personal bank and corporation tax - california

„„„„ PersonalIncome Tax

„„„„ Bank andCorporation Tax

„„„„ TABLE OF CONTENTS—INCOME TAXES

Income Taxes—Overview . . . . . . . . . . . . . . . 7

Exclusions and Exemptions

Capital Gains on Inherited Property . . . . . . . 13

Capital Gains on the Sale of aPrincipal Residence . . . . . . . . . . . . . . . . 14

Capital Gains From HousingSales to Low-Income Residents . . . . . . . 16

Employer-SponsoredEducational Assistance Programs . . . . . 18

Unemployment Insurance Benefits . . . . . . . . 19

Employer Contributions toAccident and Health Plans . . . . . . . . . . . 20

Employer Contributions to Pension Plans . . . 22

Social Security andRailroad Retirement Benefits . . . . . . . . . 24

Employer Contributions for Life Insurance . . 25

Proceeds from Life InsuranceAnd Annuity Contracts . . . . . . . . . . . . . . 26

Interest on Government Debt Obligations . . . 28

Compensation for Injuries or Sickness . . . . . 30

Employee Death Benefits . . . . . . . . . . . . . . . 31

Meals and LodgingFurnished by an Employer . . . . . . . . . . . 32

Miscellaneous Fringe Benefits . . . . . . . . . . . . 33

Scholarships, Fellowships, and Grants . . . . . 34

State Lottery Winnings . . . . . . . . . . . . . . . . . 35

Income from Investments inEconomically Depressed Areas . . . . . . . 36

Foster Care Payments . . . . . . . . . . . . . . . . . . 38

Employee Ridesharing Benefits . . . . . . . . . . 39

Employee Child andDependent Care Benefits . . . . . . . . . . . . 40

Tax-Exempt Status forQualifying Corporations . . . . . . . . . . . . . 41

Recycled or Redeemed BeverageContainer Redemption Payments . . . . . 42

Benefits Provided Under Cafeteria Plans . . . 43

Water’s-Edge Election . . . . . . . . . . . . . . . . . . 44

Limited Partnership InvestmentSource Rules . . . . . . . . . . . . . . . . . . . . . 46

Credit Union Treatment . . . . . . . . . . . . . . . . . 47

Small Business Alternative Minimum Tax . . . 48

Tuition Reduction or Waiver . . . . . . . . . . . . . 49

Scholarshare Trust Income . . . . . . . . . . . . . . 50

Capital Gains on Small Business Stock . . . . . 51

Adjustments

Contributions to IndividualRetirement Accounts . . . . . . . . . . . . . . . 53

Contributions to Self-EmployedRetirement Plans . . . . . . . . . . . . . . . . . . 54

Contributions to EducationIndividual Retirement Accounts . . . . . . . 56

Medical Savings Accounts . . . . . . . . . . . . . . . 57

Moving Expenses . . . . . . . . . . . . . . . . . . . . . 58

Health Insurance Premiums . . . . . . . . . . . . . 59

Employee Contributions to QualifiedRetirement and Salary Reduction Plans 60

Deductions

Standard Deduction . . . . . . . . . . . . . . . . . . . . 61

Casualty Losses . . . . . . . . . . . . . . . . . . . . . . 63

Medical and Dental Expenses . . . . . . . . . . . . 65

Certain Taxes Paid . . . . . . . . . . . . . . . . . . . . 67

Mortgage Interest Expenses . . . . . . . . . . . . . 69

Charitable Contributions . . . . . . . . . . . . . . . . 71

Contributions of Computers and ScientificEquipment to Educational Institutions . . 73

Contributions Made ThroughTax Return “Checkoffs” . . . . . . . . . . . . . 74

Employee Business andMiscellaneous Expenses . . . . . . . . . . . . 75

Amounts in Excess of Straight-Line . . . . . . . . 77

Pollution Control Equipment . . . . . . . . . . . . . 79

Reforestation Expenditures . . . . . . . . . . . . . . 80

Property Used in EconomicallyDepressed Areas . . . . . . . . . . . . . . . . . . 81

Table of Contents—Income Taxes

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Agricultural Costs . . . . . . . . . . . . . . . . . . . . . 83

Employer-Provided RidesharingProgram Costs . . . . . . . . . . . . . . . . . . . . 84

Exploration, Development,Research, and Experimental Costs . . . . 85

Circulation Costs for Periodicals . . . . . . . . . . 86

Small Business Expensing . . . . . . . . . . . . . . 87

Carryforward of Net Operating Losses . . . . . 88

Percentage Resource Depletion Allowance . 90

Reserve Allowance for Bad Debts . . . . . . . . . 92

Employee Stock Ownership Plans . . . . . . . . . 93

Credits

Personal Exemption . . . . . . . . . . . . . . . . . . . 94

Dependent Exemption . . . . . . . . . . . . . . . . . . 96

Blind Exemption . . . . . . . . . . . . . . . . . . . . . . 98

Senior Exemption . . . . . . . . . . . . . . . . . . . . . 99

Renters’ Credit . . . . . . . . . . . . . . . . . . . . . . 100

Senior Head of Household . . . . . . . . . . . . . 102

Prison Inmate Labor Costs . . . . . . . . . . . . . 103

Activities in Enterprise Zones andOther Economically Depressed Areas . 104

Increased Research andDevelopment Expenses . . . . . . . . . . . . 106

Employer-Provided Child Care Expenses . . 108

Low-Income Rental Housing Expenses . . . . 109

Joint Custody Head of Household . . . . . . . . 111

Salmon and Steelhead TroutHabitat Restoration . . . . . . . . . . . . . . . . 112

Manufacturers’ Investment Tax Credit . . . . . 113

Enhanced Recovery Costs . . . . . . . . . . . . . 115

Farmworker Housing Costs . . . . . . . . . . . . . 116

Rice Straw . . . . . . . . . . . . . . . . . . . . . . . . . . 117

Disabled Access Expenditures . . . . . . . . . . 118

Transportation of DonatedAgricultural Products . . . . . . . . . . . . . . 119

Child Adoption Expenses . . . . . . . . . . . . . . 120

Special Filing Status

Subchapter S Corporations . . . . . . . . . . . . . 121

Head of Household and Surviving Spouse . 123

„„„„ INCOME TAXES—OVERVIEW

This section provides information on taxexpenditure programs (TEPs) associated withthe income tax liabilities of individuals andbusinesses. These programs affect the amountof General Fund revenues raised by thestate’s first and third largest taxes—the Per-sonal Income Tax (PIT) and the Bank andCorporation Tax (BCT), respectively. Both ofthese taxes are administered by the CaliforniaFranchise Tax Board (FTB). The followingprovides a brief summary of the PIT and BCT.

PERSONAL INCOME TAX

The PIT is paid by all California residentsand nonresidents who receive income fromsources in the state. Estates and trusts are alsorequired to pay personal income taxes. Thelargest sources of taxable income under PITinclude wages and salaries, interest, divi-dends, rents and royalties, net capital gains,and net business income. Business incomeincludes the distribution of profits from part-nerships, sole proprietorships, andSubchapter S corporations to shareholders orpartners. Subchapter S corporations are alsosubject to an entity-level corporate tax ontheir net taxable income.

California’s PIT law conforms to federalPIT law in many areas, which helps simplifyboth the calculations of tax liabilities for tax-payers, as well as the administration andenforcement activities of the FTB. Filing un-der California’s PIT system, for example,builds upon preliminary steps carried out forthe calculation of federal PIT liabilities.

Basic Calculation of State Income TaxLiabilities. Figure 1 provides a flowchart ofhow California’s PIT liabilities are calculated.For the purposes of calculating PIT, there arefour basic steps involved:

• Step 1—Federal Adjusted Gross In-come. Calculation of a taxpayer’s statePIT liability first requires the calcula-tion of the taxpayer’s federal adjustedgross income (AGI). To do this, incomefrom all sources is first measured andthen modified by subtracting incomethat is exempt (or excludable) fromfederal taxation. Some of the more nota-ble examples of exempt income in-clude certain social security benefits,scholarships and fellowships, and giftsunder a certain dollar amount. Oncecompleted, this calculation provides ameasure of gross income (defined asincome from all sources except thatwhich is exempt or excluded) which isthe starting point for the taxpayer’sfederal income tax calculation. Follow-ing this, certain adjustments are madeto gross income, such as subtractingalimony paid or payments to IRAs orKeogh plans, to finally arrive at themeasure of federal AGI.

• Step 2—California Taxable Income.Federal AGI marks the starting pointfor the state income tax calculation.The next step is to make specifiedadjustments to federal AGI, subtract-ing income that is not taxable understate tax law and adding back incomethat is taxable, to arrive at California

Income Taxes—Overview

Page 8

Figure 1

Determination of California Personal Income Tax Liabilities

Step 2

Federal AGI

Federallytaxable income

exempt fromstate tax

State taxableincome

exempt fromfederal tax

CaliforniaAGI

The greater ofthe California

standarddeduction or

itemizeddeductions

Californiataxableincome

Step 3

State tax rate

California taxliability before

credits

Tax credits(including thepersonal anddependencyexemptions)

TotalCalifornia taxliability beforethe alternativeminimum tax

(AMT)

Californiataxableincome

Step 4

TotalCalifornia

tax liabilitybefore the

AMT

AMT (whereapplicable)

Final taxliability

Step 1

Exclusions

Income fromall sources

Grossincome

Adjustments

FederalAdjusted Gross

Income (AGI)

A G I .

Taxpayers are then allowed to deductfrom their California AGI the larger ofeither a fixed dollar amount (calledthe “standard deduction”) or the totalamount of their allowable itemizedexpenditures of specified types(called “itemized deductions”), toarrive at California taxable income (TI).

• Step 3—California Tax Liability. Taxrates are then applied to California TIto arrive at state PIT liability before

credits. Taxpayers are allowed taxcredits of certain types which aredirectly subtracted from their pre-credit tax liability. For most taxpay-ers, the resulting amount reflects theirincome tax liability.

• Step 4—Alternative Minimum Tax.Some taxpayers may be subject to thestate’s add-on Alternative MinimumTax (AMT), or to having their taxcredits limited under the AMT. Thelatter can occur if they reduce their


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tax liabilities below a specified thresh-old amount through the use of certainTEPs or other special tax provisions.California’s AMT-related provisionsare intended to ensure that all taxpay-ers pay a minimum state tax amount,and in essence, serve to “recapture”some of the tax revenues that other-wise would be lost due to the use oftax exemptions, exclusions, deduc-tions, and credits. California’s AMTlaw is similar in principle to the fed-eral AMT law, although there aresome notable differences (includingthe AMT tax rate and tax credit re-striction).

Marginal Tax Rates andIncome Tax Brackets. Thetax rates used to calculatestate PIT liabilities dependon both the filing status andtaxable income of the tax-payer. California has fivefiling statuses: single, mar-ried filing jointly, marriedfiling separately, head ofhousehold, and survivingspouse with dependents. Adifferent tax rate schedule isused for each filing status. Ingeneral, taxpayers must usethe same filing status onboth their federal and statetax returns. Over 84 percentof all California tax returnsfiled are from taxpayersselecting the married filingjointly or the single filingstatuses.

As noted above, eachfiling status has a corre-sponding tax rate schedule.Figure 2 provides tax rateschedules by filing status forthe 1998 tax year. AsFigure 2 shows, under Cali-fornia’s progressive incometax rate structure, taxpayers

at higher income levels pay a larger share oftheir income in taxes than do taxpayers atlower income levels. In 1998, marginal taxrates ranged from 1 percent to 9.3 percent,with an AMT rate of 7 percent. To calculatetheir state tax liability before credits, taxpay-ers use the tax rate schedule that correspondsto their appropriate filing status. For exam-ple, a single taxpayer with taxable income of$28,500 would have a state tax liability of$920.25 + (8 percent x $1,856.00), or $1,068.73.California indexes its PIT brackets annuallyfor inflation using the June- (of the prior year)to-June (of the current year) increase in theCalifornia Consumer Price Index. California’sstandard deduction and personal and de-

Figure 2

Personal Income TaxRate Schedules for 1998

If the taxable income is:

Computed Tax IsOf The

Amount OverOver But Not Over

Married Filing Jointly and Surviving Spouses with Dependents$0 $10,262 $0.00 + 1.0% $0

10,262 24,322 102.62 + 2.0 10,26224,322 38,386 383.82 + 4.0 24,32238,386 53,288 946.38 + 6.0 38,38653,288 67,346 1,840.50 + 8.0 53,28867,346 and over 2,965.14 + 9.3 67,346

Single and Married Filing Separate$0 $5,131 $0.00 + 1.0% $0

5,131 12,161 51.31 + 2.0 5,13112,161 19,193 191.91 + 4.0 12,16119,193 26,644 473.19 + 6.0 19,19326,644 33,673 920.25 + 8.0 26,64433,673 and over 1,482.57 + 9.3 33,673

Head of Household$0 $10,264 $0.00 + 1.0% $0

10,264 24,323 102.64 + 2.0 10,26424,323 31,353 383.82 + 4.0 24,32331,353 38,803 665.02 + 6.0 31,35338,803 45,833 1,112.02 + 8.0 38,80345,833 and over 1,674.42 + 9.3 45,833

Source: Franchise Tax Board.


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pendent credits also are indexed for inflation.

Because the tax brackets for single per-sons are divided at levels that are exactly halfof their married-filing-joint counterparts,California’s income tax bracket structuregenerally does not result in a “marriage pen-alty.” (At the federal level, this penalty canoccur when two single taxpayers with equalincomes are subject to lower tax liabilitiesthan are two similar taxpayers who are mar-ried.) California’s tax system results in eithermarriage neutrality or, for many taxpayers,actual marriage bonuses.

Effect of Different Marginal Tax Rates. Inmany of the reviews of TEPs relating to PIT,we indicate that the program results in dis-proportionate benefits to higher-income tax-payers due to their higher marginal tax rates.It is important to note why this happens,since its occurrence is so frequent in TEPswhich result in either deductions or exclu-sions from income.

An example of this is a married couplefiling jointly with California taxable income(TI) of $75,000. Their marginal tax rate is9.3 percent and tax liability before credits is$3,676.96. Now assume the couple has a de-duction for mortgage interest payments of$5,000. This would result in TI of $70,000 anda tax liability of $3,211.96, or $465 less thantheir liability without the deduction.

Alternatively, a married couple filingjointly with a California TI of $50,000 has amarginal tax rate of 6 percent, and a pre-credit tax liability of $1,643.22. With a mort-gage interest deduction of $5,000, their taxliability would drop to $1,343.22, or $300 lessthan their tax liability without the deduction.

Based on this example, in terms of taxessaved, the deduction is worth $165 more tothe higher-income couple. A similar resultoccurs when income exclusions are involved.

BANK AND CORPORATION TAX

Most corporations that earn income de-rived or attributable to California sources aresubject to California’s BCT. Some corpora-tions, however, are either exempt or partiallyexempt from the tax. These include insurancecompanies (which are subject to a gross pre-miums tax in lieu of a tax on net income) andnonprofit organizations (which are only sub-ject to the BCT for earned income that is unre-lated to their tax-exempt status).

Types of Bank and Corporation Taxes.There are four basic categories of taxes leviedunder the BCT:

• Franchise Tax. Most California corpo-rations are subject to the franchise tax,which is levied for the privilege ofconducting business in California. Formost corporations, a flat 8.84 percenttax rate is applied to the corporation’snet income attributable to Californiato arrive at pre-credit state tax liabili-ties. Subchapter S corporations aresubject to an entity-level tax at thereduced rate of 1.5 percent. A varietyof tax credits are available to BCTtaxpayers, as discussed in the TEPreviews which follow.

The franchise tax accounts for the ma-jority of revenues raised under the BCT,and generally is the tax being referredto when the term “corporate incometax” is used (even though there is aseparate smaller corporate income tax,as discussed below). As under PIT,corporate taxpayers who take advan-tage of certain tax preferences or specialtax provisions must complete an AMTcalculation and pay any resultingamount by which it exceeds the amountof the regular tax due. For 1998, theAMT tax rate is 6.65 percent.

• Corporate Income Tax. Corporationsthat derive income from Californiasources but do not have a substantialenough presence to be classified as“conducting business” in the state aresubject to the corporate income tax.


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(Business trusts are also taxable underthis tax.) Very few corporations actu-ally file under the corporate incometax. This tax is levied in a mannersimilar to the corporate franchise tax;however, there are a number of provi-sions unique to it. (For example, busi-nesses that file under the corporateincome tax are not subject to thestate’s minimum tax [see below] andalso may exclude income from tax-exempt securities.)

• Minimum Franchise Tax. Corpora-tions that have less than an $800 an-nual computed franchise tax liability,or no computed tax liability at all,must pay a minimum franchise tax of$800. New corporations with grossincome under $1 million pay a re-duced minimum tax of $300 the firstyear and $500 the second year. Inrecent years, the minimum tax hasapplied to the majority of Californiacorporations because their computedtax liabilities are below the minimumtax threshold. For example, in 1996,325,000 of the 430,800 total corporatetax returns that were filed (or75 percent) were subject to the mini-mum tax.

• Bank Tax. Banks and other financialinstitutions are subject to an “add-on”tax that is levied in addition to thefranchise tax. This tax is paid in lieuof personal property taxes and localbusiness taxes. Under current law, theadd-on portion of the bank tax rate is2 percent. (Prior to 1996, the rate wasset annually by the FTB to be equiva-lent to the average amount of per-sonal property and local businesstaxes paid by corporations.) Thus,banks and other financial institutionsare subject to a total corporate tax rateof 10.84 percent.

Figure 3 provides a history of CaliforniaBCT rates levied since the tax was created in

1929. As it shows, the current general fran-chise tax rate is at its lowest level since 1973.Other state corporate-related tax rates—suchas for Subchapter S corporations, the corpo-rate AMT, and banks and financial corpora-tions—have generally declined in recentyears as well. However, the corporate mini-mum tax has remained at $800 for most cor-porations since 1990.

Figure 3

Bank and Corporation Tax Rates

GeneralCorporation Rate

MinimumTaxa

1929-34 2.00% $251935-42 4.00 251943-49 3.40 251950-58 4.00 251959-66 5.50 1001967-71 7.00 1001972 7.60 2001973 8.30 2001974-79 9.00 2001980-81 9.60 2001982-86 9.60 2001987-88 9.30 3001989 9.30 6001990-96 9.30 8001997 to present 8.84 800a

Beginning in 1998, new small corporations pay a minimum taxbelow this amount.

Source: Franchise Tax Board.

Calculation of Income for Multistate andMultinational Corporations. If a corporationderives all of its income from Californiasources, the entire nonexempt portion ofincome is used in the state BCT liability calcu-lation described above. However, if the cor-poration has multistate or multinational oper-ations and has business income attributableto non-California sources, then it must appor-tion the amount of its business income attrib-utable to its California operations. Nonbusi-ness income, such as interest and royalties, isallocated to (1) the corporation’s official stateof residence, in the case of taxable income


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derived from intangibles, or (2) where rele-vant property is located, in the case of taxableincome derived from real or personal prop-erty.

Before apportioning income, the corpo-rate taxpayer must first identify the extent ofits operations that are attributable to a corpo-ration or group of corporations operating asone integrated business. This taxpayer mayelect to combine either: (1) its worldwide in-come or, (2) its income within the U.S. andcertain specified “tax havens.” The formermethod is known as the “worldwide” basisand the latter as the “water’s-edge” basis.Once this election is made, formula appor-tionment (see below) is used to determine theportion of income attributable to Californiafor tax purposes.

Formula Apportionment. California’sapportionment formula is based on looking ata firm’s average ratio of its corporate activityin California to its total corporate activity(either on a worldwide basis or water’s-edgebasis, depending on the taxpayer’s prefer-ence) for three factors: property, payroll, andsales. In California, the sales factor is double-weighted (except for mining and other extrac-tive industries, agriculture, and banking andfinancial business activity). The average com-puted ratio is then multiplied by the total netcorporate income (whether on a worldwidebasis or water’s-edge basis) to arrive at theamount of income attributable to California.This amount is then used in the calculationdescribed above to arrive at corporate state

tax liabilities.

Because the sales factor is weighted twicein computing the apportionment factor (ver-sus the alternative approach of equallyweighting all three factors), certain corpora-tions are advantaged. Specifically, the for-mula provides relative benefits to those cor-porations that are based in California butconduct most of their sales outside of thestate. This procedure serves to encourage andstimulate California-based development andproduction activities.

Calculation of Income Tax Liabilities.Corporations may choose to file their taxesbased upon either a calendar-year or fiscal-year basis (which in the latter case, com-mences in any month other than January).Corporations calculate tax liabilities basedupon a process similar to that describedabove for PIT filers. First, all income attribut-able or sourced to California must be addedup, and then tax-exempt or excluded incomeis subtracted from this amount to arrive atgross income. Next, deductions are subtractedto arrive at a measure of corporate net in-come. For most corporations, the flat8.84 percent tax rate is levied on this net in-come, yielding state BCT liabilities before taxcredits. Certain tax credits may reduce corpo-rate tax liabilities. However, as noted above,corporations are subject to the state’s AMT,which serves to recapture some of those taxrevenues that would otherwise be lost due totax exemptions, exclusions, deductions, andcredits.

Income Taxes (PIT & BCT)

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Exclusion/Exemption:

CAPITAL GAINS ON INHERITED PROPERTY

Program Characteristics Estimated Revenue Reduction

Tax Type: Personal Income Tax (PIT).

Authorization: California Revenue and Taxation CodeSections 18031 and 18036, which partiallyconform to Internal Revenue CodeSection 1014.

(In Millions)

Fiscal Year PIT

1996-97 $575

1997-98 610

1998-99 650

DESCRIPTION

This program exempts from capital gainstaxation the appreciation in the value ofproperty which has occurred prior to thetransfer of the property from a decedent to anheir. Thus, the heir's “basis” in the property,from which capital gains eventually will bemeasured, is adjusted upward to equal theproperty’s fair market value at the time of thedecedent's death. Accordingly, taxes on thecapital gains that materialize prior to thetransfer of property to heirs are permanentlyforgiven.

RATIONALE

This program provides tax relief to heirs whoinherit property that has appreciated in valuewhile held by the deceased. The originalrationale for this program was that inheritedproperty was itself subject to taxation; thus,some argued that subjecting inherited capitalgains to taxation would amount to a form of“double taxation.”

It also is frequently argued that, without thisprogram, heirs might need to sell their inher-

ited property to pay the tax on previouslyaccumulated capital gains.

COMMENTS

California eliminated its inheritance tax in1982 pursuant to Proposition 6. The state’scurrent taxes on inherited property—theestate tax and the generation-skippingtransfer tax—do not impose any real taxburden on California taxpayers, since bothrepresent so-called “pick-up” taxes. This typeof tax simply collects a state tax that wouldotherwise go to the federal government bytaking maximum advantage of the federalestate tax credits that are granted to Califor-nians for their state death-related taxes paid.Thus, the tax imposes no additional cost tothese California taxpayers. The doubletaxation rationale, therefore, no longerapplies.

The concern that heirs might need to sell theirinherited property in order to pay capitalgains taxes could be dealt with directly by atax-deferral program. A tax-forgivenessprogram is not necessary to address thisparticular concern.


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CAPITAL GAINS ON THE SALE OF A

PRINCIPAL RESIDENCE



Authorization: California Revenue and Taxation CodeSections 17131 and 17152, which gener-ally conform to Internal Revenue CodeSection 121.

(In Millions)

Fiscal Year PIT

1996-97 —

1997-98 $485

1998-99 750

DESCRIPTION

For sales and exchanges of residences occur-ring after May 6, 1997, California law allowsthe taxpayer to exclude from gross incomethe gain realized on the sale or exchange upto a maximum amount. The exclusion is al-lowed if the taxpayer used the residence as aprincipal residence for two of the previousfive years. The subsequent purchase of an-other residence is not required. The exclusionfor a given sale is limited to $250,000 for sin-gle income tax filers and $500,000 for marriedtaxpayers filing jointly. Exclusions can beclaimed for additional sales or exchangesproviding the above conditions are met. Cali-fornia law waives a portion of the two-yearoccupancy rule for Peace Corp volunteers.Additionally, it does not conform to federaltransitional provisions which allow certaintaxpayers to elect prior tax treatment for cer-tain sales.

