California budget cutters look at tax breaks

Each year Californians benefit from an estimated $50 billion in tax breaks, deductions for everything from conducting business research to raising children.

But as California faces at least an $8 billion state budget shortfall this summer, Gov. Arnold Schwarzenegger and Democratic lawmakers have begun focusing on those deductions, credits and exemptions – what budget wonks call "tax expenditures" – to help balance the books.

State leaders are battling over how to solve the budget, with Democrats pushing to increase revenue and GOP lawmakers advocating only cuts. The governor and lawmakers have yet to embrace a specific tax break, but both sides are analyzing the possibilities.

The conversation isn't likely to stop there. Assembly Democrats proposed – and Schwarzenegger's fellow Republicans in the lower house rejected – taxes on oil production and profits. Schwarzenegger, meanwhile, last week raised the possibility of taxing services.

"There's a lot of changes that are happening in California and all over the United States," Schwarzenegger said Wednesday while promoting budget changes. "I mean, we are missing a lot out there. There's whole new economies that are developing, service-oriented economies."

But as yet there is no agreement on some of the less sweeping revisions to tax breaks, such as those suggested by the Legislature's nonpartisan fiscal adviser, Elizabeth Hill.

Hill said the state could achieve better taxing and spending balance by tweaking 12 tax policies that could generate $2.7 billion in annual revenue.

Among her proposals:

• Reduce the state income tax exemption for each dependent from $294 to $94 because the 10-year-old law, Hill said, mostly benefits taxpayers making $50,000 or more.

• Limit the research and development credit that a company may claim in one year to two-thirds of its tax liability so that more businesses contribute to the state treasury.

• Extend from 90 days to one year the time a yacht, recreational vehicle or plane must be kept out of state in order for the purchaser to avoid paying sales tax.

The politics of tax expenditures are evolving. Democrats want taxes to be part of the budget solution but don't support all of Hill's ideas. Legislative Republicans say easing or repealing tax breaks amounts to raising taxes, which they oppose. Schwarzenegger, who says he opposes tax increases, has a different definition.

"I think we should not get caught up on what is something called, and what is the definition of something because that doesn't bring anyone any health care," he said in early March. "It doesn't bring anyone any education. It doesn't hire teachers. … What we need to do is fix problems and just put everything on the table and not debate what the definition of something is."

Hill's most lucrative proposal – reducing the dependent income tax exemption – would bring the state $1.3 billion in the fiscal year that starts July 1.

Lawmakers and then-Gov. Pete Wilson expanded the child dependent exemption in 1997 and 1998 when the state's budget picture was brighter and tax relief was a necessary political piece to approve the budget. Hill's proposal would lower the amount deducted for each child to the same level – $94 this year – allowed for a personal exemption.

"It's true it gives a lot of tax relief, but we're not sure what the exact purpose of the dependent credit is being set at that ($294) level," said David Vasché, director of revenue and taxation at the analyst's office. "We don't know, especially since a substantial amount of the dependent credit goes to individuals with high incomes."

Teresa Casazza, president of California Taxpayers' Association, a corporation-backed group that opposes taxes, said lowering the credit would disproportionately affect lower-income families because taxes have a bigger impact on their bottom line.

Democratic leaders like Assembly Speaker Fabian Núñez, D-Los Angeles, support more tax revenue but have not leaped to embrace the dependent exemption change. Núñez has been advocating business tax increases, and the legislative analyst has looked at the corporate tax structure as well.

Hill proposed capping the state research and development credit, which a variety of companies use for work that advances medicine and technology. Under the proposal, the credit would be capped at two-thirds of a company's tax liability in any given year, although leftover credit could be claimed in future years. California businesses currently can offset their entire tax bill using the R&D credit.

Vasché said the state has flexibility to scale back because the credit is high compared with other states. The move would generate an estimated $330 million more a year.

"There's a good federal R&D credit already available," he said. "We're not really sure what the state credit on top of the federal gives you in terms of increased R&D spending in California."

High-tech businesses worry the move could dampen investment in a state known for its high corporate tax rate.

R&D credits are "the lifeblood of innovation, not only in Silicon Valley but in California," said Kirk Everett, a lobbyist for the Silicon Valley Leadership Group, which represents executives.

Tax experts defend tax expenditures as a powerful tool that can encourage spending and stimulate the economy, but caution that lawmakers and policymakers must weigh that benefit against the loss of funding on public programs, such as cuts to public education.

"If you're thinking about cutting spending, you're also thinking about cutting benefits," said Alan Auerbach, an economics professor at the University of California, Berkeley. "It would be worth thinking about programs that are running through the tax system – whether they're meeting social objectives."

About the writer:

• Call Judy Lin, Bee Capitol Bureau, (916) 321-1115.