More than one way to tax consumption

In the US, the consumption taxes we are most familiar with are the sales tax and some excise taxes, such as on gasoline, alcohol and tobacco. We typically think of these taxes as having to be imposed at the point of purchase.  There is an advantage to this because you'll know at that time if you can afford to pay the tax. Disadvantages to this approach include that the vendor has additional compliance to collect and remit the tax (and penalties if done wrong) and the rate can't be adjusted for the income level of the buyer (although I understand many might not view this as a disadvantage).

Another form of consumption tax that has been around in proposals and policy books and reports for a few decades is the formula approach or consumed income tax. If we consider that one's income is saved and spent, we have this formula:

     Income = savings + consumption

Simple algebra converts this formula to a consumption tax:

     Consumption = income - savings

We know how to measure income, but how do we measure savings? We can look at beginning bank balances and cash stored up (in case that's a lot; a few bucks in your wallet can be ignored). To that we add increases to savings and saving spending (such as purchase of stock). Debt must also be factored in. It might get a bit complicated, but can be managed with software and good records.

Two colleagues (Drs. Foldvary and Haight, economists) and I wrote a paper on how a sales tax might be converted to a formula approach consumption tax, how to do it and the advantages and disadvantages. One advantage is that it would remove the sales tax from businesses (they would not pay it or collect it). Another advantage is that low-income/low-wealth taxpayers can be exempt. Also, the calculation can be done as a form attached to an existing income tax return. And, as noted earlier, a progressive rate structure is possible. Disadvantages include that it won't get at the underground economy and visitors to the state won't pay the tax. Partial solutions to these problems is to retain the sales tax for vehicles (cars and boards) (which also allows the sales tax to be financed along with the purchase price of the vehicle). Also, the state could add a small tax to hotel stays, perhaps collected by cities that already impose such a tax.

Another challenges is that without a sales tax, local governments, at least in California, lose a significant tax source. So, a system of sharing state revenues with local governments would be needed. That won't be popular with local governments. It can be done to have the local governments share in the state income tax which would align both levels of government to want high paying jobs in the state (today, local governments benefit more from big box retailers in their cities because of the sales tax generated).

The paper is posted here. Yes, it is long, but 2/3 of it are appendices should you seek more background information.

What do you think?

California Prop 55 - Kicking the can down the road

California always has budget problems. In 2012, temporary tax increases were voted in to raise both the state sales tax rate and the top personal income tax rate. These put California at the top among state for high tax rates. These provisions expire soon, but budget problems remain. So, Prop 55 on the November 2016 ballot calls for extending the income tax rate increase.

Per the "findings" in Prop 55:

"Unless we act now to temporarily extend the current income tax rates on the wealthiest Californians, our public schools will soon face another devastating round of cuts due to lost revenue of billions of dollars a year. Public school funding was cut to the bone during the recession. Our schools and colleges are just starting to recover, and we should be trying to protect education funding instead of gutting it all over again. We can let the temporary sales tax increase expire to help working families, but this is not the time to be giving the wealthiest people in California a tax cut that they don’t need and that our schools can’t afford."

The continuing increased rates kick in on taxable income over $250,000.  Prop 55 would result in 9.3% not being the top personal income tax rate. Instead, brackets about $250,000 would include 10.3%, 11.3% and 12.3%.  With the longstanding mental health tax, the rate on income over $1 million would continue to be 13.3% through 2031. Yes, 2031!  That's a bit hard to picture.

How many people in California have income in this range? Using IRS zip code data for 2014, here are percentage for a few selected California zip codes based on $200,000 or more of AGI (after itemized deductions, fewer would have taxable income over $200,000 and the IRS doesn't report for taxable income over $250,000):

Fresno 93728           < 1%
Sacramento  95816    5%
San Jose 95125        19%
Torrance  90503         8%

This is not representative of course, but it is safe to say that less than 5% of California individual filers have to deal with the top rates.  And for the top temporary rate of 12.3% on taxable income over $500,000, less than 1% are affected.  Of course though, many in this range have a few million of annual income which is why the increased rates at the top can bring in millions of dollars.

I call this kicking the can down the road because instead of improving our tax system, we are applying a band-aid.  Here are a few things that would be better:

• Lower individual tax rates and broaden the base by eliminating or cutting back on exclusions, deductions and credits. This also makes the system more equitable, transparent and simple.
• Broaden the sales tax base and lower the rate. The California sales tax is still based on the 1930's economy when the tax was created. We just tax consumption in the form of tangible personal property and do not tax digital items, personal services, entertainment or utilities. Thus, the sales tax base continues to shrink as items, such as books and music, move from taxable tangible form to non-taxable digital form. This is crazy.  Also, some of the items we don't tax are ones that higher income taxpayer spend more money on such as food, utilities for their large homes, entertainment and personal services.
• The state wants to reduce greenhouse gas emissions. Governor Brown just signed SB 32 and AB 197 calling for further reductions. A carbon tax or increased gasoline excise tax would help reduce emissions and generate revenue.
• "Splitting the roll" on real property taxes to tax business property at a higher rate and/or modify the valuation approach. Prop 13 rates and valuation limits have inequitable effects among businesses that are not as relevant for businesses

What do you think?

