BILL ANALYSIS                                                                                                                                                                                                    Ó



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          Date of Hearing:  August 12, 2013

                     ASSEMBLY COMMITTEE ON REVENUE AND TAXATION
                                Raul Bocanegra, Chair

                AB 653 (V. Manuel Perez) - As Amended:  August 5, 2013
           
                                       SUSPENSE
          2/3 vote.  Urgency.  Fiscal committee.

           SUBJECT  :  Economic Development

           SUMMARY  :  Establishes the California Innovation and Jobs Act,  
          which increases the amount of the research and development (R&D)  
          tax credit and codifies the California Innovation Hub (iHub)  
          Program.  Specifically,  the tax-related provisions of this bill  :  
           

          1)Provide for an increased rate of the R&D tax credit under the  
            Personal Income Tax (PIT) Law, as follows:

             a)   18% beginning on or after January 1, 2014, and before  
               January 1, 2015.

             b)   21% beginning on or after January 1, 2015, and before  
               January 1, 2016.

             c)   24% beginning on or after January 1, 2016, and before  
               January 1, 2017.

             d)   27% beginning on or after January 1, 2017, and before  
               January 1, 2018.

             e)   30% beginning on or after January 1, 2018, and before  
               January 1, 2019.

             f)   15% beginning on or after January 1, 2019.

          2)Provide for an increased rate of the R&D tax credit applied to  
            qualified research expenses, under the Corporate Tax (CT) Law,  
            as follows:

             a)   18% beginning on or after January 1, 2014, and before  
               January 1, 2015.









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             b)   21% beginning on or after January 1, 2015, and before  
               January 1, 2016.

             c)   24% beginning on or after January 1, 2016, and before  
               January 1, 2017.

             d)   27% beginning on or after January 1, 2017, and before  
               January 1, 2018.

             e)   30% beginning on or after January 1, 2018, and before  
               January 1, 2019.

             f)   15% beginning on or after January 1, 2019.

          3)Provide for an increased rate of the R&D credit applied to  
            basic research payments, under the CT Law, as follows:

             a)   27% beginning on or after January 1, 2014, and before  
               January 1, 2015.

             b)   30% beginning on or after January 1, 2015, and before  
               January 1, 2016.

             c)   33% beginning on or after January 1, 2016, and before  
               January 1, 2017.

             d)   36% beginning on or after January 1, 2017, and before  
               January 1, 2018.

             e)   39% beginning on or after January 1, 2018, and before  
               January 1, 2019.

             f)   24% beginning on or after January 1, 2019.

           EXISTING FEDERAL LAW  :

          1)Allows taxpayers engaged in a trade or business to deduct all  
            of the ordinary and necessary business expenses incurred.

          2)Allows a R&D tax credit that is combined with several other  
            credits to form the general business credit.  The R&D credit  
            is designed to encourage companies to increase their R&D  
            activities.   

          3)Specifies that the R&D credit is equal to 20% of the qualified  








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            research expenses that exceed the base year amount, as  
            defined, plus 20% of the amount paid or incurred during the  
            taxable year on research undertaken by an energy research  
            consortium.

          4)Defines "base year amount" as the product of the average  
            annual gross receipt of the taxpayer for the four taxable  
            years preceding the taxable year the credit is earned times a  
            fixed percentage, but under no circumstances may the base year  
            amount be less than 50% of the qualified research for the  
            taxable year. 

          5)Authorizes an additional credit to corporate taxpayers equal  
            to 20% of expenses paid to fund "basic research" at  
            universities and certain nonprofit scientific research  
            organizations. 

          6)States that a taxpayer was allowed, prior to January 1, 2009,  
            to elect an alternative incremental research credit for  
            determining its R&D credit.  The current federal percentages  
            are 3%, 4%, and 5%.  

          7)Allows an alternative simplified credit equal to 14% of  
            research expenses that exceed 50% of the average research  
            costs for the three preceding taxable year. 

