The 2018-19 Budget: California Hiring Tax Credits

The 2018-19 Budget: California Hiring Tax Credits MAC TAYLOR LEGISLATIVE ANALYST MARCH 2018 Summary The Existing Hiring Tax Credit. Certain California employers may claim a tax credit—called the New Employment Credit—if they hire qualified individuals and pay them at least 150 percent of the state minimum wage. However, few taxpayers have claimed the existing credit because many businesses do not qualify, the credit amount is small for lower-wage employees, and claiming the credit is complex. In 2014 and 2015 combined, just 310 taxpayers claimed about $1 million in tax credits. The Governor’s Proposal for a New Hiring Credit. The 2018-19 proposed budget includes a new tax credit—the California Hiring Credit—that would be similar to the existing credit but with several changes that should make it more attractive to employers. In particular, the proposed credit would be available to most California businesses and the amount of the credit would be larger for lower-wage employees. LAO Assessment and Recommendations. While the administration’s proposed tax credit would improve upon the existing one, we believe an even more fundamental restructuring is necessary. We suggest increasing the amount of the tax credit at lower wages by either (1) calculating the credit amount on total wages (up to a specified ceiling), or (2) setting the credit at a flat per hour dollar amount. We also suggest allowing all California businesses to claim the credit if they hire qualified workers and eliminating a restriction against part-time employment. INTRODUCTION 2024. (Businesses would be able to continue claiming the existing credit for new employees hired The Governor’s 2018-19 proposed budget through 2020.) includes a new California Hiring Credit that would In this report, we explain how the existing provide an incentive for businesses to hire certain credit works and why so few taxpayers are individuals who face barriers to employment. The claiming it. Then we describe and comment on the administration modeled the proposed California administration’s California Hiring Credit proposal, Hiring Credit after the existing—but lightly used— which would improve upon the existing credit in New Employment Credit. The administration does some respects. We conclude with some options for not propose modifying the existing tax credit. It making more fundamental changes to the credit. proposes instead to leave the existing credit in place and create a new tax credit for 2019 through analysis full gutter 2018-19 BUDGET EXISTING Excludes Some Types of Businesses. Some types of businesses may not claim the existing NEW EMPLOYMENT CREDIT credit. These include businesses that provide temporary help services, retail businesses, Credit Details restaurants and bars, casinos, and certain State’s Economic Development Programs entertainment businesses. Overhauled in 2013. California comprehensively Starting Wages Must Be at Least 50 Percent overhauled its economic development incentive Above Minimum Wage. New qualified employees programs in 2013 by replacing the “Enterprise must be hired on a full-time basis (at least 35 hours Zone” programs with three new tax provisions: per week). Additionally, to claim the existing credit, the employer must pay a new employee a starting • Manufacturer’s Sales Tax Exemption. A wage of at least 150 percent of the state minimum partial sales tax exemption for purchases of wage—in 2018, for most businesses with more certain manufacturing equipment. than 25 employees, that amount is $16.50 per • New Employment Credit. A tax credit for hour. businesses located in certain designated Credit Amount Is 35 Percent of a Portion areas that hire certain individuals. of Wages. The amount of the existing credit is • California Competes. A program that awards 35 percent of qualified wages. Qualified wages tax credits to selected businesses that agree exclude the portion of wages below 150 percent to meet multiyear hiring and investment of minimum wage. For example, a business targets. that pays a new qualified employee $20.00 per hour in 2018 could receive a tax credit based Credit Intended to Address Barriers to on 35 percent of $3.50 per hour ($20.00 minus Employment. The existing credit is intended $16.50), or $1.23 per hour. If the qualified to provide an incentive for businesses to hire employee works 2,000 hours in a given year, the individuals who, because of their personal history, taxpayer could claim a credit of $2,450 on their may have difficulty entering the workforce or qualified wages of $7,000. This works out to developing employment skills. A new full-time 6.1 percent of the $40,000 in total wages paid employee must be from one of five groups in order to the