Also see my California Tax Reform website.

Governor Brown's Tax Modernization Proposal - Is It Enough?

Governor Brown's "May Revision" budget includes a "job creation and economic development proposal." Here is the text of that proposal (page 68):

"The May Revision proposes to modernize the state’s job creation and economic development incentives. Created over 25 years ago, the Enterprise Zone program should be reshaped to meet the needs of the current economy. In its current form, it fails to encourage the creation of new jobs an instead rewards moving jobs from one place to another within the state. Additionally, the New Jobs Hiring Credit created in 2009 has not been effective at stimulating job growth. The May Revision aims to strengthen both of these programs to bolster California’s business environment and reintegrate people into the workforce.

The hiring credit will be refocused to specific areas with high unemployment and  poverty rates. This credit will be available for the hiring of long‑term unemployed workers, unemployed veterans, and people receiving public assistance. The Enterprise Zone sales tax program will be expanded to a statewide, upfront sales tax exemption for manufacturing or biotech research and development equipment purchases. Finally, the California Competes Recruitment and Retention Fund will be created, to be administered by the Governor’s Office of Business and Economic Development (GO‑Biz). GO‑Biz will negotiat agreements to provide businesses tax credits in exchange for investments and employment expansion in California.

The proposal is revenue neutral and focuses on improving the performance of those dollars already spent. It will allow California to be more effective at stimulating economic growth an creating new jobs. The program will be designed to ensure that small businesses are able to easily obtain the manufacturing sales tax exemption, and will dedicate a portion of the hiring credit and the incentive fund solely to small businesses"

It is good to look at modernization of any provision that has been around for even 10 years, let along 25. Governor Brown doesn't mention what the "needs of the current economy" are. Is it to address varying unemployment rates among California communities?  Is it to be sure the California economy can attract and support jobs in the knowledge and green economies?  Is it to be sure the state's tax system is at least in sync with others?

If it means any of the above, more is needed than reforming a jobs credit and enterprise zone incentives. Why not reform the entire sales tax system to cover more types of personal consumption - modern consumption such as personal services and digital downloads?  Why not phase in exemptions for equipment of all types of businesses? A broader sales tax base would help local governments such that equipment exemptions could cover both the state and local portions of the sales tax. Ideally, the broader sales tax base for consumers would include a lower rate.

What do you think modernization of California's tax law should include?

For more, see my 3/25/13 post on California tax reform and a short paper on weaknesses in California's tax system.

Prospects for CA Tax Reform

In addition to California voters enacting two tax propositions in November 2012, they also provided a two-thirds majority in both the Assembly and Senate of Democrats. With a supermajority of one party, any bill in which one person might have a tax increase has a better chance of passing. That, of course, doesn't guarantee it will happen or that if it did, the governor would sign it.

I have an article published this week Bloomberg BNA's Tax Management Weekly State Tax Report on Prospects for California Tax Reform. It lists and explains various weaknesses in California's tax system and what could and perhaps, should be done legislatively to improve it.

You can find the article here.

What do you think?

Tax Reform Possibilities of California's New Super Majority

 

California's requirement for any tax increase to have a 2/3 vote of the state legislature makes tax reform difficult in California. The 2/3 vote requirement was created as part of the famous Prop 13 property tax reform effort in 1978. It was tightened further in 2010 with Prop 26 when the voters said that if even one taxpayer would have a tax increase from a legislative proposal, it needs a 2/3 vote. Thus, even a revenue neutral reform bill or even a conformity bill needs a 2/3 vote. With many legislators signing the "no tax" pledge, the likelihood of reform and conformity have been slim.

That might change starting in 2013 when the incoming legislature will comprise at least 2/3 majority of Democrats - in both the Assembly and Senate. Whether this will result in tax reform remains to be seen, but the possibility of it is improved.

Yet, the voters also said with the November 6 election that they were okay with high personal income tax rates and a high sales tax rate to balance the state's budget (these will be highest among all states with a 7-year top marginal rate of 13.3% starting in 2012 and a 4-year state sales tax rate of 7.5% starting in 2013). If lawmakers either must or prefer to respect these voter-approved high rates, tax reform efforts will be limited. I say that because California's tax problems are not with its rates which were already high before the recent increases. California's tax problems are with its tax bases, such as a sales tax base still tied to the 20th century consumption patterns. Base broadening will not work without lowering the tax rates.

I've got a guest post on this topic at the Bloomberg BNA SALT Blog (12/4/12) for more information.

What do you think will happen with respect to tax legislation in California in 2013-2014?

California Assembly Hearing on Tax Expenditures

Today (February 22), the California Assembly Committee on Revenue & Taxation and the Committee on Accountability and Administrative Review held a joint hearing on Assessing Tax Expenditure Programs in Light of California's Fiscal Challenges. I gladly accepted an invitation to testify. I think this is a very important area that needs more attention because tax expenditures are growing in number and cost, continue to be overlooked in budget decisions (including when looking for spending cuts) and they violate a few principles of good tax policy.  That said though, there can be value in tax expenditures if carefully designed to best meet the state's goals and it has been determined that alternative means of meeting the goal are not as good as using the tax system.

