Assessing Recent Changes to California Competes

Assessing Recent Changes to California Competes EXECUTIVE SUMMARY California Competes awards income tax Overall, we found that, following changes to the credits to attract or retain businesses considering program made in 2018, California Competes a significant new investment in California. appears to be better targeted at awarding credits Chapter 52 of 2018 (SB 855, Committee on to businesses more likely to create a net increase Budget and Fiscal Review) made several changes in jobs. We also observed that the number of to the program and requires our office to review California Competes applications has declined and information submitted to us about the program by that the average amount awarded per company has the administration and report to the Legislature. increased. INTRODUCTION California Competes Provides Financial In addition, we were required to submit to the Incentives to Attract Business Investment. Legislature by April 1, 2020 a report evaluating the California Competes is an economic development program based on information provided to us from tax incentive program that allows the administration the administration in October 2019. to negotiate tax credit agreements with individual Structure of This Report. This report responds companies that agree to meet multiyear hiring and to the Chapter 52 reporting requirement. First, investment targets. The objective of the program we provide background information about the is to attract or retain business investment that, California Competes program and the changes that without the incentive, would occur in another state. the Legislature made in 2018. Next, we describe We previously evaluated the California Competes the effects of these changes on the program in program in 2017. 2018-19, the first year of their implementation. We Program Modified and Extended in 2018. then assess how the changes have affected the California Competes had been set to end in administration of the California Competes program July 2018, but a budget trailer bill—Chapter 52— and consider whether it is more or less effective extended it through the 2022-23 fiscal year. At that than before. Lastly, looking forward, we suggest time, California Competes was modified to refocus working to find ways to expand the pool of qualified the program on attracting jobs and investments applicants and advise the Legislature to continue its that would otherwise locate outside of California. oversight of the program. GABRIEL PETEK LEGISLATIVE ANALYST MARCH 30, 2020 analysis full gutter AN LAO REPORT BACKGROUND California Competes Is an Economic policymakers assess whether a tax expenditure Development Incentive Program. California is effective and merits continued financial support Competes is an economic development incentive from the taxpayers. Our office first evaluated the program administered by the Governor’s Office of California Competes program in 2017. In our Business and Economic Development (GO-Biz). review of California Competes, we raised several Companies must apply to the program and be concerns: selected by GO-Biz to receive a credit. The • Some Awards Likely Would Not Create successful applicants then negotiate a written Jobs Statewide. Prior to 2018, GO-Biz agreement with GO-Biz that specifies hiring and awarded about 35 percent of the total number investment targets over a five-year period. An of tax credit agreements—about 15 percent oversight committee also must approve these of the dollar value—to businesses in the agreements in a public meeting. GO-Biz posts a non-tradable sector of the state’s economy. list of tax credit agreements online. Companies Non-tradable businesses—in industries such that satisfy their agreed-upon hiring and investment as construction and healthcare, for example— terms outlined in the agreements may claim a generally must be located close to where their credit against their state corporation tax (CT) customers are. Local demand for non-tradable liabilities. Some types of companies—limited liability goods and services generally is based on companies and partnerships—do not pay CT, and location-specific factors. For example, the their owners may claim the credits against their demand for plumbing services is driven by personal income tax (PIT) liabilities. For general the number of households in an area. As information about the administration of California these businesses increase their employment, Competes, please refer to our October 2017 competing businesses employ fewer people Review of the California Competes Tax Credit than they otherwise would have. For this report. reason, awarding credits to businesses in the California Competes Cost $57 Million in 2018. non-tradable sector likely does not create jobs As of November 2019, 1,043 credit agreements statewide. had been negotiated and approved. The companies that have tax credit agreements can only claim a credit after they have met the specified amounts Figure 1 of hiring and investment. Once companies have $125 Million California Competes notified GO-Biz they are in compliance, they can Tax Credits Claimed claim the credit. Consequently, there is a significant (In Millions) delay between when the credit agreement is negotiated and when the company claims the $70 credit. Through tax year 2018, taxpayers have 60 claimed a total of $125.1 million in credits. 