The 2021-22 Budget: Business Tax Incentives

The 2021-22 Budget: Business Tax Incentives Summary Governor’s Budget Proposals. The Governor’s budget proposes several changes to taxation to support businesses, largely one-time increases in existing tax credits and exclusions: • Elective S Corporation Tax. This proposal would give the owners of S corporations a new option for restructuring their state income taxes that would enable them to reduce their federal income taxes. • Sales Tax Exclusion. A $100 million increase in the 2021 cap on sales tax exclusions awarded by the California Alternative Energy and Advanced Transportation Financing Authority (CAEATFA). • Main Street Credit. $100 million General Fund for the Main Street Small Business Tax Credit (Main Street Credit), a tax credit for small businesses that increase their number of employees. • California Competes. $430 million General Fund for California Competes to provide two types of assistance aimed at attracting or retaining businesses to California ($250 million for grants and $180 million for tax credits over two years). LAO Recommendations. Using the evaluation framework outlined in this report, we offer the following recommendations on the Governor’s proposals: • Explore Alternative Approaches to Elective S Corporation Tax. The general concept behind the Governor’s proposal has merit, but alternatives warrant the Legislature’s consideration. We suggest that the Legislature consider such alternatives in the policy committee process. • Reject Proposed Increase in Cap on CAEATFA Exclusions. Roughly two-thirds of the cost of this proposal would be borne by local governments. Additionally, the proposal’s benefits would be neither timely nor directed towards the businesses hit hardest by the pandemic. • Expand Main Street Credit Proposal. Among the Governor’s proposals, this one is best suited to assisting the businesses hit hardest by the pandemic. Consequently, we suggest that the Legislature prioritize expanding this program. For example, the Legislature could broaden eligibility and increase the value of the credit. • Reject Proposed Expansions of California Competes. These proposals would not assist the businesses hit hardest by the pandemic. The idea of adding grants to California Competes raises questions that require significant Legislative deliberation. Due to these concerns and others, we suggest that the Legislature instead focus on expanding the Main Street Credit proposal. GABRIEL PETEK LEGISLATIVE ANALYST JANUARY 2021 analysis full gutter 2021-22 BUDGET INTRODUCTION Summary of Proposals. The Governor’s • California Competes. $430 million General budget proposes several changes to taxation of Fund for California Competes to provide two businesses, largely one-time increases in existing types of assistance aimed at attracting or tax credits and exclusions: retaining businesses to California ($250 million for grants and $180 million for tax credits over • Elective S Corporation Tax. This proposal two years). would give the owners of S corporations a new option for restructuring their state income Primary Goal: Support Economic Recovery. taxes that would enable them to reduce their The Governor’s stated goal for these proposals federal income taxes. is “to support California business owners as they • Sales Tax Exclusion. CAEATFA administers reopen their doors, rehire staff, and expedite the a sales tax exclusion for purchases of state’s economic recovery.” In our view, this goal equipment for certain manufacturing is appropriate. Our evaluation of the Governor’s activities. CAEATFA may award no more proposals focuses primarily on their likely than $100 million of exclusions per year. This effectiveness with regard to the stated goal, with proposal would raise the 2021 cap on awards particular attention to the state’s role as one among by an additional $100 million. multiple levels of government. • Main Street Credit. $100 million General Report Roadmap. The second section of this Fund for the Main Street Credit, a tax credit report lays out our general framework for evaluating for small businesses that increase their these proposals. The third section summarizes our number of employees. recommendations. Each of the remaining sections focuses on one of the four proposals listed above. FRAMEWORK FOR EVALUATING PROPOSALS Which Level of Government Would • Proposals That Reduce Local Revenues. When the state spends money, it generally Forgo Revenue? cannot draw upon revenues designated for As a starting point, we advise the Legislature to local governments. The state can, however, group tax incentives into three categories depending fund state economic policies with local on the level of government that would forgo revenue revenues—for example, by exempting certain under the proposal. This approach can help purchases from local sales taxes. Although policymakers compare each proposal to alternatives the state technically can use such policies that would use the same fiscal resources. to circumvent restrictions on its ability to appropriate local revenues, doing so is not • Proposals That Reduce Federal Revenues. consistent with the spirit of those restrictions. Sometimes the state can take actions that Accordingly, we suggest that the Legislature reduce Californians’ federal tax payments, generally avoid enacting or expanding such thus increasing their after-tax incomes. From locally funded state policies. a strictly California-focused standpoint—in • Proposals That Reduce State Revenues. particular, one that places little weight on Most commonly, state tax incentives reduce federal revenue losses—such policies have state revenues. We advise the Legislature to relatively low fiscal and economic costs. weigh these proposals against other potential Consequently, the Legislature may regard them uses of state funds. more favorably than state-funded proposals. 