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California�s Tax System �
'Spending problem?' - some of it's hidden in our tax laws, SF Chronicle, 2/10/08
In order to tax income, decisions must be made as to how income should be measured. In some ways, the decisions for businesses are easier than for individuals because it is generally assumed that businesses may reduce their gross receipts by the expenses incurred to produce those receipts. But, what expenditures should individuals be allowed to subtract from their gross income? For many decades, the system has followed a policy decision based on ability-to-pay. Thus, some type of exemption (deduction) should be allowed for the taxpayer, spouse and dependents, on the assumption that individuals need some level of income to live on that should not be taxed. However, not all expenditures that affect ability-to-pay are allowed as deductions in computing taxable income.
Legislators realize that they can implement many non-tax policies through the tax system in that it is a way to provide a government benefit to someone or to encourage (or discourage) someone from doing something. For example, the government might encourage more individuals to consider buying a hybrid fuel car by offering a tax credit for doing so. This type of tax break or benefit is not for the purposes of measuring taxable income, but for providing a benefit to certain taxpayers. These types of benefits, of which there are over 100 in the federal and California income tax systems, result in reduced tax collections over what could be collected if these breaks were not part of the tax rules.
Both the federal and California governments measure the annual cost of most of these tax provisions. The process is referred to as measuring �tax expenditures.� A �tax expenditure� is a provision in a tax system that results in reduced tax collections. For example, a deduction for property taxes in the income tax reduces taxable income and thus tax liability. Thus, the property tax deduction is a tax expenditure. A tax expenditure might also just reflect choice of a rule on how to measure something, such as depreciation (such as straight line versus double-declining balance). The California Department of Finance (DOF) is required to issue an annual report of tax expenditures of $5 million or more (in terms of revenue not collected due to the particular tax expenditure). In defining tax expenditure for its report, the Department of Finance does not include a tax system feature that is part of the basic structure of the tax. For example, California�s sales tax statute bases the tax primarily on tangible personal property. Thus, the DOF does not include the inherent sales tax exemption for services and intangible property on its list of tax expenditures.
Most tax expenditures are permanent rules in the tax law rather than temporary provisions that must be reviewed when the expiration date nears. Thus, tax expenditures are rarely reviewed. If there is a need to generate additional revenue, some of the tax expenditures may come under review and be reduced or eliminated. A significant example of this occurred with the federal Tax Reform Act of 1986. That Act broadened the income tax base and lowered tax rates. Several deductions and tax credits were eliminated, such as the deductions for personal interest, as well as the investment tax credit. The lack of annual review of government spending in the form of tax expenditures is that the revenue effect of the provisions goes unchecked other than in overall projections of tax collections. For example, when the price of housing increases, people take out more debt to purchase a home and government revenues drop because individuals claim higher mortgage interest deductions. The change in the budget from this effect goes unchecked in the annual budget process.
Tax expenditures also go mostly unchecked because in critiquing an annual budget, they are overlooked because they are not part of that budget (that is, they are not listed as a spending item). In addition, in California, the process for implementing a tax expenditure (tax break) differs from direct spending in the budget process. In California, a tax break can be enacted with a simple majority vote of the legislature while the California budget approval requires a 2/3 majority vote. In addition, should the legislature want to reduce or eliminate a tax break, a 2/3 majority vote is required since the result would be increased taxes.
Generally, tax expenditures are a form of government spending because a decision is made when the deduction, exemption or credit is put in the law that it is appropriate to reduce government tax revenues to provide the tax rule.
This report includes a list of California tax expenditures that could be eliminated or pared down so as to improve equity and fairness in the tax law and to improve California�s budget situation (by increasing tax revenues).
Additional Observations on Tax Expenditures and Reform
Reasons for special tax provisions: Reasons why favorable tax provisions are included in California tax rules include:
Problems due to lack of annual review: The result of lack of regular review of tax expenditures is that some of them have outlived their usefulness or appropriateness. For example, many years ago, many senior citizens had low income and perhaps an across the board tax credit for all of them was warranted. However, today, many senior citizens are quite wealthy, yet many continue to get an income tax credit even when income is well beyond the poverty level.
In addition, lack of annual review prevents the updated cost of the benefit from being considered.
Some tax expenditures lacked appropriateness from the start, but perhaps the provision was enacted because it did not affect many individuals. However, continuation of the tax break could grow over the years increasing the inequity of that use of tax dollars. An example would be the home mortgage interest deduction (see chart below for more information).
Lack of targeting the expenditure: Some tax provisions are not targeted to the population that the benefit is intended to serve or it may favor higher income individuals. For example, the California senior exemption applies to many senior citizens with income well above the poverty level. Also, the exclusion for the value of health insurance provided by an employer provides a great benefit to high-income employees as they may get a larger benefit from their employer and the exclusion is worth more to them because they are in a high tax bracket.
Complexity: Generally, special rules, such as for home mortgage interest or certain gain exclusions add complexity to the law because of the definitions and special rules that are required to comply with the rule.
