Review of the California Competes Tax Credit

Review of the California Competes Tax Credit MAC TAYLOR • L E G I S L A T I V E A N A L Y S T • OCTOBER 31, 2017 AN LAO REPORT 2 Legislative Analyst’s Office www.lao.ca.gov AN LAO REPORT EXECUTIVE SUMMARY California Competes awards income tax credits to attract or retain businesses considering a significant new investment in California. In this report, we reviewed California Competes’ experience to date in meeting the Legislature’s goals for the program. In Some Cases, Program Has Negative Economic Effects. In our review of California Competes, we find that about 35 percent of the awards—15 percent of the total dollar value—went to businesses that sell goods and services very near to them in California. These tax credits provide “windfall benefits” as they result in no change in the overall level of economic activity in the state. Moreover, these awards inadvertently harm other, equally deserving California businesses—including most of the tens of thousands of California small businesses—because the tax credits awarded to their competitors puts them at a significant competitive disadvantage. In Many Cases, Awards Could Grow Economy but Effects Uncertain. Most of the tax credits—about 65 percent of awards representing about 85 percent of total dollar value—were awarded to businesses that sell goods and services within and outside of California. These credits may have contributed to the state’s economic growth. It is difficult, however, to assess the program’s effectiveness in attracting new investment and jobs because we cannot know what actions the businesses awarded tax credits would have otherwise taken. For example, some may have already planned to expand here. In addition, these credits have the same problem of disadvantaging all the competing companies which do not receive the credit. Broad-Based Policies Preferable. The executive branch has made a good faith effort to implement California Competes, but the problems described above are largely unavoidable. We recommend that the Legislature end California Competes. In general, broad-based tax relief—for all businesses—is preferable to targeted tax incentives. If Program Continues, Options to Make California Competes More Effective. In light of intra- state competitions to attract new business investment, we understand that the Legislature may wish to keep California Competes as an economic development tool. If the program continues, we suggest that the Legislature (1) narrow eligibility to businesses that serve markets outside of California, (2) refocus the program on attracting jobs and investments that would otherwise locate outside California, and (3) modify the small business provisions. www.lao.ca.gov Legislative Analyst’s Office 3 AN LAO REPORT 4 Legislative Analyst’s Office www.lao.ca.gov AN LAO REPORT INTRODUCTION The California Competes tax credit program law, the state may only make new California provides tax benefits to select businesses in Competes tax credit awards through 2017-18. exchange for meeting contractual hiring and Unless additional authority is granted in future investment targets. California Competes was legislation, program activities would thereafter be created in 2013 as a part of a larger deal that limited to audits and other oversight duties related replaced the state’s Enterprise Zone programs with to already awarded tax credits. In this report, we three new economic development programs. (See explain how California Competes works and review the appendix for more information about the state’s its effectiveness in attracting new investments and former Enterprise Zone programs.) Under current jobs. BACKGROUND The Governor’s Office of Business and California Competes awards are available in total Economic Development (GO-Biz) is responsible between 2013-14 and 2017-18—$30 million in year for awarding California Competes tax credits to one, $150 million in year two, and $200 million businesses. Businesses may claim the tax credit per year in each of the following three years. The only if they meet certain investment and hiring Department of Finance (DOF) annually adjusts targets set forth in written agreements negotiated the amount available to reallocate (1) credits not with GO-Biz. The Franchise Tax Board (FTB) is awarded in a prior year and (2) “recaptured” credits responsible for independently verifying whether (discussed below). In 2016-17, for example, DOF the businesses complied with the terms of those allocated $243.4 million to California Competes agreements. because $39.9 million in tax credits were not awarded during the prior year and an additional California Competes Basics $3.5 million had been recaptured. DOF may GO-Biz Administers the California Competes also reduce the amount of available California Program. GO-Biz leads the state’s economic Competes credits under certain circumstances, development activities. Among its functions, which have not occurred. GO-Biz administers the California Competes tax GO-Biz Conducts Outreach Activities credit program. In administering this tax credit Statewide. GO-Biz regularly holds workshops program, GO-Biz has several responsibilities around the state to increase awareness of California that include: increasing awareness about the Competes and the state’s other economic credit among the business community, accepting development activities. Business owners and tax credit applications, evaluating applications, other executives, accountants, and site selection negotiating tax credit agreements, and monitoring consultants attend these sessions to learn about agreement compliance for at least five years after how to apply for the tax credit. State law does not the agreements are signed. require GO-Biz to conduct outreach. However, the Amount of Tax Credits Available Has Legislature provides funding for these activities in Increased Annually. Up to $780 million in the annual budget bill. GO-Biz has held workshops www.lao.ca.gov