BILL ANALYSIS SENATE REVENUE & TAXATION COMMITTEE Senator Lois Wolk, Chair SB 1053 - Runner As Introduced February 16, 2010 Hearing: April 28, 2010 Tax Levy Fiscal: Yes SUMMARY: Enacts a State Sales and Use Tax (SUT) Exemption for Manufacturing and Software Production Equipment EXISTING LAW provides no special tax treatment to entities engaged in manufacturing or software production for purchases of equipment and other supplies. Business entities engaged in manufacturing, research and development, and software producing activities that make purchases of equipment and supplies for use in the conduct of their manufacturing and related activities are required to pay tax on their purchases to the same extent as any other person either engaged in business in California. THIS BILL would provide a partial exemption (General Fund only) from the SUT rate of 6% (5% on and after July 1, 2011) for the following purchases made by a "qualified person": Tangible personal property to be used 50 percent or more in any stage of manufacturing, processing, refining, fabricating, or recycling of property (i.e., machinery, equipment belts, shafts, computers, software, pollution control equipment, buildings and foundations), as specified. Tangible personal property to be used 50 percent or more SB 1053 - Runner Page 5 in research and development. Tangible personal property to be used 50 percent or more in maintaining, repairing, measuring, or testing any qualifying equipment. Tangible personal property purchased for use by a contractor, as specified, for use in the performance of a construction contract for the qualified persons who will use the property as an integral part of any manufacturing, processing, refining, fabricating, or recycling process or as a research or storage facility in connection with the manufacturing process. Defines a "qualified person" to mean either of the following: a person engaged in those lines of business described in Codes 3111 to 3399, inclusive, or 5112 of the North American Industry Classification System (NAICS), 2007 edition; or an affiliate of such a person, provided the affiliate is a member of the qualified person's unitary group for which a combined report is required to be filed, as provided. Specifies that the proposed exemption would not include (1) any tangible personal property that is used primarily in administration, general management, or marketing, (2) consumables with a normal useful life of less than one year, except for fuels used in the manufacturing process, and (3) furniture, inventory, equipment used in the extraction process, or equipment used to store finished products that have completed the manufacturing process. FISCAL EFFECT: The BOE states that it would incur costs to administer this bill. These costs would be attributable to, among other things, identifying and notifying qualifying entities, auditing claimed amounts, revising sales tax returns, reviewing returns with claimed exemptions, and programming. An estimate of these costs is pending SB 1053 - Runner Page 5 BOE estimates that this bill will result in a revenue loss of $600 million in fiscal year (FY) 2010-11, and $1 billion in FY 2011-12. COMMENTS: A. Purpose of Bill According to the author, "it is important that California stimulate job creation and retention across all areas of the manufacturing sector, not just green jobs. As proven with prior legislation of this nature, the multiplier effect of SB 1053 will stimulate growth of both the manufacturing and research and development sectors, which is essential to reviving California's economy." "Over the previous year, the manufacturing sector lost 106,200 jobs and on a seasonally adjusted basis, the sector lost 7,200 jobs in December 2009. Unfortunately for California's manufacturers, our state is only one of three states that tax manufacturing equipment purchases with no credit or exemption. Most other states recognize that taxing input as well as the final manufactured product is double taxation and discourages investment. Manufacturing jobs are critical to the overall health of our economy and taxing manufacturing equipment is poor tax policy that only hinders growth." B. Background For a ten-year period ending December 31, 2003, California law provided a partial (General Fund only) sales and use tax exemption for purchases of equipment and machinery by new manufacturers, and income and corporation tax credits for existing manufacturers' investments (MIC) in equipment (SB 671, Alquist, 1993). Manufacturers were defined in terms of specific federal "Standard Industrial Classification" (SIC) codes. The bill provided an exemption from the state tax portion for sales and purchases of qualifying property, and the income tax credit SB 1053 - Runner Page 5 was equal to six percent of the amount paid for qualified property placed in service in California. Qualified property was similar to the property described in this bill -depreciable equipment used primarily for manufacturing, refining, processing, fabricating or recycling; for research and development; for maintenance, repair, measurement or testing of qualified property; and for pollution control meeting state or federal standards. Qualified property also included tangible personal property purchased by a contractor, as specified, for use in the performance of a construction contract for the qualified person who would use that property as an integral part of the manufacturing process, as described. Certain special purpose buildings were included as "qualified property," as this bill proposes. New manufacturers could either receive the benefit of the exemption, or claim the income tax credit. However, existing manufacturers could only receive the benefit of the income tax credit. This sales and use tax exemption and income tax credit had a conditional sunset date. They were to sunset in any year following a year when manufacturing employment (as determined by the Employment Development Department) did not exceed January 1, 1994 manufacturing employment by more than 100,000. On January 1, 2003, manufacturing employment (less aerospace) did not exceed the 1994 employment number by more than 100,000 (it was less than the 1994 number by over 10,000), and therefore the MIC and partial sales tax exemption sunsetted at the end of 2003. Since the expiration of the partial exemption of manufacturing equipment, numerous bills have been introduced to either reinstate or to expand or modify the exemption, but have failed to pass. C. Arguments For and Against the MIC SB 1053 provides a sales and use tax exemption for manufacturing equipment that qualified taxpayers for the now-defunct Manufacturers' Investment Credit. Tax credits provide a dollar-for-dollar reduction in tax, which is SB 1053 - Runner Page 5 based on a firm's net income, so only firms that generate profits may make use of tax