RATIONALE

This program provides tax relief to home-owners who sell their residences. There aretwo apparent rationales for the program.First, in the case where the sale of a residenceis entirely or largely involuntary, due to suchfactors as changing employment or family

circumstances, the program avoids putting anadditional financial burden on certain house-holds faced with acquiring replacement hous-ing.

Second, the program provides an incentivefor households to invest more of their re-sources in owner-occupied housing than theyotherwise would. This is because the pro-gram reduces the overall costs of home own-ership, and thus raises its overall rate of re-turn as an investment. This is especially truewhen housing is compared to those otherinvestments whose capital gains are subjectto taxation.

DISTRIBUTION OF BENEFITS

This program primarily benefits higher in-come taxpayers. As shown in the accompany-ing table, about 85 percent of the total bene-fits go to those earning in excess of $100,000annually, and almost two-thirds goes to thoseearning $150,000 or more. The averageamount claimed also generally increases forthose with higher incomes. The reduction inthe average amount claimed for those in thehighest income category is a result of limita-tions on the amount of the capital gain thatcan be excluded for tax purposes.


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Capital Gains on the Sale of aPrincipal Residence Exclusion

1998 Tax Year

AdjustedGrossIncome($000)

Percent of

AverageAmountClaimed

TotalTaxpayersBenefitting

TotalAmountClaimed

$0-20 — — —20-40 1.2% 0.3% $33840-60 4.9 1.5 48760-80 18.3 6.8 62180-100 15.6 6.8 727100-150 27.4 21.5 1,302150-200 14.6 21.6 2,463200-250 7.3 13.5 3,078250-500 8.2 24.1 4,925Over 500 2.6 4.1 2,674

COMMENTS

This program is a liberalized extension of theprevious capital gains exclusion which bothstate and federal law allowed for capitalgains on sales of residences. Specifically, forsales and exchanges occurring on or prior toMay 6, 1997, there was a one-time exclusiongranted to taxpayers over age 55 of up to$125,000 for married couples filing jointlyand single taxpayers, and up to $62,500 for

married taxpayers filing separately. Thisprogram also replaces the deferral of capitalgains available to taxpayers who sold a prin-cipal residence. To qualify for the deferral,another principle residence of equal orgreater value had to be acquired within twoyears of the date of sale.

The change from the more-limited exclusionand deferral programs to the more-generousprovisions incorporated in the current pro-gram may result in a one-time “unlocking”effect, stimulating a shift toward nonhousinginvestments on the part of certain homeown-ers.

Overall, however, this provision makes hous-ing a relatively more attractive investmentthan it otherwise would be when comparedto alternative types of investments. This isbecause the exclusion essentially raises theeconomic “rate of return” on housing byreducing the taxes which eventually have tobe paid on a residence. Although the previ-ous capital gains exclusion program notedabove also raised the rate of return on hous-ing investments, the more-generous provi-sions of this current program have a strongereffect in this regard.


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CAPITAL GAINS FROM HOUSING

SALES TO LOW-INCOME RESIDENTS


Tax Type: Personal Income Tax (PIT).Bank and Corporation Tax (BCT).

Authorization: California Revenue and Taxation CodeSections 18041.5 and 24955.

(In Millions)

Fiscal Year PIT BCT

1996-97 — NA

1997-98 — NA

1998-99 — NA

DESCRIPTION

This program allows taxpayers to exclude fromtaxable income their capital gains from the saleof government-assisted low-income housingunits to low-income tenants. In order to qualifyfor the exclusion, a majority of the housingunits sold must remain in use by low-incometenants for either 30 years from the date of saleor for the remaining term of existing federalgovernment financial assistance, whichever islonger. In addition, the taxpayer must reinvestall of the proceeds from the sale in residentialproperty other than a personal residence. Thetaxpayer's “basis” in the new residential prop-erty is reduced by the amount of the gain fromthe sale. Thus, the program provides for a taxdeferral rather than permanent tax forgiveness.

RATIONALE

This program provides an incentive for own-ers of low-income housing that has been sub-sidized by the federal government to sellthe property to low-income tenants for con-tinued use as low-income housing, ratherthan sell it for, or convert it to, other purposesupon termination of the federal subsidy. Itdoes this by providing for a tax deferral onthe gain from that sale. This deferral of thetax liability amounts to an interest-free loan

from the government, which increases theeconomic gain from the property sale.

COMMENTS

The estimated PIT revenue effects for this pro-gram are not directly available. Rather, theestimates are included within the estimates for“Capital Gains on The Sale of a Principal Resi-dence.” The BCT estimates are not availabledue to the lack of comparable federal data uponwhich to base these estimates.

In the 1960s, the federal government pro-vided low-interest loans and rent subsidiesthrough various programs administered bythe federal Housing and Urban DevelopmentDepartment (HUD) and Farmers' Home Ad-ministration (FHA). In return, private devel-opers and property owners agreed to build oroperate rental projects which were protectedby low-income use restrictions. In order tostimulate private sector participation, theowners were given the option to terminatetheir contracts prior to their loan maturitydates. As owners exercise their options to selland/or as federal subsidy periods expire, thehousing units may be sold or converted tomarket-rate units, thereby displacing low-income tenants and reducing the state's sup-ply of affordable low-income housing. This


Page 17

program aims to lessen the extent to whichthis occurs.

The original state program was created byChapter 1436, Statutes of 1990 (SB 1286, Seymour).


Page 18


EMPLOYER-SPONSORED

EDUCATIONAL ASSISTANCE PROGRAMS



Authorization: California Revenue and Taxation CodeSection 17151, which partially conformsto Internal Revenue Code Section 127.

(In Millions)

Fiscal Year PIT

1996-97 $6

1997-98 4

1998-99 4

DESCRIPTION

This program allows taxpayers to excludefrom their gross income contributions madeto qualified educational assistance programsby their employers on their behalf. Theamount which may be excluded under thisprogram is limited to $5,250 annually. Inorder to qualify for this exclusion, the educa-tional program must be provided for theexclusive benefit of employees and their de-pendents, and comply with various federalrules to ensure nondiscrimination in favor ofhighly compensated employees. The exclu-sion is inapplicable to graduate level coursescommencing after June 30, 1996.

RATIONALE

This program provides an incentive for em-ployers to provide, and employees toaccept, contributions to educational assis-tance programs in lieu of taxable monetarycompensation. This is because a given level ofcontributions is worth more to employees onan after-tax basis than an equivalent amountof taxable income. The program represents apolicy designed to encourage additional con-sumption of education and stimulate an in-crease in human capital formation.

COMMENTS

This program conforms to an identical federalprogram, except that the federal programprovides an exclusion only through June 1,2000. In contrast, California law has no sunsetprovision.


Page 19


UNEMPLOYMENT INSURANCE BENEFITS



Authorization: California Revenue and Taxation CodeSection 17083.

(In Millions)

Fiscal Year PIT

1996-97 $63

1997-98 58

1998-99 53

DESCRIPTION

This program exempts unemployment insur-ance benefits from the recipient's gross in-come for tax purposes.

RATIONALE

Various reasons are mentioned for the taxrelief provided by this program. One is thatlegislatively provided social welfare benefitsshould not be taxed, since they often arestructured by policymakers with the intent ofproviding specific amounts of purchasingpower to recipients. Another is that payingtaxes on such benefits could be an especiallyonerous burden on jobless individuals, whooften have trouble paying for such basic ne-cessities as housing, food, and clothing.

COMMENTS

State law does not conform to federal provi-sions, as contained in the 1986 Federal TaxReform Act, which require certain taxpayers

to include their unemployment compensationas gross income. The intent of the federalrequirement is to treat government-paid un-employment benefits more like privatelyprovided unemployment compensation bene-fits. The latter are fully taxable to recipients inCalifornia to the extent that they exceed priorcontributions.

The subsidy provided by the program isworth disproportionately more to higher-income taxpayers than lower-income taxpay-ers, due to the former’s higher marginal in-come tax rates. Economists argue that aside-effect of this program is that it may pro-vide a disincentive for certain unemployedpersons to seek jobs, since it reduces the af-ter-tax cost of being unemployed. This couldbe particularly relevant in such cases as un-employed spouses of moderate-to-high-income taxpayers, whose economicneed for employment may be less than that oflower-income individuals.


Page 20


EMPLOYER CONTRIBUTIONS TO

ACCIDENT AND HEALTH PLANS



Authorization: California Revenue and Taxation CodeSection 17131, which conforms to InternalRevenue Code Section 106.

(In Millions)

Fiscal Year PIT

1996-97 $1,690

1997-98 1,800

1998-99 1,910

DESCRIPTION

This program excludes employer contribu-tions to accident and health plans from thegross income of employees for tax purposes.

RATIONALE

This program provides tax relief to all indi-viduals whose employers contribute to thecosts of accident and health plans that pro-vide compensation for sickness and injury.

It is argued that the program provides bothemployers and employees with an incentiveto make accident and health insurance a stan-dard part of the employees' compensationpackages. Program supporters argue that thisis a desirable social goal, because it providessecurity to workers, increases productivity,and reduces the need for the governmentitself to provide accident and health careprograms.

An additional rationale for continuing thisprogram is that paying taxes on these non-cash benefits would impose a financial hard-ship on many taxpayers.


Tax benefits under this program are concen-trated in the middle income groups. Asshown in the accompanying table, over 50percent of exclusions accrue to taxpayers

Employer Contributions to AccidentAnd Health Plans Exclusion

1998 Tax Year(Dollars In Millions)


TotalAmountClaimed

Percentof Total

$0-20 $16 0.8%20-40 442 23.240-60 507 26.660-80 372 19.580-100 238 12.5100-150 200 10.5150-200 59 3.1200-250 39 2.0250-500 21 1.1Over 500 15 0.8

with annual income of $60,000 or less, andover 70 percent go to taxpayers earning$80,000 or less. Very little of the benefits go totaxpayers earning $20,000 or less, due in part,


Page 21

to the fact that individuals in this incomeclass are more likely than those in higher-income categories to have jobs which do notinclude paid benefits. Over 80 percent of theexclusions from this program go to marriedjoint filers and heads of household.

COMMENTS

According to a February 1997 U.S. GeneralAccounting Office (GAO) study, approxi-mately two-thirds of Americans under theage of 65 have employment-based healthinsurance. The GAO estimates that in 1993,three-quarters of the workforce participatedin employer-subsidized plans such as thosethat qualify under this program. The GAOalso found that as the costs of providinghealth insurance have increased, the numberof individuals with employer-based coveragehas declined over the last few years.

The consensus view of economists is thatstate and federal programs like this one havecontributed significantly to shifting the mixof employee compensation away from wagesand salary income in favor of nonmonetaryfringe benefits. In fact, some economists be-lieve that the subsidy provided by these pro-grams has reduced the after-tax cost of healthcare to such a degree that there is excessiveuse of health care services by those with em-ployer-subsidized health plans. To the extentthat this is true, these programs can result in

a misallocation of economic resources and theescalation of health care costs.

In recent years, however, structural changesmade to many employer-based health insur-ance programs have resulted in increasedhealth-related costs being borne by the con-sumer, either through higher deductibles,greater premium payment contributions, pervisit charges, or some combination of thesefactors. To the extent that resourcemisallocations involving health-care benefitshave occurred in the past, the effect of theabove-noted increases in health-care usagecosts to the consumer should help mitigatethe inefficiencies and misallocations associ-ated with the favorable tax treatment ofemployer-based health insurance programs.

Generally speaking, the health-care benefitsunder this program provide proportionatelygreater benefits to higher-income taxpayersthan to lower-income taxpayers. This is be-cause higher-income taxpayers typically facehigher marginal income tax rates, which inturn makes a given dollar exclusion underthis program worth more to them than for alower-income taxpayer. In addition, higher-income taxpayers have been shown to partici-pate in employer-subsidized health careplans to a greater extent than dolower-income taxpayers.


Page 22


EMPLOYER CONTRIBUTIONS TO PENSION PLANS



Authorization: California Revenue and Taxation CodeSection 17501, which conforms to InternalRevenue Code Sections 401 through404a.

(In Millions)

Fiscal Year PIT

1996-97 $2,400

1997-98 2,500

1998-99 2,610

DESCRIPTION

This program excludes employer contribu-tions to qualified retirement plans and sim-plified employee pension plans (SEPs) fromthe gross income of employees, subject tocertain conditions. (Employees do, however,eventually have to pay tax on that portion ofthe retirement benefits they receive whichwas funded through employer contributions.)In general, for defined contribution plans, theallowable annual addition to a participant’saccount that can be excluded from gross in-come is limited to the lesser of 25 percent ofthe taxpayer's compensation, or $30,000.

RATIONALE

This program provides tax relief to personswho receive income in the form of employercontributions to their pension plans. This taxrelief is in the form of a tax deferral, sincethese persons eventually are subject to payingtaxes on the retirement benefits they receive.The underlying rationale for the program isthe view that employees should not have topay taxes on income until this income actu-ally is received by the employee.


Generally, the tax benefits associated withthis program are distributed over a wide

range of income classes, excluding the verylowest. As shown in the accompanying table,almost one-third of the claims are by taxpay-ers with annual earnings of $80,000 or less,with over half going to those earning$150,000 or less. Those taxpayers earningmore than $500,000 annually receive almostone-quarter of the exclusions, however, eventhough they constitute fewer than one per-cent of returns.

Employer Contributions toPension Plans Exclusion

1998 Tax Year(Dollars In Millions)


TotalAmountClaimed

Percentof Total

$0-20 $29 1.1%20-40 196 7.540-60 306 11.760-80 287 11.080-100 243 9.3100-150 345 13.2150-200 185 7.1200-250 201 7.7250-500 194 7.4Over 500 623 23.9


Page 23

COMMENTS

In the long run, the tax deferral provided bythis program has a net cost to the state. Thisis because most persons are in lower mar-ginal income tax brackets after retirement,compared to their marginal income tax brack-ets during their working years when theiremployers were contributing to their retire-ment plans. In addition, the “present value”of the deferred taxes paid in later years is less

than the value of the taxes that the statewould have received if they had been paid atthe time the employer contributions weremade, due to such factors as inflation. Gener-ally, the structure of retirement programs,especially arrangements in which employers“match” the contributions made by employ-ees, encourage a greater rate of participationand contributions than would have otherwiseoccurred.


Page 24


SOCIAL SECURITY AND

RAILROAD RETIREMENT BENEFITS




(In Millions)

Fiscal Year PIT

1996-97 $800

1997-98 825

1998-99 850

DESCRIPTION

This program exempts social security benefitsand federal railroad retirement benefits fromthe recipient's gross income for tax purposes.

RATIONALE

This program provides tax relief to socialsecurity and railroad retirement recipients.The apparent rationale is a desire to protectthe retirement income of elderly or disabledindividuals who may have high living ex-penses due to illness or infirmity.

COMMENTS

Federal law under Internal Revenue CodeSections 72(r), 86, and 105(h), provides for thepartial taxation of social security and railroadretirement benefits. For most taxpayers, theamount of these benefits that must be re-ported as income for federal tax purposesequals the lesser of one-half of the benefitsreceived, or one-half of the excess of the tax-

payer's combined income (as defined) over aspecified base amount. For 1998, the baseamount is $32,000 for married taxpayers fil-ing jointly. However, for high income taxpay-ers, up to 85 percent of social security andrailroad retirement benefits may be includedas income.

The partial taxation of these benefits at thefederal level was adopted to put social secu-rity benefits more on a par with other typesof pension benefits, which are taxable only tothe extent that the annuity or pension re-ceived exceeds a taxpayer's own directpension-related contributions.

Because a given dollar exclusion of socialsecurity benefits from state income for taxpurposes is worth more to taxpayers as theirmarginal income tax rates rise, social securityrecipients with higher amounts of taxableincome from other sources realize dispropor-tionate benefits from this state program.


Page 25


EMPLOYER CONTRIBUTIONS FOR LIFE INSURANCE




(In Millions)

Fiscal Year PIT

1996-97 $65

1997-98 65

1998-99 65

DESCRIPTION

This program exempts from an employee’sgross income that portion of the employer’scontributions to his/her group term life in-surance policy associated with the first$50,000 in individual coverage. Also exemptare contributions to life insurance policieswhich specify that the beneficiary is no lon-ger employed by the employer providingcoverage and is disabled, or the beneficiary isthe employer or a charitable organization. Inaddition, insurance contributions under aqualified pension or profit-sharing plan aretax exempt.

RATIONALE

This program, by subsidizing the cost of lifeinsurance, provides tax relief to policyholdersand an incentive for employees and employ-ers to incorporate life insurance coverage intotheir compensation packages. According tofederal reports, the original rationale for thefederal program (to which California con-forms) was two-fold. First, it was believedthat there were difficulties in properly appor-tioning group life insurance premium costs

among individual employees, since premiumcosts depend on such factors as age, health,and related mortality factors. Second, it wasbelieved that life insurance benefits wouldhelp keep family units intact upon death ofthe primary wage earner.

COMMENTS

Higher-income taxpayers benefit dispropor-tionately under this program, both because oftheir higher marginal income tax rates andbecause employer-paid life insurance is mostcommonly provided for more highly com-pensated management-level employees.

Life insurance proceeds themselves are nottaxed (see “Proceeds from Life Insurance andAnnuity Contracts”). Thus, the provision oflife insurance as a fringe benefit is completelytax exempt for many individuals. However,life insurance purchased by self-employedindividuals, or by individuals whose employ-ers do not make premium contributions, re-ceive no tax break comparable to this program.


Page 26


PROCEEDS FROM LIFE INSURANCE

AND ANNUITY CONTRACTS



Authorization: California Revenue and Taxation CodeSections 17081, 17131, 17132.5, 24302,and 24305, which generally conform toInternal Revenue Code Sections 72 and101.

(In Millions)

Fiscal Year PIT BCT

1996-97 $690 $36

1997-98 710 36

1998-99 730 36

DESCRIPTION

This program generally allows an exclusionfrom gross income for proceeds received by abeneficiary from the life insurance policy of adeceased person. (Any interest component ofsuch proceeds received as installments istaxable, however, and must be included inthe recipient’s gross income.) If the proceedsare received under circumstances other thandeath, then only the actual investment in thecontract (for example, the aggregate premiumand any other consideration paid) isexcludable from gross income.

Beginning in 1991, Chapter 1387, Statutes of1990 (AB 2663, Peace), makes amounts re-ceived under a “living benefits” contractexcludable from gross income. These types ofcontract arrangements involve situations inwhich the insured, under a life insurancepolicy, has a catastrophic or life-threateningillness or condition. In such an event, thepolicy owner can give up or transfer the rightto receive death benefits under the policy inexchange for compensation amounting to lessthan the death benefits.

RATIONALE

This program provides tax relief to personswho have been designated as beneficiaries ofdeceased persons' life insurance policies. Tothe extent that these beneficiaries were finan-cially dependent on the deceased, the pro-gram helps to stabilize their economic situa-tions. The program also provides financialrelief to individuals receiving acceleratedbenefits due to catastrophic or life threaten-ing illness, thereby helping them cope withthe financial hardships that often are associ-ated with such illnesses.

COMMENTS

Higher-income individuals are likely to bene-fit disproportionately from this program,since insurance coverage tends to be posi-tively correlated with income, and high-in-come taxpayers are in the highest marginalincome tax brackets.

Due to a developing market involving the“sale” of insurance policies to investors, therationale related to financial dependence ofbeneficiaries has been weakened. The sale ofinsurance policies generally requires that the


Page 27

investor pay the remaining premiums inexchange for being named the beneficiary ofthe policy. Proceeds received pursuant to thesale of an insurance policy would be subjectto taxation.

With few exceptions, California has been inconformity with federal law since 1987.


Page 28


INTEREST ON GOVERNMENT DEBT OBLIGATIONS



Authorization: California State Constitution, Article XIII,Section 26(b), and California Revenueand Taxation Code Sections 17088,17133, 17143, 17145, and 24272, whichpartially conform to Internal RevenueCode Sections 103 and 852.

(In Millions)

Fiscal Year PIT BCT

1996-97 $320 Minor

1997-98 350 Minor

1998-99 380 Minor

DESCRIPTION

This program exempts from gross income theinterest income earned on certain debt obliga-tions issued by the U.S. government, territo-ries of the United States, Puerto Rico, certainfederal agencies, and California state andlocal government entities. The interest re-ceived from a mutual fund also is tax exemptif government obligations (those of Californiastate and local governments and the federalgovernment) comprise 50 percent or more ofthe fund's portfolio or of a series of assetswithin the portfolio. While the interest onqualifying debt obligations is tax exempt, anycapital gains on the sale of such tax-exemptobligations must be reported as income.

The program applies to both PIT and thecorporate income tax, but not to the corporatefranchise tax.

RATIONALE

This program subsidizes the costs of govern-mental borrowing, by providing tax relief toinvestors who purchase qualifying debt obli-gations issued by California governments orby the federal government. This tax reliefencourages investors to accept lower interest

returns on these obligations which, in turn,reduces the debt-servicing costs of thesedebt-issuing governmental entities. In addi-tion, the program provides an incentive forcertain investors to purchase more govern-ment-issued debt than they otherwise would.As a result of these factors, governments areable to finance public outlays at lower coststhan would otherwise prevail.


As shown in the accompanying table (seenext page), the benefits from the programaccrue disproportionately to high-incometaxpayers. Over one-third of the claimedamount goes to the small fraction of the tax-payers earning in excess of $500,000 annually,and over one-half go to those earning morethan $200,000. The average amount claimedfor those in the highest income category is inexcess of ten times that claimed by taxpayersin any of the lowest three income categories.

COMMENTS

The revenue figures shown above only in-clude reductions due to outstanding Califor-nia state and local obligations, and mutualfund pass-through interest dividends. Norevenue-reduction amounts are included for


Page 29

federal debt obligations since, pursuant to theprinciple of “reciprocal immunity,” states areprevented from taxing the interest on U.S.government debt obligations.

Interest on GovernmentDebt Obligations Exclusion

1998 Tax Year


Percent of



TotalAmountClaimed

$0-20 9.6% 4.5% $46320-40 16.3 7.1 43540-60 16.0 8.7 52560-80 13.4 7.1 52780-100 9.6 5.8 601100-150 13.4 10.0 724150-200 5.2 6.3 1,198200-250 3.4 3.7 1,053250-500 6.7 10.0 1,448Over 500 6.5 36.8 5,614

The benefits of the tax exemption are worthproportionately more to taxpayers in highertax brackets than those in lower tax brackets.This distinction is based on the notion of ataxable yield equivalent, or the effective (aftertax) yield to the investor of an investment intax-exempt securities. The taxable equivalentyield for a California municipal bond with aninterest rate of 7 percent for a taxpayer in the9 percent tax bracket would be 7.7 percent.

For a taxpayer in the 2 percent bracket, how-ever, the taxable yield equivalent would beonly 7.1 percent. The greater benefits tohigher-income taxpayers are even more pro-nounced at the federal level because of itshigher marginal tax rates.

Despite the widespread use and long historyof tax-exempt financing for government-is-sued debt, considerable controversy amongstpublic finance experts surrounds the contin-ued broad-based use of programs like this.One reason for this involves the use of subsi-dized debt to finance projects which are notstrictly “governmental” in nature, such asindustrial projects and home purchases. Inaddition, many analysts view tax-exemptborrowing as an inequitable means of subsi-dizing governmental projects, since a dispro-portionate share of the foregone tax revenuesflows to high-income investors. Finally, inorder to generate sufficient market demandfor the debt obligations, the interest rate onsuch debt is higher than the minimum re-quired to ensure the participation of high-income taxpayers; consequently, many econ-omists would argue that a more efficientmeans of aiding local governments is throughvarious grant and loan programs. For a dis-cussion of these and other related issues re-garding this program, see The Use ofTax-Exempt Bonds in California: Policy Issuesand Recommendations, Legislative Analyst'sOffice, State of California, December 1982.


Page 30


COMPENSATION FOR INJURIES OR SICKNESS




(In Millions)

Fiscal Year PIT

1996-97 $130

1997-98 135

1998-99 140

DESCRIPTION

This program allows taxpayers to excludefrom their gross income the compensationthey receive from workers' compensation,accident insurance, and health insurance, dueto injuries or sickness. The exemption alsocovers the amount of any compensatory dam-ages awarded for injury or sickness, regard-less of whether the award is made under anin-court or out-of-court settlement, orwhether the taxpayer receives a lump-sumaward or installment payments. Punitivedamages, however, are taxable. In addition,certain amounts paid by an employer to reim-burse an employee for expenses incurred forthe care of the employee, the employee'sspouse, or the employee's dependents areexcluded from taxation.

