by Kayla Kitson
At the end of 2017, President Trump signed into law the Tax Cuts and Jobs Act (TCJA), passed with solely Republican support in Congress. As the Budget Center has previously noted, the TCJA — the most extensive revision of the tax code since 1986 — primarily cuts taxes for the wealthy and corporations while increasing the federal deficit by $1.9 trillion over 10 years, putting at risk funding for services that support low- and middle-income families.
Given the severe deficiencies of the TCJA, Californians may be surprised to learn that the new federal tax law has some potential benefits for our state — if our policymakers choose to act. There is much in the TCJA for advocates of tax fairness to dislike, including the large cut in the corporate tax rate (from 35% to 21%), the new deduction for income from “pass-through businesses,” and the reduction in the top personal income tax rate. All of these changes will lead to massive federal revenue losses. However, the new law also includes some reasonable changes that raise federal tax revenue in order to partially offset these losses, including limiting federal tax breaks that are costly, unfair, or economically inefficient. California now has the opportunity to increase state revenue by adopting (or “conforming to”) some of these provisions.
Unlike many other states, California does not automatically conform to changes in the federal tax code. Instead, it selectively conforms to the Internal Revenue Code as of a fixed date, which is currently January 1, 2015, meaning most of the changes made by the TCJA are not in effect for the purposes of calculating statetaxes for California taxpayers. Conforming to federal tax law increases simplicity for tax filers, but there are many provisions of the federal code that don’t align with the state’s policy goals. California practices “selective conformity,” allowing policymakers to conform to some federal tax provisions, but not others. Since the state sets its own tax rates on personal and corporate income, the reductions in federal rates do not apply to state-level taxes. Thus, California can end up with more income tax revenue by conforming to those TCJA provisions that limit tax deductions and exclusions while maintaining current state tax rates.
Corporations that have profits in California currently pay significantly less in state income taxes as a portion of their state profits than they did in the 1980s, partly reflecting the increase in the number and generosity of state tax breaks that have been created over the past few decades. The state can narrow some of these tax breaks by selectively conforming to federal law. While the state’s fiscal situation is currently very positive (the Legislative Analyst’s Office estimates that over $20 billion in discretionary resources is available to allocate through the 2019-20 budget process), Governor Newsom has proposed ambitious new investments that will require new ongoing expenditures, such as more than doubling the total amount of credits provided under the state’s Earned Income Tax Credit (CalEITC). The Governor proposes to offset revenue losses from the CalEITC expansion by conforming to certain federal tax law changes mainly affecting businesses. These include “flexibility for small businesses; capital gains deferrals and exclusions for Opportunity Zones; and limitations on fringe benefit deductions, like-kind exchanges, and losses for non-corporate taxpayers; among others.”
The three revenue-raisers in the Governor’s proposed conformity package — the limitations on fringe benefit deductions, like-kind exchanges, and non-corporate losses — would increase state revenue by $1.2 billion, according to recently-released estimates. The other two provisions noted would cost the state revenue and reduce the net gain to closer to $1 billion. Not mentioned in the budget proposal are two other business-related TCJA provisions that could together bring in another $1.3 billion, according to Franchise Tax Board (FTB) estimates: limitations on Net Operating Losses (NOLs) and business interest deductions. If California were to conform to these two provisions in addition to the three revenue-raisers included in the Governor’s budget proposal, the state treasury could see approximately $2.5 billion in increased annual revenue, which could be used to support investments that improve economic security and opportunity for Californians.
The remainder of this post examines these five revenue-raisers, the two revenue-losing provisions proposed by the Governor, and other revenue-losers in the TCJA that California should avoid adopting.
Revenue-Increasing Conformity Provisions
Limitations on Fringe Benefit Deductions
The TCJA places new restrictions on federal tax deductions employers may take for certain expenses, including entertainment-related activities, transportation benefits, and some meals. Under prior federal law, businesses could deduct 50% of the costs of activities “generally considered to constitute entertainment, amusement, or recreation” (for example, a sporting event or theater performance) as long as they were directly related to the active conduct of the taxpayer’s trade or business. The TCJA disallowed this deduction. The previous federal deduction for transportation-related fringe benefits, such as parking and commuter benefits, is also disallowed except to ensure an employee’s safety. Additionally, expenses related to meals provided to employees through certain on-site eating facilities or for the convenience of the employer, which were previously fully deductible, are now limited to 50% through 2025 and are not deductible in subsequent years. Taken together, conforming to these limitations would raise an estimated $160 million in state revenue.
Limitation on Like-Kind Exchanges
Generally, when taxpayers sell or exchange an asset and make a profit, they owe tax on that capital gain at the time of the transaction. Prior federal law (to which California currently conforms, with modifications) allowed taxpayers to defer taxes on gains from an exchange of a business or investment property (excluding inventory, stocks, bonds, and other securities, and other specified types of property) if it was exchanged for a similar (“like-kind”) property. The capital gain would only be recognized once the taxpayer sold or exchanged the new asset in a later taxable transaction. However, if the new asset was held until the taxpayer’s death and passed on to an heir, the capital gain would escape taxation completely. This is because the federal government and California do not levy capital gains taxes when an heir inherits property — the heir only owes tax on the increase in value between the time the property is inherited and the time it is sold.
