BILL ANALYSIS Ó Senate Appropriations Committee Fiscal Summary Senator Kevin de León, Chair AB 2389 (Fox) - Capital Investment Incentive Program and Corporation Tax Credit Amended: July 2, 2014 Policy Vote: G&F 4-2 Urgency: Yes Mandate: No Hearing Date: July 3, 2014 Consultant: Robert Ingenito This bill meets the criteria for referral to the Suspense File. Bill Summary: AB 2389, an urgency measure, would (1) modify the Capital Investment Incentive Program (CIIP), and (2) allow a tax credit under the Corporation Tax (CT) Law to a qualified taxpayer in an amount equal to 17.5 percent of qualified wages paid by the taxpayer during the taxable year to qualified full-time employees, as specified. Fiscal Impact: The bill would lead to up to $420 million in direct costs to the General Fund in forgone tax revenue over 15 years. However, under the current version of the bill, the first three years would be funded from an existing credit (up to $25 million per year). Consequently, relative to current law, the bill would reduce revenues by up to by $345 million. Credits claimed in the initial year could be lower than the cap due to the pace of initial hiring. To the extent that tax credits under this bill "crowd out" tax credits available to other employers during the first three years, a cost pressure of up to $75 million could result (see Staff Comments). The Franchise Tax Board (FTB) indicates that it would incur a one-time implementation cost of $82,000 (General Fund), related to IT changes. The Governor's Office of Business and Economic Development (GO-Biz) indicates that it would incur minor and absorbable administration costs. AB 2389 (Fox) Page 1 Potential General Fund revenue (resulting from the production of the aircraft in California and subsequent taxable economic activity) that would not have occurred absent the enactment of the tax credits. However, the amount is unknown, and the extent to which the tax credits would result in economic activity in California that would not have otherwise occurred is unclear (see Staff Comments). Background: The aircraft industry grew more rapidly over the first half of the twentieth century than any other segment of the California economy. In 1910, William Randolph Hearst offered $50,000 to the first pilot who could fly from California to the East Coast in thirty days or less; however, no one claimed the prize. That same year saw the nation's first public aviation meet, which occurred on Dominguez Ranch near Los Angeles. This event drew over 200,000 people, and the meet established initial aviation speed and endurance records. After World War I, Southern California's airplane designers and manufacturers began to construct a variety of aircraft. By 1935, the output of California's aircraft industry totaled $20 million annually ($340 million in 2013 dollars). The industry steadily grew through World War II and during the Cold War, encompassing a wide range of activities, including military and civilian aircraft, reconnaissance and communications satellites, strategic missiles, and space exploration. Sonic booms and test-rocket firings that flashed and echoed in the foothills became common occurrences in Southern California, and the region's economy became linked to the ebbs and flows of defense spending. By the early 1960s, roughly 40 percent of the $6.1 billion U.S. Department of Defense prime contracts for development, test and research work went to California. That proportion continued into the 1980s, and the industry employed roughly 500,000. 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 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 AB 2389 (Fox) Page 2 collapse of the Soviet Union and the end the Cold War led to more than 50 major defense companies consolidating into only six. Employment Development Department (EDD) employment data indicate that the Aerospace Production and Manufacturing sector declined from 214,200 in 1990 to 71,900 in 2013, an average annual decline of 8.7 percent; Los Angeles County's aerospace employment comprises roughly 60 percent of the statewide total, and shrank proportionately over the same time period. Most of the declines occurred before 2004. However, further job decline is possible because defense spending is expected to fall due to the implementation of federal budget cuts. I. Origin of the California Competes Tax Credit. The California Competes Tax Credit is an income tax credit available to businesses that seek either to come to California or grow existing operations in the State. Tax credit agreements are negotiated by GO-Biz and approved by a newly created "California Competes Tax Credit Committee," consisting of the State Treasurer, the Director of the Department of Finance (DOF), the Director of GO-Biz, one appointee each by the Speaker of the Assembly and Senate Committee on Rules. Its origins stem from the 2013-14 budget negotiations. In June 2013, the Legislature enacted AB 93 (Committee on Budget), which reformed California's economic development policies by eliminating enterprise zones (EZs) 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 EZs, and other areas that suffer from high levels of poverty and unemployment. The credit lasts from 2014 until 2019. A sales and use tax exemption on purchases of manufacturing equipment made by taxpayers within specific North American Industrial Classification System (NAICS) 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 AB 2389 (Fox) Page 3 2013-14, $150 million in 2014-15, and $200 million for the 2015-16, 2016-17, and 2017-18 fiscal years, subject to adjustments. II. Capital Investment Incentive Program. Counties and cities can choose to 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 percent of the capital incentive amount, up to $2 million annually. 