Legislative Analyst’s Office 5 AN LAO REPORT in more than 100 different California cities over received 3,045 applications between the start of the past three years. To reach a broader audience, the program and June 2017. About 300 businesses, GO-Biz also periodically hosts workshops online on average, apply for tax credits during each and has marketed the program during some out-of- application period. state trade missions. Evaluation Phase 1: Applications Ranked. GO-Biz reviews and evaluates the applications Tax Credit Application and Evaluation Process in two phases over a 90-day period. In the first California Competes tax credits are awarded phase, GO-Biz scores each application using the to businesses through a formal process. Figure 1 information provided by each business about their summarizes this process and we describe each step hiring and investment plans. The purpose of this over the following pages. Three Application Periods Figure 1 in 2017-18. The first step is California Competes Tax Credit Process to submit an application. Businesses can learn about Application the application process Businesses relocating to or expanding in California submit applications to Governor’s Office of Business and Economic Development (GO-Biz) from the GO-Biz website, with their proposed: • Tax credit request. e-mail notifications, the • Number of new jobs and average wage. workshops discussed above, • Amount of new investment. and other media. GO-Biz Evaluation accepts applications during GO-Biz evaluates applications, considering many factors. Small businesses and businesses in economically disadvantaged specified periods—three such areas receive preferences. application periods have been Negotiation scheduled for the 2017-18 fiscal GO-Biz negotiates the terms of five-year written tax credit agreements with the top applicants—including employment and investment targets. year: • July 24, 2017 to Committee Approval The California Competes Tax Credit Committee approves August 21, 2017. agreements. • January 2, 2018 to Self-Certification January 22, 2018. Businesses annually self-certify to GO-Biz whether or not they met their agreement milestones. • March 5, 2018 to Credit Claimed March 26, 2018. Businesses file taxes as normal and, if agreement milestones reached, may claim credit to reduce income taxes. Credits may be carried Businesses must submit forward if they exceed the amount of tax owed. their applications online and Compliance Verification there is no application fee. The Franchise Tax Board reviews tax filing and other information. Determines whether business in compliance with agreement. The applicants request a tax credit amount and provide Credit Recapture some information about The state can recapture tax credits from businesses that fail to achieve the agreement milestones or otherwise violate the agreement. their intended hiring and investment plans. GO-Biz has 6 Legislative Analyst’s Office www.lao.ca.gov AN LAO REPORT first phase is to weed out the businesses planning authority to decide which businesses will receive modest expansions relative to the amount of tax credit awards. While the law requires GO-Biz to tax credit they are requesting. In this process, a consider the numerous factors detailed in Figure 2, business that requests a smaller tax credit—holding GO-Biz decides how much weight to give each constant the proposed amount of hiring and factor in evaluating the applications. GO-Biz scores investment—receives a higher score. Applicants each application and then negotiates tax credit with the highest scores move on to the second agreements with the highest scoring businesses on evaluation phase. The number of applications per a case-by-case basis. period has remained stable while the amount of Some Businesses Receive Preferences. Current available tax credits has increased significantly. law provides several preferences for businesses that Over the most recent two years, more than invest and hire in economically disadvantaged 90 percent of the applications have moved on to the areas, and for small businesses. Businesses that second evaluation phase, compared to fewer than would expand in a high-unemployment or 70 percent during the first two years of California high-poverty city or county automatically move Competes. on to the second phase of the evaluation process. Evaluation Phase 2: Additional Factors (These areas have poverty or unemployment Considered. State law gives GO-Biz broad rates that are at least 150 percent of the statewide Figure 2 California Competes Tax Credit Evaluation Factors The Governor’s Office of Business and Economic Development (GO-Biz) considers the following factors when evaluating tax credit applications: 9 Number of jobs created or retained. 9 Employee compensation. 9 Amount to be invested in new equipment and other business improvements. 9 Duration of the project and of the taxpayer’s commitment to remaining in this state. 9 Prevalence of unemployment or poverty in the area. 9 Other government incentives available to the taxpayer in this state and in other states. 9 Strategic importance of the project to the state, region, or locality. 9 Opportunity for future growth and expansion in this state by the taxpayer. 9 Whether benefit to the state exceeds benefit to the taxpayer and the overall economic impact in this state. 9 Other factors regarding the taxpayer such as their financial solvency and legal history. 9 If the taxpayer is using a consultant to apply for California Competes, GO-Biz may consider the terms of the fee arrangement between the two parties. 