Under post-TCJA federal tax law, only real estate properties are eligible for like-kind exchange deferrals. For instance, an exchange of a vehicle used in connection with a business is now taxable at the federal level, but not at the state level. If California conformed to this limitation, FTB estimates that the state could gain $200 million in revenue. FTB’s latest tax expenditure report estimates the total state cost of like-kind exchange deferrals (including real estate property) for 2019-20 to be nearly $1.2 billion, suggesting that the state could gain significantly more revenue by going beyond conforming to the new federal law and simply eliminating tax deferrals for all types of like-kind exchanges. As the FTB report notes, allowing tax deferral for exchanges of some types of property and not others can be economically inefficient because it may encourage unnecessary investment in properties eligible for favorable tax treatment. And let’s not forget that the real estate industry fared quite well in the TCJA (see here and here), being exempted from several restrictions in the new law.
Limitation on Business Interest Deductions
Prior to the TCJA, businesses were generally able to fully deduct business-related interest expense from their taxable income. The new law limits the federal deduction for net interest expense (that is, interest expense minus interest income) to 30% of the taxpayer’s “adjusted taxable income” in a given tax year. Adjusted taxable income is essentially defined as business-related income before taking into account interest expense, interest income, and certain other deductions. An exception is made for interest expense incurred by vehicle dealers who finance their inventory of vehicles held for sale, known as “floor plan financing interest,” which continues to be fully deductible. The TCJA also allows any federal business interest deduction that cannot be used in a taxable year to be carried forward indefinitely and used in future tax years. Special rules apply to partnerships and S corporations to prevent partners and shareholders from double-counting deductions. Businesses with less than $25 million in gross receipts (averaged over the previous three tax years) are exempt from the new limitations, as are certain public utilities. Additionally, real estate companies and farming businesses may opt out of the new limitation.
The major justification for limiting interest deductions is that doing so reduces the tax incentive for companies to take on excessive debt. Since deductions are allowed for interest expense but not for returns to equity (in the form of dividends and capital gains paid to shareholders), the tax code makes it more attractive for businesses to finance investments with debt rather than equity. Businesses that take on high levels of debt are more susceptible to bankruptcy, and this can have ripple effects throughout an entire economy. As discussed in an International Monetary Fund report, the bias toward debt financing likely exacerbated the global financial crisis of 2007-2008 by encouraging high debt levels. Although the TCJA’s limitation on interest deductions will not fully equalize the tax treatment of debt and equity, it will at least reduce the debt bias. Conforming to this provision can raise $650 million for California while further limiting the overall tax preference toward debt.
Limitation on Net Operating Loss Deductions
A net operating loss occurs when a taxpayer’s total tax deductions exceed total income for the tax year. NOLs can be claimed by both corporate and individual taxpayers, but are usually related to losses from operating a business. Pass-through businesses like S corporations and partnerships cannot claim NOLs at the entity level, but their shareholders or partners can claim NOLs based on their respective shares of the businesses’ income and deductions. Before the TCJA, taxpayers were permitted to carry back these NOLs to offset federal taxable income, dollar-for-dollar, for up to two years prior to the year the NOL was incurred. In addition, they were able to carry forward NOLs to offset taxable income for up to 20 years into the future. As a simple example, if a corporation had an NOL of $500,000 in tax year 2017 (prior to the passage of the TCJA) and taxable income of $250,000 in each of the two previous tax years, it could file amended tax returns to claim a deduction of $250,000 in tax years 2015 and 2016, zeroing out its federal tax liability in both years. The corporation would then get a refund for previously paid taxes for those years. If it had no taxable income in the two prior years or if the NOL exceeded the corporation’s aggregate taxable income for those years, it could carry the remainder forward to reduce its tax bill in future years.
Under the TCJA, corporations and other taxpayers are no longer able to carry back their NOLs (with the exception of certain disaster-related farm losses) to offset federal taxable income. Additionally, NOL carryforward deductions are now limited to 80% of taxable income in any given year, but the 20-year limit has been removed so losses can be carried forward indefinitely. California generally conforms to pre-TCJA federal law at present, but in past years has had its own rules concerning NOLs. Prior to 2013, California had not allowed NOL carrybacks, and in certain years had limited or suspended NOL carryforwards.
There is a legitimate rationale for allowing businesses to average income over several years for tax purposes, given that businesses often incur losses in early years and during economic downturns. However, allowing NOL carrybacks can exacerbate state fiscal challenges during a recession, since it requires that the state refund tax revenues that have likely already been spent. Without NOL carrybacks, businesses may still reap the benefits of income averaging by claiming NOL carryforwards. Limiting carryforwards to a percentage of taxable income reflects the concept that even if a business isn’t profitable, it still benefits from public services like education and infrastructure and should thus be expected to pay some level of taxes. The new federal 80% limitation on NOL carryforwards ensures that corporations cannot use NOLs to entirely wipe out their tax liability in a given tax year. If California conforms to the new limits on NOL carrybacks and carryforwards, the state could bring in an additional $650 million annually in revenue.
