Legislative Analyst's Office, February 1999

California's
Tax Expenditure Programs

Income Tax Programs--Part 1

Contents

• Capital Gains on Inherited Property
• Capital Gains on the Sale of a Principal Residence
• Capital Gains From Housing Sales to Low-Income Residents
• Employer-Sponsored Educational Assistance Programs
• Unemployment Insurance Benefits
• Employer Contributions to Accident and Health Plans
• Employer Contributions to Pension Plans
• Social Security and Railroad Retirement Benefits
• Employer Contributions for Life Insurance
• Proceeds from Life Insurance And Annuity Contracts
• Interest on Government Debt Obligations
• Compensation for Injuries or Sickness
• Employee Death Benefits
• Meals and Lodging Furnished by an Employer
• Miscellaneous Fringe Benefits
• Scholarships, Fellowships, and Grants
• State Lottery Winnings
• Income from Investments in Economically Depressed Areas
• Foster Care Payments
• Employee Ridesharing Benefits
• Employee Child and Dependent Care Benefits
• Tax-Exempt Status for Qualifying Corporations

Exclusion/Exemption:

Capital Gains on Inherited Property

Description

This program exempts from capital gains taxation the appreciation in the value of property which has occurred prior to the transfer of the property from a decedent to an heir. Thus, the heir's "basis" in the property, from which capital gains eventually will be measured, is adjusted upward to equal the property's fair market value at the time of the decedent's death. Accordingly, taxes on the capital gains that materialize prior to the transfer of property to heirs are permanently forgiven.

Rationale

This program provides tax relief to heirs who inherit property that has appreciated in value while held by the deceased. The original rationale for this program was that inherited property was itself subject to taxation; thus, some argued that subjecting inherited capital gains to taxation would amount to a form of "double taxation."

It also is frequently argued that, without this program, heirs might need to sell their inherited property to pay the tax on previously accumulated capital gains.

Comments

California eliminated its inheritance tax in 1982 pursuant to Proposition 6. The state's current taxes on inherited property--the estate tax and the generation-skipping transfer tax--do not impose any real tax burden on California taxpayers, since both represent so-called "pick-up" taxes. This type of tax simply collects a state tax that would otherwise go to the federal government by taking maximum advantage of the federal estate tax credits that are granted to Californians for their state death-related taxes paid. Thus, the tax imposes no additional cost to these California taxpayers. The double taxation rationale, therefore, no longer applies.

The concern that heirs might need to sell their inherited property in order to pay capital gains taxes could be dealt with directly by a tax-deferral program. A tax-forgiveness program is not necessary to address this particular concern.

Exclusion/Exemption:

Capital Gains on the Sale of a Principal Residence

Description

For sales and exchanges of residences occurring after May 6, 1997, California law allows the taxpayer to exclude from gross income the gain realized on the sale or exchange up to a maximum amount. The exclusion is allowed if the taxpayer used the residence as a principal residence for two of the previous five years. The subsequent purchase of another residence is not required. The exclusion for a given sale is limited to $250,000 for single income tax filers and $500,000 for married taxpayers filing jointly. Exclusions can be claimed for additional sales or exchanges providing the above conditions are met. California law waives a portion of the two-year occupancy rule for Peace Corp volunteers. Additionally, it does not conform to federal transitional provisions which allow certain taxpayers to elect prior tax treatment for certain sales.

Rationale

This program provides tax relief to homeowners who sell their residences. There are two apparent rationales for the program. First, in the case where the sale of a residence is entirely or largely involuntary, due to such factors as changing employment or family circumstances, the program avoids putting an additional financial burden on certain households faced with acquiring replacement housing.

Second, the program provides an incentive for households to invest more of their resources in owner-occupied housing than they otherwise would. This is because the program reduces the overall costs of home ownership, and thus raises its overall rate of return as an investment. This is especially true when housing is compared to those other investments whose capital gains are subject to taxation.

Distribution of Benefits

This program primarily benefits higher income taxpayers. As shown in the accompanying table, about 85 percent of the total benefits go to those earning in excess of $100,000 annually, and almost two-thirds goes to those earning $150,000 or more. The average amount claimed also generally increases for those with higher incomes. The reduction in the average amount claimed for those in the highest income category is a result of limitations on the amount of the capital gain that can be excluded for tax purposes.