I was on this panel - How Do We Assess Tax Expenditures and Ensure Their Effectiveness, along with Jason Sisney with the Legislative Analyst's Office and Darien Shanske of UC Hastings College of Law.

I'll post my written testimony soon, but wanted to post part of it now in hopes of getting comments from readers. One of my suggestions to improve effectiveness was to go through the following six sets of questions.

Improving Effectiveness of Tax Expenditures

The following questions can help improve the effectiveness of proposed tax expenditures. To illustrate each question set, it is applied to a made-up proposal to provide a credit to students who prepare to teach STEM topics (science, technology, engineering and math).

1. Jurisdiction's Goals and Strategy: Have the jurisdiction's economic, societal and environmental goals been identified and articulated? To help determine if the purpose of a tax expenditure is appropriate, it must be judged by how well it helps the jurisdiction meet its goals. Thus, such goals need to be articulated. In addition, answers should be provided as to why the tax expenditure is the necessary and desired way to help achieve the goal and why alternative uses of the funds would not be better.

Example: What is the California goal that will be advanced by the tax credit? How will the credit help the state meet the goal; that is, what is the connection between the program and the goal?

2. Tax System Relevance: (A) Does the tax system hinder the jurisdiction's achievement of the goal such that modification (the addition of special rule) is needed to help the jurisdiction meet its goals? OR (B) Would the tax system be an effective and appropriate vehicle for delivering the benefit? What are the pros and cons of using the tax system to provide the incentive compared to alternative means (such as a grant)?

Example: It is unlikely that there is any tax system feature that hinders students preparing for STEM topics. Thus the question is whether the tax system is an effective and appropriate vehicle for delivering the benefit. Arguably, it is not because the FTB would have to gather information on the student's courses and major. Also, unless refundable, the credit would only be obtained if the student had a tax liability. In addition, the credit would not be delivered when needed, that is, when tuition is due. A grant program could better deliver the benefit, assuming the benefit is needed to help the state meet its goals.

3. Tax Policy Considerations: Principles of tax policy, including equity, simplicity, neutrality and efficiency, minimum tax gap and transparency should be considered in the design of the tax expenditure.

Example: Measures would be needed to be sure the student is actually preparing to become a STEM teacher. Issues would need to be addressed as to whether the credit should be refundable and whether a student claimed as a dependent should be eligible.

4. Budget Considerations: What is the estimated direct and indirect costs of the special tax rule? How long should the tax rule be in effect? How will the cost be controlled (such as setting an aggregate limit for a tax credit)?  Will the method of paying for the special rule hinder the ability of the special rule to meet its purpose or cause a greater detriment to the jurisdiction than would occur in absence of the special rule? Could greater benefits be derived for the jurisdiction through other uses of the funds (even if for a different purpose)?

Example: Legislators need an answer to the question – Why is this credit a good use of state resources? Data would need to be analyzed to determine how much the credit should be to serve as an incentive and an aggregate cap determined and implemented. Consideration should also be given to how the credit affects existing grant programs for higher education to be sure there is no duplication.  In addition, consideration is needed as to whether more resources will need to be directed to STEM instruction to ensure that the expected increase in number of STEM students can be served. Alternative uses of the funds should be evaluated to construct the best program to help the state meet its goal of increasing the number of STEM teachers.

5. Accountability Measures: What accountability measures should be included to ensure that the special tax rule is properly used? (See examples of commonly used accountability measures in the next section.)

Example: Consideration should be given to including a clawback measure should a student not become a STEM teacher. A sunset date should be added to ensure that the credit will be evaluated for effectiveness.

6. Assessment: What data is needed to determine if the special tax rule achieves its purpose? How and when will the data be collected? Should the enacting legislation also specify data collection requirements? Who will monitor collection and who will analyze the data?

Example: The enacting legislation should specify the data that is needed for evaluation purposes and who will collect it and how. The enacting legislation should also specify a measurable and appropriate goal, such as a percentage increase in the number of STEM teachers who utilized the credit.

What do you think?  

Think Long Committee Ideas for Improving California

"The Think Long Committee for California aims to offer a comprehensive approach for repairing and renovating California's broken system of governance while proposing policies and institutions vital for the state's long term future." That all sounds good!

The Think Long Committee for California of the Nicholas Berggruen Institute released a report this week that explains many of California's problems, such as outdated and decayed infrastructure and finance system. The goal of the project leading to the report was to create an "integrated set of proposals" t0 "update and modernize the state’s broken system of governance."