employee. The credit also is capped at to qualify for the credit: the long-term unemployed, 350 percent of the minimum wage—$38.50 in recent military veterans, felons, low-income 2018. This means that, regardless of an employee’s families with children, and other very low-income hourly wage, a taxpayer may not claim a tax credit individuals. in excess of $7.70 per hour worked ($38.50 minus Focused on Certain Areas. The existing credit $16.50, multiplied by 0.35). For example, if a highly is available only to businesses located in certain paid qualified employee works 2,000 hours in 2018, designated areas within California, including: the employer would be able to claim a credit for no (1) any census tract that has a high unemployment more than $15,400. rate and a high poverty rate, (2) portions of former Credit Requires Reservation, Additional enterprise zones, and (3) former military bases Filings. State law requires businesses claiming (specifically, Local Agency Military Base Recovery the existing credit to provide the state with certain Areas). For businesses with multiple locations, the information. First, the business must reserve a new hires must work in one of these areas. Current “tentative” tax credit online with the Franchise law also attempts to prevent businesses from Tax Board (FTB) within a month after hiring each replacing employees in another part of the state new qualified employee. This process requires the with new employees in one of the designated areas. business to provide information about itself and Interested employers may check to see whether the employee. Second, the credit must be claimed they are located in one of these designated areas on an original tax return (as opposed to a revised using an online map. return). Third, the business also must complete an 2 LEGISLATIVE ANALYST’S OFFICE analysis full gutter 2018-19 BUDGET “annual certification” online with FTB that includes • Starting Wage Threshold Too High. Many updated information about any employee for employers do not qualify for the existing which they previously reserved an existing credit, credit because their starting wages are less including a termination date if applicable. FTB may than 150 percent of minimum wage. Labor disallow any credit claimed if the taxpayer or the market statistics collected by the Employment taxpayer’s business failed to satisfy any of these Development Department (EDD) show that three filing requirements. many occupations have an average wage Credit Can Affect up to 11 Tax Years. The well below $16.50 per hour. For example, dry existing credit is available to the employer for up cleaning workers earn an average hourly wage to five years after hiring the qualified employee. of $13.07. Employers will often pay new hires This means that the existing credit will affect up a lower wage initially, because of their lack of to six tax years. In addition, the taxpayer may experience, increasing pay as the employees carryforward the credit for up to five years if their become more skilled. net tax liability is less than the full value of the • Credit Amount Too Small. The existing credit. credit amount may be too small to influence the hiring decisions of most employers hiring Experience to Date lower-wage workers. As we noted above, the Few Taxpayers Claiming Existing Credit. credit amount is based on just the portion of When the existing credit was first proposed, the wages that are above 150 percent of minimum administration estimated that taxpayers would claim wage and below 350 percent of minimum $22 million in the 2014 tax year and $69 million wage. This can still be a significant amount— in the 2015 tax year. These estimates were much as we show in Figure 1. The existing too high. Final, valid claims were $340,822 in 2014 credit can subsidize up to 20 percent of an (2 percent of the initial estimate) and $693,323 in employee’s annual wage at $38.50 per hour. 2015 (1 percent of the initial estimate). Over these However, for lower-wage workers, the existing first two tax years the credit was available, at credit is much smaller. For example, if a least 1,829 taxpayers claimed the credit but business paid their qualified employee $18 per 83 percent of the claims were invalid. The 310 hour—or $1.50 per hour above 150 percent valid returns were generated from hiring by a total of minimum wage—they would receive a tax of 62 individual businesses. (The number of taxpayers claiming Figure 1 the credit exceeds the number Existing New Employment Credit of affiliated businesses because Subsidizes Up to 20 Percent of Wage pass-through businesses, such as Credit as a Share of Total Wages partnerships and LLCs, generally have multiple investors and each 20% investor may claim a proportional share of