Removal or reduction of California tax provision can still provide benefit at federal level: Many of the California income tax expenditures also exist in the federal income tax. If California reduced the tax benefit, the taxpayer would still obtain a benefit at the federal level. While the taxpayer would have a new adjustment to convert federal taxable income to California taxable income, that should not be too challenging of a task. Basically, if California cuts back a tax break that also exists at the federal level, taxpayers still derive some benefit of the activity that generates the federal benefit. However, there are many tax expenditures that should also be reconsidered at the federal level for the same reasons they should be reconsidered for the PIT.
Distribution of benefits generally uneven across income levels: Tax benefits in the form of deductions tend to favor higher income taxpayers because they are in higher tax brackets (an exception is for deductions that are not available for higher income taxpayers). Also, tax credits may also favor higher income taxpayers because credits generally are not refundable (they reduce tax liability to zero with any excess credit vanishing or carrying forward to future years with no adjustment for the time value of money).
For example, the FTB reports that the senior exemption and real property tax deduction across income levels for 2002 tax returns was as follows.
For the senior exemption, 18.5% of the dollar benefit went to individuals with income of $100,000 or more while 52.2% went to those with incomes of $50,000 or more. The real property tax deduction was even more skewed to higher income individuals with 62.9% of the benefit going to those with income of $100,000 or more and 94.3% going to those with income of $50,000 or more. Part of the reason for the difference in benefit is that the senior benefit is a tax credit and so provides the same dollar-for-dollar benefit for all taxpayers (unless the credit is greater than the tax owed), while the other is a deduction and so provides a bigger benefit for those in higher tax brackets (those with higher incomes). In addition, a taxpayer must itemize deductions in order to deduct real property taxes.
Tax gap issues: The California Legislative Analyst�s Office (LAO) notes that some tax expenditures create �serious enforcement problems� by offering �many opportunities for tax evasion, especially given the relatively low level of tax auditing the state undertakes.�
Deductions versus credits: Tax expenditures in the form of tax deductions, yield greater benefit to taxpayers in higher tax brackets. For example, assume two individuals each have a mortgage interest deduction of $5,000. For a higher income individual with a marginal California income tax rate of 9.3%, that deduction provides a benefit of $465. For a lower income individual with a marginal tax rate of 4%, the tax benefit of the deduction is $200. Greater equity could be provided for many tax breaks by converting them from deductions into tax credits. Tax credits are dollar-for-dollar reductions in tax liabilities. A credit of $50 is worth $50 to all taxpayers regardless of their marginal tax rate. Thus, a mortgage interest tax credit equal to 5% of one�s mortgage interest represents a tax savings of $250 for both of the individuals in the prior example (who each have mortgage interest of $5,000).
Reform can support a rate reduction: In addition to generating revenue, reduction in some tax breaks could be combined with a reduction in tax rates which would also cause the change to be perceived as less onerous. In its 2006 report on tax expenditures, the FTB reported that elimination of the mortgage interest deduction could allow for a 10% across-the-board rate cut with the personal income tax still generating the same amount of revenue. Similarly, the FTB reported that elimination of the R&D tax credit for corporations could allow for a revenue-neutral rate reduction of 7%.
Taxing exclusions still yields taxpayer benefit: Some of the tax breaks are exclusions where something that meets the definition of income is allowed to be excluded from taxable income. The exclusion for employer-provided health insurance is an example. Assume that an employer pays $10,000 during the year towards an employee�s health insurance costs. That financial benefit is generally excluded from the employee�s taxable income. If instead, all or part of that exclusion were subject to tax, the employee would still be financially ahead. For example, if the employee is in a 9.3% marginal tax bracket, including the $10,000 in income results in $930 of tax owed. The employee has obtained a $10,000 health insurance benefit for only $930.
Another perspective: A 1999 report from the Joint Economic Committee questioned the propriety of using the term �tax expenditures� to describe tax exemptions, special deductions and credits. The report noted that the tax expenditure approach took the view that one�s income really belongs to the government rather than to the taxpayer. The report also noted that the concept of tax expenditures is problematic in that the federal income tax is a combination of an income and a consumption tax. Arguably, this theory downplays the lack of equity that exists in many tax expenditures.
Another positive perspective on tax expenditures is that they encourage a particular activity without the need for a government agency to oversee it. For example, instead of a research tax credit, the government could provide research grants through a competitive process. However, that would require that a special agency be set up to handle the grant request, review and monitoring function.
Not just personal income tax: Tax breaks exist in other California taxes including the corporate franchise tax, the sales tax and other taxes. The DOF and FTB reports include the data on these tax expenditures. Significant tax expenditures in these other taxes include (08/09 DOF data):
Critique of Selected California Personal Income Tax Expenditures: Where Changes Are Justified for Fairness & Equity
The chart below lists selected tax expenditures of $5 million or more that the Department of Finance included in its 07/08 annual report. The ones listed in the chart are some of the ones that the author believes warrant review as being too generous, inappropriate or no longer useful. All of those listed also represent a source of revenue in that cutting back on the tax expenditure is, in effect, a spending cut. A complete list of the tax expenditures that cost $5 million or more can be found at the Department of Finance website (http://www.dof.ca.gov/Research/Research.php).