9 Any other factors GO-Biz deems necessary. www.lao.ca.gov Legislative Analyst’s Office 7 AN LAO REPORT rates.) In addition, one-quarter of the California GO-Biz negotiates the amount of tax credit Competes tax credits are set aside for small available to the business in each of the five years businesses. Current law defines small businesses and the investment and hiring commitments that as having less than $2 million in annual revenues. the business must meet to claim their credit. These Throughout the process, GO-Biz evaluates these terms are summarized in a milestones exhibit that small business applications separately from the rest. is appended to each agreement. (See Figure 3 for an example of one such exhibit.) State law also requires Tax Credit Agreements the agreements include a minimum job retention Tax Credit Agreements Individually period. This is a period—three years in most of Negotiated. GO-Biz negotiates five-year written the agreements—subsequent to the initial five tax credit agreements with the highest scoring years of the agreement, during which the business applicant businesses. For each tax credit agreement, may not reduce employment below the final total Figure 3 Sample: California Competes Tax Credit Agreement “Milestones” Exhibit 2015 Tax Year 2016 2017 2018 2019 2020 (Base) Tax Year Tax Year Tax Year Tax Year Tax Year Total Total California Full-Time Employees 22 26 32 37 42 45 (Determined on an annual full-time equivalent basis) Net Increase of Full-Time Employees 4 10 15 20 23 Compared to the Base Year Minimum Annual Salary of California Full-Time $30,000 $30,000 $30,000 $32,000 $32,000 Employees Hired Cumulative Average Annual Salary of $37,500 $37,500 $37,500 $37,500 $37,500 California Full-Time Employees Hired Investmentsa $700,000 $700,000 $1,500,000 $1,300,000 $1,700,000 $5,900,000 Tax Credit Allocation $22,500 $22,500 $22,500 $22,500 $22,500 $110,000 a “Investments” means the amount the business has committed to spending on new real or personal property such as, for example, improvements to buildings, equipment, and software licenses. 8 Legislative Analyst’s Office www.lao.ca.gov AN LAO REPORT employment milestone. (Agreements also include Agreements Approved by Oversight various contractual details—such as reporting Committee. The California Competes Tax Credit requirements and the conditions under which Committee was established to approve the tax the state may recapture a tax credit. These are credit agreements negotiated by GO-Biz. The standard across most of the agreements.) All of the committee is comprised of the Director of GO-Biz, agreements are publicly available on the GO-Biz the State Treasurer, the Director of Finance, or their website. designated representatives, an appointee of the Hiring and Investment Commitments Have Senate Committee on Rules and an appointee of the Lessened. The average contractual hiring and Speaker of the Assembly. The committee meets to investment targets in these California Competes publicly approve or reject the California Competes tax credit agreements have lessened over time. tax credit agreements negotiated by GO-Biz staff. Figure 4 shows for each fiscal year the average As of July 2017, the committee has met ten times number of new full-time employees businesses and approved 775 agreements—about one-quarter committed to hiring for every $100,000 of tax of the 3,045 applications. credits and the average amount the businesses committed Figure 4 to invest for every dollar Hiring and Investment Commitments Lessened Over Time of tax credit. We believe Average Number of New Full-Time Employees that the agreement terms Business Commits to Hiring Per $100,000 of Tax Credit have lessened because the 25 number of applicants during 20 each cycle has remained stable—at between 250 and 15 350 applicants—while the 10 amount of available tax credits increased. As we noted above, 5 only $30 million was available in the first year of the program. 2013-14 2014-15 2015-16 2016-17 DOF allocated $151 million to California Competes for Average Amount Business Commits to Investing Per $1 of Tax Credit 2014-15, $201 million for $80 2015-16, and $243 million 70 for 2016-17. Since the credits 60 are awarded on a competitive 50 basis, it is not unreasonable 40 that the hiring and investment 30 targets could decline when 20 there are fewer applicants 10 competing for each tax credit 2013-14 2014-15 2015-16 2016-17 dollar. www.lao.ca.gov Legislative Analyst’s Office 9 AN LAO REPORT Types of Businesses Receiving Tax Credits Small Businesses Not Fully Utilizing 25 Percent Set Aside. California Competes reserves A wide variety of businesses have been one quarter of the tax credits for businesses with awarded California Competes tax credits. Figure 5 gross annual revenues below $2 million. As of summarizes California Competes awards by June 2017, GO-Biz has awarded 293 tax credit industrial sector. The manufacturing sector has agreements—amounting to $99 million in total—to received more tax credit awards—261, or more small businesses. This amount is about 19 percent than one-third of the tax credits by value—than of the total $528 million awarded and less than any other industrial sector. The professional, 17 percent of the $590 million that was available. scientific, and technical services sector received While GO-Biz sets aside 25 percent of the available about 25 percent of the tax credits by value, and the tax credits for small businesses, as required, too information sector received about 10 percent. Other few qualified businesses have applied to California key industrial sectors with businesses receiving Competes to utilize all of those credits. Figure 6 California Competes tax credits include wholesale shows the amount of tax credits available to small trade (9 percent), retail trade (5 percent), finance businesses and the amount actually awarded each (3 percent), and construction (3 percent). Within year. In 2016-17, GO-Biz awarded $30 million in these sectors are businesses that make or distribute tax credits to small businesses—or 49 percent of products to customers all over the world, as well the amount reserved for them. GO-Biz has sought as businesses that only sell to customers within to increase the number of small business applicants California. The nearby box provides some examples by increasing their outreach efforts and translating of the types