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.
               








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                 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  








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          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  








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               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  








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               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.









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          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  








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          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  








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          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  








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            Manufacturing


          The publicly stated intent of the bill is to support the  
          aerospace industry; consequently, it is unclear why NAICS 3359  
          is also included.