          8)Specifies that, in order to qualify for the R&D credit,  
            research expenses must qualify as an expense or be subject to  
            amortization, be conducted in the U.S. and be paid by the  
            taxpayer. 

          9)Provides that "qualified research" is research that is:

             a)   Undertaken to discover information that is technological  
               in nature; 

             b)   Primarily involves experimentation related to quality or  
               to a new or improved function or performance; and, 

             c)   Its application will be useful in developing new or  
               improved business components for the taxpayer.

           EXISTING STATE LAW  :

          1)Allows various tax credits designed to either provide tax  








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            relief for taxpayers who incur certain expenses or to  
            influence taxpayers' behavior.  

          2)Conforms California to the federal R&D credit but with the  
            following modifications:

             a)   The state R&D credit is not combined with other business  
               credits.

             b)   Both "qualified research" and "basic research" must be  
               undertaken in California.

             c)   The credit percentage for increasing qualified research  
               activities in California is 15%.

          3)Provides an alternative credit of 24% (versus the 20% federal  
            credit) for "basic research", available for "C" corporations  
            only.

          4)Sets the percentages for the alternative incremental research  
            portion of the credit lower than those of the federal credit. 

          5)Allows the R&D credit, which is permanent, for taxable years  
            beginning on or after January 1, 1987. 

          6)Allows taxpayers that are members of a combined reporting  
            group to make a one-time irrevocable assignment of eligible  
            credits to another member.  However, the assigned credits may  
            be utilized to reduce tax only for taxable years beginning on  
            or after January 1, 2010.

           FISCAL EFFECT  :  The FTB estimates an annual revenue loss of $20  
          million in fiscal year (FY) 2013-14, $95 million in FY 2014-15,  
          and $190 million in FY 2015-16.

           COMMENTS  :   

          1)The author has provided the following statement in support of  
            this bill:

               The State of California was once regarded as the gold  
               standard of innovation and a leader of disruptive trends  
               and technologies that quite literally transformed the  
               world. It was California that gave rise to the personal  
               computer (Apple and Hewlett-Packard), the counter culture  








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               (Berkeley) and ground breaking software-based platforms  
               (Google, Facebook, eBay and Amazon). Today, the state is  
               suffering from an economic malaise. In numerous surveys,  
               California is consistently ranked as having a poor business  
               climate. 

               AB 653 proposes a coordinated economic revitalization  
               strategy that not only leverages the state's  
               entrepreneurial knowhow, but also incentivizes businesses  
               to risk their capital to develop and improve the next  
               generation of cutting edge technologies. It is time to  
               begin the process of developing an economic strategy that  
               focuses on California's greatest asset: our ability to  
               innovate.

           2)What is a "tax expenditure"?  :  Existing law provides various  
            credits, deductions, exclusions, and exemptions for particular  
            taxpayer groups.  In the late 1960s, U.S. Treasury officials  
            began arguing that these features of the tax law should be  
            referred to as "expenditures," since they are generally  
            enacted to accomplish some governmental purpose and there is a  
            determinable cost associated with each (in the form of  
            foregone revenues).  This bill would enact new tax expenditure  
            programs in the form of a SUT exemption for manufacturing  
            equipment, and a new tax credit for private investments in  
            postsecondary institutions, and would increase the applicable  
            R&D tax credit percentages.

           3)How is a tax expenditure different from a direct expenditure?  :  
             As the Department of Finance notes in its annual Tax  
            Expenditure Report, there are several key differences between  
            tax expenditures and direct expenditures.  First, tax  
            expenditures are reviewed less frequently than direct  
            expenditures once they are put in place.  This can offer  
            taxpayers greater certainty, but it can also result in tax  
            expenditures remaining a part of the tax code without  
            demonstrating any public benefit.  Second, there is generally  
            no control over the amount of revenue losses associated with  
            any given tax expenditure.  Finally, it should also be noted  
            that, once enacted, it takes a two-thirds vote to rescind an  
            existing tax expenditure absent a sunset date.  This bill does  
            not include a sunset date for any of the provisions increasing  
            or creating new tax expenditures.  The author may wish to  
            include a sunset date on all of the provisions of this bill.