of businesses that have received reference material into languages other than California Competes tax credits within six of these English. industrial sectors. Use of Tax Credits Figure 5 California Competes Awards by Industry Businesses Annually Self-Certify Compliance. Percent of Dollar Amount of Tax Credits Awarded After the California Competes Tax Credit Committee approves their agreements, Wholesale Trade Manufacturing businesses awarded credits Retail Trade Other proceed with their expansion Finance and Insurance Industries projects and regular order Construction Other Industrial of business. At the end of Sectors Awarded 1 Percent or Less their fiscal year, each of the businesses must report to GO-Biz whether they Information achieved their agreement milestones. If a business met or exceeded the terms of their Professional, Scientific, agreement, they may claim and Technical Services the tax credit when they file 10 Legislative Analyst’s Office www.lao.ca.gov AN LAO REPORT their income taxes. (How Figure 6 businesses and their owners Small Businessesa are taxed depends on the form Not Fully Utilizing California Competes Set Aside of the business entity. State law treats corporations and $70 partnerships differently, for example.) If a business’ tax 60 Amount of Credits Set Aside for Small Businesses liability when they achieved 50 their agreement milestones is 40 less than the credit amount, state law allows the business 30 to carry the remaining 20 amount of tax credits forward Amount of Credits Awarded to Small Businesses for up to five subsequent 10 taxable years. GO-Biz Monitors 2013-14 2014-15 2015-16 2016-17 Agreement Status. If a a “Small business” must have gross annual revenues below $2 million. business fails to achieve its Examples of Businesses Classified in Certain Industrial Sectors The North American Industry Classification System (NAICS) is a method for grouping business establishments into standardized categories of economic production. This has several purposes, including facilitating the collection of economic data and to better understand how the structure of the economy is changing over time. The NAICS is comprised of 20 industrial sectors, such as manufacturing and information. While it may be obvious which kinds of businesses are categorized into some of these, the composition of other sectors may be less intuitive. Below, we provide several examples of businesses that have received California Competes tax credit awards in six of the most represented NAICS sectors. Manufacturing Wholesale Trade • Brewery • Athletic shoe and apparel distributor • Medical device manufacturer • Construction material distributor • Vehicle manufacturer • Cosmetics distributor Professional, Scientific, and Technical Services Retail Trade • Scientific research and development • Furniture store • Information technology consultant • Lumber yard • Certified public accountant • Online shopping website Information Finance and Insurance • Software developer • Peer-to-peer lending company • Online video streaming service • Financial advisor • Online journalism company • Insurance agent www.lao.ca.gov Legislative Analyst’s Office 11 AN LAO REPORT contractual hiring and investment targets for one Tax Credit Use Somewhat Below Expectations. year, it may not claim the tax credit in that taxable As of June 2017, we only have statistics on the year. However, such a business can “catch up” if amount of California Competes tax credits claimed it meets its agreement milestones in a following for tax years 2014 and 2015. (We do not receive tax year. The amount of tax credits a business may statistics until several years following the close of claim is tied to the specific agreement milestones. the taxable year. We will receive preliminary data For example, if a business misses its second year on the use of tax credits for the 2016 tax year in agreement milestones, but continues with the November 2017.) Taxpayers claimed $3 million project during the third year, it may claim both worth of California Competes credits in tax the second and third year tax credits in the third year 2014 and $12.6 million in tax year 2015. year. In other cases, the business may not be able Based on the terms of the tax credit agreements, to achieve and maintain its milestones because, for we anticipated somewhat larger amounts. This example, of a bankruptcy or a strategic change in shortfall suggests that (1) some businesses have its business plan. In such cases so far, GO-Biz and not achieved their agreement milestones, and these businesses have voluntarily agreed to end the (2) other businesses have carried forward a portion agreements early, allowing the state to recapture of their tax credits to future tax years because of an and reallocate those tax credits to other businesses. insufficient current-year tax liability. There have been 21 such cases as of June 2017. Tax Credits May Be Recaptured if Business FTB Reviews Records to Validate Compliance. Breaches Agreement. The California Competes State law requires FTB to “review the books and tax credit agreements specify the conditions under records” of businesses claiming a California which a business may be found in material breach Competes tax credit to ensure compliance with the of its agreement. This would happen if the state terms and conditions of the written agreements. found a business to have falsified information or FTB is not required to audit small business failed to maintain one or more of its agreement recipients, although they may do so at their milestones for the specified period. This has not discretion. After a business (or individual business yet happened. However, as mentioned above, 21 owner) files a tax return claiming a California businesses have voluntarily agreed to terminate Competes tax credit, FTB reviews the tax credit their agreements. If FTB and GO-Biz determine agreement and requests supporting information, a business is in material breach of the terms of