2 LEGISLATIVE ANALYST’S OFFICE analysis full gutter 2021-22 BUDGET Key Questions • How quickly and completely will the appropriation or allocation translate into actual To compare each proposal to alternatives, income, spending, or investment? we suggest that the Legislature consider these • By how much does the policy reduce questions: revenue? What are the alternative uses of this • Does the proposal target the businesses revenue? that have been most severely affected by the • What are the administrative costs? How costly pandemic? or difficult is it for businesses to participate? • Does the policy complement federal efforts or duplicate them? SUMMARY OF RECOMMENDATIONS Federally Funded Proposal cost of this proposal would be borne by local governments. Additionally, the proposal’s benefits Explore Alternative Approaches to Elective would be neither timely nor directed towards the S Corporation Tax. The general concept behind businesses hit hardest by the pandemic. the Governor’s proposal has merit: to restructure state tax payments of certain business owners State-Funded Proposals in a way that reduces their federal taxes without Expand Main Street Credit Proposal. Among reducing state tax collections. The Legislature the Governor’s proposals, this one is best suited has various options, however, for carrying out the to assisting the businesses hit hardest by the general aim of the Governor’s proposal. Alternative pandemic. Consequently, we suggest that the approaches could benefit a broader group of Legislature prioritize expanding this program. For taxpayers or increase state revenues without example, the Legislature could broaden eligibility reducing the after-tax incomes of Californians. and increase the value of the credit. These alternatives warrant the Legislature’s Reject Proposed Expansions of California consideration. Given the complexities of this issue Competes. These proposals would not assist and its limited relevance to the state budget, the businesses hit hardest by the pandemic. The we suggest that the Legislature consider such idea of adding grants to California Competes alternatives in the policy committee process. raises questions that require significant legislative Locally Funded Proposal deliberation. Due to these concerns and others raised by these proposals, we suggest that Reject Proposed Increase in Cap on the Legislature instead focus on expanding the CAEATFA Exclusions. Roughly two-thirds of the Governor’s Main Street Credit proposal. ELECTIVE TAX ON S CORPORATIONS Background the federal corporate income tax. Instead, their tax treatment resembles noncorporate entities such as Most S Corporation Income Taxed at partnerships and limited liability companies (LLCs). Individual Level. Corporations with 100 or fewer Specifically, they first distribute (or pass through) shareholders (owners) may choose to incorporate their income to their shareholders, who then report as “S corporations.” S corporations do not pay www.lao.ca.gov 3 analysis full gutter 2021-22 BUDGET it on their individual income tax returns. California S corporation tax would reduce these taxpayers’ taxes S corporation income similarly, except that federal taxable income, resulting in lower federal the state also imposes a 1.5 percent tax on the taxes. At the same time, they would receive a state income of S corporations at the entity level. This PIT credit to compensate for the increased cost of 1.5 percent rate is lower than the 8.84 percent rate the new S corporation tax. For most taxpayers with paid by “C corporations,” whose income (other than incomes of $1 million or more, the state PIT credit dividends paid to shareholders) is not taxed at the would fully offset the cost of the new S corporation individual level. tax. For most of those with incomes below Federal Deduction for State and Local Taxes $1 million, the credit would offset most, but not all, Limited to $10,000. Federal personal income tax of the increased cost. Regardless, total federal and filers may deduct up to $10,000 of state and local state taxes would go down for both groups. taxes (SALT) from their taxable income. Prior to the Assessment 2017 federal tax changes, there was no upper limit on the amount of state and local taxes a filer could Increases After-Tax Income of Californians deduct. Without Cost to the State. The Governor’s New Proposed Federal Rule Excludes proposal would increase after-tax incomes of Entity-Level Taxes From $10,000 Limit. In certain California business owners at little cost to November, the federal Internal Revenue Service the state. In fact, the administration estimates that introduced regulations specifying that state and their proposal could result in a modest increase in local taxes on partnership and S corporation state revenue—up to $20 million per year. Filers income imposed at the entity level (that is, before who pay a top rate below 13.3 percent will see a the business distributes income to individual small net increase in state taxes, which in most owners) do not count against