the credit.) These results 15 suggest that the existing tax $16.50 $38.50 150 percent of 350 percent of credit has been challenging or minimum wage minimum wage 10 unappealing for businesses to use. Key Reasons for Credit 5 Underutilization. Several factors appear to be contributing to the 0 low utilization of the existing tax 12 14 16 18 20 22 24 26 28 30 32 34 36 38 40 42 $44 credit: Hourly Wage www.lao.ca.gov 3 analysis full gutter 2018-19 BUDGET credit for just 3 percent of the employee’s been associated with the hiring of one qualified new annual salary. We do not know the average employee. In 2014, however, only 901 claims for wage for the groups targeted by the credit. qualified employees were made. These claims were Given that many may not have significant work associated with $340,822 in credits. Consequently, experience, their wages likely do not qualify only about 8 percent of the 11,554 reservations for the higher credit amounts. received that year ultimately resulted in a credit. • Complexity. There are complicated rules Given the number of credit reservations made, limiting which businesses and which however, the credit may have played a role in hiring employees qualify for the credit. Moreover, individuals who employers expected to be eligible the existing credit has a complex structure. for the credit but ultimately were not eligible. To The amount of the credit depends on several the extent this occurred, the credit’s availability factors that may fluctuate during the year. may have influenced employers’ decisions to hire targeted individuals. (For context, there were about • Uncertainty. Given the program’s complexity, 800,000 unemployed people in California at the end many taxpayers might be unsure of whether of 2017 and about 3.5 million new hires statewide they qualify and how much of a credit they each year.) would receive if they did. For example, a taxpayer may not know they are located outside a designated area until FTB disallows GOVERNOR’S PROPOSAL the credit. (While the online map may be used An Expanded Employment Credit. The to indicate if a location “is likely to be eligible” administration proposes a new tax credit—the for the existing credit, compliance is subject California Hiring Credit—that would be similar to the to manual verification.) A business with regular existing credit but with several notable changes. employee turnover, in another example, may The administration estimates that the proposed not know until the end of the year whether credit would reduce General Fund revenues by an their net change in employment will be large average of $50 million per year. Below, we describe enough to claim the credit. This uncertainty the proposed credit and, where appropriate, may help to explain why so many employers compare it to the existing credit. reserved credits that they ultimately were Targets Same Individuals. The proposed credit unable to claim. targets the same five categories of individuals who • Interactions With Other Tax Credits. The may face barriers to employment: existing credit overlaps with geographical areas of the state that previously qualified for • The long-term unemployed (for at least the other tax credits under the former enterprise past six months). zone programs. Many businesses that had • Recent military veterans (separated within the earned credits under those programs still past year). have credits available. FTB reports that • Ex-offenders (felony conviction). some businesses may be using their older • Recipients of California Work Opportunity enterprise zone credits, while carrying forward and Responsibility to Kids or county general any more recent existing employment credits assistance (at time of hiring). they also may have earned. Unfortunately, we • Earned Income Tax Credit recipients (for the lack specific information on the number of prior tax year). taxpayers who might be in such a situation. Available to Significantly More Businesses. Credit May Have Indirectly Increased Hiring Whereas the existing credit is available only to of Targeted Groups. California businesses made businesses in certain designated areas of the 18,628 credit reservations in 2014 and 2015 state, the proposed credit would be available to (11,554 and 7,074 reservations, respectively). If businesses statewide. In addition, restaurants these reservations were all valid, each would have and retailers—which cannot claim the existing 4 LEGISLATIVE ANALYST’S OFFICE analysis full gutter 2018-19 BUDGET credit—would be able to claim the proposed credit. • Shortens Duration of Credit. The proposed Temporary help services, casinos, bars, and certain credit would only be available for the first entertainment businesses would still be ineligible. two years of