its such as documentation of equipment purchases and agreement, they notify the business and give it time payroll records, from the business. FTB evaluates to cure the breach. If the business fails to respond that information as well as information from to GO-Biz or cannot cure the breach within an other available sources, such as the Employment agreed upon time period, the California Competes Development Department, and determines Tax Credit Committee recaptures the tax credit, whether the business has in fact met its agreement and FTB attempts to collect the amount of income milestones. tax the state is owed. 12 Legislative Analyst’s Office www.lao.ca.gov AN LAO REPORT ASSESSMENT OF CALIFORNIA COMPETES GO-Biz Implementation in California—employers that might not otherwise invest or remain here without such a financial Our assessment is that GO-Biz has incentive. In other words, California Competes is implemented the California Competes tax credit intended to affect the behavior of some businesses program in good faith. They quickly developed a to engage in economic activities in California they process—and adopted the necessary regulations otherwise would not have taken. to implement it—to award the tax credits Is California Competes Effective? In this in accordance with the program’s statutory section of the report, we assess the effectiveness requirements. Additionally, GO-Biz has attempted of California Competes toward this goal: Has to fairly balance the stated intent of the Legislature California Competes had a significant effect on to maximize the effective use of taxpayer dollars changing business behavior in attracting new with statutory requirement to consider various investment and jobs? We consider this question specific factors. As discussed below, we have found in the context of two distinct types of businesses, various areas where the Legislature may wish to those doing business in the tradable sector of the reconsider its directions to GO-Biz on how to economy and those in the non-tradable sector. implement this program. Tax Credits to Non-Tradable Businesses California Competes Intended to Affect Business Behavior Non-Tradable Goods Produced Where Sold. Businesses producing non-tradable goods States Compete for New Business Investment. and services are an essential component of the During the process of selecting the site for a economy. Non-tradable goods and services must significant new investment, a business typically be produced close to where they are consumed. considers a variety of factors—including the Such goods and services have some characteristic proximity to their customers and suppliers and the preventing them from being easily, legally, or availability and cost of skilled labor, land, energy, cost-effectively transported between where water, and other infrastructure. A business may they are produced to another state or another also consider quality of life factors, the regulatory country. For example, heavy, commonplace, and environment, and state and local taxes. State and inexpensive goods—such as gravel—are generally local governments compete openly against one not tradable. While professionals in some service another to attract such new investments—not only industries travel so that they can do business far based on those traditional factors particular to a away from where they live, this is impractical for location, but sometimes also by offering significant many others—such as a plumber or a dry cleaning tax benefits and other financial incentives. business. In addition, many business and household California Competes Intended as Economic service professionals such as hair stylists, insurance Development Tool. In this environment, the agents, and architects—to provide only three Legislature created California Competes to examples—must be licensed by the state where provide a tool to offer state tax benefits to they do business. Most businesses in industries attract or retain individual businesses that are such as education, health care, and construction considering making a significant new investment www.lao.ca.gov Legislative Analyst’s Office 13 AN LAO REPORT are generally non-tradable. (We realize that situation, the business that received the tax credit modern, inexpensive telecommunications have adjusted its behavior in response to the incentive, allowed for new business models that may blur but there was no overall increase in economic these distinctions.) Typically, such businesses only activity. Thus, the tax credit provides windfall expand when such an action would be justified by benefits. Moreover, there are serious equity an increase in demand for their product locally or implications raised by this example. The tax credit when they believe they can take market share from benefited one business to the detriment of another their local competitors. equally deserving business. Tax Credits to Non-Tradable Businesses Are Tax Credits to Non-Tradable Businesses Windfall Benefits. The California Competes tax Harm Economy. As illustrated above, California credit is a windfall benefit for most businesses Competes tax credits awarded to non-tradable operating in the non-tradable sector of the businesses have negative economic impacts. First, economy. That is, the state provides a benefit to nearly all economic growth that might be directly businesses without achieving the state’s desired attributed to the tax credit was either already going goal of increasing economic activity in the state. to occur or came at the expense of other California We illustrate this with an example. businesses. That is, the credits did not achieve the Consider what might happen when one goal set out for the program of increasing the overall non-tradable business—a plumbing service— level of economic activity in the state (jobs and/or receives a California Competes tax credit while investments). At the same time, the tax credits have its competitors do not. In the example, which “opportunity