The multi-faceted proposal is described as having three key components:

1. Empowering local governments by creating a structure that enables them to make and carry out decisions
   


2. An independent citizen watchdog organization to counter short-term thinking of elected officials and too much focus on special interests
   


3. A modernized tax system with broader bases and lower rates for most taxes

The tax proposals include lowering rates of the personal and corporate income tax as well as the sales tax. The sales tax would be expanded to include services. Multistate income would be apportioned using a mandatory single sales factor

PIT rates would be 0 to 8.5% (including the mental health tax imposed on individuals with income greater than $1 million). The only deductions would be a larger standard deduction and specified itemized deductions (mortgage interest, property taxes, charitable contributions and R&D). Most credits would be eliminated.

The corporate rate would be lowered to 7%.

The homeowner's property tax exemption (currently $7,000) would be doubled with a similar change to the renter's credit.

There is mention of the need to generate revenue to address deficits

The suggested sales tax rate on services would be 5% but 4.5 % on goods. Low-income taxpayers would receive a sales tax rebate.

The structure would enable additional revenues to be collected to reduce current deficits.

Comments:

• It is great to recognize the need to move California's tax system into the 21st century.


• Lowering rates and broadening bases is a good way to better enable a tax system to meet principles of good tax policy such as simplicity and neutrality.


• Why not further cut backs to itemized deductions? For example, there is no reason for either the federal government or the State of California to subsidize financing of an individual's vacation home. And, the $1 million debt limit should be reduced in recognition that the median home price is far less than that.


• Will the sales tax also be extended to digital goods? (it should be)


• Will the expanded sales tax base not apply to business purchases? (these should be exempt for businesses)


• A 5% sales tax rate on services and 4.5% rate on goods will bring unnecessary complexity to a system and increase the need for audits. For example, it is not always easy to distinguish a service from a good. Also, there are many businesses providing both. For example, an auto repair shop would be motivated to increase the markup on the parts and charge less for the services in order to reduce sales tax owed by customers.


• A doubling of the homeowner's exemption results in a $70 property tax reduction for homeowners ($7,000 x 1% property tax rate). It is probably not worth the change and homeowners are not, to my knowledge, calling for an increased exemption (I'm sure most homeowners don't even know about it).


• Increased renter's credit - how does this tie to the sales tax rebate? Are both needed?


• Will the sales tax rebate be refundable ? (it should be)


• Why not also increase the gasoline excise tax to help pay for improving road infrastructure and to recognize that California as ambitious greenhouse gas emission reduction targets?

I think this is all a positive step for improving California's budget, financial and infrastructure weaknesses. The tax proposals are a good start and the focus on broader base with lower rates should make for a much better tax system.

What do you think?

Modernizing the California Tax System

An NBC Bay Area Editorial of April 15, 2011 - "Revamping our Revenue Model - Bringing California's Tax System Up to Date" by Suzanne Shaw does a nice job getting right to the point about a few weaknesses in California's tax system.

She notes that the sales tax base is out of date with the new economy. That means an eroding tax base and is part of the reason for the budget problem. We have a consumption tax (the sales tax) that isn't taxing many types of personal consumption including high end consumption like personal services and digital downloads.

Thanks to Suzanne Shaw and NBC for highlighting the issues (and the links in the editorial to some of my reports on the topic). I think more people need to look into the current tax and budget situation and ask serious questions of elected officials on changes that will help the budget and the economy.

What do you think?

Enterprise zones and the role of the tax system

I saw an interesting article in the Daily News (San Fernando Valley) - "Local entrepreneurs thrive in enterprise zones" by Dana Bartholomew (3/26/11). I'll admit that what first came to mind is - well, if you are going to get tax credits and exemptions, won't that make it easier to "thrive"?

The article notes that "benefits to companies include a $37,440 tax credit for each worker hired, sales tax credits for new machinery, a 35 percent cut in city utility rates, reduced requirements for parking." How do you measure whether you have a going business with such subsidies? But ... many businesses (and individuals) get tax subsidies of some sort (percentage depletion, manufacturing deduction, various credits, and more). Generous ones for businesses can mask whether the business is truly a going concern. But how much does the subsidy have to be to get to that point? Certainly, a negative tax rate should call into question whether the business is viable and whether the government outlay could be more productive elsewhere. These can certainly be difficult issues to resolve.

The purpose of enterprise zones should be to encourage businesses to invest in areas where buildings may need major improvements and the workforce may need training. That sounds like a win for the state that would otherwise end up spending money to make improvements. If the state can help businesses to improve the area, should be a win for everyone. But how much subsidy should the business get? Should the state instead use the money directly for training centers and hiring people in the area to improve the area and start their own businesses?

Also, as noted in the article, some enterprise zones include affluent areas, such as the Warner Center area in Woodland Hills. That seems odd.

The article also quoted an accountant "who specializes in enterprise zones." Yes, this area of the tax law, like others, has generated a practice area! This accountant noted that "four out of seven failing clients in recent years [were] saved by zone tax incentives, many by filing amended returns." Well, claiming this tax incentive on an amended return points to a problem - how can you have a retroactive incentive? If the reason for the amended return was that the business only learned after the fact that it could claim tax breaks, then the tax breaks are not what led the business to invest. In such a case, the tax breaks just reward for something they were going to do anyway.