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           4)R&D credit background  :  California enacted the credit for  
            research expenses in 1987 as part of two general federal tax  
            conformity bills [AB 1172 (Klehs), Chapter 1138, Statutes of  
            1987 and SB 572 (Garamendi), Chapter 1139, Statutes of 1987].   
            The original credit percentage was 8% of qualified research  
            expenses.  Since that time, the California R&D credit rate was  
            amended several times and, finally, was increased from 12% to  
            15% in 2000 [AB 511 (Alquist), Chapter 107, Statutes of 2000].  
              The alternative incremental computation of the R&D credit  
            was adopted in 1997 [AB 1042 (Wayne), Chapter 613, Statutes of  
            1997] and was subsequently amended to reflect the changes to  
            the California research credit percentage [AB 2798 (Machado),  
            Chapter 323, Statutes of 1998].  Unlike the federal R&D  
            credit, the California R&D credit is permanent.

           5)What does the R&D credit provision do?  :  Under the PIT Law,  
            the R&D credit provision of this bill would incrementally  
            increase the credit percentage applied to qualified research  
            expenses in excess of the base amount from 15% to 30%.  The  
            increase will occur over a five-year period beginning on  
            January 1, 2014.  Under the CT Law, the credit percentage  
            applied to qualified research expenses would be incrementally  
            increased from 15% to 40% over a five-year period beginning on  
            January 1, 2014.  

            Additionally, under the CT Law, the R&D provision would  
            increase the credit percentage applied to basic research from  
            24% to 40%.  The increase would occur at a rate of 5% for  
            three years and an increase of 1% for the last year.  For  
            taxable years beginning on or after January 1, 2018, the  
            credit percentage applied for basic research will be reduced  
            from 40% to 25%.  
                
            6)The R&D credit  :  There are two main purposes for the federal  
            and California R&D credit.  First, it is intended to reduce  
            the after-tax cost of R&D investments, which is expected to  
            lead to an increase in R&D activity and to encourage taxpayers  
            to conduct R&D in the U.S. rather than in another country.   
            Similarly, the California R&D credit is designed to increase  
            R&D activity and to encourage manufacturing related to R&D to  
            be undertaken in California rather than elsewhere.  The  
            California's R&D credit provides a powerful incentive for  
            firms to conduct R&D in this state because of its high credit  
            percentages that exceed that of other states and because it is  
            permanent.  This credit, unlike many other tax incentives,  








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            does not serve as a reward for past behavior since it could  
            only be claimed for incremental increases in the taxpayer's  
            research activity.  As explained by the Joint Committee on  
            Taxation's Report, "incremental credits attempt not to reward  
            projects that would have been undertaken in any event but to  
            target incentives to marginal projects."  (Joint Committee on  
            Taxation, Description of Revenue Provisions Contained in the  
            President's Fiscal Year 2010 Budget Proposal, Part Two:   
            Business Tax Provisions, JCS-3-09, p. 17).  It is impossible,  
            however, to determine which projects would be undertaken  
            without the credit, and thus, "most incremental credit  
            proposals rely on some measure of the taxpayer's previous  
            experience as a proxy for a taxpayer's total qualified  
            expenditures in the absence of a credit", i.e. "a base  
            amount." (Id., p.18).   Nonetheless, the incentive effects of  
            incremental credits per dollar of revenue loss can be many  
            times larger than those of a flat credit.

