June 12, 2020

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California returns to familiar corporate tax changes as $4B budget solution

By
Aaron Leathley
Politico Pro

Gov. Gavin Newsom has proposed two major corporate tax changes he estimates would collect about $4.4 billion in 2020-21, softening the blow the Covid-19 pandemic has dealt California’s finances. The Legislature has largely preserved these measures in its budget agreement.

But the state’s revenue experts disagree on just how much money those proposals would raise from an already volatile corporate tax base.

What's proposed: In his May budget revision, Newsom proposed pausing corporations’ ability to deduct losses from slow years out of their taxable income in more profitable years, known as Net Operating Loss deductions. He also proposed capping the tax credits businesses can claim at $5 million total. California last adopted these types of policies during the Great Recession.

Revenues: The proposals would raise about $4.4 billion in the 2020-21 tax year and about $3.3 billion and $1.9 billion respectively in the subsequent two tax years, according to Department of Finance estimates in the governor’s budget revision.

Why: For California’s Democratic governor and the Democrat-controlled Legislature, cutting corporate tax breaks in the midst of the coronavirus recession is more politically feasible than raising taxes on less wealthy taxpayers. The proposals would shift the burden further away from low- and middle-income Californians.

"We can't balance our budget solely on the backs of children, seniors and working families," said Assemblymember Phil Ting (D-San Francisco) in a statement. "We need every sector to pitch in to lessen the budget pain, and this move helps accomplish that."

Opponents: Business groups and the tech industry in particular are fighting the proposals.

Limiting research and development incentives would undercut California companies’ development of technologies to fight Covid-19, such as a potential treatment and vaccine, said California Taxpayers Association President Robert Gutierrez in a letter opposing Newsom’s budget proposal.

“R&D is the most important activity taking place on this planet,” said Gutierrez. “We should be doing everything possible to make sure this activity happens here in California.”

TechNet, whose members include both Silicon Valley institutions like Facebook and Apple and newer household names like Zoom, Grubhub and Instacart, says the tax proposals would hobble corporations’ attempts to power California’s economic recovery and keep their employees.

“Limiting business tax credits, including the important Research and Development Tax Credit, will only hurt industries which have rushed to innovate and help maintain and create high-paying jobs for Californians across the state,” said Courtney Jensen, one of the organization’s directors, in a statement.

Backdoor borrowing? Pressing pause on corporations’ ability to deduct their losses now only to allow them to deduct their saved-up losses later might sound like borrowing money from the future, especially because businesses have a 20-year window to deduct their losses under California law. But precedent shows that suspending NOLs for a few years does result in net gains for the state, said Weatherford.

Risks: The LAO says the tax proposals could bring in between $831 million and $1.5 billion less in their first year than the Department of Finance estimated for Newsom’s budget.

The discrepancy traces back to different estimates of corporate profits. Predicting corporate profits can be like reading “tea leaves,” said Brian Weatherford, a fiscal analyst and an author of the LAO’s report. Although they generally trend upward, corporate earnings are taking a hit during the current recession, and DOF could be overestimating their resilience, he said. “We’re just starting with a lower [corporate] revenue number,” said Weatherford.

The relatively small number of high-paying corporate taxpayers also means corporate taxes are a volatile revenue source, even in strong years. If just a few corporations experience large losses, it could significantly impact total revenue in a given year.

Adding to the uncertainty, the value of credits companies claim can fluctuate wildly by year. Absent a cap like the one the governor has proposed, the total amount of Research & Development Tax Credits taken can vary by around $1 billion dollars in different years, said Weatherford.

Critiques: The NOL proposal could have the effect of taxing similar companies differently, LAO says. As currently written, the policy would apply to businesses that make more than $1 million each year.

Using an income cutoff to decide which corporations may deduct their losses over the next two years would mean that two similar firms making $1 million and $975,000 respectively would owe very different amounts in that time, the LAO report points out. The budget could address this by limiting the deductions to a certain amount, said the report. The NOL suspension would end in 2022.

What’s next: The deadline for the Legislature to pass the budget bill is Monday.

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