What about this approach:

• removal of special tax breaks


• lowering of tax rates


• infrastructure spending to improve areas with low business activity

Principles of good tax policy, particularly, simplicity, certainty, neutrality and economic growth and efficiency, are better met by a tax with a broad base and low rate.

Of course, part of the problem in California now is that the talk is about removing tax breaks but not lowering the rate because we are trying to resolve a budget shortfall. I'm not convinced that the shortfall is due to special tax breaks alone, but also to an outdated tax system (such as the sales tax). But, can the state do more than piecemeal reforms in a time of budget crisis?

What do you think?

California Budget Plan and Tax Switch

The San Francisco Chronicle has an article today on the Democrats' budget plan with a significant tax change - "Experts praise state Dems' tax plan" (8/12/10). The plan includes increasing the personal income tax rate for all except the highest bracket and the vehicle license fee (VLF), and reducing the state sales tax rate from 6% to 3.5% (ignoring the local sales tax).

It sounds interesting. Our sales tax rate - almost 10% is too high and impedes consumption and business development in the state. But our personal income tax rate is also already high and we rely on this tax for about 50% of state revenues already.

I know it is difficult to make any good tax changes in times of budget crisis, but I would like to see an effort to start expanding the sales tax base to include more types of personal consumption - particularly that of high income individuals (entertainment, personal services and digital goods). The revenue can be used to reduce the sales tax rate and provide exemptions for businesses (such as for manufacturing and R&D equipment). The broadened base would make the sales tax more equitable, help local governments (who must rely on the state to define their sales tax base), and make the state more welcoming to businesses.

Also, a higher gasoline excise tax would be a good idea given the greenhouse gas emission reduction targets the state has.

I've got a few reports and short articles on California tax reform - here.

What do you think?

State of California - Broken State

The Mercury News' Election 2010 Guide in today's paper (5/12/10) has a great picture of the "state" of California - here.

Yes - the state needs a lot of work - including tax reform - here

California AB 2148 - Poor Tax Policy

On Monday April 12, 2010, the California Assembly Revenue & Taxation Committee is scheduled to discuss 18 bills. Among them is AB 2148 which "would allow a deduction for the value of medical services contributed free of charge by a physician to a local community clinic, not to exceed specified amounts."

The deduction would be limited to the lesser of: "(A) The value of any contribution that exceeds a rate of fifty dollars ($50) per hour for any medical services rendered. (B) One thousand five hundred dollars ($1,500) per taxable year."

Problems:

• Design of an income tax. Federal income tax law, which California mostly copies, denies a deduction for the value of donated services (per Treasury Regulation §1.170A-1(g)). Federal law does allow the donor to deduct costs of expenses incurred, such as mileage and supplies, but not the value of the services. The likely reason is that the donor has no basis in the services. That is, he has not included the value of the work in his income. If someone were allowed to deduct the value of donated services, they should also include that value in their income. It would mostly be a wash (except that payroll or self-employment taxes would be owed on the labor income). The current system is simpler in that there is no need to have to value the donated services.
• Potential for abuse: While AB 2148 calls for a maximum deduction, it is still too easy to just claim the maximum. That is sort of the hidden message in that maximum. Also, what hours count? What about the time getting ready? Travel time?
• Complexity: Franchise Tax Board guidance would likely call for some type of documentation or reporting for the hours donated. This requires special recordkeeping by the doctor which would only be needed for tax purposes.
• Where would it end? AB 2148 would open the door for others asking for similar treatment. For example, many accountants donate time to help people prepare tax returns and to help non-profit organizations. Many attorneys do a lot of pro bono work. Many people donate time to many causes which could otherwise have been used to generate income. The law is better left as it is and it has been working well for decades.
• Non-conformity: The federal government is unlikely to ever adopt such a rule so the doctors would have an adjustment to their California return.

California has many tax problems. Decades of not allowing people who donate their services to get a deduction for it (or have to report their value as income) has worked well and time should not be spent to start changing this rule. Time would be better spent on:

• Broadening the sales tax base to bring it into the 21st century and lower the rate.
• Starting to reduce the pyramiding in the sales tax (AB 1812 and AB 2280 also on the agenda for April 12 would be a good start, but needs to be phased in along with base broadening). The analysis accompanying AB 2280 notes that only California, South Dakota and Wyoming require businesses to pay tax on manufacturing equipment. This means: Why would any manufacturer locate in California and pay an almost 10% surcharge on its equipment (the sales tax) when it won't be subject to that extra cost in almost every other state?!
• Phasing out and eliminating unnecessary, poorly targeted, unfair tax preferences in the personal income tax, such as the deduction for mortgage interest on a second home and on debt greater than $500,000.

For more on California tax problems and possible solutions - please see my reports on this topic - here, which cover the suggestions above and a few more.

California 21st Century Comimssion Proposal Due September 20, 2009

A second extension has given to the California Commission on the 21st Century Economy (COTCE). Per a press release by Governor Schwarzenegger, the Commission's report is due September 20, 2009 (rather than July 31). The announcement also states that the legislature will be called into special session to hear the proposals.