          The California R&D credit is believed to create additional R&D  
            jobs in the state which, arguably, are more desirable than  
            jobs in other industries.  It also allows other California  
            businesses to adopt innovations developed locally more rapidly  
            than innovations developed elsewhere.  As explained by the  
            FTB, the advantage to California "may come through something  
            economists call economies of agglomeration," which can be  
            described as the benefits several firms receive when locating  
            in close proximity.  (California Income Tax Expenditures,  
            Compendium of Individual Provisions, Updated December 2009,  
            FTB, p.17).  Specifically, cost of production may  
            significantly decline because there is a greater chance for  
            specialization and division of labor.  If this is the case,  
            many California businesses, not just those receiving this  
            credit, will gain an advantage over their rivals in other  
            states.  

           7)Why subsidize R&D?  :  Positive externalities are benefits  
            resulting from an economic activity that are enjoyed by third  
            parties.  It is a benefit that is not received directly by the  
            seller or the buyer.  California's R&D credit creates a number  
            of positive externalities such as reducing the costs of other  
            firms' innovative activity, and providing newer, better, and  
            less expensive products to the market.  (Bronwyn Hall and  
            Marta Wosinka, The California R&D Tax Credit:  Description,  
            History, and Economic Analysis, June 1999).  For example,  
            research conducted by a bio company may lead to the new  








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            medication, which can increase sales, but the benefits may  
            also include an overall healthier population.  Because the bio  
            company does not necessarily receive a direct benefit from  
            having a healthier population, it may limit itself from  
            conducting additional R&D even though a greater amount of  
            research would be better for society.  If this is the case,  
            the state can choose several avenues to encourage additional  
            research.  The most common types are subsidies and mandates.  

            In a supply and demand model, the supply curve can be thought  
            of as marginal cost and the demand curve can be thought of as  
            marginal benefit.  Equilibrium is reached where the marginal  
            cost equals marginal benefit.  Everything to the left of the  
            equilibrium point and between the marginal benefit and  
            marginal cost curves is a benefit to society because the  
            marginal benefit is greater than the marginal cost.  However,  
            in terms of R&D, the marginal benefit curve of a firm  
            investing in research may not necessarily capture the positive  
            externalities received by society.  Because of this, a company  
            may choose to curtail R&D investment.  Ideally, society would  
            want the private marginal benefit curve to be the same as  
            society's marginal benefit curve.  The disparity can be  
            thought of as a "market failure," because the amount of  
            research conducted by individual firms is less than what is  
            needed to capture the additional marginal benefits enjoyed by  
            society.  This could be remedied by providing a subsidy to a  
            researching firm, which federal and state governments already  
            provide.  The subsidy will lower the cost of production and  
            increasing the amount of research conducted by a firm.  The  
            subsidy works so long as investment is increased up to the  
            point where the marginal social benefit equals marginal cost.   
            Assuming current investment in research is less than the  
            optimal level, increasing the R&D tax credit can provide a  
            larger benefit to society than the cost of the subsidy.  

            It should also be noted that not all R&D activity provides the  
            same level of positive externalities.  In other words, the  
            benefits received by society from increased research in  
            medicine are probably greater than the benefits received from  
            other forms of research.  According to the Legislative  
            Analyst's Office (LAO), the following sectors claimed more  
            than $100 million per year in credits:  computer and  
            peripheral equipment manufacturing, communications equipment  
            manufacturing, semiconductor and other electronic component  
            manufacturing, pharmaceuticals and medicine manufacturing, and  








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            software publishers.  The subsidy may be better utilized by  
            focusing the tax credit on industries that provide the  
            greatest benefit to California.  