employment, compared to the Lowers Floor on Qualified Wages. While five years allowed by the existing credit. the existing credit is based on the portion of In addition, if a business terminates the wages between 150 percent and 350 percent of qualified employee within the first year of their the minimum wage, the proposed credit would employment (reduced from the first three lower the floor of that range to 100 percent of the years under the existing credit), the state minimum wage. This would have two important would recapture any previously claimed credit. effects. First, taxpayers would be able to claim • Accounts for Differences Between State a credit for employees that are paid below and Local Minimum Wage. The proposed 150 percent of the minimum wage—significantly credit would clarify that—when city, county, increasing the number of taxpayers able to claim and state minimum wages differ—the the credit. Second, as we show in Figure 2, the lower floor could Figure 2 make the amount of the proposed credit significantly larger than the Governor's Proposal Significantly Expands Employment Tax Credit existing credit—strengthening the incentive to hire individuals in the Credit as a Share of Total Wages targeted groups. For example, Proposed as shown in the figure, the credit Wage/Hour Credit Amounta for a qualifying employee working $12 3% $700 2,000 hours per year at $20 per 0% Existing Credit $14 8% Governor's Proposal $2,100 hour would be worth 16 percent 0% of total wages compared with $16.50b 12% $3,850 0% 6 percent under the existing $18 3% 14% $4,900 credit. (The figure assumes that $20 6% 16% $6,300 the proposed credit percentage $22 9% 18% $7,700 remains at 35 percent but, as explained below, the Legislature $24 11% 19% $9,100 would be able set the credit $26 13% 20% $10,500 percentage in the annual budget $28 14% 21% $11,900 act.) $30 16% 22% $13,300 Other Differences. There are several other notable differences $32 17% 23% $14,700 between the proposed credit and $34 18% 24% $16,100 the existing credit: $36 19% 24% $17,500 • Credit Percentage Set in $38.50b 20% 25% $19,250 Budget Act. The proposed $40 19% 24% $19,250 credit percentage would be 0 percent unless the $42 18% 23% $19,250 Legislature sets it at a higher $44 18% 22% $19,250 value in the annual budget act. This proposed change a Credit amount calculated for employee working 2,000 hours. would allow the Legislature b While the existing credit is calculated on the portion of wages between 150 percent of minimum wage, or $16.50, and 350 percent of minimum wage, or $38.50, the proposed credit is calculated on the portion of wages between to annually reevaluate the 100 percent of minimum wage and 350 percent of minimum wage. In 2018, the state minimum wage is $11.00 per hour for employers with more than 25 employees. credit percentage as part of the state budget process. www.lao.ca.gov 5 analysis full gutter 2018-19 BUDGET applicable minimum wage is whichever is taxpayers ultimately claimed only about $1 million highest. over that period. The changes proposed by the • No Annual Certification. Unlike with the administration, however, likely will increase the existing credit, the proposal would not require proposed credit’s use. The cost of the proposed the taxpayer to submit a certification of credit would also depend on the credit percentage employment to FTB every year. (The proposed set by the Legislature in the annual budget act. credit would continue to require taxpayers to Reducing Duration of Credit Is Reasonable. reserve a tentative credit within 30 days after While the proposal limits the credit to two years of they have hired a qualified new employee. qualified wages, the proposed credit amount would In addition, taxpayers must still claim the be larger than the existing credit at any wage. We proposed credit on a timely original return.) think this change is reasonable because it creates a larger upfront incentive—by providing a greater tax reduction—for a business to hire an individual LAO COMMENTS from one of the targeted categories. Few employers would let go of a trained employee once their tax A Stronger Incentive. The administration has credit is no longer available. proposed changes to the credit that should make it more attractive to employers. In particular, OPTIONS TO IMPROVE CREDIT the proposed reduction in the wage floor from 150 percent to 100 percent of the minimum wage The existing New Employment Credit is, would reduce the starting wage requirement and for the most part, ineffective and unused. The increase the amount of the credit across the board. administration’s proposed California Hiring Credit More Businesses Would Qualify. Under the would improve upon the existing credit in some proposal, all businesses in the