Cutting back or eliminating tax breaks is never easy because each one has a group of taxpayers who will want to keep it, perhaps even if a rate decrease accompanies the cut back. Change will also be difficult because many taxpayers, particularly individuals, are not aware of these breaks. For example, most people with employer-provided health insurance do not even know the amount of the benefit and that the government is providing them a subsidy by not requiring that financial benefit/gain to be included in taxable income.
Elimination of any tax expenditure will not necessarily mean that those dollars will translate into additional revenue due to behavior changes taxpayers may engage in. For example, if the charitable contribution deduction were cut back, people might make fewer contributions which might eventually result in a need for greater government expenditures to provide welfare assistance previously provided by charities.
Tax Policy Analysis
The following chart explains how better conformity efforts would satisfy the principles of good tax policy. The rating in the last column indicates how better conformity practices would improve the current system.
CA Department of Finance, Tax Expenditure Report 2007-08; http://www.dof.ca.gov/Research/documents/Tax_Expenditure_Rpt_07-08.pdf.
Franchise Tax Board, Income Tax Expenditures, 12/07; http://www.ftb.ca.gov/aboutftb/taxexp07.pdf.
Joint Committee on Taxation, tax expenditure reports; http://www.house.gov/jct/pubs_taxexpend.html.
LAO, Tax Expenditures and Revenue Options, Presented to: Assembly Revenue and Taxation Committee, 4/7/08; http://www.lao.ca.gov/handouts/Econ/2008/Tax_Expend_04_07_08.pdf.
 California Department of Finance; annual reports can be found at http://www.dof.ca.gov/Research/Research.php. Tax expenditure reports by the Franchise Tax Board can be found at http://www.ftb.ca.gov/aboutftb/plans_reports.shtml. The federal government also reports annually on the �cost� of tax expenditures in the federal tax laws. The latest report from the Joint Committee on Taxation can be found at http://www.house.gov/jec/fiscal/tax/expend.pdf.
 See CA Department of Finance, Tax Expenditure Report 2007-08, page 2; http://www.dof.ca.gov/Research/documents/Tax_Expenditure_Rpt_07-08.pdf.
 Franchise Tax Board, Income Tax Expenditures, 8/06, pages 34 and 74; http://www.ftb.ca.gov/aboutftb/plans_reports.shtml.
 LAO, Tax Expenditures and Revenue Options, Presented to: Assembly Revenue and Taxation Committee, 4/7/08, pg. 7; http://www.lao.ca.gov/handouts/Econ/2008/Tax_Expend_04_07_08.pdf.
 Franchise Tax Board, Income Tax Expenditures, 8/06, page 6; http://www.ftb.ca.gov/aboutftb/plans_reports.shtml.
 For federal income tax purposes, S corporations are taxed as pass-through entities (income taxed to owners), generally with no entity level tax. California also taxes them as pass-through entities, but also assesses an entity level tax at a rate of 1.5%.
 The amounts in the California Dept. of Finance reports do not tie exactly to those in the FTB tax expenditure reports.
 This was proposed by President Bush�s Advisory Panel on Federal Tax Reform, Final Report, 11/05 pg. 73; http://www.taxpolicycenter.org/newsevents/trp_recommendations.pdf.
 There are reasons for the federal income tax law to exempt 50% of one�s Social Security income because employee contributions to Social Security are taxed (employer contributions were deducted by the corporation). However, the federal government made a decision several years ago to tax up to 85% of Social Security income for higher income individuals.
 This analysis uses a document prepared by the American Institute of Certified Public Accountants (AICPA) Tax Division and altered to the above format by Joint Venture: Silicon Valley Network. The AICPA document, Guiding Principles of Good Tax Policy: A Framework for Evaluating Tax Proposals (2001) is available at http://ftp.aicpa.org/public/download/members/div/tax/3-01.pdf. The Joint Venture workbook is available at http://www.jointventure.org/PDF/taxworkbook.pdf. The principles laid out in these documents are frequently used tax policy analyses ones. For more information see Nellen, Policy Approach to Analyzing Tax Systems; available at http://www.cob.sjsu.edu/nellen_a/TaxReform/PolicyApproachToAnalyzingTaxSystems.pdf. Note: The author of this report (Annette Nellen) was the lead author for both the AICPA and Joint Venture documents noted here.
 President�s Panel on Federal Tax Reform, Final Report, 11/05, Chapter 5, page 71; http://taxreformpanel.gov/final-report/. Also see Treasury Background Paper on Business Taxation and Global Competitiveness, 7/07, page 24; http://www.treasury.gov/press/releases/reports/07230%20r.pdf.
 President�s Panel on Federal Tax Reform, Final Report, 11/05, Chapter 1, page 8; http://taxreformpanel.gov/final-report/.
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This page last revised on April 8, 2008. Contact Annette Nellen
The views and opinions expressed in this page are strictly those of Professor Annette Nellen. The contents of this page have not been reviewed or approved by San Jos� State University.Last Modified: Aug 14, 2018