50 Figure 1 shows how the amount of credits claimed 40 has grown over time. About $57 million in credits 30 were claimed in 2018—$45 million in CT and 20 $12 million in PIT. 10 LAO Previously Raised Concerns About California Competes. Periodically reviewing 2014 2015 2016 2017 2018 tax expenditures such as California Competes is Taxable Year important because, like direct state expenditures, they have budgetary costs. Such reviews can help 2 LEGISLATIVE ANALYST’S OFFICE analysis full gutter AN LAO REPORT • Windfall Benefits Limit Program’s an advantage to those businesses over their Effectiveness. Many businesses awarded competitors by reducing their state tax burden California Competes credits likely would have significantly. This discrepancy harms equally stayed, relocated, or expanded in California deserving businesses that are unaware of even if they had not received the tax credit. California Competes or find it inconvenient to There are strong reasons to do so, including apply to the program. access to a skilled workforce, proximity to key • Small Businesses Not Using All Available suppliers, and the personal preferences of Credits. Previously, 25 percent of the business managers. When a taxpayer receives tax credits had been set aside for small a tax credit for taking an action they would businesses. (Small businesses were defined have taken anyway, the tax credit is a windfall as having less than $2 million in annual benefit. Windfall benefits are an unavoidable revenue.) GO-Biz awarded hundreds of tax problem with California Competes—both credits to qualified small businesses but the in the case of non-tradable and tradable amounts were relatively small and totaled far businesses—but should be avoided as much less than the available amount. Negotiating as possible. (Businesses in the tradable sector and administering a credit agreement with a produce goods and services that can be small business takes about the same amount readily consumed in a location far from where of time as with any other business. they are produced.) California Competes had been set to end in 2018. • Program Inadvertently Harms Some We concluded that if the Legislature were to extend California Businesses. California Competes the program, it should more narrowly focus California provides a substantial benefit to a relatively Competes on attracting jobs and investments that small number of the hundreds of thousands of would otherwise locate outside California. companies located here. As such, it confers RECENT CHANGES TO CALIFORNIA COMPETES California Competes Changed in 2018. The Chapter 52 also reduced the total amount of new 2018 budget package extended the California credits that GO-Biz may allocate in any fiscal year, Competes credit by five years and made three from $200 million to $180 million. changes to the program: Applicants Must Demonstrate How Credit 1. Added a Requirement to Demonstrate New Will Create New Jobs. GO-Biz awards California Job Creation. Applicants must demonstrate Competes credits through a formal two-stage that award of the credit will influence evaluation and selection process. After eliminating their ability or willingness to create jobs in the least competitive applicants in the first stage California that might not otherwise be created of this process, GO-Biz requests additional here. documentation from those applicants remaining. 2. Added Factor to Consider Job Training In the second stage of this process, GO-Biz Opportunities. GO-Biz may consider the job reviews the information provided by each applicant training opportunities offered by applicants in in order to determine whether the applicant has awarding credits. demonstrated how the financial incentive of the credit will create jobs in this state that might not 3. Eliminated Small Business Set Aside. otherwise be created. In their October 2019 report A prior requirement that 25 percent of the to us, GO-Biz identified the following examples as credits be reserved for small businesses— reasons to disqualify applicants: defined as having under $2 million in annual revenue—was eliminated. www.lao.ca.gov 3 analysis full gutter AN LAO REPORT • The applicant’s proposed expansion project In addition to the above criteria, GO-Biz primarily serves a local market. In our continues to consider 12 additional factors 2017 report, we referred to such companies specified in state law when making the final as producing non-tradable goods and determination of which applicants they will services. negotiate tax credit agreements with. Examples • GO-Biz has reason to believe that the of these additional factors are the level of applicant has already committed to proceed compensation paid by the applicant, whether the with their proposed expansion in California. proposed business or project is in a disadvantaged area, the training offered to