each individual cases would be more than offset by a decline in owner’s $10,000 SALT deduction. The owner’s federal taxes. federal taxable income declines by the full amount Benefits Would Be Concentrated Among of their share of the business’s state or local Small Number of High-Income Filers. In 2018, entity-level tax, because the distributions reported more than 75 percent of total income from S on personal income tax (PIT) returns include only corporations and partnerships went to filers with post-tax business income. more than $500,000 of income. Taxpayers with incomes over $500,000 make up about 2 percent Proposal of all taxpayers. New Optional Entity-Level Tax Would Be Proposal Raises Several Questions. There Refunded on PIT. The Governor proposes to are several ways the state could restructure allow California PIT filers with income from S business owners’ taxes to achieve the general aim corporations (but not partnerships or LLCs) to pay of the Governor’s proposal. Below, we offer some an optional 13.3 percent tax at the entity level. questions to help the Legislature think through This 13.3 percent rate is equal to the top PIT whether it may prefer an alternative approach: marginal rate. In return, the filer would receive a • Should Partnerships and LLCs Be nonrefundable credit for their full share of the new Included? The administration has expressed S corporation tax. For example, if an S corporation concern about extending the proposal equally split among ten shareholders pays an to other pass-through entities such as entity-level tax of $100,000, each shareholder partnerships and LLCs on the grounds that would receive a PIT credit of $10,000. their ownership structures are frequently more Reduction in Total Federal and State Taxes complicated than those of S corporations, for S Corporation Shareholders. For many which would make it difficult to trace each individuals with S corporation income, electing filer’s prorated share of the entity-level tax to pay the new S corporation tax would reduce back to the correct business. The Legislature their total federal and state taxes. The new state 4 LEGISLATIVE ANALYST’S OFFICE analysis full gutter 2021-22 BUDGET could consider alternative approaches to (part of the 13.3 percent top PIT rate) on this issue, such as expanding the proposal incomes above $1 million. The proceeds from to include partnerships or LLCs that list only this surcharge are deposited in the Mental individuals as owners. Health Services Fund (MHSF) and used to • Should the Tax Have a Graduated Rate fund local mental health programs. While Structure? The Legislature may want to we still have limited detail on the Governor’s consider giving the proposed entity-level proposal, PIT revenue for the MHSF could tax a graduated rate structure such as drop, depending on how it is structured. If the the one used for the PIT, as opposed to Legislature moves forward with a proposal taxing all entity-level income at a flat rate like the Governor’s, we suggest it include a of 13.3 percent. Relative to the Governor’s mechanism to hold the MHSF harmless. proposal, this option should result in greater Federal Tax Policy Is Especially Uncertain tax savings for individuals with incomes below at This Time. The recent transition of the federal $1 million. administration and shift of control in the U.S. • Should the Tax Result in a Larger State Senate create some uncertainty about the future of Revenue Increase? As structured, the the $10,000 SALT limit. There is a chance federal Governor’s proposal would result in a limited leaders will seek to modify or repeal the limit. If revenue gain for the state. Alternative they lifted the SALT limit entirely, the motivation for approaches, however, could result in larger adopting a proposal like the Governor’s would be revenue increases for the state while still eliminated. providing overall tax savings to business owners. For example, using the Governor’s Recommendation structure but setting the new PIT credit at Explore Alternative Approaches to Achieve 11 percent (as opposed to 13.3 percent) of Aims of Governor’s Proposal. The general an individual’s S corporation income could concept behind the Governor’s proposal has result in state revenue gains in the hundreds merit: to restructure state tax payments of of millions of dollars per year while still certain business owners in a way that reduces increasing shareholders’ after-tax income. their federal taxes without reducing state tax This would provide less relief for the affected collections. There are various ways, however, the pass-through businesses, but would allow the Legislature could carry out the general aim of the state to fund other efforts that are consistent Governor’s proposal. These alternatives warrant the with the Governor’s stated goal of promoting Legislature’s consideration. Given the complexities economic recovery. of this issue and its limited relevance to the state • Should Mental Health Funds Be budget, we suggest that the Legislature consider Held Harmless? Proposition 63 of such alternatives in the policy committee process. 