It seems that the Commission is focusing on one multi-faceted proposal. A memo from the Commission chair Gerald Parsky notes that there will be two "workshops" on the Business Net Receipts Tax Proposal on August 26 and 28 (no location details are posted to the COTCE website yet). The COTCE will also hold its final meetings in early September (details not posted yet).

The COTCE has considered a variety of problems and fixes for California's troubled tax system. It will be interesting to see what the final proposal is and if it gets anonymous endorsement from all 14 commissioners. I have written a bit about the net receipts tax recently (7/17/09 post). I've written a fair amount about problems with California's tax system and possible solutions - see reports here. Hopefully some of these problems will be addressed without creating new ones. I'll write more soon.

What do you think of the proposals, process, likelihood for reform, etc.?

Proposal for a Business Net Receipts Tax for California Businesses - A Good Move?

The California Commission on the 21st Century Economy created by Governor Schwarzenegger and the state legislature is wrapping up its work. It is looking at some bold proposals that would make significant changes in the state's tax structure. One intriguing proposal is to create a subtraction method VAT called a "net receipts tax" for California businesses that would replace some existing taxes.

Here are a few observations I've got on this particular proposal. I hope you'll leave comments on what you think of the proposal and my observations.

The California Commission on the 21st Century Economy is looking at a variety of tax changes for CA. Tax Package 1 includes modifications to the personal income tax, elimination of the corporate income tax and state general fund sales tax, and addition of a business net receipts tax (BNRT).

Is the BNRT a sales tax?

No, although it has some similarities and differences.

It is similar because it is a subtraction method VAT. Theoretically, a VAT will raise the same amount as a sales tax but will be collected in a different manner. [Click here for background information on consumption taxes and VATs.]

Because the BNRT applies to firms selling services, intangibles and tangible personal property, it has a broader reach than the CA sales tax which today only applies to a subset of tangible personal property (for example, food is exempt).

Application of nexus, and unitary and apportionment rules will cause the BNRT to have some different effects than the existing California sales tax.

Nexus: The Commission's BNRT proposal calls for a factor presence nexus standard (per R&T §23101(b), this will be the standard in CA after 2010 if Public Law 86-272 does not apply to the business). In contrast, the nexus standard for sales tax is a physical presence. (For income tax nexus for businesses that sell tangible personal property, the standard is that of Public Law 86-272.)

Example: AB Corporation has sales of $7,000,000 to CA customers, but has no physical presence in California. AB would be liable for the CA BNRT, but today it is not liable to collect CA sales tax on sales to CA customers (the customers are required though to self-report use tax on these purchases).

Example: CD Corporation has $30,000 of property in CA which represents less than 25% of its total property. CD has no employees in CA and its sales in CA are less than $500,000 and 25% of its total sales. CD is liable to collect sales tax in CA (or it could voluntarily chose to collect sales tax) but would not be required to pay BNRT. [Note: The AB example would be far more common than the CD example.]

Unitary and apportionment: If a unitary business only has sales and operations in California, the BNRT base will be similar to the sales tax base. However, many businesses have operations and sales in more than one state. For a business with sales within and without CA, they would be subject to apportionment to determine their CA BNRT base. The Commission's BNRT proposal would apportion using only a sales factor. The numerator of the sales factor would be gross receipts in CA (presumably sales where the destination was CA) and the denominator would be gross receipts everywhere.

If the BNRT were instead a gross receipts tax (GRT), unitary reporting and apportionment should not be needed because it would be fairly easy to determine the sales with a destination in CA and the broadened nexus standard would make most businesses with CA customers subject to tax in CA. However, because there are deductions from gross receipts for the BNRT, there is a need to determine what expenses are attributable to CA versus other states. Generally, a separate accounting method will not work because of the challenges of allocating many types of expenses among operations in multiple states. Thus, the question becomes, what is the best approach for determining how much of the combined group's BNRT base represents sales in CA. The Commission proposes to use just a sales factor (percent of sales everywhere that are CA sales). That seems like a logical approach because if payroll and/or property were factored in, it would likely be distortive because the location of sales is not solely dependent on where a firm's property and payroll are located.

However, it really only seems logical if one is trying to equate the BNRT to a sales tax. The BNRT, designed as a subtraction method VAT, is supposed to be taxing value added by a firm. The value a firm adds to the inputs it buys from other firms, is primarily labor. So, why isn't payroll factored into the formula to determine how much value a firm added in CA? The reason is that the BNRT creators are trying to tie the BNRT to be a sales and use tax substitute.

Example: X Corporation has operations in CA and 3 other states. X computes its total net receipts tax base and multiplies it by a fraction where the numerator is its sales to CA and the denominator is sales everywhere. The result is X's CA BNRT base. The BNRT should be the same whether X has most of its labor in CA or a different state.

The BNRT will apply to almost all types of businesses (some financial services firms and insurance companies are excluded) while today's CA sales tax only applies to a subset of tangible personal property.

A sales tax is a very visible tax because it is added to a customer's bill at the time of sale. A BNRT would not be included on a customer's bill, although some portion of it would likely be included in the price charged. If a credit method VAT were used instead, it would be noted on invoices.