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. III. Tax Credits. Current 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, in the absence of the tax credit, they would not do. DOF is required to annually publish a list of tax expenditures, which currently total around $50 billion per year. Proposed Law: This bill would enact the following two tax incentives: Capital Investment Incentive Program. This bill would, among other things, modify the definition of a "qualified manufacturing facility" such that it would apply to businesses described within Code 3359 or 3364 of the 2012 AB 2389 (Fox) Page 4 North American Industrial Classification System (NAICS) Manual. These NAICS Codes contain firms manufacturing electrical equipment and components, and establishments engaged in aerospace product and part manufacturing. This bill would also temporarily modify the definition of a "capital investment incentive amount". Currently, as noted above, a proponent pays property taxes on no less than the first $150 million of the facility's assessed value and then may receive a property tax rebate for the taxes paid on the facility's value in excess of $150 million. This bill would authorize a local government to rebate property tax revenues paid on the facility's assessed value above $25 million (instead of $150 million per current law). Program administration would be shifted to GO-Biz. These modifications would cease to be operative on July 1, 2015. Thereafter, the capital investment incentive program would revert to its current form, with certain modifications, and will remain in effect until January 1, 2018. However, incentive programs established before these dates would be effective for their full term. Wage and Property Credit. AB 2389 would enact a tax credit equal to 17.5 percent of wages paid during the taxable year to qualified employees, on a full-time equivalent basis. To qualify, taxpayers must be major, first-tier subcontractors (as defined) awarded a subcontract to manufacture property for ultimate use in or as a component of advanced strategic aircraft, and pay wages to employees (1) such that at least 80 percent 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 (2) that average a minimum 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. The cap is set at $25 million annually for the first five years, $28 million annually for the middle five years, and $31 million annually for the final five years (for a 15-year total of $420 million). FTB must allocate the credit on a first-come, first-served basis, and taxpayers can carry forward the credit for seven years. AB 2389 (Fox) Page 5 Staff Comments: This bill is the result of negotiations between the Administration and Lockheed Martin (LM) in support of LM's efforts to win the bidding for the Advanced Strategic Aircraft Program (ASAP). According to the author, the State would receive a significant net benefit from enacting the bill. Specifically, the result would be an increase of 750 aerospace jobs (and the retention of another 350 existing jobs), roughly 4,800 indirect jobs, and additional jobs created by smaller suppliers. One study concludes that each aerospace job created would lead to an additional 3.8 jobs in the State, and that the bill would generate $1.2 billion in net state and local tax revenue over the 15-year period. However, these job and revenue estimates are likely overstated; if this bill is not enacted, the $420 million over 15 years would be available for other purposes, such as broader-based tax reductions, or investments in education or infrastructure. These potential alternative uses of the $420 million would also increase economic activity and revenues, albeit by an unspecified amount. Thus, the net impact from this bill would likely be less than $1.2 billion. The view that this tax program could pay for itself was echoed by DOF staff testifying before the Senate Governance and Finance Committee on July 1, 2014. The representative indicated that it is the Administration's expectation that the amount of the tax credits used will be completely offset by higher income tax, corporation tax and property tax revenues spurred by subsequent increases in economic activity. However, the DOF testimony is a departure from current practice, and raises key process questions for the Committee: will DOF routinely apply the revenue estimation methodology it used on this bill to other tax legislation, and will it make this methodology available to the public? The Committee regularly considers proposed legislation that would change the base and/or the rate of a given tax. With respect to determining