Capital Gains on the Sale of a Principal Residence Exclusion
1998 Tax Year
Adjusted Gross Income ($000)	Percent of		Average Amount Claimed
	Total Taxpayers Benefitting	Total Amount Claimed
$0-20	--	--	--
20-40	1.2%	0.3%	$338
40-60	4.9	1.5	487
60-80	18.3	6.8	621
80-100	15.6	6.8	727
100-150	27.4	21.5	1,302
150-200	14.6	21.6	2,463
200-250	7.3	13.5	3,078
250-500	8.2	24.1	4,925
Over 500	2.6	4.1	2,674

Comments

This program is a liberalized extension of the previous capital gains exclusion which both state and federal law allowed for capital gains on sales of residences. Specifically, for sales and exchanges occurring on or prior to May 6, 1997, there was a one-time exclusion granted to taxpayers over age 55 of up to $125,000 for married couples filing jointly and single taxpayers, and up to $62,500 for married taxpayers filing separately. This program also replaces the deferral of capital gains available to taxpayers who sold a principal residence. To qualify for the deferral, another principle residence of equal or greater value had to be acquired within two years of the date of sale.

The change from the more-limited exclusion and deferral programs to the more-generous provisions incorporated in the current program may result in a one-time "unlocking" effect, stimulating a shift toward nonhousing investments on the part of certain homeowners.

Overall, however, this provision makes housing a relatively more attractive investment than it otherwise would be when compared to alternative types of investments. This is because the exclusion essentially raises the economic "rate of return" on housing by reducing the taxes which eventually have to be paid on a residence. Although the previous capital gains exclusion program noted above also raised the rate of return on housing investments, the more-generous provisions of this current program have a stronger effect in this regard.

Exclusion/Exemption:

Capital Gains From Housing Sales to Low-Income Residents

Description

This program allows taxpayers to exclude from taxable income their capital gains from the sale of government-assisted low-income housing units to low-income tenants. In order to qualify for the exclusion, a majority of the housing units sold must remain in use by low-income tenants for either 30 years from the date of sale or for the remaining term of existing federal government financial assistance, whichever is longer. In addition, the taxpayer must reinvest all of the proceeds from the sale in residential property other than a personal residence. The taxpayer's "basis" in the new residential property is reduced by the amount of the gain from the sale. Thus, the program provides for a tax deferral rather than permanent tax forgiveness.

Rationale

This program provides an incentive for owners of low-income housing that has been subsidized by the federal government to sell the property to low-income tenants for continued use as low-income housing, rather than sell it for, or convert it to, other purposes upon termination of the federal subsidy. It does this by providing for a tax deferral on the gain from that sale. This deferral of the tax liability amounts to an interest-free loan from the government, which increases the economic gain from the property sale.

Comments

The estimated PIT revenue effects for this program are not directly available. Rather, the estimates are included within the estimates for "Capital Gains on The Sale of a Principal Residence." The BCT estimates are not available due to the lack of comparable federal data upon which to base these estimates.

In the 1960s, the federal government provided low-interest loans and rent subsidies through various programs administered by the federal Housing and Urban Development Department (HUD) and Farmers' Home Administration (FHA). In return, private developers and property owners agreed to build or operate rental projects which were protected by low-income use restrictions. In order to stimulate private sector participation, the owners were given the option to terminate their contracts prior to their loan maturity dates. As owners exercise their options to sell and/or as federal subsidy periods expire, the housing units may be sold or converted to market-rate units, thereby displacing low- income tenants and reducing the state's supply of affordable low-income housing. This program aims to lessen the extent to which this occurs.

The original state program was created by Chapter 1436, Statutes of 1990 (SB 1286, Seymour).

Exclusion/Exemption:

Employer-Sponsored Educational Assistance Programs

Description

This program allows taxpayers to exclude from their gross income contributions made to qualified educational assistance programs by their employers on their behalf. The amount which may be excluded under this program is limited to $5,250 annually. In order to qualify for this exclusion, the educational program must be provided for the exclusive benefit of employees and their dependents, and comply with various federal rules to ensure nondiscrimination in favor of highly compensated employees. The exclusion is inapplicable to graduate level courses commencing after June 30, 1996.

Rationale

This program provides an incentive for employers to provide, and employees to accept, contributions to educational assistance programs in lieu of taxable monetary compensation. This is because a given level of contributions is worth more to employees on an after-tax basis than an equivalent amount of taxable income. The program represents a policy designed to encourage additional consumption of education and stimulate an increase in human capital formation.

Comments

This program conforms to an identical federal program, except that the federal program provides an exclusion only through June 1, 2000. In contrast, California law has no sunset provision.