2004 established a 1 percent surcharge CAEATFA EXCLUSION Background countywide rates, with a statewide average of 8.6 percent. The rate includes: California’s Sales Tax. California charges a sales tax on retail sales of tangible goods. • 3.94 percent for the state’s General Fund. The overall rate ranges from 7.25 percent • 3.31 percent to 6.56 percent for various local to 10.5 percent depending on citywide and programs, including 1.06 percent to counties www.lao.ca.gov 5 analysis full gutter 2021-22 BUDGET for criminal justice, mental health, and social the partial exemption, but some (such as many services under 2011 Realignment. recycling facilities) would not. (Businesses cannot apply both discounts to the same purchase.) CAEATFA Exclusion. CAEATFA administers a Figure 2 compares key features of the CAEATFA sales tax exclusion for purchases of equipment exclusion and the partial exemption. for the four types of activities listed in Figure 1. CAEATFA Exclusion Is Oversubscribed. Participants in this program can buy equipment CAEATFA awards the sales tax exclusion at monthly without paying any portion of the sales tax—state or Figure 1 local. (Our office published a detailed report on the CAEATFA Eligibility Categories program, Evaluation of a Sales Tax Exemption for Year Added Certain Manufacturers, in Category to Program Equipment Is Used… Examples 2018). Exclusion Overlaps ...to make or to design Biomass Processing, Alternative 2010 something that uses an Solar Panel Manufacturing, With Another Program. In Source alternative energy source. Biogas Capture addition to the CAEATFA exclusion, the state offers ...to make or to Electric Vehicle a partial exemption that Advanced 2010 design an advanced Manufacturing Transportation allows manufacturers transportation technology. and some other types of businesses to buy ...in an advanced Aerospace, Advanced equipment without paying 2012 manufacturing process. Biopharmaceuticals, Manufacturing Fiberboard, Metals the 3.94 percent state General Fund portion of the sales tax. Most ...to process or to use Mixed Recycling, Recycled 2015 recycled feedstock to Composting purchases made under Feedstock make another product. the CAEATFA exclusion would be eligible for CAEATFA = California Alternative Energy and Advanced Transportation Financing Authority. Figure 2 Comparing Two Sales Tax Policies Feature CAEATFA Exclusion Partial Exemption Exemption from state General Fund sales Yes. Yes. tax? Exemption from other parts of sales tax? Yes. No. Aggregate cap? Statutory hard cap: CAEATFA cannot award None. In 2019, purchasers applied more than $100 million of exemptions per $270 million of exemptions to $6.9 billion of year (roughly $1.2 billion of equipment). equipment. Cap binding since 2015. Individual cap? Regulatory soft cap: $10 million of Statutory hard cap: $200 million of equipment exemption per year (roughly $115 million of per year (roughly $8 million of exemption). equipment). How to claim. Submit extensive application, wait for staff Fill out one-page certificate, then purchase review and board meeting vote, then equipment. purchase equipment. CAEATFA = California Alternative Energy and Advanced Transportation Financing Authority. 6 LEGISLATIVE ANALYST’S OFFICE analysis full gutter 2021-22 BUDGET board meetings. Chapter 677 of 2012 (SB 1128, administration estimates that the proposed increase Padilla) prohibits CAEATFA from approving more in the annual cap would have a direct fiscal cost to than $100 million of exclusions in any calendar the state and local governments totaling $38 million year. This cap has become more binding over time. over a five-year period, starting in 2021-22. This Before 2019, exclusions were available for most estimate is less than $100 million for two reasons: of the year. In 2019, awards hit the cap in July. In • Based on historical usage rates, the 2020 and 2021, the program already had received administration estimates that participants applications for more than $100 million by the first would use $60 million of the additional application deadline—before the calendar year had $100 million awarded. even begun. • The overlap with the partial exemption would Recent Awards Have Gone to Various Types offset an estimated $22 million of the General of Manufacturers. Historically, Tesla accounted for Fund revenue loss resulting from the additional a large share of CAEATFA exclusions. In the last exclusions used. couple of years, however, CAEATFA has awarded exclusions to manufacturers across a variety of Breakdown of Direct Fiscal Effect. The overall industries, as illustrated in Figure 3. $38 million effect includes: Participants Often Do Not Use the Full • $5.6 Million General Fund Revenue Amount Awarded. The benefits and costs of the Loss. Net of the partial exemption, the program depend on the amount of exclusions administration estimates that the additional ultimately used. For each dollar of exclusions exclusions would reduce General Fund awarded, the administration estimates that revenues by $5.6 million. participants use a total of $0.60 within five years, on average. • $7.5 Million Backfill to 2011 Realignment. Article XIII, Section 36(d) of California’s Proposal and Direct Fiscal Figure 3 Effects Exclusions Recently Awarded by Industry One-Time Share of Exclusions Awarded, 2019 to 2020 Increase in Annual 20% Cap. The Governor proposes raising the 2021 aggregate 15 cap on awarded exclusions from $100 million to $200 million on a 10 one-time basis. If CAEATFA did not allocate all of the 5 additional funds by the end of 2021, the remaining portion Aerospace Biogas Renewable Fertilizer Cardiovascular Semiconductor Electric Advanced Other would roll over to Manufacturing Capture Diesel Production Technology Fabrication Vehicle Robotic and Production Manufacturing Equipment