Is the BNRT an income tax?

No. The BNRT is a consumption tax. While the formula for a subtraction method VAT looks like an income tax (except there is no deduction for labor costs, depreciation or interest expense, and fixed assets are expensed), it is not an income tax because it is not based on net income and it exempts savings from tax.

Because it is not an income tax, businesses selling tangible personal property do not get the nexus protections (clarifications) of PL 86-272. The nexus standard for the BNRT must meet constitutional requirements (of the due process and commerce clauses), which might be an economic presence (making a market in the state). Thus, more businesses will be subject to the CA BNRT than are subject to the California corporate or personal income tax.

However, if the current congressional proposal to modernize PL 86-272 were ever to be enacted, businesses would only be subject to a business activity tax (such as perhaps, the BNRT) if they were present in the state for at least 15 days during the year (that is a very brief summary of H.R. 1083). Under that version of PL 86-272, far fewer businesses would have BNRT obligations in California and the desired revenue goals would not be achieved.

Some questions and observations about the proposed BNRT and its formula:

Instead of expensing assets when acquired, an accelerated depreciation system is used in the Commission proposal. This is contrary to a consumption tax. If this adjustment is made due to the desire to raise a certain amount of revenue, it would be better to raise the tax rate rather than make the BNRT a combination of an income and consumption tax.

The Commission calls for the Finnigan rule to be used to source sales of the combined/unitary group. This likely has little impact given that the nexus standard is broadened for the BNRT making it more likely that any firm with sales in CA will have nexus in the state and its sales would go into the CA sales factor numerator anyway. However, the Finnigan throwback approach should reduce the throwback sales that are included in the CA sales factor numerator making that a more attractive approach than the Joyce rule.

Will any credits be usable against the BNRT?

What happens to NOL and credit carryovers that corporations have from the corporate income tax?

With a single sales factor apportionment (after 2010) and various tax credits, such as for research, today's CA corporate income tax has significant economic development elements to it. The current system should encourage businesses to locate payroll and property in CA and sell to people outside of the state. Without the credits, it is not clear if CA would be a desirable place to locate unless you have lots of sales outside of CA and CA's BNRT is lower than what the business would pay in other states. If the BNRT is enacted along with repeal of both the corporate income tax and the state-level general sales tax, CA should become more attractive to capital intensive firms such as manufacturers (although many states already exempt manufacturing equipment from sales tax). The state might not be as attractive for labor intensive firms who already pay little sales tax, but have significant labor costs which do not reduce the BNRT base. However, the labor intensive firm would gain little from moving its labor force outside of the state because, having CA sales, it would still be subject to the BNRT. Also, because payroll is not used to apportion the combined/unitary BNRT base, there should be no change in its CA BNRT.

Could the BNRT be viewed as a sales tax rather than a business tax? If yes, then a physical presence nexus standard would apply. Also, the tax might not be applicable to food under the CA constitution. When Ohio enacted its gross receipts tax (called a Commercial Activity Tax) a few years ago, food vendors were successful at the trial court level in holding that the tax was really a transaction tax which under Ohio law cannot be imposed on food (see Tax Notes article on this). California's constitutional restriction is narrow prohibiting only a sales and use tax: Article XIII, Section 34 of the California Constitution reads: “Neither the State of California nor any of its political subdivisions shall levy or collect a sales or use tax on the sale of, or the storage, use or other consumption in this State of food products for human consumption except as provided by statute as of the effective date of this section.” Could the NRT be viewed as a sales tax?

The BNRT is similar to the Michigan Single Business Tax (SBT) that it had for many years, but recently replaced with a different tax. Why did Michigan abandon its SBT and what lessons can we learn from that state's experience? [For some background on this – see the Michigan tax agency website, a 2003 Michigan report on the SBT and a 2007 Tax Foundation report.]

It would be interesting for firms to calculate their CA tax liability under the BNRT to get a sense of how the BNRT would change tax liabilities for CA firms.

What might businesses do to reduce their BNRT liability?

• Increase sales to other states and countries.
• Hire contractors rather than employees so they get to deduct those labor costs (wages and payroll taxes do not reduce the BNRT base).

Additional information:

• Presentation to the Commission by Robert Cline of Ernst & Young (6/16/09)
• Franchise Tax Board Analysis

What do you think (about the proposals and the accuracy and completeness of my observations)?

Proposed Tax Increases in California: Overlooking the 21st Century

California legislators continue to struggle with how to close the $15 billion budget gap even as the year has begun and the budget deadline has passed. On July 8, the Budget Conference Committee developed a plan that restores some proposed cuts and proposed a package of six tax increases. Five of the increases involve the individual income tax and corporate franchise tax while the sixth calls for efforts to collect some of the state's uncollected taxes (reduce the tax gap).