RATIONALE

This program provides tax relief to qualifiedtaxpayers on the grounds that injuries orsickness often impose significant economichardship, and can limit the ability of individ-uals to pay for such basic necessities as hous-ing, food, and clothing. Under these condi-tions, taxes on compensation for injuries orsickness are viewed as a particularly onerousburden.

COMMENTS

This program covers the disability benefitsreceived under state statute, but does notapply to amounts received as reimbursementfor medical expenses claimed as income taxdeductions in prior years.


Page 31


EMPLOYEE DEATH BENEFITS



Authorization: California Revenue and Taxation CodeSections 17131,17132.5, and 17132.6which generally conform to InternalRevenue Code Section 101(b).

(In Millions)

Fiscal Year PIT

1996-97 $2

1997-98 2

1998-99 2

DESCRIPTION

This program allows tax-exempt treatmentfor the qualified employer-provided deathbenefits of employees deceased prior to Au-gust 21, 1996, by allowing beneficiaries toexclude from their income for tax purposesup to $5,000 of noninterest-related deathbenefits they receive. Formerly, certainnoninterest-related amounts paid by an em-ployer to an employee’s beneficiaries on ac-count of the employee’s death werenontaxable up to a total amount of $5,000,regardless of the number of employers in-volved. This $5,000 exclusion, however, wasrepealed in 1997 for both California and fed-eral tax purposes for deaths occurring afterAugust 20, 1996. The exclusion program con-tinues for survivor benefits paid under cer-tain circumstances (see “Comments”).

RATIONALE

This program provides tax relief to a quali-fied decedent's beneficiaries with the original

rationale apparently being that death benefitsoften are used by such individuals to adjustto the economic hardships caused by thedeath of decedents, and/or to cover thedeath-related expenses they may face (suchas burial costs). However, the fact that theprogram no longer applies to new decedents(except as noted below), suggests that thisoriginal rationale is no longer viewed as suffi-cient to justify the program.

COMMENTS

Federal changes embodied in the TaxpayerRelief Act of 1997 included a provision thatexcludes from gross income certain survivorbenefits paid as an annuity to the immediatefamily of a public safety officer killed in theline of duty. California incorporated thisprovision as a federal conformity measurethrough Chapter 322, Statutes of 1998(AB 2797, Cardoza), with an effective date ofJanuary 1, 1998.


Page 32


MEALS AND LODGING

FURNISHED BY AN EMPLOYER



Authorization: California Revenue and Taxation CodeSection 17131, which conforms toInternal Revenue Code Section 119.

(In Millions)

Fiscal Year PIT

1996-97 $24

1997-98 24

1998-99 24

DESCRIPTION

This program allows the exclusion from grossincome of the value of meals and lodgingfurnished by an employer (other than themilitary) to an employee, spouse, or depend-ent. To qualify for the exemption, the mealsor lodging must be provided at the em-ployer's place of business and for the conve-nience of the employer. In addition, for thevalue of lodging to be exempt, the taxpayermust be required to accept the employer-provided lodging as a condition of employ-ment. This means that the taxpayer mustaccept the lodging in order to fulfill the re-quirements of the job.

RATIONALE

This program provides tax relief to taxpayerswho are required to live in or eat at facilitieswhich are owned by their employers. Theprimary rationale for the program is to sim-plify tax administration. For example, thevalue to an employee of employer-providedmeals or lodging is often difficult to establish.

In addition, the lodging provided by an em-ployer may simply duplicate rather thansubstitute for private quarters, in which caseits value to the employee could be negligible.

COMMENTS

In some cases, such as a live-in housekeeperor resident apartment manager, employer-furnished meals and lodging may representa large portion of the employee's total com-pensation. To the extent that the employee'sregular wages are lower as a result of thisprogram, the government ends up subsidiz-ing occupations that are characterized bysuch forms of compensation.

The program also provides an incentive foremployers and employees to rely more thanthey otherwise would on such nonwagecompensation, since the after-tax value of adollar of this form of nonwage income isgreater than that of a dollar of regular taxablewage income.


Page 33


MISCELLANEOUS FRINGE BENEFITS




(In Millions)

Fiscal Year PIT

1996-97 $185

1997-98 200

1998-99 210

DESCRIPTION

This program provides a tax exemption toemployees for specified types of em-ployer-paid fringe benefits that they may bereceiving. These benefits include: (1) specialservices provided to employees at no directcost to them (such as free stand-by flightsprovided by airlines to their employees);(2) employee discounts for products andservices sold by the employer; (3) use of com-pany equipment (such as a company car);and (4) “de minimis” fringe benefits (such aspersonal use of an employer's copying ma-chine or use of on-premises eating or gymna-sium facilities).

RATIONALE

The rationale for this program depends onthe type of fringe benefit involved. For in-stance, program supporters argue that theexemption for employer-provided gymna-sium facilities is intended to provide employ-ers with an incentive to improve the wellbeing and productivity of their employees.The rationale for the exemption of certainother benefits often appears to be based pri-marily on administrative considerations, suchas the difficulty of determining the value toindividual employees of the specific benefitinvolved.


Page 34


SCHOLARSHIPS, FELLOWSHIPS, AND GRANTS




(In Millions)

Fiscal Year PIT

1996-97 $24

1997-98 27

1998-99 31

DESCRIPTION

This program allows taxpayers to excludefrom gross income any qualifying scholar-ships, fellowships, and tuition grants or re-ductions they receive that are used for quali-fied educational expenses. This includes tui-tion and fees for enrollment and attendanceat an educational institution, as well as fees,books, supplies, and equipment required foreducational courses. The exclusion does not,however, apply to the portion of the scholar-ships, fellowships, and grants which is usedto pay for room and board.

RATIONALE

The rationale for the tax relief that this pro-gram provides to the recipients of scholar-ships, fellowships and grants appears to re-late to the problem of uniformity in the treat-ment of different taxpayers. According tofederal sources, the related federal tax-exclu-sion program (to which California's programconforms) initially required that all scholar-ship, fellowship and grant income be in-cluded as gross income, unless the taxpayercould show that it was a gift (this is becausegifts are nontaxable, as specified). However,when the Internal Revenue Code of 1954 was

enacted, the present program was adopted onthe grounds that it would treat all taxpayersconsistently and uniformly, and eliminate theneed to determine whether a “gift” was in-volved. Thus, the rationale for the program isthat it provides equity among different tax-payers and is administratively convenient.

Another rationale offered by the program’sproponents is that recipients of scholarships,fellowships and grants often are studentswho have limited economic resources of theirown. Thus, the program helps relieve some ofthe economic difficulties they face andthereby encourages increased educationalattainments in our society.

COMMENTS

The program applies to amounts received forsuch incidental expenses as travel, research,clerical assistance, and equipment, but doesnot apply to amounts received for teaching,research work, or similar services. In manycases the value of scholarships, fellowships,and grants is small enough that the recipi-ents, who frequently are students with onlylimited outside income, would have little orno tax liabilities in the program's absence.


Page 35


STATE LOTTERY WINNINGS



Authorization: California Government CodeSection 8880.68.

(In Millions)

Fiscal Year PIT

1996-97 $27

1997-98 27

1998-99 28

DESCRIPTION

This program exempts from gross income anywinnings from the California State Lottery.

RATIONALE

This program presumably was intended toprovide a tax incentive for individuals toparticipate in the state lottery. It does this byincreasing the “take-home” value of win-nings from lottery wagering.

COMMENTS

This program was established in November1984 by Proposition 37, which enacted theCalifornia State Lottery Act of 1984.

State lottery winnings are subject to federalincome taxation, to the extent that they ex-ceed lottery wagering losses. Gambling win-nings other than lottery winnings aresubject to both state and federal income taxa-tion, to the extent that they exceedgambling losses.


Page 36


INCOME FROM INVESTMENTS IN

ECONOMICALLY DEPRESSED AREAS



Authorization: California Revenue and Taxation CodeSections 17231, 17233, 24384.5, and24385.

(In Millions)

Fiscal Year PIT BCT

1996-97 NA NA

1997-98 NA NA

1998-99 NA NA

DESCRIPTION

This program exempts from gross income theinterest received from investments made instate-designated economically depressedareas, including Enterprise Zones and the LosAngeles Revitalization Zone (LARZ). Forexample, the interest income from a loan to abusiness that expands its operations in anEnterprise Zone area is tax-exempt. The loanmust be used solely in connection with activi-ties within an Enterprise Zone or LARZ, andthe taxpayer must have no equity or owner-ship interest in the business(es) involved.

RATIONALE

This program provides an incentive for in-vestments to be made in economically de-pressed areas of the state, by increasing theafter-tax investment return that taxpayers canearn on loans to businesses which are locatedin such areas. Proponents argue that thisincreased rate of return may be necessary toinduce investments in areas where such in-vestments are perceived to face higher-than-average financial risks.

COMMENTS

In recent years, over two-thirds of all stateshave enacted some form of tax incentives for

businesses operating in economically de-pressed areas. These incentives differ widelyin their purpose and coverage. Some of thetax incentives currently made available bystates include tax exemptions for businessesinvesting capital within a designated geo-graphic area or zone, income tax creditsbased on the number of eligible employeeshired by businesses in these locales, andproperty tax abatement programs for landand structures in such areas.

The problems of economically disadvantagedareas can take many forms, including a de-clining or stagnant base of economic activi-ties, an inadequately trained or skilled laborforce, a dilapidated public infrastructureinvolving poor-quality educational and trans-portation facilities, and a depressed privateinfrastructure involving run-down businessand residential structures.

Arguments in Support. Supporters of thisprogram argue that, given such factors, thesegeographic areas are worthy of financial sub-sidies, at least to “put them on track” to elimi-nate these adverse conditions. In addition,supporters argue that there often is evidenceof some type of “market failure” that makesit especially difficult for these areas to deal


Page 37

with their problems—including imperfectinformation among investors about the posi-tive investment opportunities that these areasmay offer. Thus, supporters argue, govern-ment should “get involved” to help to correctthese areas’ problems. They note that thebenefits to be realized from such involvementinclude both private-sector economic gainsand public-sector improvements, such asreduced crime.

Other supporters argue that, while marketfailures may be important to address, theprogram can be justified on equity groundsalone. According to this view, government-provided incentives to businesses in de-pressed areas can result in greater economicopportunities for the people residing in them,thereby benefitting both individual residentsand the public generally.

Arguments Against. Critics of this programargue that it is an ineffective and inefficientmeans of stimulating new economic activity,and that it simply encourages relocation ofexisting businesses to the designated areas asopposed to the creating of truly “new” enter-prises. This view holds that a “zero-sum”game is involved, with such tax incentivesbenefitting certain localities at the expense ofothers. Some critics go even further, arguingthat the tax incentives represent such a smallpart of the cost calculation for a business thatthey simply constitute a “windfall benefit”for business behavior that would have oc-curred anyway.

Given the above, the controversy about theprogram’s merits seems to largely revolvearound the geographic scope of the pro-gram’s evaluation, for example, whether thefocus is on the economic effect on the tar-geted impact area alone or the change in thelevel of economic activity for the state or aregion as a whole. Supporters argue that evenif the program does not increase economicactivity for the state generally, it still is justi-

fied on distributional grounds if it benefits aparticular disadvantaged area. They also notethat there may be efficiency gains resultingfrom relocating investment from high-em-ployment labor markets to low-employmentlabor markets, as otherwise under-utilizedresources are tapped.

Empirical Evidence. Empirical evidence ismixed as to the efficiency and effectiveness ofthis and similar programs. For example, inWhat Do We Know About Enterprise Zones?(Tax Policy and the Economy, Volume 7,National Bureau of Economic Research, 1993),evidence is presented of increased investmentand reduced unemployment claims withinenterprise zones in Indiana. Also, a reportprepared for the New Jersey Department ofCommerce that surveyed firms receivingsuch tax incentives found that about one-third said they were the sole or major factorin their investment decision (see Rubin andArmstrong, The New Jersey Enterprise Program:An Evaluation, 1989). However, data from theU.S. Census Bureau indicates that the eco-nomic well-being of enterprise zone residentshas not significantly improved since thezones were established.

The California Bureau of State Audits (BSA)conducted a review of the effectiveness of theemployment and economic incentives of Cali-fornia enterprise zones and program areas (aformer state program). Based on statistics pro-vided by the California Employment Develop-ment Department, the BSA found that businessand job growth in the enterprise zones andprogram areas generally exceeded the growthin the counties in which they were located.However, the BSA was unable to determinewhether this growth was the result of tax incen-tive programs per se versus other factors (seeCalifornia Trade and Commerce Agency, TheEffectiveness of the Employment and EconomicIncentive and Enterprise Zone Programs CannotBe Determined, November 1995).


Page 38


FOSTER CARE PAYMENTS




(In Millions)

Fiscal Year PIT

1996-97 $2

1997-98 2

1998-99 2

DESCRIPTION

This program allows taxpayers to excludefrom gross income the payments they receivefrom state, local, and nonprofit agencies asreimbursement for the costs of taking care ofa foster child. To qualify, a foster child mustlive in the taxpayer’s home.

RATIONALE

This program provides an incentive for indi-viduals to take on the responsibilities of car-ing for foster children. The payments and taxexclusion are intended as compensation for

and to cover expenses associated with fostercare.

COMMENTS

Supplemental payments made by the state ora tax-exempt child-placement agency as“difficulty-of-care payments,” are alsoexcludable from gross income for tax pur-poses. These are intended as compensationfor the additional expense associated with thecare of a foster child with a physical, mental,or emotional handicap.


Page 39


EMPLOYEE RIDESHARING BENEFITS



Authorization: California Revenue and Taxation CodeSections 17090 and 17149, which partiallyconform to Internal Revenue CodeSection 132.

(In Millions)

Fiscal Year PIT

1996-97 NA

1997-98 NA

1998-99 NA

DESCRIPTION

This program allows taxpayers to excludefrom their gross income the compensation orany other benefits they receive from an em-ployer for their costs of participating in aqualified ridesharing program. The exemp-tion covers compensation or other benefitsreceived for commuting in a third-partyvanpool, private commuter bus, or subscrip-tion taxipool, and for monthly transit passesthat are used by an employee or the em-ployee's dependents. It also covers such bene-fits as carpooling, free or subsidized parking,bicycling, ferry use, travel to or from atelecommuting facility, and any alternativetransportation method that reduces the use ofmotor vehicles in traveling to or from a placeof employment.

RATIONALE

This program provides tax relief to employ-ees who participate in ridesharing programs,

and an incentive for employers to makeridesharing benefits a part of their employees'overall compensation. The program's under-lying rationale is based on the view that statetax incentives are needed to encourage em-ployees and employers to use ridesharingprograms as a means of alleviating trafficcongestion and reducing air pollution.

COMMENTS

The exemption provided by this programoriginally was established by Chapter 25,Statutes of 1982 (AB 548, Ryan), and wasallowed for income years 1981 through 1985.Chapter 1444, Statutes of 1986 (SB 1794,Beverly), which extended the exemptionthrough 1990, was repealed in 1987. Thecurrent program was enacted byChapter 1437, Statutes of 1988 (SB 1904,Morgan).


Page 40


EMPLOYEE CHILD AND DEPENDENT CARE BENEFITS



Authorization: California Revenue and Taxation CodeSection 17131, which partially conforms toInternal Revenue Code Section 129.

(In Millions)

Fiscal Year PIT

1996-97 $28

1997-98 31

1998-99 34

DESCRIPTION

This program allows taxpayers to excludefrom their gross income the compensation orother benefits they receive from an employerfor qualified child and dependent care ser-vices. In addition to exempting these em-ployer-provided benefits, an employee mayexempt the amount of child and dependentcare benefits received through a salary-reduc-tion agreement entered into with an em-ployer. In this case, the employee elects toreceive a salary reduction in the amount ofthe additional employer-paid child or de-pendent care benefits.

RATIONALE

This program provides tax relief for employ-ees who receive child and dependent carebenefits through either of the methods above,and an incentive for employers to make suchbenefits a part of their employees' overallcompensation package. The program's under-lying rationale is that it benefits society as awhole in several ways. One of these ways,proponents argue, is through increased laboroutput and productivity, which occurs be-cause the availability of child care enables

more individuals to work and reduces em-ployee absenteeism and turnover. Anothercited benefit of the program is a reduction inthe need for government-provided child careprograms.

COMMENTS

This program covers payments or servicesprovided by the employer for child or de-pendent care services, which enable or assistthe taxpayer to work. To qualify for the pro-gram, the assistance must be provided undera plan that does not discriminate in favor ofofficers, owners, or higher-paid employees,and which meets various other requirements.

Federal tax law, to which California con-forms, limits the exclusion for employee childcare benefits (both those paid by the em-ployer and those provided through employeesalary reductions) to $5,000 per year ($2,500in the case of married individuals who file taxreturns separately from their spouse), begin-ning in 1987. Individuals are allowed to usethis income exclusion in conjunction with thetax credit for child and dependent care expenses.


Page 41


TAX-EXEMPT STATUS FOR QUALIFYING CORPORATIONS


Tax Type: Bank and Corporation Tax (BCT).

Authorization: California Revenue and Taxation CodeSections 23701 through 23710.

(In Millions)

Fiscal Year BCT

1996-97 $92

1997-98 97

1998-99 99

DESCRIPTION

This program allows an exemption from theBCT franchise and income taxes for the in-come of qualifying tax-exempt nonprofit andcharitable organizations. (The BCT franchisetax is levied against all banks and corpora-tions doing business in the state. In contrast,the BCT income tax is imposed on banks andcorporations that do not do business in thestate, but which have income from Californiasources, such as holding companies and firmsengaged only in interstate commerce.)

This exemption extends to the minimumfranchise tax imposed on corporations whichotherwise would have a tax liability less thanthat amount. Qualifying organizations arestill subject to taxes on "unrelated businessincome,” which includes income associatedwith activities that are not directly related totheir tax-exempt status. For example, a church

would have to pay taxes on the incomeearned from the lease of its personal propertyto a business, even though its income fromreligious-related activities would be tax ex-empt.

RATIONALE

This program provides tax relief to organiza-tions which are engaged in various charita-ble, or otherwise not-for-profit, activities. Thetax-exempt status generally applies to non-profit religious, charitable, educational, andscientific organizations. Certain homeowner-ship organizations, civic and business organi-zations, and financial cooperatives also qual-ify for tax-exempt status. The commonly citedrationale for exempting such organizationsfrom taxation is that they provide social bene-fits which are worthy of indirect public finan-cial support.


Page 42


RECYCLED OR REDEEMED BEVERAGE

CONTAINER REDEMPTION PAYMENTS




(In Millions)

Fiscal Year PIT BCT

1996-97 NA NA

1997-98 NA NA

1998-99 NA NA

DESCRIPTION

This program allows taxpayers to excludefrom gross income the amounts they receivefor returning recyclable beverage containersto state-designated recycling centers.

RATIONALE

This program provides an incentive for tax-payers to return beverage containers to recy-cling centers. The program's underlying ratio-nale is that resource conservation and litterreduction are worthy of public financial sup-port.

COMMENTS

This program was enacted by Chapter 1290,Statutes of 1986 (AB 2020, Margolin), whichestablished a statewide recycling program forcertain types of beverage containers. Theprogram's exclusion covers the amounts thata taxpayer receives as a refund/redemptionvalue. The term “refund value” refers to theminimum refundable value established bythe California Department of Conservation(DOC) for each type of beverage container.Generally, the current refund value is2.5 cents per container.


Page 43


BENEFITS PROVIDED UNDER CAFETERIA PLANS



Authorization: California Revenue and Taxation CodeSection 17131, which generally conformsto Internal Revenue Code Section 125.

(In Millions)

Fiscal Year PIT

1996-97 $170

1997-98 195

1998-99 220

DESCRIPTION

This program allows employees to excludefrom their gross income benefits receivedfrom cafeteria plans. Such cafeteria plans areemployer-sponsored benefit packages thatoffer employees a choice between takingmonetary compensation or qualified benefits.The employee is allowed to choose amongthe “qualified benefits” that a particular em-ployer’s plan offers, which can include suchbenefits as accident and health coverage,group-term life insurance coverage, or childand dependent care benefits. Qualified bene-fits cannot include deferred compensationplans, except for certain plans maintained byeducational institutions. If the employeechooses to take monetary compensation in-stead of the qualified benefits, the monetarycompensation must be included in gross in-come subject to taxation.

RATIONALE

This program creates an incentive for em-ployers to provide, and employees to accept,contributions made to benefit plans in lieu ofmonetary compensation. This is because agiven contribution amount to such a programis worth more to employees on an after-taxbasis than an equivalent amount of taxableincome. In addition, the program providesboth employers and employees with an in-centive to make these types of benefits a stan-dard part of the employees' compensationpackage. The rationale advanced for the pro-gram is that it furthers a desirable social goal,because it improves workers' income securityand reduces the need for governments toprovide these benefit programs themselves.

COMMENTS

California has been largely in conformitywith federal law regarding cafeteria planbenefits since 1987.


Page 44


WATER’S-EDGE ELECTION




(In Millions)

Fiscal Year BCT

1996-97 $335

1997-98 340

1998-99 355

DESCRIPTIONThis program gives a unitary multinationalcorporation the option of computing its Cali-fornia taxable income on a “water's-edge”basis, which means the company's tax liabil-ity is determined on the basis of its UnitedStates income only, instead of on the basis ofits worldwide income. (That is, nondomesticincome may be excluded for tax-computationpurposes.)

A qualifying water's-edge corporation is alsoallowed to deduct a percentage of its foreigndividends. Corporations electing to file on awater’s-edge basis must do so for a seven-year period following the year of election.

RATIONALEThis program provides tax relief to multina-tional corporations by allowing them to com-pute their taxes using an alternative method.The net effect is that they are allowed to ex-clude the activities of foreign operations forthe purposes of calculating California taxliabilities under BCT. One rationale for theprogram is that it is burdensome for somemultinationals to keep track of all theirworldwide income sources and amounts forthe sole purpose of computing California’stax liability. The water's-edge election pro-vides these corporations with an alternativethat makes it easier and less costly for them to

comply with California's tax laws, because itrelies on the same information now requiredfor federal tax purposes.

It also is argued by proponents that theworldwide method could result in an un-fairly high allocation of income for Californiatax purposes, and that the water's-edgemethod reduces this distortion.

DISTRIBUTION OF BENEFITSAs shown in Figure 1, the benefits of thewater’s-edge election are claimed by a broad

Figure 1

Water's-Edge ElectionTax Benefits by Receipt

1998 Income Year

TotalReceipts(In Millions)

Percent of


TotalAmountClaimed

Under $1 13.3% 0.1%1–10 26.7 0.110–50 25.3 0.150–100 6.0 0.5100–500 16.5 4.2500–1,000 5.1 7.8Over 1,000 7.2 87.4


Page 45

spectrum of businesses, based on total re-ceipts. However, total benefits accrue dispro-portionately to larger corporations. This isdue to the fact that corporations with world-wide operations who can benefit from awater’s-edge election tend to be large entities.Figure 2 indicates that the total benefits asso-ciated with the program accrue largely tomanufacturing and to finance, real estate, andinsurance enterprises.

COMMENTSThis program was enacted by Chapter 660,Statutes of 1986 (SB 85, Alquist), and is appli-cable for tax years beginning in 1988.

Figure 2

Water's-Edge ElectionTax Benefits by Industry

1998 Income Year

Industry Type

Percent of

GrossState

Product


TotalAmountClaimed

Agriculture,Forestry & Fishery

3.0% 0.9% 0.1%

Construction 3.8 0.8 0.1Manufacturing 15.9 20.6 50.9Services 25.1 13.1 0.2Trade 18.2 45.1 1.1Finance, RealEstate & Insurance

25.9 17.0 30.7

Utilities &Transportation

8.2 2.5 17.1


Page 46


LIMITED PARTNERSHIP INVESTMENT SOURCE RULES




(In Millions)

Fiscal Year PIT

1996-97 $10

1997-98 10

1998-99 10

DESCRIPTION

This program exempts from taxation divi-dends, interest, or gains and losses from qual-ifying investment securities of limited part-nership members who reside outside of Cali-fornia, and whose only contact with this stateis through a broker, dealer, or investmentadvisor located in the state. “Qualified invest-ment securities” include, but are not limitedto, common stock, bonds, and mortgage-based or asset-backed securities.