Manufacturing Surgical 2022. Production Manufacturing Systems and Tools Estimated Direct Fiscal Effect: $38 Million. The www.lao.ca.gov 7 analysis full gutter 2021-22 BUDGET Constitution requires the state to reimburse, must fill out extensive applications, wait for board or “backfill,” the 2011 Realignment fund for approval, and submit periodic reports to CAEATFA. revenue losses resulting from actions such These requirements make participation more costly, as the one proposed. Consequently, the but they have led to greater transparency than the Governor’s proposal anticipates General state typically provides regarding the use of tax Fund payments to 2011 Realignment totaling expenditures. $7.5 million. Benefits Occur Gradually. Historically, the • $24.7 Million Revenue Loss for Local usage rate of exclusions has peaked one to two Programs. Aside from 2011 Realignment, years after the participant receives the award. As a the administration’s estimates suggest that result, many of the benefits of exclusions awarded the proposal would reduce local sales tax in 2021 will not materialize quickly enough to revenues by $24.7 million. address the current economic crisis. Recent Regulations Try to Manage Awards Assessment Within Cap. In 2019 and 2020, CAEATFA issued emergency regulations to address various issues, Direct Fiscal Estimates Reasonable. The including the growing demand for exclusions. We estimates described above provide suitable inputs highlight some of the key regulations in Figure 4. for the Legislature’s fiscal calculations. These regulations provide some examples of Proposal Primarily Locally Funded. After the the many options available to CAEATFA and to General Fund backfill to 2011 Realignment, local the Legislature for managing awards within the governments would bear roughly two-thirds of the $100 million annual cap. direct fiscal cost of the proposal. Proposal Does Not Target Hardest-Hit Recommendation Businesses. The pandemic has forced many Recommend Rejecting Governor’s Proposal. businesses to reduce their operations or close. As noted above, the Governor’s proposal relies These adverse effects have been especially primarily on local funding. By rejecting this severe for businesses in the travel, retail, food and proposal, the Legislature would allow local hospitality, health and wellness, and personal care governments to exercise their own judgment services sectors. The CAEATFA exclusion offers regarding the best use of these resources. assistance primarily to the manufacturing sector, Furthermore, the CAEATFA exclusion does not which has not been among the hardest-hit sectors provide rapid relief to the businesses most severely of the economy. affected by the pandemic and economic crisis. Allocation Process Is Complex. To use the CAEATFA exemption, equipment purchasers Figure 4 Recent Regulations Try to Manage Awards Within Cap • Reduced “soft cap” on individual awards from $20 million to $10 million. • Set aside $20 million for smallest applications (less than $2 million each). • Set aside $15 million to be awarded competitively to large applications (more than $10 million), with each applicant receiving, at most, an additional $10 million. • Changed evaluation process to award slightly higher scores to applicants who do not qualify for partial exemption. • Created a new requirement for participants to make at least 15 percent of the projected purchases within 18 months of receiving the award. 8 LEGISLATIVE ANALYST’S OFFICE analysis full gutter 2021-22 BUDGET MAIN STREET CREDIT Background credit in each quarter in which they incur a loss in gross receipts, as opposed to just once a year. Legislature Created $100 Million Credit for Businesses Hurt by Pandemic in 2020. In Proposal September 2020, the Legislature created the Main Another $100 Million Proposed for Tax Year Street Credit, which provides income or sales tax 2021. The Governor proposes to make $100 million credits to eligible small businesses that added available for a credit similar to the Main Street jobs in the second half of 2020. Each eligible Credit in 2021. The Administration has said that it business receives a credit of $1,000 for each new plans to pattern the credit after the newly extended job. Eligibility is restricted to firms that meet two federal ERC, but has not yet provided new statutory conditions: (1) they have 100 or fewer employees language. and (2) their gross receipts dropped by at least half between the second quarter of 2019 and the Assessment second quarter of 2020. These eligibility criteria were patterned, in part, after the federal Employee Credit Relatively Well-Targeted to Businesses Retention Credit (ERC). The state capped the Affected by Pandemic… Compared to other total amount of credits available to all businesses proposals in the Governor’s package, this proposal at $100 million and allotted the credits on a is relatively well-targeted to businesses impacted first-come, first-served basis. by the pandemic for two reasons. First, eligibility is limited to businesses that have experienced a drop Federal Credit Based on Retention of in gross receipts during the pandemic. Second, Employees, Not Addition. The federal government the credit is available to many businesses in the created the ERC in March 2020 as part of the hardest-hit industries, such as travel, retail, food Coronavirus Aid, Relief, and Economic Security and hospitality, health and wellness, and personal Act. The ERC provided