the revenue impacts of such proposals, debate exists over whether to use "static analysis" or "dynamic analysis." The main difference between the two is that dynamic revenue analysis attempts to take into account both the direct behavioral effects and the broader economic feedback effects of tax law changes on the amount of revenues collected. In contrast, static analysis does not attempt to measure these AB 2389 (Fox) Page 6 dynamic effects. Rather, it assumes that such things as the size of the tax base, and spending and other decisions by individuals and businesses, are unaffected by tax law changes. The Legislative Analyst's Office (LAO) has noted that, in theory, revenue estimates should incorporate all dynamic effects in order to accurately measure how actual tax collections will be affected by law changes. In practice, however, the LAO notes that a number of factors make this a challenge. First, accurately modeling dynamic effects is inherently difficult. This in part is due to data limitations and lack of knowledge about exactly how taxpayers behave. Second, the way that tax changes are financed matters. For example, does a tax reduction result in lower governmental services of some sort or involve backfilling lost revenues from another source? The dynamic effect on revenues is affected by the specific answer. Third, dynamic effects can be very complicated. They can involve a wide range of considerations from spending and investment decisions, to interstate migration flows, to decisions about working. In addition, the timing of dynamic effects can be hard to pinpoint. Given these and other issues, questions have been raised about the reliability of dynamic estimates, whether or not they should be used in budgetary calculations, and whether they make sense from a cost/benefit perspective. California had a dynamic revenue estimating requirement in place for DOF from 1994 through 2000 under Chapter 393, Statutes of 1994 (SB 1893, Campbell). The State worked with University of California economists to construct a large economic model capable of looking at dynamic effects, and DOF was given resources to provide information on dynamic effects in its analyses of tax bills and proposals. The legislation requiring dynamic analysis was ultimately allowed to sunset. Despite not routinely doing full-blown dynamic analysis for tax measures, current revenue estimates for tax bills do often incorporate significant assumptions about the direct behavioral responses of taxpayers affected. As one example, proposals to increase cigarette taxes incorporate research results about how higher cigarette prices reduce consumption. Because of the difficulties inherent in perform dynamic revenue analysis, the fact that the implementing legislation sunset and the model housed at DOF ceased to be used, this Committee relies AB 2389 (Fox) Page 7 on static analysis when scrutinizing revenue proposals. DOF generally does as well. The Administration's public statement that the tax credits under this bill would be offset by higher future revenues is a major departure from the status quo. Potential Cost Pressures. As noted previously, California Competes is currently subject to annual caps. These caps are intended to limit revenue losses to ensure that last year's replacement of EZs with new tax reductions is revenue-neutral. The Committee just made its first allocation of tax credits. Specifically, 396 firms reportedly applied for credits totaling over $500 million, well in excess of the $30 million first-year cap. The current version of this bill sets aside a portion of the credits that would be available under California Competes and reserves them for LM. Thus, firms will be competing for a smaller amount of tax credits than would be the case absent this bill, which could result in a cost pressure to restore the tax credits available under California Competes to the original amounts. Setting a Precedent? As noted by staff from the Senate Governance and Finance Committee, other firms could threaten to move employment out of state unless they receive significant, expedited tax benefits. To the extent that this occurs, future revenues could be lower than what would occur on the natural, and the net fiscal impact would be unclear. NAICS Codes. Finally, under the provisions of the bill, certain tax relief would be available to firms in two four-digit NAICS Codes. One of them is NAICS 3364, "Aerospace Products and Parts Manufacturing". The other NAICS category affected by the bill is NAICS 3359, "Other Electrical Equipment and Component Manufacturing". This industry group comprises establishments manufacturing electrical equipment and components (except electric lighting equipment, household-type appliances, transformers, switchgear, relays, motors, and generators). The primary subcomponents of this NAICS code are as follows: 33591 Battery Manufacturing 33592 Communication and Energy Wire and Cable Manufacturing 33593 Wiring Device Manufacturing 33599 All Other Electrical Equipment and Component AB 2389 (Fox) Page 8 Manufacturing The publicly stated intent of the bill is to support the aerospace industry; consequently, it is unclear why NAICS 3359 is also included.