costs”—that is, they consume state we illustrate in Figure 7, Alex’s Plumbing Co. resources that would have otherwise benefited the has a similar and equally sized competitor, Zoe’s state’s residents. For instance, the funds dedicated Plumbing Co., and together they employ 40 people to the credits could have otherwise been used on in total. The demand for plumbing services other state spending priorities or on tax reductions increases over time and, in this example, the to state residents or businesses. (We discuss two plumbing businesses will also expand by a opportunity costs more below.) Finally, the credits combined total of six new employees to meet that create an uneven playing field, benefitting a handful increase in demand. If neither business receives of businesses while disadvantaging other businesses. special treatment, both Alex’s and Zoe’s will, being Many Non-Tradable Businesses Awarded similar, expand at about the same pace. However, Credits. We estimate that about 35 percent of the should Alex’s receive a tax credit, it would have a California Competes tax credit agreements were competitive advantage over Zoe’s—perhaps Alex’s made with non-tradable businesses. (We have would be able to pay its employees somewhat higher attempted to distinguish between the primary wages and charge a little bit less for its services. industry of the business and the specific project Alex’s receives a credit if it hires ten new employees. when possible.) However, most of these tax credits However, in this example, the total demand for awards were relatively small. As a result, we plumbing services in the town can only support estimate that only about 15 percent of the dollar a total increase of six new plumbing employees. value of the tax credits were awarded to such Zoe’s must therefore lay off four employees. In this businesses. 14 Legislative Analyst’s Office www.lao.ca.gov AN LAO REPORT Figure 7 Tax Credits to Non-Tradable Businesses Are Windfall Benefits Present Day Alex’s Plumbing Co. and Zoe’s Plumbing Co. are two similar and equally sized hypothetical plumbing businesses. Alex’s Plumbing Co. Zoe’s Plumbing Co. The local demand for plumbing services increases over time. This increase in demand will support a total of six additional plumbers. Alex’s receives a California Competes tax credit, Zoe’s does not. Five Years Later Alex’s Plumbing Co. Zoe’s Plumbing Co. Alex’s hires ten additional employees. However, the tax credit will not create more local demand for plumbing services. Since the increase in demand will only support an increase of six plumbers, Zoe’s— which is disadvantaged—must cut its staff by four employees. The tax credit is a windfall because the net increase in employment in this town is six with or without the tax credit. www.lao.ca.gov Legislative Analyst’s Office 15 AN LAO REPORT Tax Credits to Tradable Businesses the difference in that firm’s decision to locate in Have Uncertain Economic Effects California. Credits to Tradable Businesses May Still Tradable Businesses Spur Economic Growth. Have Negative Impacts. Providing credits to Many goods and services are tradable. Most tradable businesses can still result in the same manufactured goods, for example, can easily negative effects associated with credits awarded be shipped to another state or another country. to non-tradable business. The simplest example Inexpensive and quick telecommunications is a business that had already planned to expand and transportation also allow many services to in California. Such a business has little to lose in also be tradable. A management consultant, for applying for a California Competes tax credit. example, can live and work in California and have Moreover, there is no way to know with any clients located anywhere in the world. (For many certainty the actual plans of any business applying professions, this tradability can vary significantly to the program. Accordingly, many credits to depending on the area of specialization within their tradable businesses still produce windfalls and are, field. For example, some accountants specialize in therefore, ineffective at attracting new investment tax preparation for local clients, while others work and jobs. The state has also disadvantaged all other for clients elsewhere.) Tradability is important in competing businesses that did not receive a credit. the context of California Competes because the Actual Effects of Credits to Tradable expansion of such businesses need not come at the Businesses Unknown. In order for the credit expense of other California businesses—economic program to be successful, it must change a growth is not a zero sum game. business’s decision-making in such a way that Most Credits Given to Tradable Businesses. increases jobs and/or capital investment in About 85 percent of the tax credit dollars have California. GO-Biz can attempt to focus on certain been awarded to businesses that produce goods factors that maximize this impact. For example, and service that are, or could be, tradable. In these it could look at businesses or sectors that already cases, it is possible that the credit changes business had a history of migrating outside the state or look behavior that results in expanded economic activity at businesses that were being induced to move in California. For example, consider a hypothetical with tax breaks offered by other states. Ultimately, manufacturing business, Dan’s Manufacturing however, there is no way of knowing what effect Co., which is headquartered in California, but the California Competes tax credits have because makes and exports products to customers all over we cannot know what firms receiving the credits the world. Dan’s currently employs 20 people at would actually have done absent the credit. Given its California headquarters and 40 people at its this, it will always be difficult—if not impossible— current factory. The business is planning to expand. to assess the effectiveness of California Competes. If