The 2022-23 Budget: Temporary Limits on Business Tax Provisions

The 2022-23 Budget: Temporary Limits on Business Tax Provisions JANUARY 2022 Summary. This post provides background on NOL Suspension Affects About 4,000 temporary limits on the use of net operating loss Taxpayers. Assembly Bill 85 suspended the use deductions and business tax credits. It describes of NOL deductions by corporations and individuals the Governor’s proposal to lift these limits one that have net business income over $1 million for year early and provides some comments to 2020, 2021, and 2022. Figure 1 provides the Legislature. summary information about those taxpayers that had business income over $1 million and Background used NOL deductions in 2019. The figure shows State Temporarily Raised Business Taxes that 339 personal income tax (PIT) payers and to Address Anticipated Budget Problem. 3,866 corporation taxpayers had business income The onset of the COVID-19 pandemic had over $1 million and used a NOL deduction. far-reaching negative impacts on the state The figure also shows the use of NOL deductions economy and significantly impacted the state by corporate taxpayers across industry sectors. budget. In anticipation of a $54 billion budget In 2019, for example, 619 taxpayers operating problem, Chapter 8 of 2020 (AB 85, Committee in the manufacturing industry had more than on Budget) limited the use of net operating loss $1 million in income and deducted $3 billion in deductions and business credits for 2020, 2021, NOLs in total. The administration estimates that and 2022 to temporarily increase tax revenue. This the NOL suspension increased revenues by about is a budget solution that the state previously has $2 billion in 2020-21. used, for example, to address the budget problem caused by the Great Figure 1 Recession in 2008. NOLs Deducted by Selected Taxpayers Net Operating Loss Deductions 2019 Smooth Business Profits and Losses Over Time. Companies and Number of Returns With NOLs, Amount of NOLs individuals often incur operating Business Income >$1 Million Claimed (Billions) losses associated with their business Personal Income Tax Returns activities in some years. These Resident 314 $1.9 companies are able to carry the net Nonresident 25 0.1 operating losses (NOLs) forward Totals 339 $2.0 Corporation Tax Returns into future tax years and deduct Retail and wholesale trade 895 $2.7 NOLs from their operating income. Industry unknown 724 3.9 The ability to deduct NOLs allows Manufacturing 619 3.0 business taxpayers to smooth profits Services 454 1.2 and losses over time. California Information 386 1.1 tax law allows business taxpayers Other industries 788 3.7 to carry forward such NOLs for up Totals 3,866 $15.6 to 20 years. NOLs = net operating losses. Business Tax Credits Often Encourage Governor’s Proposal Certain Types of Behavior. Tax credits are Lifts Temporary Limits on Business Tax provisions in California’s tax laws that allow Provisions. The Governor’s budget proposes to taxpayers to directly reduce their taxes dollar end, one year early, temporary limits on the ability for dollar. Most business tax credits provide an of businesses to use NOL deductions and tax incentive for companies to alter their behavior in credits to reduce their tax payments. Lifting the certain ways. For example, the New Employment NOL deduction and credit limits will reduce tax Tax Credit allows a company to claim a credit if they revenues by an estimated $5.5 billion in 2022-23. hire a qualified new full-time employee. The largest Figure 3 shows how the administration estimates state business tax credit is the credit for qualified that the proposal would affect General Fund research and development (R&D) expenditures. revenues. Revenue increases in the years following Taxpayers claimed about $3.1 billion in R&D credits 2022-23 because NOL deductions and credits that in 2019. All other business credits amount to less would have been used in future years instead will be than $1 billion combined. used in 2022-23. Credit Limits Likely Affect Fewer Than 100 Ending NOL and Credit Limits Early Is Corporations. Assembly Bill 85 limited the amount of most business tax credits any taxpayer could Reasonable claim to $5 million for 2020, 2021, and 2022. Lifting the limits one year early would be Figure 2 lists the tax credits limited by AB 85 reasonable for a couple of key reasons. and the amounts of each claimed in 2019 by the affected corporation taxpayers. Some affected Figure 2 taxpayers may have had several credits, for example, an affected corporation may have had Tax Credits Used by Selected both California Competes and R&D credits. The Corporation Taxpayers $5 million limit on credits likely has affected fewer 2019 than 100 corporation taxpayers. (No individual business owner was affected by this provision Number of Amount Credit Taxpayers (Millions) because none had more than $5 million in credits available to apply against the PIT. Taxpayers are Research and development 59 $2,147 Enterprise zones —a 258 allowed to carry unused credits forward to use Film productionb —a 109 in a future tax year. While different credits can Prior year alternative minimum tax —a 63 be carried forward for varying amounts of time, California Competes —a 27 R&D credits never expire. The administration New Advanced Strategic Aircraft —a 19 estimates that the limit on business credits Totals 80 $2,623 increased revenues by about $2 billion in 2020-21. a Fewer than ten taxpayers. The number may not be displayed to protect taxpayer confidentiality. Interaction Between Suspending NOLs and b Includes credits from both the first and second film tax credit programs. Limiting Credits. Some corporations have large balances of both NOLs and credits. If the state restricts the use of NOLs, Figure 3 such corporations will increase Estimated Revenue Change From Governor’s Proposal their use of credits. For this reason, to End Limits on Business Taxes placing limits on both NOLs and FY 22-23 FY 23-24 FY 24-25 FY 25-26 credits results in a larger revenue effect than limiting either NOLs or Personal income tax -275 8.5 42.5 33 credits separately. The administration Corporation tax -5,225 161.5 807.5 617 Totals -5,500 170.0 850.0 650 estimates that this interaction effect FY = fiscal year. increased revenues by an estimated $600 million in 2020-21. 2022-23 Budget Series 2 Budget Solution No Longer Needed. Improved Budget Resilience in Future The state’s actual revenue situation improved Years. The temporary limits on NOLs and credits significantly faster than the state anticipated when effectively shift tax revenue from future years to it adopted the temporary limits on NOL deductions the present. Given the strong budget position at and credits. The unusual economic effects of the present, it is not prudent to increase revenues in pandemic resulted in unexpected growth in General the current year if those increases come at the Fund revenues. The 2020-21 Budget Act forecast expense of reduced revenues in future years, when 2022-23 revenues of $132 billion—an amount that the budgetary situation is less certain. In addition to reflected a sharp decline in 2020-21, followed by increasing future revenue, the Governor’s proposal slower than average growth. The Governor’s budget could improve budget resilience by maintaining the now forecasts that 2022-23 General Fund revenues option to again place temporary limits on NOLs will be $196 billion, or 49 percent, higher that the and credits should the state face a similar budget projection when these business tax provisions were problem in the future. enacted. The provisions were enacted to address the anticipated budget problem, not to raise revenue for new state spending. 2022-23 Budget Series 3 2022-23 Budget Series 4 LAO PUBLICATIONS This post 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. 2022-23 Budget Series 5