RATIONALE

This program provides tax relief to membersof limited partnerships residing outside ofCalifornia that make use of investment ser-vices within the state, on the grounds that

such activity does not constitute “doing busi-ness” in the state.

COMMENTS

Prior to this program, members of limitedpartnerships were subject to taxation on in-vestment income because they were deemedto be “doing business” within the state, eventhough they did not physically reside in Cali-fornia. This increased the cost of using invest-ment services in California, placing this in-dustry at a comparative disadvantage in Cali-fornia relative to other states such as NewYork and Massachusetts, which had rulesexempting limited partnership investmentsource-income from taxation.


Page 47


CREDIT UNION TREATMENT




(In Millions)

Fiscal Year BCT

1996-97 $13

1997-98 13

1998-99 13

DESCRIPTION

This program exempts credit unions andnonprofit cooperative associations from thestate minimum franchise tax. This is theamount that a corporation must pay, regard-less of income. It is currently $800 for mostcorporations, although new, small corpora-tions pay a lower minimum franchise tax.

RATIONALE

This program provides tax relief to creditunions and nonprofit cooperative associa-

tions, based on the rationale that the primarygoal of these organizations is to provide low-cost financial services to members who mightnot otherwise have access to such services.

COMMENTS

While credit unions and nonprofit coopera-tive associations are exempt from any mini-mum franchise tax, credit unions must pre-pay a tax of $25 when they incorporate underthe laws of California, or when they qualifyto transact business in California.


Page 48


SMALL BUSINESS ALTERNATIVE MINIMUM TAX



Authorization: California Revenue and Taxation CodeSections 17062,17309, 23036, 23453,23455 through 23457, and 23459, whichgenerally conform to Internal RevenueCode Sections 55 through 59.

(In Millions)

Fiscal Year PIT BCT

1996-97 NA NA

1997-98 NA NA

1998-99 NA NA

DESCRIPTION

For certain businesses and individuals whichhave large amounts of deductions, credits,exemptions, and exclusions, the AlternativeMinimum Tax (AMT) may limit the amountof these “tax preference” items that may beclaimed, or may impose an additional tax orlimit tax credits receivable to ensure thatthese taxpayers are not receiving more than a“reasonable” amount of benefits from thesepreference items. This program exempts cer-tain small businesses from the state AMT.

To qualify for this treatment, the taxpayermust (1) own or have ownership interest in a

trade or business, and (2) have aggregateadjusted gross receipts of less than $1 millionfrom these trades or businesses. Proportion-ate interest in a partnership, regulated invest-ment company, real estate investment trust,and real estate mortgage investment conduitare includable in the gross receipt totals.

RATIONALE

This program provides tax relief to qualifiedsmall businesses, thereby increasing theireconomic viability. The rationale is based onthe belief that encouraging the developmentof small business helps the vitality of stateand local economies.


Page 49


TUITION REDUCTION OR WAIVER



Authorization: California Revenue and Taxation CodeSection 17131, which conforms toInternal Revenue Code Section 117(d).

(In Millions)

Fiscal Year PIT

1996-97 NA

1997-98 NA

1998-99 NA

DESCRIPTION

This program allows an exclusion from grossincome for tuition reductions or waivers re-ceived by an employee of a qualified educa-tional institution for undergraduate educa-tion provided to the employee, the em-ployee’s spouse, or dependent children. Italso provides tuition reductions or waiversfor graduate education of the employee, whomust be engaged in teaching or research ac-tivities for the qualifying educational institu-tion.

The educational institution may provide thetax-exempt tuition reduction or waiver onlyif it does not discriminate in favor of highlycompensated employees. A qualified educa-tional institution must maintain a regularfaculty and curriculum, and have a regularlyenrolled student body in attendance at theinstitution.

RATIONALE

This program provides tax relief to universityand college employees based on the rationalethat individuals in these occupations shouldbe provided additional public support for

their activities and because of the perceivedimportance of education. Schools have ar-gued for the exemption as an added benefitto attract and maintain highly sought-afteremployees, who otherwise might be hired atother universities or by private sector compa-nies. (This reasoning, however, does not pro-vide a rationale for public financial support ofthis program.)

COMMENTS

On several occasions in the late 1970s andearly 1980s, the Internal Revenue Service(IRS) and some Members of Congress at-tempted to review or repeal this program, butmet with strong resistance. As a method ofcurbing its use, the federal government re-stricted the use of the tax-exempt tuitionreduction to undergraduate education only,except in the case of an employee who isconcurrently attending graduate school.

Due to rising costs in recent years, some uni-versities have limited the amount of tuitionreduction to new employees as a means ofcutting costs; however, many still provide afull tuition waiver.


Page 50


SCHOLARSHARE TRUST INCOME



Authorization: California Revenue and Taxation CodeSections 17140, 23735, 24306, and24328.

(In Millions)

Fiscal Year PIT

1996-97 —

1997-98 Minor

1998-99 $1

DESCRIPTIONThe Golden State Scholarshare Trust programwas established by the state to encouragefamilies to save for the post-secondary educa-tion expenses of their children. Contributionsunder a Scholarshare Trust Account are notincluded for state tax purposes in gross in-come. Earnings on contributions under theScholarshare Trust Account are not taxablewhen earned, but rather included in the bene-ficiaries’ gross income upon distribution foreducational purposes.

Contributions to and earnings on the trust mustbe used for qualified higher education expensesat a public or private post-secondary institution,including the following: tuition, fees, books,supplies, and (in most cases) room and board.Maximum contributions to the ScholarshareTrust Account are limited to estimated qualifiedexpenses that can be incurred for a designatedbeneficiary to obtain a baccalaureate degree atan institution of higher education in Californiawithin four years.

RATIONALEThis program is one of several incorporatedinto state law that makes it financially easier for

families to afford to send their children to col-leges, universities, or other post-secondaryeducational institutions. The underlying ratio-nale is that higher education is worthy of publicfinancial support.

COMMENTSWhile the major thrust of this program is tomake it easier for households to pay for post-secondary education, there are broader issuesassociated with this program. In particular, ifthere exist social benefits to post-secondaryeducation in addition to private benefits, a less-than-optimal amount of education may resultin the absence of programs like this. Since theafter-tax price of post-secondary education islowered through this program, it would typi-cally be expected to result in an increase in theamount of education undertaken.

Some argue that sufficient public support forhigher education already occurs and thatprograms such as this may actually stimulateconsumption in excess of the appropriateamount.


Page 51


CAPITAL GAINS ON SMALL BUSINESS STOCK



Authorization: California Revenue and Taxation CodeSection 18152.5, which partially conformsto Internal Revenue Code Section 1202.

(In Millions)

Fiscal Year PIT

1996-97 —

1997-98 —

1998-99 $15

DESCRIPTIONThis program provides a PIT exclusion for50 percent of the gain from the sale or ex-change of qualified small business stock thatis held for more than five years. The amountof the exclusion may not exceed the greater ofthe following (for a married couple filing ajoint return) (1) $10 million, or (2) ten timesthe amount of the qualified small businessstock under specified conditions. Theseamounts are halved for single taxpayers. Thestock must be issued by a C corporation be-tween January 1, 1993 and January 1, 1999 inorder to qualify for the exclusion.

Qualified stock must be issued by a corpora-tion with less than $50 million in total grossassets (before and after the stock issuance),and 80 percent of its total dollar payroll mustbe attributable to employment in California.“Qualified businesses” are those where atleast 80 percent of the business assets areused to conduct qualified business or tradeactivities. Qualified business, in general, doesnot include professional or financial servicesor the hospitality industry. The measure wasdesigned primarily to promote startup opera-tions in manufacturing and related activities.

RATIONALEThe program was conceived of as a means bywhich small businesses in particular industriescould gain access to the capital markets more

easily than they otherwise would. Small, newor expanding businesses may face more sub-stantial hurdles in raising funds for growththan large business entities. This program rep-resents an effort to reduce the costs of access torequired financial capital.

COMMENTSThe federal government also has a PIT exclu-sion for 50 percent of small business stockgains held for five years or more. The designof the state’s provision was largely based onthe federal law but does not incorporate cer-tain of its provisions including the rollover ofcapital gains.

The small business stock exclusion, whichresults in a reduction in capital costs, repre-sents an attempt to address what are per-ceived as multiple issues relating to smallbusinesses. These issues may stem from mar-ket failure of some type, but may also relateto the achievement of other social goals. Forexample, some argue that small businessesand industries face a capital shortage; that,for some reason, insufficient funds are beingchanneled to small businesses. This may bedue to insufficient or inaccurate information,or an aversion to perceived high-risk ven-tures. Some feel that by increasing the returnto investors, additional capital can be chan-neled into the small business sector.


Page 52

Other proponents suggest that the cost ofcapital itself is the problem, and that a sub-sidy is necessary for small business start-upsand expansions to be viable. Finally, somesupporters take the view that small busi-nesses are worthy of special support, perhapsbecause they may be more labor intensivethan larger businesses, or because small busi-nesses tend to be a substantial source of prod-uct development and innovation.

Economists differ, and empirical evidence isinconclusive, regarding the validity of someof the claims regarding the positive aspects ofsmall business activities or the existence ofcapital shortage for this sector. Even if thejustifications given for the program are accu-rate, there may exist alternative ways to assistsmall business enterprise.


Page 53

Adjustment:

CONTRIBUTIONS TO INDIVIDUAL

RETIREMENT ACCOUNTS



Authorization: California Revenue and Taxation CodeSections 17085, 17201, 17203, 17210.6,17501, 17504 through 17509, 17551, and17554, which largely conform to InternalRevenue Code Sections 219 and 408.

(In Millions)

Fiscal Year PIT

1996-97 $51

1997-98 57

1998-99 62

DESCRIPTION

This program allows a deduction when com-puting adjusted gross income (AGI) for con-tributions to a taxpayer’s Individual Retire-ment Account (IRA). The annual maximumdeduction permitted is the lesser of $2,000 or100 percent of the individual’s compensation.A nonworking spouse may make a deduct-ible IRA contribution of up to $2,000. Themaximum aggregate contribution for a mar-ried couple is the lesser of $4,000 or100 percent of their combined compensation.

If a taxpayer is a participant in an employer-sponsored retirement plan, the above deduc-tion limitation is gradually reduced and theneliminated at a certain point. For the 1998 taxyear, taxpayers who belong to em-ployer-established pension programs canclaim the full deduction, provided their AGIis below $30,000 for single filers, and $50,000for married joint-return filers. For incomesabove these amounts, the deduction is gradu-ally phased-out, and then eliminated alto-gether for taxpayers whose AGI exceeds$40,000 for single filers and $60,000 for mar-ried joint-return filers.

RATIONALE

This program provides an incentive for tax-payers to save for retirement. It does thisby permitting taxpayers to defer taxes on IRAcontributions until they are withdrawn (afterage 59½), thereby increasing the investmentearnings on such monies.

In addition, the program provides tax relief toIRA account owners, to the extent that theirmarginal income tax rates are lower whenthey retire compared to when they are work-ing.

COMMENTS

California has generally been in conformitywith federal law regarding deductions forIRA account contributions since 1987. Thestate incorporated changes made at thefederal level for tax years beginning in 1996regarding maximum deductible contributions.


Page 54

Adjustment:

CONTRIBUTIONS TO SELF-EMPLOYED

RETIREMENT PLANS



Authorization: California Revenue and Taxation CodeSections 17501, 17504, 17506, and17507, which generally conform to InternalRevenue Code Sections 219, 401 through404, 408, and 415.

(In Millions)

Fiscal Year PIT

1996-97 $145

1997-98 155

1998-99 170

DESCRIPTIONThis program allows a deduction when com-puting adjusted gross income (AGI) for ataxpayer's contributions to a self-employedretirement plan (these plans are usually re-ferred to as “Keogh” plans).

For defined contribution plans, the deductionis limited to the lesser of $30,000 or 25 percentof earned income. For defined benefit plans,the annual normal retirement benefit limita-tion is the lesser of $90,000 or 100 percent ofaverage compensation for the highest threeconsecutive years of active plan participation.The $90,000 limitation is adjusted annuallybased on the cost of living; for 1998, this ad-justed figure was $130,000. California lawrequires that amounts used as earned incomefor federal income tax purposes must also beused for state income tax calculations.

RATIONALEThis program provides self-employed indi-viduals an incentive to save for retirement, bygranting them the same basic type of taxdeferral that is available to individuals whoare covered by employer-established retire-ment programs.

DISTRIBUTION OF BENEFITSThe accompanying table indicates that taxpay-ers receiving benefits from this program arebroadly distributed across the income spec-trum. However, the majority of benefits accrueto those in the upper-income categories, withalmost 80 percent of amounts claimed by tax-payers earning more than $100,000. Average

Contributions to Self-EmployedRetirement Plans Adjustment

1998 Tax Year


Percent of



TotalAmountClaimed

$0-20 1.6% 0.1% NA20-40 6.3 1.2 $16740-60 11.0 4.1 33360-80 14.1 8.1 51980-100 11.5 7.5 591100-150 19.9 18.5 842150-200 11.0 16.2 1,333200-250 6.3 12.1 1,750250-500 12.6 23.1 1,667Over 500 5.8 9.3 1,455

benefits also increase as income increasesthroughout most of the income spectrum.


Page 55

COMMENTSIn general, no distinction is made between(1) pension, profit-sharing, and other retire-ment plans, including simplified employeepension plans established by corporations;and (2) plans established by self-employedindividuals and partnerships. In addition,

contributions and deductions for aself-employed participant in a qualified planare limited in the same way as those of anemployee participant. California has beenlargely in conformity with federal law in thisarea since 1987.


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Adjustment:

CONTRIBUTIONS TO EDUCATION

INDIVIDUAL RETIREMENT ACCOUNTS



Authorization: California Revenue and Taxation CodeSections 17085, 17201, 17210.6, 17501,and 17505 through 17509, which gener-ally conform to Internal Revenue CodeSections 219 and 408.

(In Millions)

Fiscal Year PIT

1996-97 —

1997-98 $1

1998-99 7

DESCRIPTION

This program allows for an exclusion fromgross income when computing adjusted grossincome (AGI) for earnings on contributions toan Individual Retirement Account (IRA)established for the purpose of funding achild’s post-secondary educational expenses.Under the program, up to $500 per child, peryear may be contributed to an educationalIRA, effective for tax years beginning after1997. Earnings on contributions are distrib-uted tax-free provided that they are used forthe purposes of the child’s qualified post-secondary education expenses.

Qualified expenses include tuition, fees,books, supplies, equipment, and (in mostcases) room and board. The program is avail-able for taxpayers with modified AGI of up to$150,000 (joint returns) and $95,000 (singletaxpayers). The program is phased out for

filers with modified AGI between $150,000and $160,000 (joint returns) and $95,000 and$110,000 (single taxpayers).

RATIONALE

This program provides favorable tax treat-ment of investment earnings specifically setaside for a child’s post-secondary education.Although contributions to the education IRAthemselves are not deductible from income,the incentive to earmark savings for educa-tional purposes involves recognition of thehigh costs of education and the necessity ofpost-secondary education for many careers.Proponents argue that encouraging suchbehavior is deserving of public support.

COMMENTS

California generally conforms to federal taxlaw with regard to education IRAs.


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Adjustment:

MEDICAL SAVINGS ACCOUNTS



Authorization: California Revenue and Taxation CodeSections 17201, 17215, and 24343.3,which generally conform to Internal Reve-nue Code Sections 106, 138, and 220.

(In Millions)

Fiscal Year PIT BCT

1996-97 $4 NA

1997-98 8 NA

1998-99 10 NA

DESCRIPTION

This program allows small business employ-ers and self-employed individuals to createtax-favored Medical Savings Accounts. Ingeneral, employer or employee contributionsare limited to 65 percent of the annual healthinsurance deductible for taxpayers with indi-vidual insurance coverage. The comparablelimitation for taxpayers with family coverageis 75 percent.

Employer contributions are excluded, andemployee contributions deductible, from theemployee’s income for tax purposes. Anyearnings accumulated in the Medical SavingsAccount are tax-free. Contributions and earn-ings placed in this account may be with-drawn for medical purposes without penalty.Withdrawals made for other purposes may

be subject to tax, as well as a penalty, undercertain circumstances.

RATIONALE

This program provides an incentive for tax-payers to save for medical treatment andemergencies. It does this by permitting tax-payers to defer taxes on their Medical SavingsAccount contributions and for employers, todeduct contributions made to employee ac-counts.

COMMENTS

This program provides a “double” tax incen-tive. First, it lowers the adjusted gross incomeof taxpayers by exempting from income all ofthe contributions they make towards theirMedical Savings Account. Second, it does nottax earnings accumulated or withdrawals madefor medical purposes.


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Adjustment:

MOVING EXPENSES



Authorization: California Revenue and Taxation CodeSections 17072, 17076, 17084, 17134.5,17201, and 17218, which conform toInternal Revenue Code Sections 62, 67,82, 132, and 217.

(In Millions)

Fiscal Year PIT

1996-97 $20

1997-98 20

1998-99 20

DESCRIPTION

This program allows taxpayers an above-the-line deduction when computing their ad-justed gross income (AGI) for the qualifiedmoving expenses they incur, associated withbeginning a new job in a new location. Onlythose expenses that are not paid or reim-bursed by the employer are deductible. Theallowable expenses taken as a deduction incalculating AGI are those direct expensesassociated with relocation, but specificallyexcluding: (1) meals consumed while travel-ing and living in temporary quarters near thelocation of new employment; (2) preliminaryhouse-hunting travel prior to the move;(3) temporary living expenses for up to 30days in the general location of new employ-ment; and (4) lease expenses associated withthe new or old residence.

In order for the taxpayer to claim the deduc-tion, the move must meet two basic tests—a

distance test and a time test. The distance testrequires that the taxpayer’s new employmentmust be at least 50 miles further from thetaxpayer’s old residence than the formerplace of employment was from the taxpayer’sold residence. The time test requires that thetaxpayer be employed on a full-time basis atthe new location for at least 39 weeks duringthe 12-month period following the move.Self-employed individuals must work in thenew location for at least 78 weeks during thetwo years following the move in order toclaim the deduction.

RATIONALE

This program provides tax relief to individu-als whose employment requires that theyrelocate. The basic rationale is that such mov-ing expenses actually are a type of employeebusiness expense that is necessary in order toearn income, and that employees often havelittle control over incurring such expenses.


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Adjustment:

HEALTH INSURANCE PREMIUMS



Authorization: California Revenue and Taxation CodeSections 17201, 17270, and 17273,which partially conform to InternalRevenue Code Section 162.

(In Millions)

Fiscal Year PIT

1996-97 $34

1997-98 46

1998-99 50

DESCRIPTION

Under this program, self-employed taxpayersare allowed to deduct a percentage of thecosts they incur for health insurance premi-ums for themselves and their families, not toexceed the taxpayer’s earned income fromhis/her trade or business. California lawallows self-employed taxpayers to deduct40 percent of their costs for health insurancepremiums. This deduction may be takenregardless of whether the taxpayer itemizesdeductions.

RATIONALE

The purpose of this program is to encouragetaxpayers to provide health insurance forthemselves and their families. The program’srationale reflects the view that self-employedindividuals incur these business-related ex-penses which can be treated in the same fash-ion as business-related expenses incurred bylarger corporations.

COMMENTS

Federal tax law increased the deductible per-centage for health insurance premiumsfrom 25 percent to 30 percent for tax yearsbeginning after 1994. The percentage deduc-tion for federal purposes increases to40 percent for the 1997 tax year and thenincreases further at fairly regular intervalsthereafter until the deductible percentagereaches 100 percent for tax years beginningafter 2006.

For tax year 1997, the California deductiblepercentage was 40 percent, with the amountscheduled to decline to 25 percent for subse-quent tax years. However, underChapter 322, Statutes of 1998 (AB 2797,Cardoza) and Chapter 323, Statutes of 1998(AB 2798, Machado), the 40 percent deduct-ibility is scheduled to continue.


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Adjustment:

EMPLOYEE CONTRIBUTIONS TO QUALIFIED

RETIREMENT AND SALARY REDUCTION PLANS



Authorization: California Revenue and Taxation CodeSection 17501, which conforms to InternalRevenue Code Sections 401 through404a, 408, and 457.

(In Millions)

Fiscal Year PIT

1996-97 —

1997-98 —

1998-99 —

DESCRIPTION

This program allows an exclusion from grossincome for a taxpayer's contributions to aqualified employer-sponsored retirementplan, a simplified employee pension plan(SEP), or a cash or defined-arrangement plan(CODA) such as a 401(k), 403(b), or 457 plan.Taxpayer contributions to a CODA are lim-ited annually and vary by type of plan.

RATIONALE

This program provides individuals with anincentive to participate in employer-spon-sored retirement plans and salary reductionplans, by permitting them to defer taxes ontheir contributions until they are “with-drawn” as benefits after retirement. Thisdeferral reduces the cost of funding a speci-

fied level of retirement benefits, because thepresent value of taxes paid upon the with-drawal of benefits is less than the presentvalue of the taxes that would be paid whenthe contributions are made, due to such fac-tors as inflation. In addition, the programprovides a further tax reduction to such indi-viduals to the extent that their marginal in-come tax rates are lower when they retire andreceive retirement distributions compared towhen they made the contributions.

COMMENTS

The revenue effects of this program areincluded in those for the program “EmployerContributions to Pension Plans.” Californiahas generally been in conformity with federallaw since 1987. See comments under “Em-ployer Contributions to Pension Plans.”


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Deduction:

STANDARD DEDUCTION



Authorization: California Revenue and Taxation CodeSections 17041, 17073, and 17073.5.

(In Millions)

Fiscal Year PIT

1996-97 $840

1997-98 910

1998-99 950

DESCRIPTION

This program allows taxpayers who do notitemize their income tax deductions to claima standard deduction. The deduction amountfor the 1998 income year was $2,642 for sin-gle-return taxpayers and $5,284 forjoint-return taxpayers. The standard deduc-tion is indexed annually for inflation, as mea-sured by the percent change in the CaliforniaConsumer Price Index for June of the tax yearcompared to June of the preceding year.

RATIONALE

This program is intended to simplify state taxadministration and the tax-computation pro-cess for taxpayers who have less than a speci-fied level of itemized tax deductions.


As shown in the accompanying table, thestandard deduction is a program which isused heavily by lower-to-moderate incometaxpayers. Almost 75 percent of the taxpayersclaiming the standard deduction have $40,000or less in annual income, and over three-quarters of all deductions go to taxpayersearning $60,000 or less annually. For the low-est income class, the great majority of benefits(in excess of 90 percent) go to single taxpay-ers or married taxpayers filing separately.

Average claims for this deduction decline inthe higher income categories due to the in-creased prevalence of the use of itemizeddeductions.

Standard Deduction

1998 Tax Year


Percent of



TotalAmountClaimed

$0-20 39.6% 13.8% $5720-40 33.9 35.8 17440-60 15.9 28.3 29460-80 5.5 12.2 36780-100 2.1 4.7 364100-150 1.6 3.3 341150-200 0.5 0.8 280200-250 0.2 0.4 308250-500 0.5 0.7 240Over 500 0.3 0.2 143

COMMENTS

Considerable disagreement exists regardinghow the tax expenditure associated with thestandard deduction should be defined andmeasured. The revenue reduction amountsshown above represent the amounts the statewould gain if the standard deduction wereeliminated altogether, and those taxpayerswho would otherwise claim it were instead


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left with itemizing their deductions. Thus, fora single taxpayer with itemizable deductionsof $1,000, the revenue reduction for this pro-gram would be based on an increased deduc-tion of $1,642 (reflecting the excess of thestandard deduction over the taxpayer’sitemizable deductions).

However, alternative ways of defining andcomputing the tax expenditure amount havebeen suggested which can lead to signifi-cantly different revenue effects. For example:

• One view is that the standard deduc-tion is part of the “basic tax structure”because it is available to all taxpayers.In this view, the standard deductiondoes not give rise to any tax expendi-ture, and only those itemized deduc-tions in excess of the standard deduc-tion are tax expenditures.