it does not receive a California Competes tax credit, Dan’s will build a second factory employing Other Issues 40 new employees in another state. If it receives Price and Income Effects. The demand for all a tax credit, it will agree to build the factory goods and services, regardless of whether they are in California. In this case, the credit results in tradable or not, is affected by their price—demand economic activity that otherwise would not take increases as price decreases. Prices of tradable place in the state. Similarly, a credit provided to an goods are affected by global supply and demand out-of-state firm considering expansion could make 16 Legislative Analyst’s Office www.lao.ca.gov AN LAO REPORT but the prices of non-tradable goods can vary Opportunity Costs. Tax credits provide special significantly among places, depending on local state tax benefits for some taxpayers. As such, tax supply and demand factors. In addition, higher credits have obvious fiscal impacts in that they reduce incomes in a region can increase the demand for state revenue. In doing so, tax credits reduce the many goods and services there. The California amount of money that is available for other purposes. Competes tax credit may affect the local prices, California Competes will reduce state revenues by up supply, and demand of some goods and services to $780 million over about 15 years, resources that in areas where non-tradable businesses receive state policymakers could otherwise use to fund other a tax credit. This may also increase wages—the state programs, reduce debt, or allow for alternative price of labor—for some employees, leading to tax reductions. Whatever this foregone revenue higher household incomes (and higher incomes would have funded would have benefitted the subsequently increase the demand for some goods state’s residents in some way. This foregone benefit and services). All of these changes have complicated is the opportunity cost of California Competes. The economic effects—positive for some people, Legislature has to consider the benefits of California negative for others—beyond those discussed above. Competes with the benefits of alternative uses of the tax resources funding this program. RECOMMENDATION AND OPTIONS Allow California Competes to End of their net income), or (3) other policy changes to improve the state’s business climate generally. Broad-Based Benefits Preferable to Targeted Tax Incentives. California Competes—as a tax Options if This Program Is Continued credit program—has similar issues inherent in If, on the other hand, the Legislature decides to other such programs, such as the motion picture continue California Competes, we suggest several production tax credit and the research and changes that could partially address the problems development tax credit. These include windfall we have noted. Possible changes include: benefits, economic inefficiency, the unequal treatment of similar taxpayers, and opportunity • More narrowly targeting the program to costs. For these reasons, we generally are highly tradable businesses. skeptical of tax programs that target specific • Refocusing the program on its core businesses or industries. If the Legislature is mission as a tool for interstate economic inclined to provide some amount of tax relief—or development competitions. some other economic development incentive—to businesses, we would recommend ending • Modifying the small business provisions. California Competes and instead adopting a broad- Narrow Eligibility to Tradable Companies. based policy change generally applicable to all An important change would be to prohibit GO-Biz businesses. Such policies could include (1) reducing from awarding California Competes tax credits the corporate tax rate, (2) reducing the minimum to businesses that primarily sell to customers in tax (under current law, nearly all business entities California. GO-Biz has made hundreds of awards annually pay a minimum tax of $800 regardless www.lao.ca.gov Legislative Analyst’s Office 17 AN LAO REPORT to local service providers such as accountants, auto Competes continues, the Legislature could clarify mechanics, residential contractors, and medical in law that this is its main focus. doctors—all businesses with predominantly Modify Small Business Provisions. California local clients. Some of these businesses clearly Competes provides no benefits to most of state in their advertising that they serve a specific California’s small businesses. Only several hundred geographic area—“now serving Fresno, Clovis, and such businesses, out of many tens of thousands, Madera,” in one example. To effectuate this change, have received a tax credit award. In fact, many GO-Biz could, for example, be required to review small businesses are harmed when a competing the tax returns of applying businesses and their business is awarded a significant benefit that they affiliates during the application process—which do not also receive. If the Legislature would like would indicate how much of their income comes to help small businesses, a policy that benefits from California sources. Exceptions to such a rule all such businesses would be significantly more should be very limited—for example, to California beneficial than California Competes. Consistent businesses with very strong prospects for using with these goals and the need to refocus California their tax savings to fund an expansion of sales to Competes on its original purposes, we recommend out-of-state customers. eliminating the requirement under current law Refocus Credit to “Level Playing Field” that 25 percent of the tax credits be reserved for With Other States, Countries. The very name small businesses. If California Competes continues, of this program—California Competes—evokes under the options we outline above, some small its goal: to help California compete against other businesses that are in the tradable sector of the states and countries to convince businesses