           8)Should the R&D credit be increased?  :  As noted above, the  
            quantity of R&D is optimal at the point where marginal social  
            benefit equals marginal cost.  According to the Joint  
            Committee on Taxation, "there is evidence that the current  
            level of research undertaken in the United States, and  
            worldwide, is too little to maximize society's well-being."   
            (JCS-3-09, p. 11).  However, the report also explained that  
            "it is difficult to determine whether, at the present levels  
            and allocation or additional tax benefits for research would  
            increase or decrease overall economic efficiency."  Id.   
            Additionally, the purpose of the California R&D credit has  
            less to do with capturing the positive externalities and  
            spillovers associated with R&D and more to do with simply  
            bringing R&D research to California.  Because barriers  
            preventing the flow of information across state lines are  
            virtually non-existent, encouraging companies to conduct  
            research in California may not necessarily confine the  
            benefits of that research in the state.  (California R&D Tax  
            Credit, p. 4).  It may be possible that the manufacturing  
            developed from research conducted in California will take  
            place in other states. 

            It has, however, been reported that state R&D credits are,  
            indeed, effective at increasing R&D in the state.  (D. Wilson,  
            Beggar thy Neighbor?  The In-State, Out-of-State, and  
            Aggregate Effects of R&D Tax Credits, Federal Reserve Bank of  
            San Francisco, January 2008).  Specifically, it has been found  
            that a 1% point increase in a state's effective R&D credit  
            rate leads, in the long run, to a 3%-4% in R&D spending within  
            the state.  (Id., pp. 14-15).   However, the study has shown  
            that nearly all of this R&D increase "comes at the expense of  
            reduced R&D spending in other states," such that R&D  
            nationwide, essentially, has remained unchanged.  (Id).   
            Undoubtedly, it is easier for some R&D firms to move their  
            activity to California than it would be for them to move it to  
            another country.  Thus, a California credit appears to be  
            necessary for the state to remain competitive with other  
            states in attracting and maintaining research and development  
            business activity, which not only creates desirable jobs but  
            also allows other California businesses to adopt innovations  
            developed locally more rapidly.








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            Accepting the notion that additional state subsidies for  
            research are warranted, California's budgetary limitations  
            need to be taken into account.  There are various private  
            transactions among individuals that create positive  
            externalities, (e.g. education, healthcare, technology) but  
            California's limited budget allows for only so much in  
            subsidies.  It is true that additional R&D could increase the  
            benefits California receives from medical research, but it can  
            also receive such benefits by investing directly in  
            educational institutions.  Additionally, the Committee may  
            wish to consider whether the benefits of the marginal increase  
            in the amount of California research activities outweigh the  
            costs of reduced state funding for other important public  
            services.  In 2003, The LAO prepared an overview of the  
            California R&D Tax Credit and suggested that no further  
            expansion of the state R&D tax credit occur without convincing  
            evidence that it is warranted.  The LAO further recommended  
            that the Legislature consider reducing the credit or phasing  
            it out over time, especially in light of the substantial  
            direct revenue losses of the existing R&D tax credit and the  
            state's budgetary position.

           9)Double-Referral  :  This bill was heard in the Assembly  
            Committee on Jobs, Economic Development, and the Economy on  
            April 23, 2013, and passed out of that Committee on a vote of  
            9 to 0.

           10)Related Legislation  :  

            AB 486 (Mullin), introduced in the current legislative  
            session, provides manufacturers, software producers,  
            biotechnology and life, engineering, and physical researchers  
            and developers, a SUT exemption for qualifying TPP.  AB 486  
            was held in the Assembly Committee on Appropriations.

            AB 2278 (Anderson), introduced in the 2009-10 legislative  
            session, conforms to the federal credit percentage for  
            increasing research activities and conforms to the federal  
            alternative incremental research credit.  AB 2278 was held in  
            this Committee.

            AB 1484 (Anderson), introduced in the 2009-10 legislative  
                                    session, conforms to the federal credit percentage for  
            increasing research activities and conforms to the federal  








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            alternative incremental research credit.  AB 1484 was never  
            heard in this Committee.

           REGISTERED SUPPORT / OPPOSITION  :   

           Support 
           
          None on file

           Opposition 
           
          None on file
           
          Analysis Prepared by  :  Carlos Anguiano / REV. & TAX. / (916)  
          319-2098