credits. Additionally, tax credits may exceed tax due for the year in which the firm generates the credit, but can often carry the credit forward to future years. Even then, the Legislature can limit the use of tax credits, as it did for the 2008 and 2009 tax years, when it capped the use of credits and Net Operating Loss deductions to 50% of a taxpayer's liability (AB 1452, Committee on Budget, 2008). Sales tax exemptions are superior to tax credits because it benefits all companies that purchase qualified equipment, regardless of whether the firm is profitable. It has been argued that there is no way to directly or even indirectly measure the effect of the MIC on jobs because the connection is so tenuous. Also, it has been argued that there is no way to tell whether equipment was purchased in response to the MIC or whether it would have been bought anyhow without the credit. In an October 2002 report put out by the Legislative Analyst's Office, An Overview of California's Manufacturers' Investment Credit, the following arguments against and in support of these tax incentives were presented: Arguments In Support of the MIC Investment Incentive-The MIC effectively reduces the price of new capital, and leads to greater investment. Adherents of this view suggest that a firm considering a capital investment is much more likely to undertake such investment with the MIC in place. Proponents argue that this marginal cost reduction can have a significant positive impact on investment decisions. Relocation Incentive-California has become a more attractive place relative to other states for business since the credit has been in place. The argument here is that tax credits do influence corporate location decisions and dissuade businesses from moving their SB 1053 - Runner Page 5 activities out of California. Manufacturing industry representatives stated and continue to state that the MIC plays an important role in both expansion and business location decisions. Efficient Job Allocator-Competition for business among states is an efficient job allocator. This argument holds that the nation benefits from the redistribution of jobs that may occur due to the use of investment tax credits. This is based on the notion that jobs are worth more in areas with higher unemployment, and that such areas are likely to have relatively aggressive tax credit programs. These areas will be able to attract businesses away from regions that do not value the jobs as highly. Other Arguments. Advocates of the MIC also emphasize that the MIC offers significant indirect benefits to the state in terms of investment and job growth that result in additional state revenues. They also point out the importance of manufacturing to the overall state economy in terms of economic stability and the high value-added nature of the employment in this sector. Arguments against the MIC Inequitable Taxation-The MIC results in giving a tax advantage to manufacturing over other business activities, as well as providing an advantage to capital investment over labor. This view holds that since only one type of industry (and production factor) benefits from the tax credit, the remaining industries face relatively higher costs, and are therefore at a competitive disadvantage. Such preferential treatment can also result in inefficient resource allocation according to this view. Relocation Rather Than Creation-The MIC results in few new jobs, but rather pits states against each other in competing for jobs. The argument here is that corporate tax breaks are no more than a transfer of government funds to private businesses, and in the end, the national SB 1053 - Runner Page 5 economy is unaffected. In this view the competition among states in offering various tax incentives represents a form of "prisoners' dilemma"-in which each state would be better off if none offered such incentives. If one state does offer them, however, it is in the interest of other states to do the same. Inefficient Development Policy-Tax incentives have a negligible impact on economic growth, and any job creation that does occur does so at a substantial cost per job. Proponents of this view also hold that some of the tax credits will go to companies which would have made the same investments, regardless of the tax incentive. That is, the tax credit did not induce the investment, yet the company receives "windfall benefits" in the form of reduced taxes. Ineffective Development Policy-Taxes are a very small percentage of overall business costs and thus have little effect on business decisions. Labor, transportation, land, and other factors typically constitute much more significant proportions of total costs than do taxes. Therefore, according to those who hold this view, tinkering with this particular cost is unlikely to result in a large shift or expansion of business compared to the adverse fiscal effects that such measures can have on the state. D. Administrative and technical concerns Should the measure advance from the Committee's suspense file, the Committee should amend the measure to address the following administrative and technical concerns: In defining "qualified person," it is recommended that the bill require that the qualifying entity be primarily engaged in the activities described in the referenced codes. This is an important issue and one that generated many disputes when the Board of Equalization (BOE) administered Section 6377 SB 1053 - Runner Page 5 previously. Another issue relates to the proposed definitions for the types of property included and excluded from the proposed exemption. For example, on page 4, lines 20 and 37, the bill refers to the items having a useful life of one year or more (or less than one year). In order to lessen potential audit disputes, the bill should contain some mechanism for determining the useful life. Perhaps some reference to the provision in the California income tax laws for depreciating assets should be incorporated into the bill. Subdivision (g) of proposed Section 6377 (see page 6, line 3) provides for an exemption from tax for specified leases of qualified property and limits this exemption for a six-year period. This limitation is modeled after a provision in former Section 6377 that provided a state tax exemption solely to new manufacturers' leases of equipment. Since this bill would provide the exemption for all qualifying persons, it appears the limitation in subdivision (g) is unnecessary and should be stricken. Otherwise, long-term leases of qualifying property would not enjoy the same tax privileges that the bill would provide to actual purchases of the same property. Support and Opposition Support:Cal-Tax, BayBio Oppose:American Federation of State, County ad Municipal Employees, AFL-CIO, California Tax Reform Association --------------------------------- SB 1053 - Runner Page 5 Consultant: Meg Svoboda