• Another view is that the standarddeduction is a tax expenditure whichis claimed, either directly or indi-rectly, by all taxpayers. This view isbased on the notion that it is not pos-sible to distinguish between itemizeddeductions, which are tax expendi-tures, and the standard deduction,which is really a “proxy” for someminimal level of itemized deductions.Under this view, the cost of this pro-gram should reflect not only the stan-dard deductions explicitly claimed bynonitemizers, but also the standarddeductions which itemizers implicitlyreceive from the “zero bracketamount” that is built into the state'stax rate schedules. In other words,this view holds that, to identify thefull cost of this tax expenditure pro-gram, one must add together (1) thestandard deductions claimed bynonitemizers, and (2) that portion ofthe itemized deductions claimed byitemizers which is equivalent to thestandard deduction.


Page 63

Deduction:

CASUALTY LOSSES



Authorization: California Revenue and Taxation CodeSections 17131, 17207, and 24347.5which largely conform to Internal RevenueCode Section 165.

(In Millions)

Fiscal Year PIT BCT

1996-97 $15 $1

1997-98 20 1

1998-99 20 1

DESCRIPTION

This program allows as a deduction fromgross income any qualifying casualty lossesthat exceed 10 percent of federal adjustedgross income (AGI), to the extent that theselosses are not compensated for by insuranceor other means. In addition, the programallows that subgroup of casualty losses asso-ciated with certain officially designated disas-ters (as proclaimed by the President or theGovernor) to be (1) carried back as a deduc-tion against income for the prior year, and/or(2) carried forward as a deduction againstfuture income for up to five years. Fifty per-cent of the amount of any such loss remain-ing after five years may be carried forwardfor the next ten taxable years.

The term “casualty loss” includes losses aris-ing from fire, storm, shipwreck, floods, andother such casualties, or from theft. Eachseparate casualty or theft loss is deductibleonly to the extent that it exceeds $100, and thetotal of all individual losses is deductible onlyto the extent that it exceeds 10 percent offederal AGI.

California law incorporates federal law al-lowing a deduction for corporate losses sus-tained and not compensated by insuranceproceeds or other means. The corporate pro-

visions regarding the deduction and carry-over of disaster losses are the same as theprovisions under the PIT.

RATIONALE

This program provides tax relief to thoseindividuals, businesses, and corporate enti-ties which suffer large casualty losses, have atax liability, and (in the case of PIT) are ableto itemize deductions. The most commonlycited rationale for the program is that it helpsto relieve the hardships that these losses canimpose on such individuals and firms.

COMMENTS

This program has a number of important sideeffects and tax-equity considerations. First,because the program shifts part of the cost ofa taxpayer's property losses to the generaltaxpayer, it serves as a form of indirect prop-erty insurance. As such, it reduces the costs ofnot having insurance and gives taxpayers anincentive to purchase less private insurancethan they otherwise might. Insurance canresult in a phenomenon known as “moralhazard,” whereby an insured individual be-haves in a manner which results in increasedrisk since the full costs of such behavior arenot directly borne by the taxpayer. Privateinsurers attempt to control these tendenciesby instituting experience-adjusted insurance


Page 64

premiums and deductibles. This tax programcan be perceived as a supplemental insurancepolicy, but without such protective devices.

Second, depending on the size of a casualtyloss and a taxpayer's income level, differenttaxpayers sustaining identical casualty lossescan be provided different amounts of taxrelief, due to such factors as the 10 percentthreshold, the $100 minimum-loss require-ment, and differences in marginal income taxrates. For example, a high-income taxpayermay not be able to claim any deduction for a$5,000 casualty loss due to the 10 percentthreshold, whereas a low-income taxpayerwould qualify for a large deduction. Con-

versely, the dollar amount of tax relief pro-vided for a given dollar amount of casualtyloss in excess of the 10 percent threshold willbe greater for a higher-income taxpayer thanfor a lower-income taxpayer, due to the dif-ference in their marginal tax rates.

The estimated revenue amounts shown aboveare for revenue reductions associated onlywith the deduction for casualty losses. Therevenue reduction estimates for disas-ter-related losses depend on the type andscope of the disaster, and reflect largercarryback/carryforward deduction allowances.


Page 65

Deduction:

MEDICAL AND DENTAL EXPENSES




(In Millions)

Fiscal Year PIT

1996-97 $110

1997-98 115

1998-99 120

DESCRIPTION

This program allows taxpayers to claim adeduction for specified medical and dentalexpenses related to treatment of the taxpayer,spouse, and dependents, to the extent thatthese expenses exceed 7.5 percent of federaladjusted gross income (AGI) and are notcompensated for by insurance or othermeans.

Qualifying medical expenses include pay-ments for diagnosis, cure, mitigation, treat-ment, or prevention of disease, includingcertain related travel costs and lodging ex-penses. They also include the costs of pre-scription drugs, plus nonprescription insulin.For tax years after 1996, the definition ofmedical care was expanded to include quali-fied long-term care and long-term care insur-ance premiums.

RATIONALE

This program provides tax relief to individu-als who incur nonreimbursed medical ex-penses. The rationale for the program is thatsuch expenses can impose extraordinary andinvoluntary financial burdens. In addition,the program provides some incentive fortaxpayers to seek proper medical attentionand preventive medical care, thereby improv-ing the overall level of public health.


As shown in the accompanying table, thenumber of taxpayers benefitting from medi-

Medical and Dental ExpenseDeduction

1998 Tax Year


Percent of



TotalAmountClaimed

$0-20 12.2% 2.5% $5120-40 33.3 16.8 12440-60 25.6 21.0 20260-80 15.3 17.7 28480-100 6.0 12.6 517100-150 5.4 14.3 654150-200 1.2 7.6 1,500200-250 0.4 2.5 1,500250-500 0.6 4.2 1,667Over 500 0.1 0.8 NA

cal and dental expense deductions is broadlydistributed, but concentrated in the lowerand moderate income categories. Total dollardeductions are also concentrated in thelower-to-middle income categories, with over40 percent of the total deductions going tothose taxpayers earning $60,000 annually or


Page 66

less. The average benefit from the programincreases with income except in the highestincome group.

COMMENTS

Although the basic rationale for this programrelates to the involuntary nature of manymedical expenses, the deduction itself can beclaimed for a variety of expenses that do notnecessarily fall into this category. Such ex-penses include those for rest cures, and otherbasically “optional” expenses, many of whichare not covered under medical insuranceprograms because insurers consider them tobe discretionary.

This program gives rise to a number of eco-nomic side effects and tax-equity consider-ations. For example, because the program

essentially shifts certain health-related ex-penses to the general taxpayer, it provides aform of indirect health insurance to individu-als. Thus, it can give individuals an incentiveto purchase less private health insurance thanthey otherwise might.

The tax subsidy given for a dollar of medicalexpenses also can differ under the program,depending on such factors as a taxpayer'sincome level and amount of total medicalexpenses. For instance, the tax subsidy forlow dollar amounts of medical expenses canbe greatest for certain low-income taxpayers,since the 7.5 percent threshold can disqualifyhigher-income taxpayers from claiming them.On the other hand, the tax subsidy for highdollar amounts of medical expenses can begreatest for higher-income taxpayers, due totheir higher marginal income tax rates.


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Deduction:

CERTAIN TAXES PAID



Authorization: California Revenue and Taxation CodeSections 17201, 17220, and 17222, whichpartially conform to Internal RevenueCode Section 164.

(In Millions)

Fiscal Year PIT

1996-97 $658

1997-98 671

1998-99 706

DESCRIPTIONThis program allows taxpayers to claim anitemized deduction for the amount of certainproperty taxes, vehicle taxes, and other taxespaid to the state and its local governments.Specifically, the program allows a deductionfor: (1) state, local, and foreign real propertytaxes; (2) state and local personal propertytaxes (including only the portion of the statevehicle license fee that does not representannual charges for vehicle registration andvehicle weight); (3) one-half of self-employ-ment taxes; and (4) other state, local, andforeign taxes relating to a trade or business,or to a property held for the production ofincome. Generally, California law is the sameas federal law except that California specifi-cally prohibits the deduction of state, local,and foreign income, war profits, and excessprofits taxes.

RATIONALEThis program provides tax relief under therationale that already-paid taxes reduce theamount of a taxpayer's net income, therebyreducing the taxpayer's ability to pay stateincome taxes. The program also has beenjustified on the grounds that income shouldnot be subject to double taxation by Califor-nia state and local governments.

DISTRIBUTION OF BENEFITSThe largest portion of taxes which is deduct-ible under PIT is the local property tax. Theincome distribution of the deductibility ofproperty taxes is shown in the accompanying

Real Property Taxes Deduction

1998 Tax Year


Percent of



TotalAmountClaimed

$0-20 1.8% 0.2% $1620-40 11.3 3.5 5640-60 21.6 11.9 10260-80 21.6 17.0 14580-100 14.7 15.9 200100-150 16.6 23.2 258150-200 5.0 9.0 331200-250 2.5 5.3 395250-500 3.3 8.8 491Over 500 1.7 5.3 586

table. The program largely benefits middle-income taxpayers, both in terms of the ofnumber of taxpayers benefitting, as well asthe distribution of total deductions. Averagebenefits increase along with income due tothe high correlation between income andhome values.


Page 68

COMMENTSThis program is available only to taxpayerswho claim itemized deductions on their stateincome tax returns. These taxpayers tend tofall disproportionately into moderate-incomeand higher-income brackets. Because of thistendency, along with both the state's gradu-ated marginal tax bracket structure and thepositive relationship between increases in thelevel of taxes paid and income, the tax reliefprovided by this program generally increaseswith income levels.

By allowing deductions for local taxes paid,this program makes it less expensive on anafter-tax basis for individuals to consume agiven level of publically provided services. Itenables individuals living in communitieswith a high appetite for public services toavoid bearing the entire cost of the increase in

taxes necessary to support such services,since a portion of the cost can be offset in theform of lower state income tax liabilities. Thisissue is less important at the state level thanat the federal level, but still has ramificationsfor state fiscal policy.

The federal Budget Reconciliation Act of 1990limited the aggregate amount of itemizeddeductions including this one, which can beclaimed by taxpayers with adjusted grossincome (AGI) over a certain amount, depend-ing on the year involved. This amount was$124,500 in 1998 for joint-return filers and$62,250 for married, filing separately taxpay-ers. California law limits 1998 itemized de-ductions for taxpayers with AGI in excess of$116,777 for single-filers and married taxpay-ers filing separately, and $233,556 for joint-return filers.


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Deduction:

MORTGAGE INTEREST EXPENSES




(In Millions)

Fiscal Year PIT

1996-97 $2,770

1997-98 2,880

1998-99 3,030

DESCRIPTION

This program generally allows taxpayers todeduct the amount of qualified mortgageinterest expenses paid or accrued within ataxable year. Qualified mortgage interestincludes interest on indebtedness secured bya taxpayer's residence, including interestincurred in acquiring, constructing, substan-tially improving, or refinancing the residence.Interest on indebtedness to purchase secondhomes and vacation homes, and interest onhome-equity borrowing, also qualify for thededuction. The aggregate amount of indebt-edness incurred to purchase, construct, orimprove a home may not exceed $1 million(or $500,000 for a married individual filing aseparate return). The total amount of intereston a home-equity loan generally may notexceed interest on indebtedness of more than$100,000 (or $50,000 for a married taxpayerfiling a separate return).

RATIONALE

This program provides an incentive for homeownership. This is because most home pur-chases require mortgage financing, and thisdeduction reduces the net after-tax costs ofsuch borrowing. It often is claimed that homeownership is worth encouraging on thegrounds that it generates substantial publicbenefits, including neighborhood stability,

promotion of civic responsibility, and encour-agement of proper maintenance of residentialstructures by occupants.


The accompanying table indicates by incomeclass the distribution of the mortgage interestdeduction. The program provides a substantial

Mortgage Interest ExpenseDeduction

1998 Tax Year


Percent of



TotalAmountClaimed

$0-20 2.2% 0.3% $10420-40 12.7 3.9 26640-60 22.9 12.8 48160-80 21.0 18.2 74580-100 14.2 16.7 1,020100-150 15.7 23.8 1,307150-200 4.7 8.9 1,642200-250 2.3 5.1 1,925250-500 3.0 7.6 2,179Over 500 1.4 2.9 1,760

proportion of benefits to middle and upper-middle income classes, with over 70 percentof total deductions accruing to taxpayers


Page 70

earning between $40,000 and $150,000 annu-ally. The average benefit increases with in-come for all but the highest income class. Thelatter is due to a decline in the prevalence ofmortgages in this income class, as well as theeffect of limitations on itemized deductions.

COMMENTS

One of the side-effects of this program is thatit encourages consumers to finance theirhomes and other purchases through borrow-ing, even if their income level is high enoughto avoid the need to do so. In this sense, somemight argue that the program provides someincentive for “over-borrowing.” The programalso encourages taxpayers to increase theamount they spend on housing because itreduces the after-tax costs of such expendi-tures. In addition, the program dispropor-tionately benefits higher-income individuals,who are most likely to purchase their ownhomes. Higher-income individuals also real-ize greater tax savings for a given dollaramount of interest deductions due to theirhigher marginal income tax rates.

It should be noted that the federal BudgetReconciliation Act of 1990 placed additionallimitations on the aggregate amount of item-ized deductions (including this one) whichcan be claimed by a taxpayer with adjustedgross income (AGI) over a specified amount.California law also has limits on the aggre-gate amount of deductions which may beclaimed by taxpayers. These limits are dis-cussed under the program entitled,“Certain Taxes Paid.”

We previously reviewed the economic andfiscal effects of this program (see LegislativeAnalyst's Report on the 1988-89 Tax Expendi-ture Budget: Overview and Selected Reviews, andThe Personal Income Tax Itemized Deduction forMortgage Interest Expenses). Our major find-ings, which we believe still are applicable,were that although the program is at leastpartially successful in enabling certain tax-payers to buy homes, it is relatively ineffi-cient. For example, the interest rate subsidiesmade available under the program provide“windfall” benefits to many taxpayers whowould have purchased homes in the absenceof the program, and encourage certain indi-viduals to over-consume housing by buyingbigger and more expensive homes than theyotherwise would. The result may be that thisprogram, coupled with other programs grant-ing housing preferential treatment,results in a misallocation of resources. Reduc-ing, but not eliminating, subsidies for hous-ing could result in a more efficient allocationof resources while still preserving the socialbenefits that result from home ownership.

Given these findings, we previously haverecommended that the Legislature considerthe following options: (1) limit the amount ofmortgage interest which may be deducted,(2) eliminate or limit the deduction for secondhomes and nonhousing expenses, (3) convertthe current deduction into a maximum taxcredit that reduces the overall regressivity ofthe derived tax benefit from the program andpotentially reduces its revenue effect, and(4) use the savings from “tightening up” eli-gibility under this program to provide addi-tional subsidies targeted at low-incomehouseholds and first-time home buyers.


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Deduction:

CHARITABLE CONTRIBUTIONS



Authorization: California Revenue and Taxation CodeSections 17201, 17251.5, 17275.5,18648.5, 24344, and 24357 through24359.1 which especially conform toInternal Revenue Code Section 170.

(In Millions)

Fiscal Year PIT BCT

1996-97 $740 $39

1997-98 750 40

1998-99 810 41

DESCRIPTION

This program allows taxpayers to deduct cashand specified noncash contributions to charities,religious organizations, governmental bodies,and other qualifying nonprofit organizations.The itemized deduction for PIT taxpayers isgenerally limited to 50 percent of adjusted grossincome (AGI). The deduction available underBCT law may not exceed 10 percent of Californiataxable income. Contributions that exceed thesepercentage limitations may be carried forwardfor use in future tax years for up to five years.

RATIONALE

This program provides an incentive for tax-payers to donate cash, property, or services toqualifying charitable organizations. It doesthis by reducing the net after-tax cost to thegiver making a contribution. The underlyingrationale for the program is that qualifyingcharitable organizations provide sociallybeneficial services which are viewed as beingworthy of indirect state financial support.


Charitable contributions are a flexible expen-diture for many taxpayers, especially those in

the higher-income categories. The concentra-tion of the benefits of this program in thehigh income categories is shown in the ac-companying figure. For example, over

Charitable Contributions Deduction

1998 Tax Year


Percent of



TotalAmountClaimed

$0-20 1.8% 0.3% $3120-40 12.0 3.4 6740-60 21.8 9.4 10160-80 21.4 13.1 14380-100 14.5 12.5 201100-150 16.4 18.9 268150-200 4.9 7.7 364200-250 2.4 4.5 440250-500 3.2 9.7 699Over 500 1.7 20.5 2,879

40 percent of the deductions claimed are bythose taxpayers earning at least $150,000 perannum, with over 20 percent by those earn-ing $500,000 or more. The average deductionfor those in the highest income class is morethan four times as large as that for the nexthighest income class.


Page 72

COMMENTS

One effect of this program is that, for PITtaxpayers, the state government providesdonors with a subsidy that, per dollar of do-nation, increases in value as the donor's mar-ginal income tax bracket rises. Economists

widely agree that permitting a deduction forcharitable contributions tends to stimulatethe volume of charitable donations, althoughthere are differences of opinion regarding theexact nature and magnitude of this response.


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Deduction:

CONTRIBUTIONS OF COMPUTERS AND SCIENTIFIC

EQUIPMENT TO EDUCATIONAL INSTITUTIONS



Authorization: California Revenue and Taxation CodeSections 24357 and 24357.9.

(In Millions)

Fiscal Year BCT

1996-97 NA

1997-98 NA

1998-99 $4

DESCRIPTION

This program allows corporations to claim alarger-than-normal deduction for contribu-tions of computers, software, and scientificequipment to institutions of higher educa-tion. The deduction is equal to the lesser of:(1) the taxpayer's “basis” in the equipment,plus one-half of the difference between thisbasis and the equipment's market value; or(2) twice the taxpayer's basis in the equip-ment. For example, if a computer manufac-turer donated two computers and a printer toa community college with a total productioncost of $500,000 and a market value of$800,000 under this program, the companycould have claimed a deduction of $650,000($500,000 for the depreciable basis plusone-half of $300,000). Without this program,

the deduction would have been limited to$500,000.

RATIONALE

This program provides companies with anincentive to donate computers, computersoftware, and other scientific equipment tocolleges and universities. The view was thatthese donations would enhance student per-formance at less cost than if the equipmentwas directly provided by the government.

COMMENTS

This program, which was originally sched-uled to sunset was continued in conformitywith federal tax provisions pursuant to Chap-ter 322, Statutes of 1998 (AB 2797, Cardoza).


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Deduction:

CONTRIBUTIONS MADE THROUGH

TAX RETURN “C HECKOFFS”


Tax Type: Personal Income Tax (PIT)


(In Millions)

Fiscal Year Amount

1996-97 Minor

1997-98 Minor

1998-99 Minor

DESCRIPTIONThis program allows taxpayers to make cer-tain tax-deductible contributions simply bydesignating a specific contribution amountfor one or more specified purposes on theirstate income tax return.

The recipient programs to which such taxdeductible “check-off” contributions may bedesignated under this provision include:

• California Fund for Senior Citizens.

• California Seniors’ Special Fund.

• Endangered and Rare Fish Fund.

• Wildlife and Plant Species Conserva-tion and Enhancement Account (in theFish and Game Preservation Fund).

• State Children’s Trust Fund.

• Alzheimers’ Disease and RelatedDisorders Research Fund.

• California Breast Cancer Research Fund.

• California Public School Library Pro-tection Fund.

• California Firefighters’ Memorial Fund.

• California Drug Abuse ResistanceEducation Fund (D.A.R.E.).

• California Military Museum Fund.

RATIONALEhis program provides an incentive for taxpay-ers to make donations to specified programs.The underlying rationale for this is that theseprograms are socially beneficial, and viewedas deserving of governmental encouragementand financial support.

COMMENTSThese check-off contributions on state taxreturns are deductible on federal income taxreturns as itemized charitable deductionsbecause they are contributions to a state gov-ernment. For state income tax purposes, thisprogram provides that they are deductiblecharitable contributions on the income taxreturn for the year in which the check-offcontributions were made.


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Deduction:

EMPLOYEE BUSINESS AND MISCELLANEOUS EXPENSES



Authorization: California Revenue and Taxation CodeSections 17072,17076, 17201, 17269,and 17270, which partially conform toInternal Revenue Code Sections 67, 68,162, and 212.

(In Millions)

Fiscal Year PIT

1996-97 $400

1997-98 420

1998-99 450

DESCRIPTION

This program allows a taxpayer to deductfrom gross income a portion of certainunreimbursed expenses. These include:

• Business expenses, including travel,meals, entertainment, and lodging.

• Miscellaneous expenses related to:(1) producing or collecting taxableincome; (2) management, conserva-tion, or maintenance of income-pro-ducing property; and (3) tax returnpreparation fees.

Generally, a taxpayer may claim a deductionfor 50 percent of meal and entertainmentexpenses to the extent that this 50 percentamount exceeds 2 percent of the taxpayer'sfederal adjusted gross income (AGI). Prior to1995, taxpayers could deduct 80 percent ofmeals and entertainment expenses—a per-centage that was reduced pursuant to Chap-ter 881, Statutes of 1993 (SB 671, Alquist).

RATIONALEThis program provides tax relief to employ-ees on the grounds that qualifying expendi-tures are a direct cost of earning income and,therefore, should be deductible.

DISTRIBUTION OF BENEFITSThis program is used by all income groups,but most heavily by those in the middle-in-come categories. Over three-quarters of tax-payers benefitting from the deduction earn$100,000 annually or less. In terms of benefitdollars, however, these taxpayers receiveonly about half of the deductions claimed.

Employee Business andMiscellaneous Expense Deduction

1998 Tax Year


Percent of



TotalAmountClaimed

$0-20 2.1% 0.4% $7720-40 12.5 5.1 15340-60 24.1 15.1 23560-80 22.7 18.1 29880-100 14.6 15.4 393100-150 15.5 22.6 546150-200 3.9 7.9 755200-250 1.7 3.4 762250-500 2.2 6.2 1,074Over 500 0.9 5.8 2,455


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COMMENTSThis program provides an incentive for em-ployers to require, and employees to be will-ing to incur, certain job-related expenses.For example, the program increases the likeli-hood that an employee will be willing topay his/her own way to a business confer-ence, particularly if the conference is of per-sonal interest because of its location or theprofessional opportunities it offers.

Federal and California tax law place addi-tional limitations on the aggregate amount ofdeductions, such as this one, which can beclaimed by a taxpayer with AGI over a speci-fied amount. These income limits are dis-cussed under the section regarding the de-duction for “Certain Taxes Paid.”


Page 77

Deduction (Accelerated Depreciation):

AMOUNTS IN EXCESS OF STRAIGHT-LINE



Authorization: California Revenue and Taxation CodeSections 17201, 24349, and 24354.1,which generally conform to InternalRevenue Code Sections 167 and 168.

(In Millions)

Fiscal Year PIT BCT

1996-97 $287 NA

1997-98 294 NA

1998-99 305 NA

DESCRIPTION

Depreciation deductions enable taxpayers torecover their investments in income-produc-ing assets, such as equipment and buildings,over specified periods of time. This programallows taxpayers to claim depreciation deduc-tions in excess of “straight- line” depreciationon physical assets that are used in the pro-duction of income. Under the traditionalstraight-line depreciation method, a prop-erty's value is depreciated evenly over itsuseful economic life span.

Under this program, several more-generousaccelerated depreciation methods are allowed.The permitted methods vary, depending onthe type of property involved and when it isplaced in service. These alternative methodsinclude: (1) 200 percent, 150 percent, and125 percent declining-balance methods; (2) thesum-of-years-digits method; and (3) other meth-ods, such as the sinking-fund method.

Accelerated depreciation methods enabletaxpayers to recover the costs of replacingtheir income-producing capital assets soonerthan they otherwise would, through the de-ferral of tax liabilities, and thereby realize anincreased rate of return on investments. Forexample, if a machine purchased for $20,000

had a useful life of 20 years and a salvagevalue of $2,000 after this period of time, un-der the straight-line method, the taxpayercould claim a depreciation deduction of $900per year.