retail and food respects. Notably, the proposal increases the credit services industries—about 170,000 establishments, size and makes it available statewide. However, to according to EDD—would become eligible for be effective, we believe the credit needs a more the proposed credit. This change alone opens up fundamental restructuring. eligibility for the credit to more than 10 percent of the state’s roughly 1.4 million private business Increase Credit Amount establishments. At Lower Wages Statewide Credit Preferable to Geographically Workers targeted by the tax credit face one or Limited Credit. Unlike the existing credit, which more barriers to employment including limited skills, is only available to businesses in certain areas of little work history, or long-term unemployment. the state, the proposed credit would be available Consequently, many of these individuals will only to businesses statewide. This change treats qualify for jobs at or close to minimum wage. The similar taxpayers—employers hiring new workers credit as currently proposed, however, provides from among the targeted categories—similarly. much less benefit to employers hiring people This change also reduces the possibility of jobs making below 150 percent of minimum wage shifting within the state without growing the overall (between 0 percent and 12 percent of wages) than economy. it does to people making 350 percent of minimum Fiscal Estimate Uncertain. The administration wage (25 percent). As a result, the credit may not estimates that the proposed credit would reduce provide a sufficient incentive to the employers most General Fund revenues by $50 million per year, likely to hire the targeted workers. We recommend but this estimate is uncertain. Estimating the adopting a different structure that would provide fiscal effect of a new tax provision is difficult. For a significantly higher subsidy at lower wages. We example, the administration initially estimated suggest two options to consider: the cost of the existing credit to be $91 million over the 2014 and 2015 tax years combined, but 6 LEGISLATIVE ANALYST’S OFFICE analysis full gutter 2018-19 BUDGET • Apply Credit Percentage to Total Wages. Eliminate Certain Limitations In this option, the amount of the credit Allow All Businesses to Claim Credit. The would be based on a constant percentage of proposed credit would still exclude temporary help total wages up to a ceiling of, for example, agencies, bars, and casinos from claiming the tax 150 percent of minimum wage (instead of credit. Such exclusions likely will reduce the credit’s the portion of wages above 100 percent of use. In addition, limiting the industries eligible for minimum wage). If the Legislature set the rate the credit reduces the potential job opportunities at 35 percent, then credit amounts would for targeted workers. For instance, temporary help range from $7,700 (at minimum wage) up to agencies can provide useful work experience for $11,550 (at 150 percent of minimum wage) individuals with limited work history. for employees working 2,000 hours per year Make Part-Time Employment Eligible for in 2018. a Credit. The proposed credit would only be • Flat Credit Amount. In this option, the available to employers that hire new full-time employer would receive a flat amount of, for qualified employees. This requirement assumes example, $4 per hour. The Legislature could that a full-time job is preferable to a part-time adjust the amount in the annual budget act job when that may not always be the case. In or set the amount to increase on a schedule some cases, an employer may prefer to hire new over time. This would provide a much greater employees on a part-time evaluative basis before subsidy for lower-wage employees. increasing the employee’s hours or promoting them Both the existing and proposed credits have to a full-time position. In other cases, individuals complicated rules for calculating the amount. looking to reenter the workforce after a long period This complexity—and associated uncertainty— of unemployment may prefer a part-time job. likely are among the reasons the existing credit is Regardless of whether a qualified employee is hired underutilized. An advantage of the options provided on a full-time or part-time basis, the individual will above is that they would be simpler to calculate gain experience that could help to reduce barriers and understand. to employment in the future. Consequently, we recommend eliminating this requirement from the new credit. www.lao.ca.gov 7 analysis full gutter 2018-19 BUDGET LAO PUBLICATIONS This report was prepared by Brian Weatherford and reviewed by Ryan Miller and Carolyn Chu. 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. 8 LEGISLATIVE ANALYST’S OFFICE