BILL ANALYSIS Ó SENATE GOVERNANCE & FINANCE COMMITTEE Senator Lois Wolk, Chair BILL NO: AB 2389 HEARING: 7/1/14 AUTHOR: Fox FISCAL: Yes VERSION: 6/25/14 TAX LEVY: Yes CONSULTANT: Grinnell CAPITAL INVESTMENT INCENTIVE PROGRAM: CORPORATION TAX CREDIT: NEW ADVANCED STRATEGIC AIRCRAFT PROGRAM (URGENCY) Enacts two tax credits for subcontractors performing contracts for new advanced strategic aircraft programs. Background and Existing Law The aerospace industry in California began with a few aircraft builders during World War I, and then vastly expanded in the mobilization for World War II. The industry steadily grew during the cold war, encompassing a wide range of activities, including military and civilian aircraft, reconnaissance and communications satellites, strategic missiles, and space exploration. By the 1980s, about 40 percent of the aerospace business nationwide resided in southern California, and the industry employed close to a half-million people. One of the region's strongest selling points for aerospace was its environment: the clear blue skies and ample open spaces were ideal for testing new aircraft. California also was home to a variety of related industries, particularly petroleum, as well as to top-notch research universities and a large labor pool. Defense spending peaked at $557 billion in 1985 (in constant fiscal 2009 dollars) and then began a downward trend. The Soviet Union collapsed in December 1991, ending the Cold War: in the next decade, more than 50 major defense companies consolidated into only six. According to the Employment Development Department's Labor Market Information Division, California employment in the Aerospace Production and Manufacturing sector declined almost by half from 139,300 in 1993 to 70,800 in 2013, although almost all of the decline occurred before 2004. Additionally, defense spending is expected to fall due to the implementation of federal budget cuts. AB 2389 - 6/25/14 -- PageB I. Capital Investment Incentive Program. Counties and cities can pay a "capital investment incentive amount" for 15 years to attract qualified manufacturing facilities. A proponent pays property taxes on no less than the first $150 million of the facility's value, and then receives a property tax rebate for the taxes paid on the facility's value above that amount. In return for this property tax rebate, the proponent must pay a community service fee equal to 25% of the capital incentive amount, up to $2 million a year. The proponent must sign a community services agreement that spells out the fee, payment conditions, a job creation plan, and provisions to recapture the incentive payments if the proponent fails to run the facility as agreed. A city or special district may pay the county or city an amount equal to the amount of property tax revenue that the local government receives from the facility's property taxes paid on the facility's value over $150 million. To qualify for this tax rebate program, a qualified manufacturing facility must: Have an initial investment in real and personal property over $150 million, certified by the Business, Transportation, and Housing Agency. Be within the county or city offering the capital incentive program. Be operated by a business within specified Standard Industrial Classification Codes or a business that recovers minerals from geothermal resources. Be engaged in commercial production or manufacture of products. The Legislature originally passed the tax rebate program to help Placer County officials attract an Intel plant, but they never use d the law (SB 566, Thompson, 1997). Legislators expanded the definition of a qualified manufacturing facility to include CalEnergy Company's plan to extract minerals from geothermal brine (SB 133, Kelley, 1999.) In 2009, the Legislature expanded the program to include manufacturers that produce of electricity using solar, wind, biomass, hydropower, or geothermal resources, shifted the program to the Trade and Commerce Agency's successor, the Business, Transportation and Housing Agency, and chose to sunset the program entirely in 2017 (AB 904, V.M Perez, 2009). In 2012, the Legislature expanded the AB 2389 - 6/25/14 -- PageC program to include research and development facilities as defined, raised the threshold amount to $250 million, and shifted program administration from the now-defunct Business, Transportation, and Housing Agency to the Governor's Office of Business and Economic Development (GO-Biz), which successfully enticed the Samsung Corporation to expand a facility in San Jose (SB 1006, Committee on Budget and Fiscal Review). However, the bill repealed all of its changes on June 30, 2013. II. Tax Credits. California law allows various income tax credits, deductions, and sales and use tax exemptions to provide incentives to compensate taxpayers