In contrast, under the 200 percent decliningbalance method, the taxpayer could claim anannual depreciation allowance twice thepercentage amount permitted under thestraight-line method. Thus, the first year'sdepreciation allowance for this propertywould be $1,800.

RATIONALE

By enabling taxpayers to defer some of theirtax liabilities, the program provides an incen-tive for taxpayers to invest in income-produc-ing assets. This is due to the fact that the de-ferral of tax liabilities amounts to an inter-est-free loan from the government, whichincreases the rate of return on capital invest-ments. In addition, such tax deferments re-duce investment payback periods, thus im-proving the financial liquidity of investors.Another rationale for the program is that itcompensates property owners for the failureof the tax code to adjust the depreciable basisof property upward over time for the effectsof inflation.


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COMMENTS

Estimated revenue reductions for PIT underthe accelerated depreciation program are forequipment and property (including rentalproperty) and are based on federal estimatesadjusted for California. The BCT estimatesare not provided since comparable federaldata are not available and since Californiahas not fully conformed to the modified ac-celerated cost recovery system (MACRS) fordepreciation.

In theory, depreciation allowances are in-tended to permit taxpayers to deduct the trueeconomic costs of using assets that are in-curred in the production of their income.Another way of looking at this is that depre-ciation allowances compensate taxpayers forthe loss in productive capability of their in-come-producing property as it ages, so that,at the end of the property's life, the accumu-lated depreciation benefits permit it to bereplaced. The revenue reductions associated

with this program are based on the cost ofallowable depreciation above and beyondthat allowed under the straight-line method.

From a pure economic perspective, however,the technically correct measure of deprecia-tion-related tax expenditure costs is theamount by which actual depreciation claims(however computed) exceed pure economicdepreciation (that is, the decline in physicalproductivity of an asset) over time. This tech-nically correct tax expenditure amount islikely to be less than that reported above,because the tax code does not adjust the de-preciable basis of property for inflation.Many view the mid-point asset depreciationrange (ADR) system based on 150 percentdeclining balance depreciation as a reason-able approximation of the economic life ofcorporate capital investment. The ADR sys-tem was used for federal purposes between1971 and 1980, and assigned particularclasses of assets with a prescribed useful life.


Page 79


POLLUTION CONTROL EQUIPMENT



Authorization: California Revenue and Taxation CodeSections 17250 and 24372.3, which gen-erally conform to Internal Revenue CodeSection169.

(In Millions)

Fiscal Year PIT BCT

1996-97 — NA

1997-98 — NA

1998-99 — NA

DESCRIPTION

This program allows taxpayers to depreciatethe cost of pollution control facilities over a60-month period, as opposed to a 10-yearperiod which would otherwise apply. Quali-fying facilities must be located within Califor-nia and be appropriately certified by the Cali-fornia Air Resources Board or the State WaterResource Control Board.

RATIONALE

This program provides tax relief for busi-nesses that are required by federal, state,and/or local regulations to install pollutioncontrol equipment. This tax relief takes theform of allowing taxpayers to, in effect, defersome of their tax liabilities by giving themlarger depreciation write-offs during the

early years following an investment in quali-fying pollution control equipment. This taxdeferral amounts to an interest-free loan fromthe government, which, in turn, increases thefinancial ability of taxpayers to make suchrequired investments.

COMMENTS

Revenue estimates for this program are basedon federal sources. The PIT revenue reduc-tions stemming from this program are in-cluded in the revenue reduction estimates inthe earlier section “Amounts in Excess ofStraight-Line.” The BCT estimates are notprovided due to the absence of comparablefederal data upon which to base the estimates.


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REFORESTATION EXPENDITURES



Authorization: California Revenue and Taxation CodeSections 17201, 17278.5, and 24372.5,which partially conform to Internal Reve-nue Code Section 194.

(In Millions)

Fiscal Year PIT BCT

1996-97 NA NA

1997-98 NA NA

1998-99 NA NA

DESCRIPTION

This program allows PIT and BCT taxpayersto amortize over a seven-year period up to$10,000 per year of certain qualifying refores-tation expenditures. Qualifying expendituresinclude the direct costs of forestation andreforestation, including site preparation,seeds or seedlings, labor, and equipmentcosts.

RATIONALE

This program apparently is intended to givetaxpayers an incentive to reforest privatelands where logging and timber-related activ-ities have depleted available stocks of timber.Thus, the program provides an incentive forincreasing the future supply of harvestabletimber. It accomplishes this by permittingtaxpayers to recover their capital costs more

quickly, thereby deferring tax liabilities. Thetax deferral amounts to an interest-free loanfrom the government, which, in turn, in-creases the rate of return on such invest-ments. Rapid amortization for activities withlengthy payoff periods, such as reforestation,also dramatically improves the cash-flowposition of investors, and thus, their financialliquidity.

COMMENTS

California law is the same as federal law withthe following modification: effective fortaxable years beginning after 1996, Californialaw limits the tax deduction to expensesassociated with qualified timber located inCalifornia. In contrast, for income yearsbeginning before 1997, there was no limita-tion as to where the timber property had tobe located.


Page 81


PROPERTY USED IN ECONOMICALLY

DEPRESSED AREAS



Authorization: California Revenue and Taxation CodeSections 17266, 17267.6, 17268, 18036,24356.4, and 24356.8.

(In Millions)

Fiscal Year PIT BCT

1996-97 NA NA

1997-98 NA NA

1998-99 NA NA

DESCRIPTION

This program allows taxpayers to claim accel-erated depreciation write-offs for certainqualified business property used in desig-nated economically depressed areas of thestate, including an Enterprise Zone, LocalAgency Military Base Recovery Area(LAMBRA), Targeted Tax Area, and the LosAngeles Revitalization Zone (LARZ). In gen-eral, the program permits a taxpayer to “ex-pense” (that is, immediately deduct as a cur-rent business-related expense) a certain por-tion of the costs of these types of property.Sunset dates under two components of theprogram are January 1, 1998 (LARZ) andJanuary 1, 2003 (LAMBRA).

RATIONALE

This program provides an incentive for tax-payers to make business investments in eco-nomically depressed areas of the state. It doesthis by enabling taxpayers to use expensingto defer tax liabilities. This deferral amountsto an interest-free loan from the government,which, in turn, increases the rate of return ontaxpayers' investments and improves theircash-flow position. The underlying rationalefor this program is that the stimulation ofinvestments in economically depressed areascan lead to improved economic conditions.

This in turn, can result in various social bene-fits, including reduced state costs for unem-ployment and welfare benefits.

COMMENTS

Taxpayers are permitted to expense a certainportion of the cost of qualified property un-der this program, depending upon the type ofarea. In the case of property located in a Tar-geted Tax Area (for taxable years beginningafter 1997), or Enterprise Zone (for taxableyears after 1996), a taxpayer can expense40 percent of the cost of the property subjectto a dollar limit of $100,000 in years one andtwo of the area's designation, $75,000 in yearsthree and four, and $50,000 thereafter. Theremaining 60 percent of a property's depre-ciable basis is subject to being written-offusing standard depreciation options.

In the case of property located in a LAMBRA,for taxable years beginning after 1994 butbefore 2003, taxpayers may elect to expense aportion of the cost of qualifying property. Thecost that may be taken into account is $5,000for the first two years following designationas a LAMBRA, $7,500 for the second andthird taxable years after designation, and$10,000 for every year thereafter.


Page 82

In the case of property located in LARZ, fortaxable years beginning after 1991 and before1998, the taxpayer may elect to expense prop-erty purchased for exclusive use in a trade orbusiness located within the zone.

In each case, the expensing deduction is re-captured (included in income) if the propertyceases that is, to be used in the designatedarea at any time before the close of the secondtaxable year after the property was placed inservice.


Page 83


AGRICULTURAL COSTS



Authorization: California Revenue and Taxation CodeSections 17201, 24369, and 24377,which conform to Internal Revenue CodeSections 175 and 180.

(In Millions)

Fiscal Year PIT BCT

1996-97 $7 $7

1997-98 7 7

1998-99 7 8

DESCRIPTION

This program allows taxpayers to “expense”(that is, immediately deduct as a current busi-ness-related expense) soil, water conserva-tion, and fertilizer expenditures, up to a max-imum of 25 percent of their gross incomefrom farming. Any qualified expenses inexcess of the 25 percent limitation, however,may be carried forward and expensed infuture years. In the absence of this program,the qualifying expenditures would be consid-ered capital expenditures to be written off.

RATIONALE

This program provides a tax incentive toencourage certain types of farming-relatedconservation investments, particularly thosewith lengthy developmental and paybackperiods. The program accomplishes this byallowing very rapid cost write-offs that, ineffect, permit the deferral of taxes on farmingincome. This amounts to an interest-free loanfrom the government, which in turn, raisesthe rate of return on qualifying investments

and shortens their payback periods. The pro-gram also has been rationalized as a way ofsimplifying record-keeping for small farmingbusinesses.

COMMENTS

Qualifying expenditures include those for:the treatment or moving of earth (includingleveling, grading, furrowing, and otherimprovements); the fertilization of land; theconstruction of water channels, drainageditches, and similar water conservationprojects; the eradication of brush; and theplanting of windbreaks.

The federal 1986 Tax Reform Act restricted ataxpayer’s ability to expense agriculturalcosts for federal tax purposes to those expen-ditures which are consistent with a soilconservation plan approved by the SoilConservation Service of the Department ofAgriculture. California has adopted theselimitations as well.


Page 84


EMPLOYER-PROVIDED RIDESHARING PROGRAM COSTS



Authorization: California Revenue and Taxation CodeSections 17090, 17149, and 24343.5.

(In Millions)

Fiscal Year PIT BCT

1996-97 NA NA

1997-98 NA NA

1998-99 NA NA

DESCRIPTIONThis program allows taxpayers to “expense”(that is, immediately deduct as a current busi-ness-related expense) costs associated withproviding ridesharing programs for employ-ees. The deduction covers a taxpayer's ex-penses to provide for: company commutervans or bus service to employees; subsidizingemployee commuting expenses in third-partyvanpools, private commuter buses, or sub-scription taxipools; free parking facilities forcarpools; and certain other ridesharing pro-grams. In addition, taxpayers are allowed anaccelerated (36-month) depreciation deduc-tion for costs of facility improvements foremployee ridesharing, bicycling, and walkingprograms.

RATIONALEThis program provides an incentive for em-ployers to establish ridesharing programsfor their employees. It does this by allowingemployers to partially offset their costs forsponsoring such programs by deferring taxpayments. The program is based on the argu-ment that state tax incentives are needed toencourage employees and employers to useridesharing programs so as to alleviate trafficcongestion, reduce air pollution, and reducegasoline consumption.

COMMENTSIt is possible that certain noncapitalridesharing expenses, such as subsidies formonthly transit passes, may be deductible bythe employer as a business expense, evenwithout this program. This is because an em-ployer may consider such expenses to be“ordinary and necessary” in some situationsand therefore deductible as a regular businessexpense. Thus, in some cases, employersbenefit from the program only to the extentthat it allows them to recover their costs forcapital-related ridesharing expenditures(such as for vehicles and facilities) over ashorter- than-normal time period.

The argument traditionally put forth in ex-plaining this type of program revolvesaround achieving the optimal amount ofdriving by individuals. Because of the socialcosts associated with car travel (like air andnoise pollution), individuals do not bear theentire costs of car transportation. As a result,an over-consumption of car travel by individ-uals may occur. By lowering the costs of ride-sharing and other related policies, this pro-gram makes alternative forms of transporta-tion more attractive, leading to an increase inparticipation. Proponents argue that the re-sult of such intervention is a decrease in con-gestion and a more efficient deployment oftransportation-related economic resources.


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EXPLORATION, DEVELOPMENT,RESEARCH, AND EXPERIMENTAL COSTS



Authorization: California Revenue and Taxation CodeSections 17201, 17260, 17681, 24423,and 24365, which generally conform toInternal Revenue Code Sections 174, 193,and 263A.

(In Millions)

Fiscal Year PIT BCT

1996-97 $7 $81

1997-98 10 87

1998-99 10 93

DESCRIPTION

This program allows taxpayers to either “ex-pense” (that is, immediately deduct as a cur-rent business-related expense) or amortizemore rapidly the costs of (1) research or ex-perimental activities, and (2) qualified min-ing-related exploration and developmentcosts for mines and mineral deposits.

Qualified expenditures associated with re-search and experimental activities may be eitherdeducted currently or amortized over a 60-month period at the election of the taxpayer.The option to immediately deduct versusamortize research and experimental expendi-tures applies only to expenditures that aredeemed reasonable.

Qualified exploration and development activitiesmay be either expensed or, for developmentactivities only, amortized at the taxpayer’selection. Exploration expenses are those paidprior to the development period. Developmentexpenses are those that are incurred after theexistence of ores or minerals in commercially

marketable quantities has been established. Ifamortization is chosen over expensing, thismust occur over a 10-year period.

RATIONALE

This program provides an incentive for tax-payers to undertake research and experimen-tal projects, and to locate and recover miner-als from the earth, by enabling them to more-quickly deduct their associated costs. Thisfaster deduction, in effect, enables taxpayersto defer their taxes. The tax deferral amountsto an interest-free loan from the government,which, in turn, raises the real rate of return onqualifying expenditures and improves thetaxpayer's cash-flow position.

The underlying rationale for the program isthat research and experimental projects, andexploration and development activi-ties—while often of great long-term impor-tance to the state and its citizens—are inher-ently risky, and often do not generate anyincome for the taxpayer until a considerableperiod of time has passed.


Page 86


CIRCULATION COSTS FOR PERIODICALS



Authorization: California Revenue and Taxation CodeSections 17201 and 24364, whichconform to Internal Revenue CodeSection 173.

(In Millions)

Fiscal Year PIT BCT

1996-97 $2 $2

1997-98 2 2

1998-99 2 2

DESCRIPTION

This program allows taxpayers to “expense”(that is, deduct immediately as a current busi-ness-related expense) costs for establishing,maintaining, or increasing the circulation ofa periodical. Alternatively, the program al-lows such costs to be amortized over athree-year period. In the absence of this pro-gram, these costs would have to be capital-ized, and then amortized over whatever pe-riod of time the taxpayer was able to deter-mine that the expenditure resulted in in-creased income.

Suppose for example, that a taxpayer spends$100,000 for advertising and promotionalactivities during the current year in order toincrease over the next five years the circula-tion of a magazine the taxpayer publishes.This program allows the taxpayer to deductthe entire $100,000 as an expense on his orher current-year tax return or, if the taxpayerprefers, deduct it over a three-year period—

as opposed to having to spread the $100,000deduction over five years.

RATIONALE

The rationale for this program appears to beadministrative in nature, and relates to thedifficulty of identifying exactly when thebenefits of circulation-related expenses arerealized. In principle, these costs should bedeductible when the benefits they generateare experienced in the form of increased in-come. In practice, however, it often is difficultto determine which individual periodicalsubscriptions result from advertising or pro-motional expenses, including how to treatmultiple renewals of subscriptions over time.For this reason, it is simpler from a tax ad-ministration perspective not to require tax-payers to capitalize their costs, but rather toallow taxpayers to deduct them either imme-diately or over a fairly moderate, specifiedtime period.


Page 87


SMALL BUSINESS EXPENSING



Authorization: California Revenue and Taxation CodeSections 17201 and 17255, which gener-ally conform to Internal Revenue CodeSection 179(b)(1).

(In Millions)

Fiscal Year PIT

1996-97 $2

1997-98 5

1998-99 11

DESCRIPTION

This program permits small businesses toexpense rather than depreciate up to a specifiedamount of business personal property ac-quired each year. For 1997, the maximumexpensing allowed was $13,000. This amountwill increase to $16,000 for 1998 andincrementally thereafter until it reaches$25,000 in 2003. However, the expensingdeduction cannot exceed the taxable incomederived from the associated trade or businessduring the tax year involved. This programdoes not apply to C corporations, but doesapply to most small businesses (partnerships,proprietorships, limited liability corporations,and S corporations).

RATIONALE

This program provides tax relief to smallbusinesses for the purchase of business per-sonal property (such as adding machines,furniture, and computers). It accomplishes

this by allowing businesses to offset theircosts by deferring tax payments. The tax de-ferral amounts to an interest-free loan fromthe government, which in turn improves thetaxpayer’s cash-flow situation and rate ofreturn.

COMMENTS

For 1997, the federal government allowedtaxpayers to expense up to $18,000 of busi-ness personal property. Beginning in 1998,this amount is scheduled to incrementallyincrease until the year 2003, when the annualexpensing limit will be $25,000. For bothfederal and California purposes, the deduc-tion under this program is reduced (but notbelow zero) by the excess of the total invest-ment in qualified property over $200,000 in agiven tax year. The excess of the deductionover otherwise-allowable depreciation isrecaptured if the property ceases to be usedpredominantly in the particular trade orbusiness before the end of its recovery period.


Page 88

Deduction:

CARRYFORWARD OF NET OPERATING LOSSES



Authorization: California Revenue and Taxation CodeSections 17041, 17276 through 17276.3,24416, 24416.1 through 24116.3, 25108,and 25110, which partially conform toInternal Revenue Code Section 172.

(In Millions)

Fiscal Year PIT BCT

1996-97 $97 $360

1997-98 102 365

1998-99 90 375

DESCRIPTION

General Provisions. This program generallyallows taxpayers to carryforward, for up tofive years, a portion of their net operatinglosses (NOLs). Generally, most businessesmay carryforward 50 percent of their “ex-cess” net operating losses in any given year(that is, the unrecovered losses that exceedtheir taxable incomes in that year) to offsettheir income in the following five years, andthereby reduce their cumulative state taxliabilities. For an NOL incurred prior to Au-gust 6, 1997, a 15-year carryover is permitted.

Extensions to the carryover period are avail-able for NOLs incurred prior to or during1991 and 1992, when NOL deductions weretemporarily suspended due to state budget-ary problems associated with the early-1990s’recession. Additional restrictions on NOLdeductibility apply to water’s-edge corpora-tions and those taxpayers subject to incomeallocation and apportionment. Californiadoes not allow NOL carrybacks (that is, theapplication of deductions to a previous year’sincome), unlike treatment under the parallelfederal program.

Special Provisions. Special rules apply to

NOLs incurred by small businesses, newbusinesses, bankrupt taxpayers, and busi-nesses operating in an Enterprise Zone, theLos Angeles Revitalization Zone (LARZ), ora Local Agency Military Base Recovery Area(LAMBRA). Businesses operating in Enter-prise Zones, the LARZ, or LAMBRAs maycarryforward 100 percent of their net operat-ing losses for 15 years, and use them to offsetincome earned in future years attributable tothose designated areas. Under certain circum-stances, 100 percent carryover also is avail-able to small and new businesses, but withtruncated carryover periods. For bankrupttaxpayers, a ten-year carryover period ap-plies.

Example. Consider a business that incurs anexcess net operating loss of $70,000 duringone tax year. If the business earns a net profitof $25,000 in the second year and $40,000 inthe third year, under this program using a50 percent carryforward, the taxpayer canapply $25,000 in losses to the second-yearprofits, thus completely eliminating his taxliability in that year. In addition, the $10,000in net operating losses “left over” can beapplied to the third-year profits, reducing histaxable income in that year to $30,000.


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RATIONALE

This program is intended to provide tax relieffor businesses that incur operating losses. Inaddition, it is an attempt to recognize that ataxable year is an arbitrary period of timewith respect to measuring income and losses.For example, a firm might incur expenses inan early year (that result in net operatinglosses), in order to produce income (resultingin profits) in a later year. From an economicperspective, these losses and profits are re-lated, and basing the firm's tax only on itsreported net profits in individual years, butnot accounting for loss years, overstates thenet economic income resulting from the in-vestment for the period as a whole.

The tax benefits associated with carryforwardof net operating losses is heavily weightedtowards smaller business in terms of the pro-portion of those claiming the deduction.Figure 1 below indicates that almost three-quarters of those claiming the deduction arefrom businesses with total receipts of lessthan $1 million. Total benefits are moreevenly distributed across all sizes of industry,although a large proportion goes to busi-nesses with total receipts of $1 billion ormore. Figure 2 shows the distribution ofbenefits according to type of industry.


The tax benefits associated with carryforwardof net operating losses is heavily weightedtowards smaller business in terms of the pro-portion of those claiming the deduction. Fig-ure 1 below indicates that almost three-quar-ters of those claiming the deduction are frombusinesses with total receipts of less than$1 million. Total benefits are more evenlydistributed across all sizes of industry, al-though a large proportion goes to businesseswith total receipts of $1 billion or more. Fig-ure 2 shows the distribution of benefits ac-cording to type of industry.

Figure 1

Carryforward of Net OperatingLosses Deduction by Receipt

1998 Income Year


Percent of


TotalAmountClaimed

Under $1 73.0% 10.6%1–10 20.9 17.510–50 4.1 15.150–100 0.4 7.2100–500 1.2 18.3500–1,000 0.2 5.0Over 1,000 0.3 26.3

Figure 2

Carryforward of Net OperatingLosses Deduction by Industry

1998 Income Year

Industry Type

Percent of

GrossState

Product


TotalAmountClaimed


3.0% 2.2% 1.9%


25.9 18.7 29.1


8.2 2.1 8.0

COMMENTS

For federal tax purposes, a 100 percentcarryforward of NOLs for 20 years is permit-ted along with a two-year carryback. Thecarrybacks must be applied, when possible,before any carryforward is allowed.


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Deduction:

PERCENTAGE RESOURCE DEPLETION ALLOWANCE



Authorization: California Revenue and Taxation CodeSections 17681, and 24831 through24833.

(In Millions)

Fiscal Year PIT BCT

1996-97 $10 $25

1997-98 10 30

1998-99 10 30

DESCRIPTION

This program allows taxpayers to claim afixed percentage deduction for resource de-pletion, which generally proves to be in ex-cess of the deduction amount that otherwisewould be allowed under the normalcost-depletion method. Under the program, aspecified percentage of gross income (de-pending on the type of resource involved)may be deducted as a depletion allowance,except that this depletion amount cannotexceed 50 percent of a taxpayer's related netincome before applying the depletion deduc-tion, or 100 percent in the case of oil and gasproperties.

California conforms to federal tax law regard-ing the percentage depletion for oil and gaswells, and for geothermal deposits. Depletionrates are limited to: (1) 22 percent for regu-lated domestic natural gas; (2) 10 percent fornatural gas from geopressurized brine;(3) 15 percent for domestic crude oil and nat-ural gas from certain independent producers;and (4) 15 percent for geothermal depositslocated in the U.S. California also adoptsfederal percentage depletion provisions fordepletable assets other than oil, gas, and geo-thermal deposits, and with regard to naturalresources located in continental shelf areas.

Under this program, a taxpayer who ownsand operates a natural gas well that pro-duces, for example, $100,000 in gross income,is allowed to claim a deduction for 22 percentof this amount ($22,000). This deduction isintended to offset the physical and economicresource costs associated with depleting theoil reserves in the well.

RATIONALE

This program provides an incentive for tax-payers to explore for and develop oil, gas,and other mineral resources. The underlyingrationale for the program is that such activi-ties can be extremely costly and inherentlyrisky.

COMMENTS

The term “percentage depletion” differs from“cost depletion.” Cost depletion allows for therecovery of the initial costs of discovering,purchasing, and developing mineral reservesover the period during which a reserve pro-duces income. Each year the taxpayer de-ducts the portion of the cost that is propor-tional to the fraction of the resource reservethat has been depleted in that year. Thus,under cost depletion, the amount of cost re-covered through depletion allowances cannotexceed the original cost of acquiring anddeveloping the reserve.


Page 91

In contrast, under the percentage depletionmethod, a taxpayer deducts a fixed percent-age of gross income from the reserve as a de-

pletion allowance, regardless of the amountactually invested.


Page 92

Deduction:

RESERVE ALLOWANCE FOR BAD DEBTS



Authorization: California Revenue and Taxation CodeSection 24348, which generally conformsto Internal Revenue Code Section 166.

(In Millions)

Fiscal Year BCT

1996-97 NA

1997-98 NA

1998-99 NA

DESCRIPTION

This program allows financial institutions toelect to use the “reserve allowance” for de-ducting their losses from bad debts. Underthis method, a deduction is allowed for areasonable addition to what is known as a“bad debt reserve account.” These are ac-counts set up by the taxpayer as an allowanceagainst the possibility that some debts maybe uncollectible. The amount allowed in theaccount is generally based on the taxpayer'spast experience with bad debts.

