April 12, 2016 2015-127
The Governor of California
President pro Tempore of the Senate
Speaker of the Assembly
Sacramento, California 95814
Dear Governor and Legislative Leaders:
As requested by the Joint Legislative Audit Committee, the California State Auditor presents this audit report concerning the benefits and cost-effectiveness of state corporate income tax expenditures (tax expenditures). Defined as tax benefits for qualifying corporations, tax expenditures—which together cost the State more than $5 billion in forgone tax revenues in fiscal year 2012–13—include exemptions from certain taxes, deductions from taxable income, credits that reduce total tax liability, exclusions that do not tax certain income, and elections that allow a choice in how taxes are calculated.
This report concludes that adopting oversight methods that other states use would improve the effectiveness of the State’s current and future tax expenditures, providing the Legislature with more information and a better accounting of their effectiveness and impact. These practices include the use of clearly stated policy objectives to define the Legislature’s intent in enacting the tax expenditures, corresponding performance measures, and sunset provisions to prompt legislative review and to create the ability to more easily modify or repeal them if needed. By consistently following these best practices, existing tax expenditures could be improved while simultaneously reducing the risk of creating new ineffective incentives.
We reviewed six of the largest California tax expenditures for the most recent three years. For two of the tax expenditures—the research and development (R&D) credit and the minimum franchise tax exemption—a lack of oversight or evaluation has resulted in insufficient evidence to determine if they are fulfilling their purposes. Without appropriate evidence to confirm their effectiveness, it is not clear that the amount of forgone revenue associated with these two tax expenditures—$1.5 billion alone for the R&D credit in fiscal year 2012–13—is being well spent or if these funds could be better allocated to fulfill the same policy objectives. Three other tax expenditures—the water’s edge election, the low‑income housing credit, and the film and television credit—appear to be achieving their purposes, but improvements would make them more effective. For example, the water’s edge election allows corporations to exclude from their reportable income what they derive from the foreign portions of their business, but may also provide unintended benefits that reduce state revenue, such as allowing corporations to shield income in offshore tax havens. Extending the water’s edge to countries considered tax havens, as other states have done, could result in additional state revenue of $20 million to $40 million without violating the purpose of the tax expenditure. Finally, the Subchapter S corporation election, which offers businesses an alternative to the standard Subchapter C corporation filing status, appears to be achieving its purpose.
ELAINE M. HOWLE, CPA