that incur certain expenses, such as child adoption, or to influence behavior, including business practices and decisions, such as research and development credits. The Legislature typically enacts such tax incentives to encourage taxpayers to do something that but for the tax credit, they would not do. The Department of Finance is required to annually publish a list of tax expenditures, currently totaling around $50 billion per year. In 1998, the Legislature enacted two tax credits which led to some work on the Joint Strike Fighter (JSF) being performed in California (AB 2797, Machado, 1998). Taxpayers that were contractors or subcontractors that manufacture property for ultimate use in a JSF could claim: The wage credit is equal to 50% of wages paid up to 150% of the minimum wage, not to exceed $10,000 per year, per employee, that are direct costs allocable to property manufactured in this state for ultimate use in a JSF, with certain limitations. The property credit, equal to 10% of the cost of qualified property used by a taxpayer primarily in qualified activities to manufacture a product for ultimate use in a JSF, with certain exceptions. Taxpayers could carry forward credits for eight years, but the credit expired in 2006. Estimates vary for number of taxpayers claiming the credit, and its fiscal effect: FTB projected revenue losses between $10 million to $35 million in 2003 and 2004 from the credits, with 15 taxpayers claiming them, but stated no credit had been claimed before 2002. However, the Department of Finance indicated a first-year cost of $60 million for 1998. A recent Congressional Research Service report indicates AB 2389 - 6/25/14 -- PageD that the United States' existing long-range bomber fleet is reaching a critical point at its operational life span, and states "military analysts are beginning to question just how long these aircraft can last and continue to be credible weapons systems." A recent news report indicates that the Unites States Air Force's five-year spending plan includes funds to develop a new long-range bomber, and a congressional press release indicates funding for a new bomber program. Other news reports state that the United States Air Force will issue a request for proposals, and that Northrop Grumman may compete against a joint bid from Boeing and Lockheed Martin to build it. The author wants to reenact the Joint Strike Fighter credits, and expand the Capital Investment Incentive Program in the hopes that future "advanced strategic aircraft programs" will be constructed in California. Proposed Law Assembly Bill 2389 enacts two tax incentives: I. Capital Investment Incentive Program. AB 2389 changes the program to: Lower the threshold of annual property tax revenues the taxpayer must pay to be eligible for an incentive from $150 million to $25 million, Changes the codes for business eligible for the program from any business within 3500 to 3899 of the Standard Industrial Classification to companies within 3359 or 3364 of the North American Industrial Classification System Codes, The measure also makes conforming changes, and provides that specified events constitute good cause for the purpose of waiving recapture for failure to perform, Shifts program administration to GO-Biz, and Repeals these changes as of January 1, 2016, but provides that any incentive program established before that date remains in effect for its full term. Extends the sunset on the entire program from 2017 to 2018, and again clarifies that any incentive program established before that date remains in effect for its full term. II. Wage and Property Credit. AB 2389 enacts a tax credit equal to 17.5% of wages paid during the taxable year to AB 2389 - 6/25/14 -- PageE qualified employees, on a full-time equivalent basis. To qualify, taxpayers must be major, first-tier subcontractors awarded a subcontract to manufacture property for ultimate use in or as a component of advanced strategic aircraft, and pay wages to employees: Where at least 80% of his or her services are directly related to the taxpayer's subcontract work on new advanced strategic aircraft for the United States Air Force, and Paid for services not less than an average of 35 hours a week, or is a salaried employee, as defined. The credit lasts from the 2015 taxable year until the 2029 taxable year, and is subject to an annual cap for all taxpayers set at $25 million annually for the first five years, $28 million for the five years after that, and $31 million for the last five years. FTB must allocate the credit on a first-come, first-served basis, and taxpayers may only claim credits on original, timely-filed returns. Taxpayers can carry forward the credit for seven years. The bill prohibits taxpayers from claiming the credit unless the taxpayer reduces the bid made to subcontract work