During a given year, debts that becomeuncollectible are charged against a taxpayer'sbad debt reserve, which reduces the balancein the reserve. The taxpayer makes additionsto the reserve account to (1) offset the amountof bad debts which have been charged offand (2) allow for future bad debt charge-offs(attributable to increases in accounts receiv-ables). The deduction is allowed for both ofthese kinds of additions to a bad debt reserve.In the absence of the program, the taxpayerwould be required to use the “specificcharge-off method,” under which the tax-payer would deduct bad debts only whenthey are found to be uncollectible.

RATIONALE

This program provides tax relief to financialinstitutions that incur bad debts, to the extentthat it allows them to claim a deduction forbad debt losses prior to the time the lossesactually occur. The tax relief takes two forms.First, the early claiming of bad debt lossesincreases the “present value” of the deduc-tion for bad debts to the taxpayer. Second, by“spreading out” deductions for bad debts, theprogram lessens the chance that a taxpayerwill be unable to deduct the full amount ofsuch debts, due to having insufficient offset-ting income in any one year.

COMMENTS

According to federal reports, the federaldeduction (to which California generally hasconformed) for bad debt reserves was firstallowed in 1947, when there was fear of apostwar economic downturn. It was intendedto reflect the banking industry's experiencewith bad debts during the depression period.The difference in annual bad debt deductionsbetween the reserve and specific charge-offmethods could be a gain or a loss in anygiven year.


Page 93

Deduction:

EMPLOYEE STOCK OWNERSHIP PLANS



Authorization: California Revenue and Taxation CodeSections 18042 and 24601 through24612, which generally conform toInternal Revenue Code Sections 401through 424, and 1042.

(In Millions)

Fiscal Year PIT BCT

1996-97 $1 $5

1997-98 1 3

1998-99 1 3

DESCRIPTION

This program allows California employersthat provide employee stock ownership plans(ESOPs) to their employees a PIT and BCTdeduction for dividends paid to an ESOP,when those dividends are paid by the ESOPto participants or used to retire ESOP debt. Italso allows the deferral of capital gains on thesale of stock to an ESOP if the proceeds areused to acquire a similar type security.

RATIONALE

This program conforms California ESOPprovisions with federal law, thereby simplify-ing tax administration and compliance. It alsogives an incentive to employers to providetheir employees with this form of compensa-tion as an option.

COMMENTS

Effective for income years beginning after1997, this deduction is unavailable to Sub-chapter S corporations under both Californiaand federal law.


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Credit (Person Specific):

PERSONAL EXEMPTION



Authorization: California Revenue and Taxation CodeSections 17054, 17054.1, 17056, and17733.

(In Millions)

Fiscal Year PIT

1996-97 $800

1997-98 825

1998-99 860

DESCRIPTIONThis program allows all individual taxpayersto claim a personal exemption tax credit. Theamount of the credit depends on the tax-payer’s filing status. The credit is indexedannually, based on the California ConsumerPrice Index. For 1998, the credit amounts are$70 for single taxpayers and $140 for marriedcouples filing jointly. Nonresidents who arerequired to file a California tax return areallowed partial personal exemption credits,based on the ratio of their California adjustedgross income (AGI) to their total (multistate)AGI.

The exemption credits are phased out fortaxpayers whose AGI exceeds a thresholdamount. For 1998, for single taxpayers thecredit is reduced by $6 for each $2,500 orfraction thereof by which the taxpayer’s AGIexceeds $116,777; for married taxpayers filingjointly, the credit is reduced by $12 for each$2,500 or fraction thereof by which the tax-payer’s AGI exceeds $233,556.

In addition, California’s personal exemptioncredits may be reduced or eliminated alto-gether under the state’s Alternative Mini-mum Tax (AMT).

RATIONALEThis program provides broad-based tax reliefto California taxpayers. The rationale for theprogram is that taxpayers have a certain min-imum amount of expenses and this programprovides assistance through the tax system inmeeting those expenses.

DISTRIBUTION OF BENEFITSThe personal exemption credit is a programwhich benefits primarily lower- and moderate-income groups. As shown in the accompany-

Personal Exemption Credit

1998 Tax Year


Percent of



TotalAmountClaimed

$0-20 22.8% 14.2% $5720-40 26.9 24.1 8240-60 19.9 21.9 10160-80 12.5 16.0 11780-100 7.3 9.8 124100-150 7.5 10.2 124150-200 2.0 2.8 130200-250 1.0 1.2 122250-500 0.1 0.1 NAOver 500 — — —


Page 95

ing table (see next page), almost 70 percent oftax returns receiving benefits and over60 percent of the total benefits received go totaxpayers earning $60,000 or less annually.As indicated above, there are income limitsplaced on the program, making its use moreinfrequent in the higher-income categories.Average benefits are quite similar acrossincome groups except in the lowest category,where low tax liabilities can keep the entire

credit from being utilized (the credit is notrefundable).

COMMENTSFederal law allows exemptions in the form ofdeductions from AGI, as opposed to the useof tax credits, as under this program. Thefederal exemption amount for 1998 is $2,700per taxpayer, taxpayer’s spouse, and for eachdependent.


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DEPENDENT EXEMPTION




(In Millions)

Fiscal Year PIT

1996-97 $380

1997-98 390

1998-99 1,356

DESCRIPTION

This program allows all taxpayers to claim atax credit for each of their dependents. For1997, the credit amount was $68 per depend-ent. Under California’s 1997 tax relief pack-age, this amount was to be increased to $120in 1998 and $222 in 1999. However, theseamounts were changed as part of the 1998-99budget agreement, in Chapter 322, Statutes of1998 (AB 2797, Cardoza). The amount for1998 was increased to $253 and the amountfor 1999 will be $227. In addition, the exemp-tion amount will be indexed annually basedon the California Consumer Price Index, be-ginning in 2000.

The phase-out provisions with respect to thecredit for high-income taxpayers and require-ments for nonresident taxpayers are the sameas those listed under the immediately preced-ing tax credit program “Personal Exemption.”In addition, California’s dependent exemp-tion credits can be reduced or eliminatedaltogether under the state’s alternative mini-mum tax (AMT).

RATIONALE

This program provides tax relief to taxpayerswho are financially responsible for the sup-port of dependents, such as children or theaged. The rationale for this program is that

such financial responsibilities reduce theability of individuals to pay taxes.


The accompanying table shows the distribu-tion of benefits from this program, based onincome class. The program is one whichlargely benefits taxpayers in the lower- and

Dependent Exemption Credit

1998 Tax Year


Percent of



TotalAmountClaimed

$0-20 13.9% 2.3% $5520-40 31.0 21.3 23140-60 20.4 27.5 45360-80 13.7 19.9 48680-100 8.4 11.8 472100-150 8.5 12.0 474150-200 2.4 3.3 449200-250 1.1 1.5 435250-500 0.7 0.4 207Over 500 — — —

moderate-income categories. Roughly twothirds of all returns receiving some benefitfrom the program involve taxpayers earning$60,000 or less on an annual basis. Over one-


Page 97

half of the total benefits from the programalso go to this group of taxpayers. Averagebenefits are very similar over most incomeclasses. They are smaller only for the twohighest and two lowest income categories,due to the effect of income limits and thenonrefundable nature of the credit, respec-tively.

COMMENTS

Federal law allows a dependent exemption inthe form of a deduction from adjusted grossincome, as opposed to providing a tax credit,as under this program. The federal exemptionamount for 1998 was $2,700 for each depend-ent. In general, California allows a dependentcredit for everyone for whom a federal de-pendent exemption is allowed.


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BLIND EXEMPTION




(In Millions)

Fiscal Year PIT

1996-97 $1

1997-98 1

1998-99 1

DESCRIPTION

This program allows a taxpayer who is blindto claim an additional personal exemption taxcredit. The amount of this credit (which isindexed annually for inflation based on theCalifornia Consumer Price Index) is $70 for1998.

RATIONALE

This program provides tax relief to those whoare blind, based on the rationale that individ-

uals with certain types of diminished physi-cal abilities have increased expenses and/ordecreased earnings potential.

COMMENTS

Instead of a tax credit, federal law (InternalRevenue Code Section 63 [f]) provides anadditional deduction from adjusted grossincome (AGI) for blind taxpayers who do notitemize their deductions. In 1998, the amountof this deduction is $850 for married taxpay-ers (whether filing separately or jointly) andsurviving spouses, and $1,050 for single taxpayers.


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SENIOR EXEMPTION




(In Millions)

Fiscal Year PIT

1996-97 $81

1997-98 82

1998-99 87

DESCRIPTION

This program allows taxpayers over the ageof 65 to claim an additional personal exemp-tion tax credit. The amount of this credit(which is indexed annually for inflation) is$70 in 1998. In the case of a husband and wifefiling a joint return, if both are over the age of65, the amount of the credit is $140 in 1998.

RATIONALE

This program provides tax relief to those overthe age of 65 under the rationale that such

persons are more vulnerable to high medicalor personal care expenses as a result of illnessor infirmity.

COMMENTS

Federal law allows an additional deductionfrom adjusted gross income for taxpayers age65 or over. For 1998 the amount of this deduc-tion is $850 for married individuals (whetherfiling separately or jointly) and survivingspouses, and $1,050 for single individuals.


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RENTERS’ CREDIT



Authorization: California Revenue and Taxation CodeSection 17053.5.

(In Millions)

Fiscal Year PIT

1996-97 —

1997-98 —

1998-99 $133

DESCRIPTIONThe renters’ credit allows taxpayers to deducta specified amount from their tax liabilities,providing that they rent their principal placeof residence. For the years 1993 through 1997,the credit was suspended for reasons largelyrelated to state budget problems. As part ofthe 1998-99 budget plan, (Chapter 322, Stat-utes of 1998 [AB 2797, Cardoza]), the creditwas restored and modified. Beginning in the1998 tax year, the credit will be $60 for singlefilers and $120 for joint filers, and will beavailable only on a nonrefundable basis. Inaddition, the credit is income-limited, withthe single-return and joint-filer annual in-come limits set at $25,000 and $50,000, respec-tively. At various times, this program hasallowed qualified renters to claim a refundabletax credit and was not income limited.

RATIONALEThe renters’ credit provides tax relief to rent-ers, and is intended to offset the propertytaxes that renters indirectly pay through theirrental payments. Although landlords actuallypay the property taxes on rental propertiesand are allowed to deduct them as a businessexpense, it is generally acknowledged that atleast a portion of such payments are “passed-on” to tenants in the form of higher rentalpayments. Thus, proponents argue that in theabsence of this program, renters would be

treated inequitably relative to homeownerswho receive the homeowners’ exemption asa form of tax relief. As such, the credit issometimes viewed as the renters’ equivalentof the homeowners’ exemption.

Another rationale often offered for the pro-gram is that it provides tax relief to renters,many of whom have low incomes. With itscurrent structure of income limits, the creditwill now only be received by renters withlower incomes.

DISTRIBUTION OF BENEFITSAs indicated above, the renters’ credit pro-gram is limited to those taxpayers with lowerand moderate incomes. The accompanying

Renters' Credit

1998 Tax Year


Percent of


TotalAmountClaimed

$0-20 2.7% 0.1%20-40 46.0 36.840-60 21.3 16.560-80 17.2 26.380-100 12.9 20.3Over 100 — —


Page 101

table indicates the distribution of its benefitsby income class both in terms of the numbersof returns and share of total benefits received.These distributional estimates are based onthe past use of the program prior to its sus-pension, and adjusted for the effect of subse-quent income limits.

COMMENTSThe renters’ credit was established in 1972with amounts ranging from $25 to $45, de-pending on the taxpayer’s adjusted grossincome. Program changes in 1976 resulted ina fixed dollar amount for the credit of $37.This amount was increased to $60 (for singletaxpayers) and $137 (for joint and head-of-household filers) in 1979. In 1982, legislationestablished a separate credit amount of $99for joint-custody, head-of-household taxpay-ers. This separate amount for joint-custody,head-of-household taxpayers was eliminatedin 1987. The current credit amounts represent

a reduction from $137 to $120 for marriedcouples filing joint returns, heads of house-holds, and surviving spouses. The $60 creditfor single taxpayers has remained the samesince 1979.

Originally, this program was funded throughan annual General Fund appropriation be-cause of requirements related to the discon-tinued Federal Revenue Sharing program.Under that program, the amount of federalfunds available to the state depended par-tially on its level of “tax effort” relative toother states, which was computed by takinginto account the state's level of revenue col-lections. Thus, by funding the renters’ creditthrough an appropriation instead of a reve-nue reduction, the state was able to show agreater “tax effort” and thereby increase itsrevenue-sharing allocation. The program iscurrently classified as a revenue program.


Page 102


SENIOR HEAD OF HOUSEHOLD




(In Millions)

Fiscal Year PIT

1996-97 Minor

1997-98 Minor

1998-99 Minor

DESCRIPTION

This program allows elderly taxpayers whoqualify as head of household to claim a per-sonal income tax credit in an amount equal to2 percent of their taxable income, not to ex-ceed $860 in 1998. This credit is only availableto taxpayers with adjusted gross income ofless than $45,675.

RATIONALE

This program provides tax relief to elderlytaxpayers 65 years or older who have low ormoderate incomes. The rationale for this is

that the ability of such individuals to paytaxes often is limited, given their incomeconstraints and their need to provide forspecial retirement expenses, such as healthcare.

COMMENTS

This program was established byChapter 1154, Statutes of 1990 (SB 389, Sey-mour) and applies to tax years beginning onJanuary 1, 1990 and thereafter. The maximumcredit amount is indexed annually for infla-tion, and the credit is not refundable.


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Credit (Activity Based):

PRISON INMATE LABOR COSTS




(In Millions)

Fiscal Year PIT BCT

1996-97 Minor Minor

1997-98 Minor Minor

1998-99 Minor Minor

DESCRIPTION

This program allows employers a tax creditequal to 10 percent of the wages they pay toeach state prison inmate employed in a joint-venture program for the purpose of produc-ing goods or services. For purposes of thisprogram, a joint-venture employer is anypublic entity, nonprofit or for-profit entity,organization, or business which contractswith the California Department of Correc-tions for the purpose of employing inmatelabor. These work programs are to be pat-terned after business operations found out-side of prison, and priority consideration isgiven to inmate employment which will re-tain or reclaim jobs in California, supportemerging California industries, or create jobsto fill a void in the labor market.

RATIONALE

This program provides an incentive for Cali-fornia businesses to use state prison inmatelabor. The rationale for the program is that itwill provide meaningful work to prison in-mates that will enhance their prospects foremployment once they are released fromprison, and also will benefit the Californiaeconomy. In addition, the wages earned byinmates are subject to deductions for taxes,prison room and board, restitution to crimevictims, and support of the inmate’s family.

COMMENTS

The revenue losses associated with this pro-gram are speculative due to uncertaintiesregarding the number of qualifying joint-venture programs and the annual compensa-tion of those employed. This program wasenacted by Proposition 139 in the statewidegeneral election in November 1990.


Page 104


ACTIVITIES IN ENTERPRISE ZONES AND

OTHER ECONOMICALLY DEPRESSED AREAS

Program Characteristics Estimated Revenue Reductions


Authorization: California Revenue and Taxation CodeSections 7089, 17052.13, 17052.15,17053.8, 17053.9, 17053.10, 17053.11,17053.17, 17053.33, 17053.34, 17053.45,17053.46, 17053.70, 17053.74, 17053.75,23612, 23612.5, 23622, 23623, 23623.5,23625, 23645, and 23646.

(In Millions)

Fiscal YearPIT BCT

1996-97 $50 $102

1997-98 58 107

1998-99 19 114

DESCRIPTION

These programs allow qualified taxpayers toclaim tax credits for certain expenditures orincome earned in economically depressedareas of the state, including those that havebeen designated as Enterprise Zones, LocalAgency Military Base Recovery Areas(LAMBRA), the Los Angeles RevitalizationZone (LARZ) or, for specified types of activi-ties, within Targeted Tax Areas and Manufac-turing Enhancement Areas. There are threetypes of income tax credits available.

Wages Paid to Disadvantaged Persons. Em-ployers can receive a credit equal to a portionof the wages paid to qualified “disadvan-taged individuals.” Generally, qualified indi-viduals are those who were unemployed oreconomically disadvantaged prior to the dateof hiring. For employers in Enterprise Zones,LAMBRA, LARZ, Targeted Tax Areas andManufacturing Enhancement Areas, theavailable tax credit is 50 percent of the wagespaid during the first year, 40 percent for thesecond year, 30 percent for the third year,20 percent for the fourth year, and 10 percent

for the fifth year. In addition, a credit of50 percent of wages paid to area residentswho were hired to do construction workwithin the zone was available to LARZ em-ployers through 1997. A credit claimed underthis program, together with the sales and useincome tax credit (see below), is limited to thetax attributable to income from the desig-nated area.

Credits are generally recaptured if employeesare terminated prior to a prescribed timeperiod (generally one year). Unused creditsmay be carried over and applied to offsettaxes on income from the area in succeedingtax years. Generally, the available credit isreduced to the extent other credits aregranted to the same employer for area activi-ties. The eligibility for employers in LARZexpired January 1, 1998. Eligibility for em-ployers in a LAMBRA expires January 1,2003.

Taxes Paid by Enterprise Zone Employees.Enterprise Zone employees can receive anincome tax credit of 5 percent of their “quali-


Page 105

fied wages,” up to a maximum of $525. Thecredit is reduced by 9 cents for each $1 inwages in excess of “qualified wages,” as de-fined in the federal Internal Revenue Code,Section 3306(b). The credit is nonrefundable,and unused portions may not be carried for-ward.

Sales Tax on Machinery. An employer canreceive an income tax credit for the amount ofsales and use taxes paid on the purchase ofmachinery or parts used for specific purposesin Enterprise Zones, LAMBRA, LARZ, andfor certain activities, within Targeted TaxAreas. The credit, together with amountsclaimed under the wages credit (discussedabove), is limited to the amount of income taxattributable to the incentive area. The credit isnonrefundable, but unused portions may becarried forward into succeeding tax years.

RATIONALE

These programs are intended to provide in-centives for stimulating employment andbusiness activity in economically depressedareas of the state. These areas typically eitherhave higher costs associated with conductingeconomic activity or are perceived as being

high-cost, low-productivity areas. The creditsrepresent an attempt to reduce costs andmake the areas more attractive for undertak-ing investments and conducting economicactivity.

COMMENTS

These programs were initially established in1984 by the state’s Enterprise Zone Act andEmployment and Economic Incentive Act,and amended in 1985. The Employment andEconomic Incentives Act was repealed andessentially replaced by the Enterprise ZoneAct of 1996. The LARZ, LAMBRA, TargetedTax Areas, and Manufacturing EnhancementAreas were added later as qualifying for cer-tain tax credits under these programs.

Pursuant to Chapter 323, Statutes of 1998(AB 2798, Machado), the credits availableunder these programs were expanded andenhanced. For additional related information,see comments regarding the effectiveness oftax incentives for Enterprise Zones and re-lated areas discussed under the program“Income From Investments in EconomicallyDepressed Areas.”


Page 106


INCREASED RESEARCH AND DEVELOPMENT EXPENSES



Authorization: California Revenue and Taxation CodeSections 17052.12 and 23609, which par-tially conform to Internal Revenue CodeSection 41.

(In Millions)

Fiscal Year PIT BCT

1996-97 $10 $270

1997-98 11 330

1998-99 12 350

DESCRIPTION

This program allows taxpayers to claim a taxcredit for a portion of certain additional in-crements to their research and development(R&D) expenses. The credit may be applied to“qualified” research conducted either “in-house” or by contract. Qualified research isdefined as research that is: (1) technologicalin nature; (2) intended to be useful in thedevelopment of a new or improved product,service, computer software, technique, for-mula, or invention of the taxpayer; (3) heldfor sale, lease, or license, or used by the tax-payer in a trade or business; and (4) per-formed in California.

Beginning in 1997, the R&D credit is equal to11 percent of the taxpayer’s additional quali-fied research expenses for the tax year, over aspecified percentage of the taxpayer’s aver-age annual gross receipts for the four preced-ing taxable years. For BCT taxpayers, an addi-tional credit equal to 24 percent of the tax-payer’s basic (defined as university) researchis availaable. To the extent that the creditexceeds the taxpayer's net tax liability in thetaxable year, the excess may be carried for-ward and used to reduce tax liabilities insubsequent years.

Under certain conditions, a specified formula

may be used to calculate an alternative incre-mental credit. This alternative incrementalcredit was increased pursuant to Chapter 323,Statutes of 1998 (SB 2798, Machado).

RATIONALE

This program provides an incentive for tax-payers to invest in R&D activities by reduc-ing the after-tax cost of making such invest-ments. The underlying rationale is that ifsuch incentives were not available, industrywould “underinvest” in R&D activities froma social point of view.


The accompanying table (see next page)shows the distribution of benefits from theprogram by industry, based on number ofreturns and the amount of tax benefits re-ceived. Almost 60 percent of the returnsclaiming the credit are from electronics firmsand other manufacturing enterprises. Thedollar amount of tax benefits are even moreheavily weighted towards these types ofindustries, with over two-thirds of the totalbenefits going to these two industry groups.Electric and electronic equipment industriesalone claimed almost one-half of the credits.


Page 107

Increased Research andDevelopment Expenses Tax Credit

1998 Income Year

Industry Type

Percent of


TotalAmountClaimed

Electrical andElectronics Equipment

26.8% 46.6%

Chemicals andAllied Products

3.9 10.0

Food and KindredProducts

0.9 0.3

Other Manufacturing 29.2 20.9Other 39.2 22.3

COMMENTS

According to the Research Institute of Amer-ica, over one-third of all states offer a taxcredit to businesses for R&D conductedwithin their state. The amount of the taxcredit a business can claim varies from stateto state largely due to the differences in thebase period used and the percent of expensesapplicable. The federal government also pro-vides a tax credit for R&D expenditures,which differs in several respects from theCalifornia credit.

Supporters of R&D credits argue that the sub-sidy they provide is needed to encourageincreased investment by private industry inemerging areas of technological change anddevelopment—investment which would notoccur in the absence of the credit. A numberof economists support this view.

Some opponents of the credit, however, arguethat it does little to spur additional invest-ment, and that its costs far outweigh the ben-efits to society. Other critics of R&D creditsargue that while underinvestment in R&Dwould occur in the absence of interventionprograms, tax credits are an inappropriatemechanism through which to address the

problem. Some, for example, put forth a di-rect R&D subsidy as an alternative approach.

Evidence regarding the effectiveness of theR&D credit remains ambiguous. Althoughthere do not appear to be any studies thathave analyzed the effectiveness of Califor-nia’s R&D tax credit, numerous analyses ofthe federal credit have been conducted. TheU.S. General Accounting Office (GAO), forexample, reports that some additional re-search spending was stimulated by the taxcredit, with most of the benefits going tolarge manufacturing corporations. However,GAO also reported that in 1992, 79 percent ofcorporations earning R&D credits had accu-mulated more general business tax creditsthan could be used. Thus, the marginal incen-tive provided by additional R&D tax creditswas reduced (see U.S. GAO, Tax Policy: Addi-tional Information on the Research Tax Credit,1995). Some studies regarding the effective-ness of the credit found it to have a relativelyminor impact on R&D spending by U.S. cor-porations (see, for example, Eisner, Albertand Sullivan, The New Incremental Tax Creditfor R&D: Incentive or Disincentive?, NationalTax Journal, V. 37, 1984; and Karier, Closingthe R&D Gap: Evaluating the Sources of R&DSpending, Jerome Levy Economics Institute,Working Paper #22, 1995).

The GAO’s recent review of eight separatestudies regarding the R&D credit indicatesthat the effectiveness of the credit is still opento debate. While four of the reviewed studieslinked the R&D credit to additional researchspending that exceeded the cost of the credit,the remaining four did not support this claimor were inconclusive. The GAO determinedthat, due to data limitations and methodolog-ical issues, available studies are inadequate tothe task measuring the effectiveness of thecredit (see U.S. GAO, Tax Policy and Adminis-tration: Review of the Effectiveness of the Re-search Tax Credit, 1996).