firms with 100 or fewer care services. employees a credit for 50 percent of wages paid to employees they retained in 2020 (up to $5,000 per …However, Leaves Out New Businesses in employee). Similar to the Main Street Credit, Affected Sectors. One limitation, however, of tying businesses are eligible for the ERC if their quarterly eligibility to a drop in gross receipts from the prior gross receipts dropped by at least half compared year is that new businesses would not be able to to the same quarter in 2019. Firms with smaller qualify, as these businesses did not have gross drops in gross receipts were eligible if they had receipts in 2019 or early 2020. Nonetheless, new to suspend or curtail operations in response to businesses in heavily impacted industries may governmental shutdown orders. face challenges with expanding and hiring new employees in the coming months. Federal Eligibility Criteria Changed for 2021. In December 2020, the federal government Not All Main Street Credits Claimed. Nearly expanded the ERC and extended it through the first 10,000 businesses applied for a total of $56 million half of 2021. To be eligible for the extended ERC, a of Main Street Credits in 2020. This suggests that, business’s 2021 quarterly gross receipts must be at despite a fair amount of interest among businesses, least 20 percent below the same quarter in 2019. the credit could have been set at a higher value Firms founded in 2020 also are eligible if their 2021 without exhausting the $100 million allocation. quarterly gross receipts are at least 20 percent Recommendation below the same quarter in 2020. The new law increased the share of employees’ wages eligible Expand Governor’s Proposal. As this proposal for the credit from 50 percent to 70 percent (up is better targeted to businesses most in need of to $7,000 per employee). Firms also may take the assistance, we suggest the Legislature focus its www.lao.ca.gov 9 analysis full gutter 2021-22 BUDGET resources on expanding this program. For example, are in certain sectors—based on their North the Legislature could supplement the Governor’s American Industry Classification System code. $100 million by (1) rolling over unused funds from Such an approach, however, could create the 2020 Main Street Credit and (2) redirecting additional administrative responsibilities for $250 million from the Governor’s California the California Department of Tax and Fee Competes grant proposal to this program. This Administration and the Franchise Tax Board would provide for a roughly $400 million credit (FTB). program. Given this larger pot of money, we would • Increasing the Value of the Credit. We also suggest the Legislature expand the Governor’s suggest increasing the value of the credit proposal by: beyond $1,000 per employee. One option would be to set the credit at a percentage • Broadening Eligibility to Other Impacted of wages paid to each new employee—as Businesses. We suggest considering which with the ERC. For example, if funding for the groups of businesses impacted by the credit program were increased to $400 million, pandemic would not be served either by the the value of the credit could be increased Governor’s proposal or by the federal ERC. to 40 percent of wages (up to $4,000 per One example is newly formed businesses employee) and still provide credits for roughly in heavily impacted sectors. An option to twice as many new hires as the Main Street include these businesses would be to allow Credit. new businesses to qualify for the credit if they CALIFORNIA COMPETES Program Provides Financial Incentives have raised concerns about the effectiveness of state financial incentives for hiring or business to Attract or Retain Businesses investment. (We analyzed the program in a California Competes Is an Economic 2017 report, Review of the California Competes Development Incentive Program. The Governor’s Tax Credit, and in a 2020 report, Assessing Recent Office of Business and Economic Development Changes to California Competes.) The California (GO-Biz) administers California Competes, a Competes program has some features intended to program intended to attract or retain businesses address these concerns: that are considering making new investments in California. Companies seeking tax credits apply • Competitive Application Process. GO-Biz to GO-Biz, and the administration negotiates tax allocates the credits through a competitive credit agreements with selected applicants. application process. For example, only GO-Biz awards up to $180 million in credits each 56 of the 375 companies that applied to the fiscal year, plus any unallocated or recaptured program during the 2019-20 fiscal year were credits from the prior year. (The state may recapture successful. GO-Biz evaluates each application the credit if the taxpayer does not satisfy the based on various factors, such as the number terms of the agreement.) Businesses can use of jobs proposed, the amount of investment these credits to reduce their tax liabilities for the proposed, and whether the business is PIT or the corporation tax. In 2019, the California located in an area with high unemployment. Competes credit reduced state General Fund • Applicants Must Explain How Credit Will revenues by $38 million. Influence Hiring and Investment Choices. Since 2018, GO-Biz must disqualify any Program Has Features Intended to Address Some Common Concerns. Our office and others business that cannot credibly explain