporation filings could be a contributing factor for decreased corporate tax revenues (and increased personal income tax revenues). Table 3 reflects that C-Corporation filings have decreased by 38.5 percent since 2000, while S‑Corporation filings increased by more than 140 percent over the same time.
An S-Corporation is a corporation formed under state civil law or any business entity that elects under federal law to be taxed under Subchapter S. An entity that has elected to be taxable as an S-Corporation for federal tax purposes is also treated as an S-Corporation for California tax purposes. An S‑Corporation generally offers liability protection to its owners (shareholders) and is a conduit where the profits or losses of the S corporation flow through to the personal income tax return. Instead of being subject to the flat 8.84 percent corporate income tax rate, S‑Corporation profits are potentially subject to higher tax rates (up to 13.3 percent pursuant to Proposition 30 of 2012). While this factor does not make up a large component of corporate tax proceeds, it is generally indicative of how the General Fund’s reliance on corporate tax revenues is decreasing.
According to data provided by the FTB, Table 4 shows in greater detail the impact of S‑Corporations on personal income tax and corporation tax liabilities, totaling hundreds of millions of dollars each year. Tax year 2011 is based upon actual data, and 2012 forward are FTB estimates:
(dollars in millions) Source: FTB
The changes made to business tax policies in the 2007-08, 2008-09 and 2009-10 state budgets were significant and continue to impact state tax collections. Despite attestations by the ruling party to the contrary, those decisions appear to be responsible for both the spike in corporate tax collections and for the depressed collections over the last five years. Decisions to accelerate future taxes to pay for government programs were intentional with the potential impacts on future tax revenue collection understood.
Moreover, businesses will continue to feel the effects of these changes well into the future. The Legislature should allow time for the corporate tax structure to settle down to “a new normal” before making additional changes that will both reinforce the state’s hostility toward business and continue to suppress business tax collections.
Finally, it would be disingenuous to compare current year profits and Wall Street performance to 3 year old income tax data. Instead, future decisions must recognize the limitations of data and make comparisons relative and in context to the data available.
For more information on this report or other tax issues, contact Scott Chavez or Joe Shinstock of the Senate Republican Caucus at 916/651-1501.
1 Legislative Analyst’s Office: The 2014-15 Budget: California’s Fiscal Outlook. http://www.lao.ca.gov/reports/2013/bud/fiscal-outlook/fiscal-outlook-112013.pdf
2 See: AB 1452 (Committee on the Budget), Chapter 763, Statutes of 2008. Also See: SB 858 (Committee on Budget and Fiscal Review), Chapter 721, Statutes of 2010.
3 Franchise Tax Board, Taxpayer data Exhibit B-9, page 1 of 2, " Taxpayers With NOL Deductions" https://www.ftb.ca.gov/aboutFTB/Tax_Statistics/Revenue_Estimating_Exhibits_1213.pdf