by an amount that reflects a good faith estimate of the credit. All references to the credit and ultimate cost reductions must be made available by the taxpayer to the Franchise Tax Board (FTB) upon request. The bill sets forth provisions to determine full-time equivalents, allows FTB to issue regulations exempt from the Administrative Procedures Act necessary to implement the bill, and contains an urgency clause. State Revenue Impact Pending. Comments 1. Purpose of the bill . According to the author, "AB 2389 is an economic incentive package that will support the aerospace industry, specifically an "advanced strategic aircraft program." Specifically this bill creates a tax AB 2389 - 6/25/14 -- PageF credit program for the aerospace industry which would total on average $25 million to $31 million per year for 15 years. Under this bill, there are no unaccountable tax giveaways. The credits sunset, are subject to annual caps, and only are provided based on jobs that will be created to work on the advanced strategic aircraft program. Specifically, Credits sunset after 15 years. Credits are capped at: o $25 million for five years; o $28 million for the next five years; and o $31 million for next five years. Credits provided only on a qualified employee basis where that employee is spending 80% of their time working on the advanced strategic aircraft program. AB 2389 expands the ability of a local government to pay an investment incentive, to include qualified aerospace facilities and other specified manufacturing facilities until July 1, 2015. Capital investment incentives are amounts up to the amount of ad valorem property taxes paid by the qualified facility, less 25%. The urgency clause is needed because the Department of Defense (DoD) is currently evaluating several programs to recapitalize its military assets and initiatives. Proposal deadlines require legislation to be finalized prior to the July recess." 2. Process . The Senate Governance and Finance Committee is hearing AB 2389 only five days after the bill's provisions went into print last Thursday, June 26th. The author indicates that the Legislature must enact AB 2389 immediately for any of the advanced strategic aircraft program work to take place in California, because potential subcontractors must submit information to DOD to evaluate in July. However, because DOD programs are confidential due to national security concerns, no independent information exists to verify the deadlines for DOD review compelling legislative action, or that AB 2389's package of tax incentives are the right amount, but not too much, to steer the work to California. Instead, the Committee can only rely on statements from parties involved in recent confidential negotiations between the Governor's Office and Lockheed Martin Aeronautics Company. In May, when the Committee considered SB 998 (Knight), which granted tax benefits to aerospace companies, no mention was made of the AB 2389 - 6/25/14 -- PageG necessity of these tax benefits, or the incipient need to enact them before July. Should the Committee approve $420 million in corporation tax credits over 15 years without complete and verified information? If so, it should expect other firms to threaten to shift employment out of California unless the Legislature grants them significant tax benefits outside the usual process for considering legislative bills. The Committee may wish to consider whether it has the information necessary to approve AB 2389, and the precedent it sets if it does so. 3. Good model . While AB 2389 requires a significant leap of faith, the taxpayer doesn't claim any credits unless they win the subcontract, and employ individuals in the state to perform the subcontract, similar to the JSF credit. Additionally, the measure requires the taxpayer to reflect the credit's value as part of the subcontract bid, although it's unclear how many potential taxpayers are bidding for the subcontract. However, one drawback of AB 2389's credit is that taxpayers can claim it using the same costs that they can deduct as ordinary business expenses. The committee may wish to consider whether the taxpayer should get only the credit in addition to the deduction. 4. Single industry . The Committee considers many proposals for tax incentives similar to AB 2389's tax incentives for aerospace companies. When considering competing claims for finite tax benefits, one way to assess each proposal is to consider what the state is buying with the foregone revenue of tax credits. The state's low-income housing tax credit buys needed housing that must be affordable for up to 50 years. Research and development tax credits can lead to superior consumer products, or cures and remedies for illnesses. Manufacturing incentives like advanced strategic aircraft programs can result in factories and other forms of capital stock, while incentives for movie production may lead to additional employment in the state, but movie productions set up, shoot, and leave quickly. Incentives for aerospace firms will likely lead to increases in human capital, as skilled engineers and technicians are necessary to work on these highly complex projects, with positive spillovers to areas around the locations where they perform the work. The Committee may wish to consider the merits of subsidizing aerospace companies instead of competing claims. 