how the credit will directly affect its business decisions 10 LEGISLATIVE ANALYST’S OFFICE analysis full gutter 2021-22 BUDGET here. While such assessments are subjective, $35 million in 2022-23, $50 million in 2023-24, and GO-Biz appears to make a good faith effort to $85 million in later years. fulfill this requirement. Create $250 Million California Competes • Businesses Must Meet Hiring and Grant Program. The Governor’s budget includes Investment Commitments. Successful $250 million one-time General Fund to allow the applicants negotiate written agreements with California Competes program to provide cash GO Biz that specify hiring and investment grants. GO-Biz would award grants, instead of targets over a five year period. The credits, using the existing California Competes - businesses may not claim the credit until application and evaluation processes. The - they first meet their hiring and investment administration could pay grants to successful commitments. The state recaptures credits applicants either in full upon approval or in from businesses that do not comply with the increments based on hiring and investment terms of the agreements. Depending on the milestones. In addition to existing program criteria, agreement terms, the state may recapture an applicant would need to meet one of the only part of the amount. For example, if a following criteria to qualify for a grant: business had committed to hiring 100 new • Establish at least 500 net new jobs. employees but only hired 80, the state might • Make a significant infrastructure investment, recapture 20 percent of the tax credits. as defined by the director of GO-Biz. Latest Round Differed From Prior • Commit to a high-need or high-opportunity area of the state Periods • Receive a designation from the Director of More Businesses Applied for Credits in 2020. GO-Biz that the application is a strategic GO-Biz usually holds three application periods priority to the state. each fiscal year. California Competes received an average of 145 applications per period during the If a business violated the terms of its agreement, last two fiscal years. However, California Competes including not meeting its hiring and investment received an unprecedented 451 applications during commitments, GO-Biz would instruct FTB to the first period of the 2020-21 fiscal year. recapture the grant. FTB would attempt to collect the amount in the same manner that FTB attempts GO-Biz Awarded Bigger Agreements to collect a delinquent tax liability. to Fewer Businesses. In this round, GO-Biz negotiated credit agreements with four applicants. Assessment of Overall California All four agreements were for relatively large Competes Proposal amounts—between $5.2 million and $29.8 million. Go-Biz typically awards around 20 agreements Does Not Target Industries Most Severely per application period for lower amounts. The Affected by the Pandemic. The pandemic has average agreement in the prior two years was for forced many businesses to reduce their operations $3.3 million. or close. Businesses in the travel, retail, food and hospitality, health and wellness, and personal care Governor Proposes to Expand services sectors have been especially hard hit. California Competes in Two Ways The majority of California Competes awards go to businesses in three industries: (1) manufacturing; Expand Existing Program by $180 Million (2) professional, scientific, and technical services; Over Two Years. The Governor proposes to and (3) financial services. Of the four companies increase the total amount of California Competes awarded tax credit agreements in November 2020, credits that GO-Biz may award in 2020-21 and for example, two are manufacturers and two are 2021-22 by $90 million per year. The administration financial services companies. While the pandemic estimates that the resulting reductions in General has affected these industries in many ways, they Fund revenue would be $10 million in 2021-22, www.lao.ca.gov 11 analysis full gutter 2021-22 BUDGET generally have not been affected to the same large amount of state tax to use all of the credits degree as industries that require close contact. they have earned. Despite Program Features, Concern Assessment of Proposed Grants About Effectiveness Remains. State financial incentives—which may include tax credits or Growing Businesses Often Have Low grants—can influence business decisions. The Taxes, and Credit Not Refundable. When new state, however, will never be able to distinguish businesses are growing rapidly, they often do not perfectly between business decisions that result have positive tax liabilities because their deductions from a financial incentive on the one hand, and from wages, interest, and depreciation may decisions that businesses would have made greatly exceed their revenue. In 2019, only about irrespective of the incentive on the other hand. one-quarter of the state corporation taxpayers In the latter scenario, the incentive is a financial owed more than the $800 minimum franchise tax. windfall for the business. As described above, Like all of the state’s business tax credits, California some features of California Competes reflect Competes credits are not refundable. That said, if well-intended efforts to address this issue, but such a taxpayer owes less tax than the amount of their efforts inevitably have serious limitations. credit, they may carry the balance forward for up to High Recapture Rate Raises Concerns. six