to economy could still qualify for tax credits. These locate, stay, and expand here. Unfortunately, typically would be small businesses exporting GO-Biz has negotiated about one-third of its tax goods and services outside California. Recognizing credit agreements with California businesses that some eligible small businesses may lack the that compete primarily against other California resources and expertise to competitively apply for businesses. These tax credits are windfall benefits. the California Competes tax credit, the Legislature, As we explained above, many of the tax credits in adopting this option, could require GO-Biz to also inadvertently harm other, equally deserving devote some amount of staff resources to assist California businesses—many of them small eligible small businesses in applying for the businesses—that do not receive tax credits. These amended program. agreements also take a significant amount of time Conclusion to negotiate and monitor—time that GO-Biz could otherwise use to pursue better agreements. To this The competitiveness of the California end, we recommend that the Legislature consider economy—compared to that of other states clarifying and emphasizing its intent regarding the and countries—is a longstanding concern of program in state law. We believe the original intent state policymakers. Hearing complaints about of the program was to win competitions against California’s regulatory environment and the other states and countries for major or growing relatively high rates of some state and local taxes, businesses seeking to locate, relocate, or expand— lawmakers have attempted over the years to devise for example, to attract businesses with tax incentive programs that cut taxes for select businesses— offers from other states and countries. If California aiming to help bolster the state’s ability to attract 18 Legislative Analyst’s Office www.lao.ca.gov AN LAO REPORT and keep high-value employers, while at the by the program are not as focused as they should be same time minimizing public revenue losses. on winning economic development competitions The Legislature’s efforts to devise programs like with other states to attract major employers that California Competes are understandable in this sell to customers around the country and the world. context. However, we have repeatedly found that We recommend that the Legislature consider tax benefits delivered selectively to a small portion providing broad-based tax benefits to all California of California businesses are highly problematic. businesses instead of continuing California Picking winners and losers inevitably leads to Competes. Alternatively, if the Legislature wishes problems. In the case of California Competes, we to continue the program, we suggest changes that are struck by how awarding benefits to a select would focus it on helping California compete to group of businesses harms their competitors in attract and retain high-value employers while California. We also think the resources consumed avoiding harm to existing California businesses. www.lao.ca.gov Legislative Analyst’s Office 19 AN LAO REPORT APPENDIX California’s Enterprise Zone (EZ) rapidly. In 2010, the hiring and sales tax credits Programs: 1984 Through 2013 resulted in $698 million of reduced corporation and personal income tax revenues for the state. EZs Encouraged Business Expansion in This amount grew at an average annual rate of Certain Targeted Areas. For nearly three decades, 18 percent between 2000 and 2010. Statewide, the state’s primary economic development however, most rigorous research found that EZs did programs provided extensive tax benefits to not create a net increase in jobs or increase the rate employers that relocated to or expanded in areas of job creation. While some EZs may have resulted targeted by the Legislature based largely on the in more job growth in a particular place, most of socioeconomic characteristics of the geographic those jobs were likely shifted from other parts of area and the prevailing level of economic the state. distress there. EZs were first adopted in 1984 and Economic Development Programs Overhauled subsequently expanded several times to also include in 2013. The Legislature comprehensively changed Manufacturing Enhancement Areas, Targeted Tax state economic development programs in 2013. Areas, and Local Agency Military Base Recovery Chapter 69 and Chapter 70 of 2013 (AB 93, Areas. (It was common to collectively refer to all of Committee on Budget, and SB 90, Galgiani) these programs as “Enterprise Zones.”) The intent eliminated EZs and replaced them with three new of the EZ programs was to use the state’s tax code economic development programs: to increase economic opportunities for the people living and working in economically distressed areas • A partial sales tax exemption for purchases of the state. The tax benefits offered to businesses of certain manufacturing equipment. located in EZs included hiring credits, sales and use • A tax credit for hiring by qualified tax credits, accelerated depreciation, net interest businesses in certain, specified areas. deductions for lenders, and a longer carryforward of net operating losses. There were about 40 active • California Competes—a program that EZs in 2012. provides hiring and investment tax credits State’s Former EZ Programs Ineffective. The to select businesses on a case-by-case basis. EZ programs were popular and their use grew LAO Publications This report was prepared by Brian Weatherford and reviewed by Ryan Miller and Jason Sisney. The Legislative Analyst’s Office (LAO) is a nonpartisan office that provides fiscal and policy information and advice to the Legislature. To request publications call (916) 445-4656. This report and others, as well as an e-mail subscription service, are available on the LAO’s website at www.lao.ca.gov. The LAO is located at 925 L Street, Suite 1000, Sacramento, CA 95814. 20 Legislative Analyst’s Office www.lao.ca.gov