A problem with aiming to close a specified budget shortfall is that it is too easy to look at the amounts various changes could raise and massage it until you hit your needed number. Math wins out over strategy. while the committee has reasons for each of the five tax increases, they are fairly weak, such as - we had these high rates in the past. Why does that mean they make sense for California's economy and society now? What about cutting back on tax deductions, exclusions and credits that are too generous or poorly targeted such that they benefit taxpayers who don't need a benefit? What about shaping our tax laws to support our economic, societal and environmental goals? For example, policymakers are working to find ways to get California to reduce its GHG emissions. So, why not enact a carbon tax?

While a primary purpose of this tax increase package is to help get a discussion going and to push Republicans to come up with an alternative plan, some of these tax proposals could remain. We'll have to see. Here's my thoughts on each of the proposals and if they are moving California's tax system into the 21st century.

Proposal 1: Add two new tax brackets to the individual income tax. The 10% rate would apply to joint returns with income above $321,000 and the 11% rate would apply to joint returns with over $642,000 of income. We have had these high rates before. Without the change, this income would be taxed at 9.3% and 10% if over $1 million.

Comments: California is already a high income tax rate state. Our income tax is very volatile because the bulk of it is collected from a small number of high income individuals. When their income goes down, in essence, the entire state feels it. This is also because the personal income tax is about 50% of our general fund revenues. California law is designed such that, for example, a family of 4, no income tax would be owed until their income was over $44,000. I've got more information on this volatility in a 2007 report.

There are flaws with many of the tax deductions, credit and exclusions in the personal income tax. For example, CA follows federal law in allowing mortgage interest to be deducted on a primary and second residence and on up to $1.1 million of debt. This tax break is worth more to high income individuals. Why is the state subsidizing home purchases beyond the median home price and on a second home as well? This rule is provides too generous of a benefit to high income/wealthy individuals. It should be cut back and perhaps even converted to a tax credit to eliminate its skew to higher income individuals.

Raising the rate rather than fixing the base just leaves Califorrnia labeled as a high tax state, gives high income individuals pause to question if they should live elsewhere, makes tax planning more attractive and continues to leave the base problems for another day.

The California Budget Project notes that in an economic downturn, tax increases are better than spending cuts. But I don't see any reason to get that tax revenue in such a way that increases the volatility of tax collections and doesn't help California's economy. I think we need to replace part of the PIT with an environmental (polluter pays) tax and broaden the sales tax base to bring in the items higher income individuals tend to be the buyers of (personal services, entertainment, digital downloads). A polluter pays tax could be a carbon tax, it could be a utility tax on bills above what the average would be for a family of four living in a 1200 square foot house.
This is a poor proposal.

Proposal 2: Suspend use of corporate NOLs for 3 years.

Comment: The committee's write-up describes this as closing a "tax loophole for large corporations." But, corporations of all sizes are allowed to carryover NOLs and the committee provides no information about any corporations using the carryover provision in any way other than how intended. Thus, it is not a loophole.

[Two of the proposals were described as closing loopholes and neither one is a loophole. For more on this - see my op ed in the San Diego Union Tribune (7/11/08)]

Instead of completely denying corporations use of their NOLs for 3 years, it should be more helpful to the business (and the state) to instead provide that in any year, an NOL carryover cannot reduce taxable income by more than 70% (or some other percentage). This means that when a corporation has positive income, it will pay some level of tax even though it has an NOL carryover. It still gets full use of its NOL, it will just take longer to use it.

This proposal could be improved.

Proposal 3: Suspend the indexing of the individual income tax brackets, apparently, just for one year.

Comment: This is a disguised tax rate increase. For example, if an individual's 2008 income goes up due to a cost-of-living raise, they may end up in a higher tax bracket. Even if this is for just one year, it is a disguised tax rate increase. Also, even if the suspension of indexing is just for one year, the effect will last forever because higher rates will kick in at lower income levels and those are the brackets that will be indexed going forward.

This is a poor proposal. There are more transparent ways to generate additional tax revenues.

Proposal 4: Reduce the dependent credit for individuals with AGI above $150,000. A few years ago, to benefit families, the credit amount for dependents was raised to $294 while the personal credit is $94. A key purpose of these credits is to help measure ability to pay.
Comment: This changes was also described as closing a tax loophole for upper-income income. However, it is not a loophole (see article). There isn't really any strong reason why the dollar amounts of these credits should be different. Also, for high income individuals, the amount of the credits is phased out. However, these are high income levels, such as about $150,000 for single taxpayers.

Proposal 5: Increase the corporate franchise tax rate from 8.6% to 9.3%. This rate had been in place a few years ago and so is described as restoring the franchise tax.

Comment: California already has high tax rates. Rather than making them higher, consideration should be given to broadening the tax base and perhaps lowering the rate.

Proposal 6: Increase tax enforcement efforts to help generate about 1.5 billion.

Comment: This is great. It is always good to be sure the tax gap (amount of tax owed, but not collected) be kept to a minimum. Rather than increasing a tax or creating a new tax, see about collecting more of the taxes already on the books.

Given the push to make changes that lead to closing the $15 billion shortfall, math won out over making tax reforms that would help our economic, societal and environmental goals. But, it is likely just a start to further budget debates. We'll see what other tax increases are proposed and which, if any, of the ones from July 8 are continued.

What do you think?