years. Even then, some businesses might not be GO-Biz recaptures credits from businesses able to use the full amount of the credits they have that did not achieve their negotiated hiring or earned. investment commitments by the end of their Proposed Grants Respond to This Issue but five-year agreements. Over the past year, hundreds Raise Significant Questions. The administration of agreements have ended. Overall, the state correctly notes that not all taxpayers benefit from recaptured roughly one-third of the dollar amount of tax credits. Grants are one way to address this credits awarded ($122 million) during the first three issue, but there may be others. For example, years of the program. Ideally, credit recaptures the state could allow a portion of the tax credits should be unusual, but the state has recaptured all to be transferable or refundable. The state also or part of the credits from the majority the California could temporarily allow taxpayers who cannot Competes agreements that have ended. The high use credits to sell some of them back to the state recapture rate suggests that many businesses at a discount. Even these more modest changes with tax credit agreements could not accurately would represent a significant shift in the state’s predict their future hiring and investment choices. longstanding approach to economic development Additionally, the high recapture rate raises new incentives. concerns about the number of new private-sector How Would State Manage Risks of Grants? jobs created by this program. Public data about the The existing California Competes program does tax credit agreements and recaptures are limited. not allow businesses to claim credits until they A better understanding of the high recapture achieve their hiring and investment commitments. rate could help the Legislature improve California The high recapture rate noted above indicates Competes or similar programs in the future. that this caution has been justified. We suggest Businesses Seem to Be Struggling to Use Tax that the Legislature consider the risk to the state Credits. GO-Biz has awarded $1.2 billion in credits from paying grants in full upon the approval of since 2014. Of this amount, after accounting for the the California Competes agreement. FTB could five-year structure of the tax credit agreements and have difficulty recovering grant funds from certain the credit recaptures, we estimate that business businesses, such as those with minimal assets or have earned roughly $500 million in California under bankruptcy protection. The Legislature could Competes tax credits. The amount of credits that consider putting in place additional guardrails, such taxpayers have actually used—about $160 million— as setting a maximum grant amount or requiring is significantly lower. Many taxpayers with California that grants only be paid upon the business meeting Competes credits appear to not owe a sufficiently its commitments. 12 LEGISLATIVE ANALYST’S OFFICE analysis full gutter 2021-22 BUDGET Growing Companies Have Unprecedented are at historically low levels, making borrowing Access to Private Funding. Another advantage inexpensive. of a grant over a tax credit is that the business Recommendation does not have to wait to receive the money. Under current economic conditions, however, the types Reject Proposed One-Time Expansions of of businesses served by California Competes—in California Competes. California Competes is not a particular, businesses that are expanding—have suitable vehicle for addressing the economic effects good private sector financing options. Growing of the pandemic because it does not target the businesses can raise funds in two ways: they can hardest-hit industries. Furthermore, because the sell stock equity or borrow money from a bank (or hiring and investment agreements cover a five-year a non-depository lender). Despite the challenging period, the timing of any potential economic economic conditions because of the pandemic, benefits does not address the urgency of the this is a remarkably good time for businesses to current economic situation. While the Governor’s raise capital through either approach. There were grant proposal responds to this timing issue to nearly 1,600 initial public offerings in the United some extent, it raises other important issues for the States in 2020, a 42 percent increase over 2019. Legislature to consider. As discussed elsewhere With the stock market at all-time highs, many other in earlier parts of this report, another program— corporations raised capital by selling additional the Main Street Credit—gives the Legislature a shares of stock. At the same time, interest rates better way to use General Fund resources to help businesses during this economic crisis. CONCLUSION The Governor’s budget proposes several that the Legislature prioritize expansion of the Main changes to taxation to support businesses. Two Street Credit, explore alternative structures for an key factors for evaluating these proposals are: elective S Corporation tax, and reject the proposed (1) which level of government would forgo revenue, one-time expansions of the CAEATFA exclusion and and (2) which businesses would receive assistance. California Competes. Based on these criteria and others, we recommend LAO PUBLICATIONS This report was prepared by Seth Kerstein, Brian Weatherford, and Justin Garosi, 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. 13 LEGISLATIVE ANALYST’S OFFICE