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Archive for May, 2018

Give the senator credit. He keeps trying to peddle his “tax modernization” bill, altering subsequent versions to deal with the opposition or disinterest it has received so far. His rationale is that today’s state tax structure does not reflect the current nature of the economy, one that is based more on services than in the past, and is far more volatile due to its growing reliance on personal income tax.

According to the state’s analysisBeginning on January 1, 2020, SB 993 imposes the tax (on the receipt of the benefit of a service by a business in California) on a “qualified business,” defined as “a person, corporation, partnership, sole proprietorship, limited liability company and limited liability partnership engaged in business to provide a product or service for the purpose of producing income taxable under federal income tax law.”

The rate business will pay starts at .75% in 2020 and climbs to 3% in 2022, thereafter.

The current sales and use tax on goods will be reduced by .5% in 2020, then to 2% by 2022.

The state revenue impact has not been estimated.

Senator Hertzberg told an audience at a recent community breakfast that the end result would be revenue neutral.  As I reported earlier, it is advisable to check his math, since he considered additional taxes of $10B per year that would have been generated by his original bill to be revenue neutral.

SB 993 is as complex as any tax legislation can be, so any projection as to its revenue impact is premature, except perhaps in Hertzberg’s mind. If he has run the numbers -even at the 30,000-foot-level – that supports its neutrality, then why not share them?

Sales and use tax revenue has decreased from 61% of the general fund back in 1950, to 20% today, and the service industry has grown much larger than the agricultural and manufacturing sectors. But data published by the California Department of Finance show sales and use tax revenue has grown from $2B per year in 1970 to $37B today. So, while a much smaller share of the pie, it is a much larger pie. How big a pie do we need, or can we afford?

Let us not forget that service companies pay income taxes, too, along with sales taxes on purchased goods.  The growth of this sector, then, has increasingly contributed to the state’s treasury over the years.

So to say California’s tax collections have been limited by the shift in the economy’s constituent parts is misleading.

Understanding the sources of tax revenue is also important.

For example, take Subchapter S corporations. These are hybrid entities resembling partnerships but limit liabilities (as C corporations do). The net income is passed directly to the owners, not through declared corporate dividends.  The pass-through eliminates double taxation associated with C corporations (on the corporate tax return and again on the individual shareholders’ personal returns to the extent of dividends).

Partnerships and sole proprietorships also pass earnings on to the owners in a similar fashion, also avoiding double taxation.

The use of pass-through structures has increased significantly since 1980: in 2013,  U.S. income earned in the pass-through sectors accounted for 51% of total business income (C and S corporations plus sole proprietorships and partnerships), compared to only 21 percent in 1980, per the US Department of Treasury, Office of Tax Analysis Working Paper prepared in 2016.

As you can imagine, this muddies the waters in any kind of tax revenue source analysis. One needs to carve out the pass-through income reported on individual returns to compare apples to apples over time. Knowing the commercial portion of personal income is critical in assessing the effect of applying sales tax on services sold by businesses.

A sales tax paid on services received by S corporations and other pass-through entities  will effectively fall on the individual taxpayers who own them. Although they will be receiving a tax break related to their personal purchases under SB 993, they will absorb the impact of the services tax from their businesses. Not all business owners or S corporation shareholders are rich. As a result, Hertzberg’s plan could end up hurting middle-income residents.

Before levying a sales tax on services, one should consider if the companies require a disproportionate share of the state’s resources.  Do, let’s say, architectural firms require  more roads, power and water than those in manufacturing or agriculture?  We shouldn’t be applying additional taxes simply because there is an opportunity to do so. There should be demonstrable correlation.

We also need to understand how much in the way of state income taxes service companies have contributed relative to all sources over time…and how much more the share will grow. It does not make sense to discourage their business customers from buying their products, but that’s what the sales tax will tend to do, as well as add to users’ costs, particularly businesses without the resources to develop in-house alternatives.

The state can smooth out the volatility in revenue by carefully managing the reserve fund, socking away the surplus from good years, and drawing them down when things head south. Sacramento already has the means and process to do that. This would be preferable to layering another tax, one which will be very difficult to administer, on top of the existing structure. It just takes some competent management.

The benefit to the residents of lowering the sales tax on personal purchases of goods could be short-lived. County and city governments may see it as an opportunity to propose additional local sales taxes. The thinking being that few would mind paying an additional quarter-point or so if they are receiving a 2% break.

I am not saying a services sales tax is inappropriate in all cases, but let’s not make the service sector a piñata for the politicians to break open and grab the goodies.

 

 

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The only thing as bad as Congress impulsively passing a tax reform bill, is conjuring a half-baked, equally impulsive countermeasure.

But that is precisely what State Senator Kevin de Leon and Assembly Member Autumn Burke are proposing with SB227 and AB2217.  The latter is a recent development.

Both bills allow taxpayers to donate to charitable entities sanctioned or controlled by the state in return for tax credits on their California returns.  SB227 would have contributions funneled through a state entity named The California Excellence Fund. AB2217 would have qualified charitable entities pass 90% of the donations to the state’s general fund. The entities would issue “Golden State Credits” to the donors, who in turn would use then to reduce their tax liability to the state….and also deduct them as charitable contributions on their federal returns.

The bottom line is that a very high percentage of the donations end up in the state treasury.

The sponsors are counting on the precedent of similar programs in a number of states being condoned by the IRS.  However, many of these are essentially one-off credits and not part of a wide-ranging policy, as would be the case in California.

In the grand scheme of things, existing tax credit donations are relatively small, and were virtually irrelevant under the old tax law.  It did not really matter if one took a charitable deduction in lieu of one for state tax  – the total deductions, all other things being equal, were the same. Note that SALT deductions were not allowed if the taxpayer was subject to the AMT.

But if California, New York and other high income states implement workarounds allowing higher income taxpayers to re-characterize state tax payments as charitable deductions across the board, rest assured the IRS will take a hard look.

If the states do not back down, the issue will end up in the courts and taxpayers who avail themselves of the credits would be at risk of owing penalties and fines if the IRS prevailed.

New York passed a version of the workaround which is similar to California’s (it also passed another that involves a payroll tax…not an approach California is pursuing).

If de Leon and Burke were smart, they would wait to see how New York’s plan is received by the IRS, then modify California’s accordingly, rather than subjecting the state’s higher income taxpayers to audits.  That could be the last straw that will send more of them to Nevada.

 

 

 

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