employees, and the • The applicant does not explain how the credit strategic importance of the business or project to will affect its business decision with respect to the state. the proposed project. PROGRAM OUTCOMES IN 2018-19 Number of Applications Has Significantly and $74.8 million to application period 3. GO-Biz Declined. GO-Biz usually holds three application is not required to award all of the available tax periods each fiscal year. California Competes credits if there are not enough qualified applicants. received an average of 300 applications per In 2018-19, GO-Biz did not award the full amounts application period during the first five years of the in either the second and third application periods— program. Since the program was changed in 2018, specifically, it awarded only $70.1 million during the number of applications has declined to about application period 2 and $55.8 million during 160 per application period. Figure 2 shows the application period 3. total number of applications in each fiscal year. Figure 2 Not All Available Credits Fewer California Competes Applications and Allocated Every Period. GO-Biz Awards Since Program Modified in 2018 awards up to $180 million in credits each fiscal year. The state 1,000 also recaptures credits from 900 947 companies that do not meet 896 856 800 the terms of their agreements. 806 These recaptured credits may 700 be rolled over and awarded in 600 the subsequent year, in addition 500 to the base allocation. For 495 2018-19, a total of $219.8 million 400 was available ($180 million plus 300 $39.8 million of recaptured 259 275 200 212 credits). GO-Biz predetermines a 182 100 set amount of credits it will award 72 to applicants in each period. 2014-15 2015-16 2016-17 2017-18 2018-19 In 2018-19, GO-Biz allocated $70 million to application period 1, $75 million to application period 2, 4 LEGISLATIVE ANALYST’S OFFICE analysis full gutter AN LAO REPORT Average Credit Agreement Amount Is of credits received by some other industrial Bigger. GO-Biz signed tax credit agreements sectors—especially wholesale and retail trade— with 72 applicants in the 2018-19 fiscal year. This has significantly declined since the program was is a lower number than before the program was changed in 2018. changed. Figure 2 shows that GO-Biz previously Number of Jobs Created Unclear. The awarded significantly more credits each year. companies awarded credits in 2018-19 agreed to Consequently, while the size of the awards varies create more than 13,000 jobs and invest a total widely, the average amount of each agreement of $2 billion. We cannot say whether these figures is significantly bigger. The average amount of the represent the net economic impact of these tax 72 agreements in 2018-19 was $2.7 million. The credit agreements in California. As we noted in our average agreement was under $1 million before the 2017 evaluation of the program, the full effects of Legislature changed the program in 2018. the credits on the state’s economy are somewhat Manufacturers Receive the Biggest Share of uncertain. Some of these companies may have Credits. Forty-seven manufacturing companies, increased their hiring here in other ways or may 65 percent of the total number of awards in even have proceeded with their projects here even 2018-19, signed California Competes tax credit if they had not received a credit. At the same time, agreements. As shown in Figure 3, these account some of the projects likely also have spillover for about 60 percent of the total awards by benefits—through which other companies, such as dollar value, a significant increase since 2017 suppliers and distributors, subsequently increase when they accounted for 37 percent. The share their hiring and investments here. Figure 3 California Competes Awards by Industry Dollar Amount of Tax Credits Awarded 2014 Through 2017 Fiscal Year 2018-19 Other Industries Other Industries Manufacturing Information Manufacturing Professional, Scientific, Information and Technical Services Professional, Scientific, and Technical Services www.lao.ca.gov 5 analysis full gutter AN LAO REPORT LAO ASSESSMENT OF THE PROGRAM IN 2018-19 Modified Program Appears to Be Better qualify for a tax credit agreement. This has Targeted. The changes made to the program in resulted in only limited consideration of the other 2018 appear to have more narrowly targeted the 12 statutory factors. A larger, more competitive program to tradable businesses. In particular, the applicant pool might result in the additional factors requirement for applicants to demonstrate how having more effect on which companies receive the credit influences their ability to create new awards. We are uncertain whether the smaller jobs in California, by the applicant or any other number of applicants reflects the more explicit company, has led GO-Biz to address many of the focus on tradable businesses or too few qualified concerns we raised about California Competes in companies are aware of the program. our 2017 evaluation. In their October 2019 report Fewer Credit Awards May Reduce Oversight to us, GO-Biz describes how they implemented the