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  






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          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  






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          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.