5. One company ? AB 2389 is intended to help the Lockheed AB 2389 - 6/25/14 -- PageH Martin Aerospace Company increase employment in California. While estimates show the state receiving a significant net benefit from enacting the bill, should the state direct its economic development programs to help individual firms? Doing so gives the appearance of favoritism, and sets a precedent for others to ask for similar treatment. 6. Or not ? Northrop Grumman has requested amendments to AB 2389 to extend its tax benefits to prime contractors of advanced strategic aircraft systems, similar to the JSF credit. Northrop states that because AB 2389 is limited only to subcontractors, including prime contractors allow the state to benefit regardless of whoever ultimately wins the contract. Northrop adds that it expects the contract to only have two bidders, and it will bid as a prime contractor. 7. Priorities. Last year, the Legislature enacted AB 93 (Committee on Budget), which reformed California's economic development policies by eliminating enterprise zones and other geographically-targeted economic development areas, instead allowing three new tax benefits: Tax credits for wages paid by taxpayers to qualified employees within former enterprise zones, and other areas that suffer from high levels of poverty and unemployment. The credit lasts from the 2014 taxable year until the 2019 taxable year, A sales and use tax exemption on purchases of manufacturing equipment made by taxpayers within specific North American Industrial Classification System codes, capped at $200 million annually per taxpayer, effective July 1, 2014, and ending July 1, 2022. The California Competes Tax Credit, where the California Competes Tax Credit Committee can award various tax credits up to an annually capped amount to taxpayers who apply. The Committee can grant $30 million in tax credits in 2013-14, $150 million in 2014-15, and $200 million for the 2015-16, 2016-17, and 2017-18 fiscal years, subject to adjustments. The credit sunsets in 2025. Firms eligible for AB 2389's tax benefits can apply to the Committee for California Competes Tax Credits; both the bill and the program seek to increase employment in the state by granting tax benefits. However, California Competes is currently subject to caps intended to limit AB 2389 - 6/25/14 -- PageI revenue losses to ensure that last year's reforms are revenue-neutral, and the Committee just made its first allocation of tax credits. One option to assist potential contractors for advanced strategic aircraft systems while limiting fiscal losses would be to deduct the value of AB 2389's tax credits from California Competes' total. However, AB 2389's fixed dollar, fifteen year commitment outlasts California Competes' current sunset and allocation caps. A second option could split the difference by deducting only AB 2389's costs in the first five years, but grant the rest of the credit for years six through fifteen. A final option is for California Competes to award Lockheed Martin a credit based on its current statutory authority since those credits are specifically meant for this type of negotiation between the Governor's office and individual companies. The Committee may wish to consider amending AB 2389 to account for its overlap with California Competes, and limit the risk of revenue loss. 8. Take a walk on the supply side . Since 2008, the Legislature has granted significant tax incentives to reduce employers' costs in the hopes they will deploy revenue that would have flowed to the state in taxes to increase employment, often referred to as "supply-side economics." AB 2389 offers another step in this direction, despite academic research generally dispelling the relationships between tax reductions and employment. Among these: Allowing corporations to share tax credits, and taxpayers to carry forward net operating losses for 20 years, or carry them back three years with delayed effect (AB 1452, Committee on Budget, 2008), Elective sales-factor only apportionment (since repealed by initiative, but an alternative may be returning due to litigation), motion picture production tax credits, and small business hiring credits (ABx3 15 (Krekorian)/SBx3 15 (Calderon), Sales and Use Tax Exclusions for renewable energy