Burden. The California Competes program also new requirement. GO-Biz treats this requirement as made fewer awards in 2018-19. Since fewer a mandatory threshold. GO-Biz rejects applications awards are being made, members of the oversight that cannot explain or show how the credit will committee may have more time to review each tax create a net increase in California employment. credit agreement. In addition, GO-Biz staff also Administration of Threshold Requirement may be able to spend more time on outreach and Is Subjective. While an increased focus on managing the program. demonstrated job creation is a positive step, the Qualified Small Businesses Appear to Be challenge remains that enforcing this threshold Competitive. Before the program was changed unavoidably requires GO-Biz to make subjective in 2018, 25 percent of the credits were set aside judgments. The October 2019 GO-Biz report for small businesses—defined as having annual included detailed narrative justifications for each revenue below $2 million. In our 2017 report, we award that was made in the 2018-19 fiscal year. We observed that there were too few eligible small observed a wide degree of variation between the business applicants to use all of the available reasoning described for whether the credit would credits. Moreover, many of the small businesses influence the decisions of the applicants. However, that received credits prior to the 2018 change GO-Biz made a significant effort to document were non-tradable businesses and would not how, in their view, the applicant satisfactorily have been able to demonstrate how the credit demonstrated how the credit would influence would influence their ability to create new jobs in their ability to create new jobs in California. This California. While GO-Biz did not track how many assessment is necessarily a subjective one and of the applicants in 2018-19 had annual revenue reasonable people could disagree about whether an of less than $2 million, they indicated that few of applicant meets the threshold. the 72 companies awarded credits would have Limited Application Pool Affects Ability previously qualified as a small business. However, to Consider Other Factors. In 2018-19, the by other measures, many of the credit recipients California Competes program had significantly are not large companies. About 45 percent of the fewer applications. While fewer applications has credit agreements are with companies with annual allowed GO-Biz to spend more time evaluating revenue below $15 million and about 10 percent each one, there is a less competitive pool of have no annual revenue (but some of these likely qualified applicants. Of the applicants who move are owned by large companies). There is no into the second stage of the evaluation process, indication that otherwise qualified small businesses most are subsequently rejected because they are in any way disadvantaged by the evaluation cannot demonstrate how the credit would influence process. their ability to create new jobs in California. Consequently, nearly all of the remaining applicants 6 LEGISLATIVE ANALYST’S OFFICE analysis full gutter AN LAO REPORT FUTURE CONSIDERATIONS Develop Outreach Strategy to Expand 2017. Nonetheless, any program that is allowed Applicant Pool. A larger pool of qualified this level of subjective judgment runs the risk of California Competes applicants would increase making inappropriate decisions under different the competition for available credits. This would circumstances. Consequently, such programs then allow GO-Biz to prioritize companies that need to be transparent and be subject to formal also scored well on the other 12 factors that are of oversight. To this end, GO-Biz makes the tax credit importance to the Legislature. The Legislature may agreements public before the oversight committee consider requiring GO-Biz to develop a focused meets to approve them. Moreover, the oversight outreach strategy aimed at further increasing committee includes a majority of members—the awareness of the California Competes program, State Treasurer and two Legislative appointees— especially among out-of-state businesses that who are independent from the administration. In may be considering expanding in or relocating to addition, when extending the program in 2018, the California. Legislature took steps to continue its oversight of Continue Legislative Oversight. California the program by enacting the 2023 sunset date. Competes provides GO-Biz with a significant At that time, we recommend that the Legislature amount of flexibility and discretion. The evaluation assess whether California Competes continues and selection process requires GO-Biz to make to accomplish its intended purpose and make a subjective judgments. In our view, GO-Biz has decision about extending the credit based on those administered the program in good faith and has findings. responded seriously to the concerns we raised in www.lao.ca.gov 7 analysis full gutter AN LAO REPORT LAO PUBLICATIONS This report was prepared by Brian Weatherford, and reviewed by Brian Uhler 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