Limitation on Losses for Non-Corporate Taxpayers
For taxpayers that have interests in so-called “pass-through businesses” such as S corporations, partnerships, limited liability companies, and sole proprietorships, the TCJA limits the federal deduction for business losses that can offset other income, such as salary and investment income. Prior to the TCJA, business losses could be used to reduce or even zero out federal tax liability, even for individuals with significant income from non-business sources. As with any tax deduction for individuals, higher-income taxpayers receive a larger tax benefit per dollar deducted because they are in higher tax brackets. Federal law now only allows taxpayers to deduct up to $250,000 in “excess business losses” (defined as the amount by which business-related deductions exceed business-related income). The threshold amount is $500,000 for married taxpayers filing joint returns. Any excess business losses above the threshold would have to be carried forward to offset income in future tax years as part of the taxpayer’s NOL. This limitation is scheduled to sunset after 2025 for federal tax purposes. FTB estimates that conforming to the excess business loss limitation would generate $850 million for California.
Revenue-Losing Conformity Provisions
The Governor also has indicated that he wants California to conform to two additional TCJA provisions that would result in state revenue losses – losses that would partially offset the increased revenues from the other conformity provisions. Specifically, the Governor is calling for “flexibility for small businesses,” which is likely a reference to the TCJA’s provision allowing more “small” businesses to use simplified accounting methods. Primarily, this provision increases the size threshold for small businesses that may use the cash method of accounting (rather than the accrual method) from $5 million in gross receipts to $25 million. Under the cash method, businesses recognize income when it is received and expenses when they are paid; under the accrual method, income and expenses are recognized when they are incurred. The cash method allows some businesses to defer taxes by recognizing more expenses in the current tax year and postponing income to the next year. As the Joint Committee on Taxation explains, the cash method is “administratively easy and provides the taxpayer flexibility in the timing of income recognition” while accrual methods “generally result in a more accurate measure of economic income.” Conforming to this provision would make filing taxes simpler for California businesses affected by the change in federal law, since it would be administratively burdensome to use different accounting methods for federal and state tax purposes. However, it would also reduce the revenue gains from enacting other conformity items by about $100 million (though this number would likely decrease over the next several years, consistent with the 10-year federal revenue estimates).
The Governor also proposes to conform — at least in part — to the new federal Opportunity Zone tax incentives, which allow individual and corporate investors to defer and reduce their capital gains taxes if they invest in economically distressed communities that meet certain federal criteria and have been designated by states as Opportunity Zones. The tax incentives are very generous to investors and come with few strings attached. Although the incentives may encourage increased investment in some underserved communities, there is also a risk that the subsidies may accelerate gentrification and displacement in some areas or be used for projects that have little benefit for current community residents. Conforming to these tax incentives would cost the state an estimated $37 million in the first year, rising to $70 million in the following year — but the long-term costs would be higher than suggested by the early year estimates since the tax incentives become more generous as Opportunity Zone investments are held longer. The Budget Center will explore these new incentives in more detail in future publications.
Beyond the items highlighted in the Governor’s budget, the TCJA contains some large new unnecessary federal tax breaks for businesses that would cost California significant revenue if the state were to adopt them. For instance, one set of provisions would repeal the federal corporate Alternative Minimum Tax (AMT) and temporarily allow corporations to claim a partially refundable tax credit for AMT paid in previous years. These provisions together would cost the state $300 million or more if adopted by California, according to FTB. Even more concerning is the new federal 20% deduction for pass-through business income, which would reduce state revenues by $2.6 billion per year if adopted. The pass-through deduction is as poorly designed as it is costly; an estimated three-fifths of the federal tax benefits will go to the richest 1%, and this tax break is vulnerable to myriad abuses by higher-income taxpayers. The Governor does not propose conforming to these poorly-conceived federal provisions, and the state should avoid adopting them as they would not enhance state tax fairness.
Looking Forward
Over the next several months, the Newsom Administration and the Legislature will need to carefully consider the various tax conformity options in terms of their effects on the state budget as well as the fairness and efficiency of the tax code. Adopting any provision that increases taxes on any state taxpayer will likely require a two-thirds vote in each house of the Legislature, which could be an uphill battle politically. Conforming to selected portions of the recent federal tax law offers policymakers an opportunity to raise revenues for new investments by limiting inefficient or unnecessary business tax breaks while resisting pressures to adopt new tax breaks that are not needed. Doing so would make California’s tax code fairer, offset some of the harmful and inequitable aspects of the TCJA, and make significant funding available to support state policy goals and invest in the low- and moderate-income Californians who have benefitted less from recent federal tax cuts.
Courtesy of California Budget & Policy Center