manufacturing (SB 71, Padilla, 2010) and advanced manufacturing (SB 1186, 2012), Expanding the Community Development Financial Institution credit from $10 million to $50 million (AB 32, J. Pérez, 2013). Specifically for aerospace, exempting property used in space flight from the personal property tax (AB 777, Muratsuchi, 2014). AB 2389 - 6/25/14 -- PageJ 9. Tradeoffs . Tax benefits directed at specific industries do two things: First, they reward behavior that would have occurred without the subsidy, so-called "deadweight loss." Some firms won't employ more persons, pay higher wages, or reimburse more tuition because of the tax benefit, instead increasing returns to capital in amount equal to the amount of the tax credit. In these instances, the state receives no marginal benefit, and transfers wealth from purposes it would otherwise spend money on for government purposes to the firm. Second, the bill may generate additional employment, wage payments, and economic activity; the incentive will lower production costs at the margin in amounts necessary for firms to choose to make products in California instead of somewhere else. A successful tax credit leads to more economic activity at the margin than its deadweight loss, but no tax credit has yet conclusively demonstrated that its benefits outweigh its costs. The Committee may wish to consider how much additional economic activity AB 2389 will spur versus its deadweight loss. Additionally, enacting a new tax benefit requires cuts in spending or higher taxes to match the amount of foregone revenue resulting from AB 2389. Tax credits do not pay for themselves: the state's last effort of "dynamic revenue analysis" indicates that while dynamic effects are definitely present and visible, their effects are generally relatively modest.<1> The Committee may wish to consider whether the benefits resulting from this manufacturing incentive are worth the tradeoff of cuts in spending or taxes on other activities. 10. Tax competition . States often compete against each other with grants, loans, regulatory incentives, and tax benefits to attract firms to locate within its borders. When successful, states can increase employment, but it's not a free lunch. The Legislative Analyst's Office recently stated: "When government does not offer industry subsidies, businesses in those industries generally locate their economic activities where they would best be suited. For example, agriculture generally plants crops where ---------------------- <1> "Whatever Happened to Dynamic Revenue Analysis in California?" John David Vasche, prepared for the Federation of Tax Administrators, September, 2006. AB 2389 - 6/25/14 -- PageK they are most productive and manufacturing generally locates where it has the best access to inputs, labor, and markets. State film and television subsidies shift activity from where it would otherwise locate to somewhere else without necessarily improving the output or yielding any greater social benefit. At the same time, these subsidies reduce funds for other state priorities, including spending on programs or reductions in tax rates that would benefit all taxpayers equally." Engaging in tax competition is a dangerous game: should California expand its incentives, it should expect other states to follow, fueling a so-called "race to the bottom." The Committee may wish to consider the merits and risks of engaging in tax competition generally, and for defense contractors specifically. 11. Back and forth . Enacted in 1850, the property tax has long served as the foundational revenue source for local agencies to fund services like public safety, health, and education. Until 2011, the Community Redevelopment Law allowed local officials to set up redevelopment agencies (RDAs), prepare and adopt redevelopment plans, and finance redevelopment activities; however, the Legislature dissolved more than 400 redevelopment agencies in 2011 at the request of the Governor, choosing to instead divert these revenues from economic development back to core public services. AB 2389 brings back the use of property taxes for economic development by allowing local agencies to rebate property taxes on property worth more than $25 million back to taxpayers. Are property taxes for public services, or for economic development? The Committee may wish to consider the criteria for allowing local agencies to use property tax revenues for economic development purposes. 12. Urgency . AB 2389 is an urgency measure that will take effect immediately if it's enacted. As such, both houses must approve the bill by 2/3 vote. Assembly Actions Assembly Floor 72-2 Assembly Revenue and Taxation 9-0 AB 2389 - 6/25/14 -- PageL Support and Opposition (06/30/14) Support : California Conference of Machinists and Aerospace Workers; LAEDC. Opposition : None received.