Page 108


EMPLOYER-PROVIDED CHILD CARE EXPENSES



Authorization: California Revenue and Taxation CodeSections 17052.17, 17052.18, 23617,and 23617.5.

(In Millions)

Fiscal Year PIT BCT

1996-97 $1 $5

1997-98 1 5

1998-99 Minor 3

DESCRIPTION

The PIT and BCT provide employers severaltax credits for child care assistance programs.These tax credit programs allow employers todeduct the costs of certain contributions to-ward employee child care expenses incurredbetween January 1, 1988 and January 1, 2003.Specifically, employers may deduct:

• Thirty percent of the startup costs ofestablishing a child care program, thecosts of constructing a child care facil-ity, and/or the costs of child carereferral services, up to $50,000 per taxyear.

• Thirty percent of the cost of contribu-tions to a qualified child care plan. Aqualified care plan may include onsiteor offsite child care centers, in-homecare, and specialized centers whichprovide care for children withshort-term illnesses. Qualifying con-tributions may not exceed $360 perqualified dependent per tax year.

In order to qualify for the tax credit, thesecosts must be associated with programs pri-

marily used by children of the taxpayer'semployees who are under the age of 15. Tothe extent that the credit amounts exceed ataxpayer's net tax liability in the year theexpenses are incurred, they may be carriedforward and used to offset the taxpayer'sliability in future years, but not by more than$50,000 in any one tax year.

RATIONALE

This program is intended to give employersa financial incentive to provide for the childcare needs of their employees. It does this byreducing the after-tax cost of making theseprovisions.

COMMENTS

Employers must reduce their basis cost (whichis used for purposes of determining capitalgains and losses when property eventually issold) in child care facilities on which a taxcredit is claimed, by the amount of the creditclaimed for those facilities. A taxpayer canelect to take depreciation in lieu of claimingthe credit. Pursuant to Chapter 323, Statutesof 1998 (AB 2798, Machado), this programwas extended from January 1, 1998 toJanuary 1, 2003.


Page 109


LOW-INCOME RENTAL HOUSING EXPENSES



Authorization: California Revenue and Taxation CodeSections 17058 and 23610.5, which par-tially conform to Internal Revenue CodeSection 42.

(In Millions)

Fiscal Year PIT BCT

1996-97 $6 $23

1997-98 6 24

1998-99 6 24

DESCRIPTIONThis program provides a tax credit for inves-tors for a portion of the costs of investing inlow-income rental housing projects. Theamount of the credit depends on the amountneeded by the investor in order to make theproject economically feasible. This amount isdetermined by the California Tax Credit Allo-cation Committee, which reviews programapplications and allocates credits based oncertain previously established legislativepriorities.

Generally, the percentage of costs for whichcredits may be claimed is based on federalguidelines. The maximum amount the com-mittee may award to a project is designed sothat the present value of four annual creditpayments generally equals 30 percent of aninvestor's qualified basis in the low-incomehousing units. “Qualified basis” is roughlyequal to the acquisition, construction, and/orrehabilitation costs of the units. In exchangefor the tax credits, the investor must committo renting a specified percentage of units tolow-income individuals based on one of thefollowing options:

• Renting 20 percent of the units to indi-viduals whose income is no more than50 percent of area median income.

• Renting 40 percent of the units toindividuals whose income is no morethan 60 percent of area median in-come.

The rent on these program units based oneither option may not exceed 30 percent ofthese specified income limits.

RATIONALEThis tax credit program is intended to in-crease the number of affordable rental hous-ing units available to low-income householdsin California, by reducing the after-tax coststo developers and investors who produce andinvest in such units.

COMMENTSThis program complements a federal taxcredit program which also works to promotethe development of low-income housing. Themaximum federal tax credit that can beawarded is generally equal to 70 percent (ona present-value basis) of a taxpayer's quali-fied basis in the project, spread over a ten-year period. A project that receives the maxi-mum in both state and federal credits re-ceives 100 percent of the taxpayer's qualifiedbasis over a 10-year period. Both the state andfederal programs are administered by theCalifornia Tax Credit Allocation Committee.


Page 110

The state program is authorized as long asthe federal program continues in existence.California requires that the compliance pe-riod over which the program requirementsnoted earlier must be adhered to extend for30 consecutive years, rather than the 15-yearfederal period.

Chapter 1222, Statutes of 1993 (AB 1438, Cal-dera), expanded this credit to allow insurancecompanies to qualify. Specifically, insurancecompanies are allowed a share of the annualcredit allocated for investments in low-in-come housing and can use the credit to offsettheir gross premiums tax.


Page 111


JOINT CUSTODY HEAD OF HOUSEHOLD




(In Millions)

Fiscal Year PIT

1996-97 NA

1997-98 NA

1998-99 NA

DESCRIPTION

This program allows a tax credit for divorcedor separated individuals who do bear signifi-cant costs in order to maintain a home for adependent for part of the year, but do notprovide the principal residence for a depend-ent (and, therefore, do not qualify for themore-advantageous “head-of-household”filing status).

Specifically, the program allows a tax creditequal to the lesser of (1) 30 percent of a tax-payer's net tax or (2) a maximum amountdetermined annually ($281 in 1998). The pro-gram is available to divorced or separatedtaxpayers who (1) live apart from a spousefor at least six months prior to the end of thetax year, and (2) provide for at least one-halfof the cost of maintaining the principal resi-dence of a dependent for at least 146 days butnot more than 219 days of the tax year. (Ataxpayer who maintains the principal resi-dence of a dependent for more than 219 daysof the tax year qualifies for the more-advanta-geous head-of-household filing status.)

RATIONALE

This program is intended to provide tax reliefto taxpayers who are single, or married andliving apart, and who care for dependentssuch as children for a significant portion ofthe tax year. The program's rationale reflectsthe view that, in the case of taxpayers whohave to maintain households in order to carefor dependents, their economic burdens aregreater than those of individuals with nosuch responsibilities.

COMMENTS

Federal law defining “head of household”was incorporated into California law byreference for post-1986 tax years. In order forthe head-of-household filing status to beclaimed, the household must be the principalresidence of the qualifying dependent formore than 219 days of the year. Chapter 1537,Statutes of 1982 (AB 2520, Sher) created aspecial “joint custody” head-of-householdfiling status with its own personal exemptioncredits and tax rates. This separate filingstatus was replaced with this tax credit byChapter 1138, Statutes of 1987 (AB 53, Klehs).


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SALMON AND STEELHEAD TROUT

HABITAT RESTORATION




(In Millions)

Fiscal Year PIT BCT

1996-97 Minor Minor

1997-98 Minor Minor

1998-99 Minor Minor

DESCRIPTION

This program, which sunsets on December 1,2000, provides a tax credit equal to the lesserof (1) 10 percent of the qualified costs paid orincurred for salmon or steelhead trout habitatrestoration, up to $50,000 per taxpayer, or(2) the amount certified by the CaliforniaDepartment of Fish and Game (DFG). Thecredit may be used to offset tax liabilitiesduring years in which the expenses are in-curred, and any unused credit may be used tooffset tax liabilities in future years.

To be able to claim the credit, the taxpayermust apply to the DFG. The department isresponsible for certifying that the taxpayer’sproject has met specified criteria and for au-thorizing the actual amount of credit that thetaxpayer may claim. The project must meetthe following criteria: (1) meet the objectivesof the Salmon, Steelhead Trout, and Anadro-mous Fisheries Program Act and contributeto the increase in production of salmon and

trout by improving certain habitat conditions;(2) provide employment to unemployed fish-ing or forestry industry persons in countieswith a higher-than-average annual rate ofunemployment as specified by the Employ-ment Development Department; and(3) undertake work that does not includeconstruction of office, storage facilities, ga-rages, maintenance buildings, hatchery facili-ties, permanent surface roadways, bridges,wells, or pumping equipment. The amount ofcredit allowable must be reduced by theamount of any grant or cost-sharing paymentfor the project made by a public entity.

RATIONALE

This program provides an incentive for tax-payers to undertake projects to restore thehabitats of salmon and steelhead trout. Itdoes this by offsetting a portion of the costsincurred through a credit that is applied to-wards the taxpayer’s tax liability.


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MANUFACTURERS’ INVESTMENT TAX CREDIT




(In Millions)

Fiscal Year PIT BCT

1996-97 $34 $390

1997-98 34 395

1998-99 34 390

DESCRIPTIONThis program provides a tax credit intendedto encourage manufacturing activity andinvestment in the state. It provides qualifiedtaxpayers an income tax credit equal to6 percent of the qualified costs incurred forconstruction, acquisition, or lease of qualifiedproperty that is placed in service in Califor-nia.

• "Qualified taxpayers" are personsengaged in specified businesses asdescribed in the Standard IndustrialClassification (SIC) Manual.

• "Qualified costs" include (1) amountson which the taxpayer paid sales anduse tax and that are considered capi-tal acquisitions, and (2) the value ofany capitalized labor costs that aredirectly related to the construction ormodification of qualified property.

• "Qualified property" means tangiblepersonal property that is depreciableor computer software used primarilyin manufacturing, research, pollutioncontrol, recycling, or in maintaining,repairing, measuring, or testing prop-erty used in such activities. It alsoincludes, for certain activities, specialpurpose buildings and foundationsthat are primarily used in connection

with manufacturing, refining, pro-cessing, fabricating, or research andstorage.

If the property is removed from California,the credit is "recaptured" by adding the creditamount received back on to the appropriateyear’s net tax liability of the taxpayer. In gen-eral, unused credits may be carried forwardfor up to eight years to offset tax liabilities. Inthe case of qualified small businesses, thecarryforward period is ten years.

RATIONALEThis program provides an incentive for quali-fied taxpayers to expand their investments inmanufacturing and research property in Cali-fornia. It does this by offsetting a portion ofthe costs incurred through a credit that isapplied towards their tax liabilities.

DISTRIBUTION OF BENEFITSThe accompanying table (see next page)shows the distribution of benefits of the pro-gram for various industries, based on numberof returns and by total amount of tax benefitsinvolved. Over one-half of the total dollaramount of benefits of the program goes toelectronics and petroleum refining firms.Another one-quarter accrues to other types ofmanufacturing enterprises.


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Manufacturers’Investment Tax Credit

1998 Income Year

Industry Type

Percent of


TotalAmountClaimed

Electrical andElectronics Equipment

13.2% 26.9%

Petroleum Refining 0.7 25.1Chemicals and

Allied Products4.5 5.6

Food and KindredProducts

7.6 7.4

Other Manufacturing 56.5 27.4Other 17.6 7.4

COMMENTSA sales and use tax exemption of 5 percent isavailable for new businesses that first com-mence activity in California after 1993 andhave not been in existence for more thanthree years. However, if a taxpayer claimsthis program’s income tax credit, then thetaxpayer cannot claim the sales and use taxexemption.

This credit essentially reduces the cost ofcapital acquisitions, and consequently couldresult in a relative shift away from labor andtowards capital. This could be coupled withincreased labor demand as a result of overallreduced manufacturing costs, and an increasein production.

Pursuant to Chapter 323, Statutes of 1998(AB 2798, Machado), the credit was expandedto include taxpayers engaged in softwaredevelopment, computer programming, andcomputer integrated systems design.


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ENHANCED RECOVERY COSTS



Authorization: California Revenue and Taxation CodeSections 17052.8 and 23604, which gen-erally conform to Internal Revenue CodeSection 43.

(In Millions)

Fiscal Year PIT BCT

1996-97 Minor Minor

1997-98 Minor $2

1998-99 Minor 2

DESCRIPTION

This program provides a tax credit for5 percent of the qualified costs associatedwith “enhanced recovery” of oil and gas(such as pumping heated liquids or gassesinto a well to enhance the flow of these mate-rials). This credit applies only tononvertically integrated producers for pro-jects located within California. Unused cred-its may be used to offset tax liabilities in thefuture, for up to 15 years. If the taxpayer’scosts qualify for another credit, the taxpayermust make an election between credits. Notax deduction is allowed for costs for whichthe credit is allowed.

RATIONALE

This program provides an incentive for busi-nesses to use more efficient oil and gas recov-ery technologies by partially offsetting theassociated costs.

COMMENTS

This program conforms with a federally en-hanced oil recovery tax credit program. Thefederal program provides a tax credit for15 percent of the qualified costs incurred.


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FARMWORKER HOUSING COSTS



Authorization: California Revenue and Taxation CodeSections 17053.14, 23608.2, and23608.3.

(In Millions)

Fiscal Year PIT BCT

1996-97 Minor Minor

1997-98 Minor Minor

1998-99 Minor Minor

DESCRIPTION

This program provides a tax credit in theamount of the lesser of: (1) 50 percent of thecosts associated with building, repairing, ordonating farmworker housing; or (2) theamount certified by the California Tax CreditAllocation Committee. To claim the credit, thetaxpayer must enter into an agreement with thecommittee to build or donate housing meetingspecified criteria, with the credit available onlyduring the year when the housing is completedand occupied.

A tax credit is also available to lenders whoprovide low-interest loans for farmworker

housing. It is equal to half of the differencebetween market interest rates and the ratesactually charged. California requires a compli-ance period of 30 years to be eligible for thecredit.

RATIONALE

This program provides a tax incentive fortaxpayers to provide suitable housing forfarmworkers. The rationale is that the incen-tive to farm owners and others will stimulatethe provision and construction of suitablehousing for farmworkers.


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RICE STRAW




(In Millions)

Fiscal Year PIT BCT

1996-97 Minor Minor

1997-98 Minor Minor

1998-99 Minor Minor

DESCRIPTION

Upon certification by the California Depart-ment of Food and Agriculture, this programprovides a tax credit in the amount of $15 perton of rice straw that is grown in Californiaand purchased by the taxpayer. The taxpayermust be an “end user” of rice straw; that is,the taxpayer must use the rice straw for pro-cessing, generation of energy, manufacturing,export, prevention of erosion, or for any otherpurpose exclusive of open burning.

Under the program, the department issuestaxpayers a certificate specifying the amountof any tax credit allocated. Up to $400,000 peryear in total tax credits may be allocated on afirst-come, first-served basis. Any claimedbut unused credits may be carried forward by

taxpayers to offset their tax liabilities in fu-ture years, for up to ten years.

RATIONALE

The program is aimed at reducing the openburning of rice straw by farmers, therebyreducing the air pollution impacts of suchburning. It does so by providing an incentivefor taxpayers to purchase rice straw for otherpurposes. The rationale is that rice straw canbe put to more productive uses than simplyopen burning; however, it often is morecostly for the user to choose such other op-tions. This program is intended to partiallyoffset the costs of purchasing the rice straw sothat taxpayers will be encouraged to use ricestraw in a more efficient manner.


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DISABLED ACCESS EXPENDITURES



Authorization: California Revenue and Taxation CodeSections 17053.42 and 23642, which gen-erally conform to Internal Revenue CodeSection 44.

(In Millions)

Fiscal Year PIT BCT

1996-97 Minor Minor

1997-98 Minor Minor

1998-99 Minor Minor

DESCRIPTION

This program provides a tax credit for50 percent of up to $250 of qualified expendi-tures to eligible small businesses that provideaccess to disabled individuals. Thus, thisprogram allows a California credit up to amaximum of $125. To qualify for the credit,the business must (1) have earned less than$1 million in gross receipts in the previousyear, and (2) employ not more than 30 full-time employees.

Qualified expenditures include those costsassociated with complying with the Ameri-cans With Disabilities Act of 1990. This in-cludes removing physical barriers that blockentrance to a business and acquiring equip-ment to aid in servicing individuals withspecified disabilities, such as hearing and

vision impairments. Any unused credit maybe carried forward to offset tax liabilities infuture years.

RATIONALE

This program complements an already-estab-lished federal tax credit. It also provides anincentive to qualified businesses to makecertain “minor” improvements that may notexceed the threshold to qualify for the federalcredit.

COMMENTS

The federal government provides a tax creditfor 50 percent of qualified expenditures ex-ceeding $250 and up to $10,250. This programcovers the initial $250 of qualified expenditures.


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TRANSPORTATION OF DONATED

AGRICULTURAL PRODUCTS




(In Millions)

Fiscal Year PIT BCT

1996-97 Minor Minor

1997-98 Minor Minor

1998-99 Minor Minor

DESCRIPTION

This program provides a tax credit for50 percent of transportation costs paid orincurred by a taxpayer that are related to thetransportation of donated agricultural prod-ucts to a nonprofit, charitable organization.Upon receipt, the charitable organizationfurnishes the donor with a certificate specify-ing the transportation of donated agriculturalproducts, including the type and amount ofproducts donated and the distance trans-ported. Any unused tax credit may be carriedforward to offset tax liabilities in future years.

RATIONALE

This program provides an incentive for tax-payers to donate or incur the costs for trans-port ing agricul tural products tocharitable organizations. The underlyingrationale is that charitable organizations areproviding a socially beneficial service bydistributing agricultural products to needyindividuals, and that this service is worthy ofindirect state support. By partially offsettingthe costs of transporting the agriculturalproducts, the program encourages more tax-payers to donate or incur the costs of trans-porting these products. Thus, more agricul-tural products may reach charitable organiza-tions than otherwise would without the incentive.


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CHILD ADOPTION EXPENSES




(In Millions)

Fiscal Year PIT

1996-97 $1

1997-98 1

1998-99 1

DESCRIPTION

This program provides a tax credit equal to50 percent of the qualified costs of an adop-tion of a minor child who is a legal residentor citizen of the United States and was in thecustody of a public adoption agency of thisstate. Qualified costs include fees for requiredservices, travel and related expenses for theadoptive family that are directly related tothe adoption process, and medical fees andexpenses not reimbursed by insurance thatare directly related to the adoption. The taxcredit may offset tax liabilities up to $2,500

per child in the year that the adoption papersare ordered. Any unused credit may be car-ried forward to offset tax liabilities in futureyears.

RATIONALE

This program provides tax relief to familieschoosing to adopt a child. The underlyingrationale is that adoption provides a sociallybeneficial service which is worthy of publicfinancial support.


Page 121

Special Filing Status:

SUBCHAPTER S CORPORATIONS

Program Characteristics Estimated Revenue Effect


Authorization: California Revenue and Taxation CodeSections 17087.5, 18006, and 23800through 23813, which partially conform toInternal Revenue Code Sections 1361through 1379.

(In Millions)

Fiscal Year PIT BCT

1996-97 +$217 $1,185

1997-98 +236 1,175

1998-99 +255 1,235

DESCRIPTION

This program allows eligible small businesscorporations to elect Subchapter S corpora-tion status for purposes of determining theirtax liability. The so-called “S” corporationspay taxes on corporate income at a reducedrate of 1.5 percent, except for financial institu-tions, which are subject to a 3.5 percent rate.The S corporations are not subject to the Al-ternative Minimum Tax (AMT) but are subjectto the applicable corporate minimum tax.Individual shareholders of an S corporationpay personal income taxes on their pro ratashare of corporate income.

In contrast to S corporations, a regular “C”corporation pays taxes on its corporate in-come at a rate of 8.84 percent (or10.84 percent for financial institutions), forincome earned beginning on or after January1, 1996. Corporate shareholders in C corpora-tions pay taxes on corporate earnings only tothe extent that such earnings are paid out ofdividends.

In order to be eligible to elect S corporationstatus, a corporation must have (1) a validfederal S election in effect, (2) fewer than 75shareholders, and (3) only one class of stock.

Those corporations which meet these criteriaand make a federal S election are deemed tohave made an S election for state purposes aswell. However, a corporation may make aseparate state election to be treated as a Ccorporation for state tax purposes, even if afederal S election has been made.

RATIONALE

This program is intended to provide tax reliefto small corporations while still allowingthem to take advantage of the limited liabilityaspect of corporate status. Generally, busi-nesses that make an S election pay less intaxes than they would as C corporations.


The benefits of the Subchapter S special filingstatus accrue largely to small-to-mid-sizedcompanies, as shown in Figure 1 (see nextpage). Almost three-quarters of the corporatetaxpayers benefitting from the program areenterprises with receipts of less than$1 million per year. In terms of total benefitsreceived, over two-thirds of benefits go toenterprises with receipts of $50 million orless. Figure 2 (see next page) indicates thedistribution of benefits of Subchapter S filingstatus by type of enterprise. The industry


Page 122

sector that benefits the most in dollar termsfrom the Subchapter S filing status is manu-facturing, which accounts for 36 percent ofthe total benefits. (The distribution of benefitsis based only on the effects of the program onBCT revenues and does not include any offsetdue to increases in PIT revenues.)

Figure 1

Subchapter S CorporationsTax Benefits by Receipt

1998 Income Year


Percent of


TotalAmountClaimed

Under $1 74.0% 7.3%1–10 20.7 32.710–50 4.6 28.650–100 0.4 10.5100–500 0.3 9.7500–1,000 0.1 10.4Over 1,000 0.1 0.8

Figure 2

Subchapter S CorporationsTax Benefits by Industry

1998 Income Year

Industry Type

Percent of

GrossState

Product


TotalAmountClaimed


3.0% 2.4% 3.0%


25.9 16.9 8.3


8.2 3.7 3.4

COMMENTS

The revenue increases for PIT result from twofactors: (1) unlike C corporation income, alloperating income from S corporation earn-ings is passed through to shareholders andtaxed as personal income; and (2) nonresidentshareholders must pay California personalincome taxes on earnings. These revenueincreases may be partially offset by the pass-through of losses to shareholders, which canbe deducted from income.

Under federal law, an election of S corpora-tion status completely eliminates any taxliability of the corporation itself. All incomeand expenses are passed through to share-holders, and there is no entity-level tax im-posed. Net income is taxed on a pro rata basisas if it were received as individual income.

According to data from the Franchise TaxBoard, there were 118,514 S corporations inCalifornia in 1996, with a reported net incomeof $12.5 billion and tax liabilities of$282 million.

Federal conformity legislation in the form ofChapter 612, Statutes of 1997 (SB 1233, Lock-yer), and Chapter 610, Statutes of 1997 (SB 5,Lockyer) contained several provisions affect-ing S corporations. In particular, scheduledincreases in the tax rate were eliminated andthe 1.5 percent entity-level tax rate was re-tained. In addition, the number of allowableshareholders was expanded from 35 to 75.The legislation also liberalized shareholdereligibility, allowed various financial institu-tions to be S corporations, and permitted Scorporations to have wholly owned subsidiaries.


Page 123

Special Filing Status:

HEAD-OF-HOUSEHOLD AND SURVIVING SPOUSE



Authorization: California Revenue and Taxation CodeSections 17042, 17046, and 17054,which partially conform to InternalRevenue Code Sections 2, 151, and 152.

(In Millions)

Fiscal Year PIT

1996-97 NA

1997-98 NA

1998-99 NA

DESCRIPTION

This program allows taxpayers who care fordependents to qualify for lower tax rates thanare available to single persons or to marriedpersons filing separate returns. This programis intended to provide tax relief to heads-of-households who are single, or married butliving apart, and surviving spouses. Surviv-ing spouses qualify for a larger personal ex-emption in addition to the lower tax rates.

RATIONALE

The program's rationale reflects the view thattaxpayers who have to maintain householdsin order to care for dependents have greatereconomic burdens than do individuals withno such responsibilities. In addition, the pro-gram reflects the view that tax relief may beneeded by many surviving spouses in orderto be able to maintain their economic status.

COMMENTS

Federal law definitions for the head-of-household and surviving-spouse filing sta-

tuses were incorporated into California lawby reference for post-1986 tax years. In orderto claim the head-of-household filing status,a taxpayer must provide the principal homeof the qualifying dependent for over one-halfof the year. In addition, the taxpayer mustpay more than one-half of the cost of main-taining that household. A surviving spouse isa taxpayer whose spouse died within twoyears prior to the taxable year involved, whocares for a dependent child, and has not re-married.

Chapter 846, Statutes of 1990 (AB 3086,Klehs), provides that taxpayers with anondependent relative living in the homequalify for head-of-household filing status.For example, if a single custodial parent hasmoved into the home of her widowed father,the father would qualify as a head-of-house-hold. Although the child is the custodial par-ent's dependent, the grandfather qualifies toclaim the head-of-household filing statusbecause he provides more than one-half ofthe cost of maintaining the home.


Page 124

personal bank and corporation tax - california

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