Exclusion/Exemption:

Unemployment Insurance Benefits

Description

This program exempts unemployment insurance benefits from the recipient's gross income for tax purposes.

Rationale

Various reasons are mentioned for the tax relief provided by this program. One is that legislatively provided social welfare benefits should not be taxed, since they often are structured by policymakers with the intent of providing specific amounts of purchasing power to recipients. Another is that paying taxes on such benefits could be an especially onerous burden on jobless individuals, who often have trouble paying for such basic necessities as housing, food, and clothing.

Comments

State law does not conform to federal provisions, as contained in the 1986 Federal Tax Reform Act, which require certain taxpayers to include their unemployment compensation as gross income. The intent of the federal requirement is to treat government-paid unemployment benefits more like privately provided unemployment compensation benefits. The latter are fully taxable to recipients in California to the extent that they exceed prior contributions.

The subsidy provided by the program is worth disproportionately more to higher- income taxpayers than lower-income taxpayers, due to the former's higher marginal income tax rates. Economists argue that a side-effect of this program is that it may provide a disincentive for certain unemployed persons to seek jobs, since it reduces the after-tax cost of being unemployed. This could be particularly relevant in such cases as unemployed spouses of moderate-to-high-income taxpayers, whose economic need for employment may be less than that of lower-income individuals.

Exclusion/Exemption:

Employer Contributions to Accident and Health Plans

Description

This program excludes employer contributions to accident and health plans from the gross income of employees for tax purposes.

Rationale

This program provides tax relief to all individuals whose employers contribute to the costs of accident and health plans that provide compensation for sickness and injury.

It is argued that the program provides both employers and employees with an incentive to make accident and health insurance a standard part of the employees' compensation packages. Program supporters argue that this is a desirable social goal, because it provides security to workers, increases productivity, and reduces the need for the government itself to provide accident and health care programs.

An additional rationale for continuing this program is that paying taxes on these noncash benefits would impose a financial hardship on many taxpayers.

Distribution of Benefits

Tax benefits under this program are concentrated in the middle income groups. As shown in the accompanying table (see next page), over 50 percent of exclusions accrue to taxpayers with annual income of $60,000 or less, and over 70 percent go to taxpayers earning $80,000 or less. Very little of the benefits go to taxpayers earning $20,000 or less, due in part, to the fact that individuals in this income class are more likely than those in higher-income categories to have jobs which do not include paid benefits. Over 80 percent of the exclusions from this program go to married joint filers and heads of household.

Employer Contributions to Accident And Health Plans Exclusion
1998 Tax Year (Dollars In Millions)
Adjusted Gross Income ($000)	Total Amount Claimed	Percent of Total
$0-20	$16	0.8%
20-40	442	23.2
40-60	507	26.6
60-80	372	19.5
80-100	238	12.5
100-150	200	10.5
150-200	59	3.1
200-250	39	2.0
250-500	21	1.1
Over 500	15	0.8

Comments

According to a February 1997 U.S. General Accounting Office (GAO) study, approximately two-thirds of Americans under the age of 65 have employment-based health insurance. The GAO estimates that in 1993, three-quarters of the workforce participated in employer-subsidized plans such as those that qualify under this program. The GAO also found that as the costs of providing health insurance have increased, the number of individuals with employer-based coverage has declined over the last few years.

The consensus view of economists is that state and federal programs like this one have contributed significantly to shifting the mix of employee compensation away from wages and salary income in favor of nonmonetary fringe benefits. In fact, some economists believe that the subsidy provided by these programs has reduced the after-tax cost of health care to such a degree that there is excessive use of health care services by those with employer-subsidized health plans. To the extent that this is true, these programs can result in a misallocation of economic resources and the escalation of health care costs.

In recent years, however, structural changes made to many employer-based health insurance programs have resulted in increased health-related costs being borne by the consumer, either through higher deductibles, greater premium payment contributions, per visit charges, or some combination of these factors. To the extent that resource misallocations involving health-care benefits have occurred in the past, the effect of the above-noted increases in health-care usage costs to the consumer should help mitigate the inefficiencies and misallocations associated with the favorable tax treatment of employer-based health insurance programs.

Generally speaking, the health-care benefits under this program provide proportionately greater benefits to higher-income taxpayers than to lower-income taxpayers. This is because higher-income taxpayers typically face higher marginal income tax rates, which in turn makes a given dollar exclusion under this program worth more to them than for a lower-income taxpayer. In addition, higher-income taxpayers have been shown to participate in employer-subsidized health care plans to a greater extent than do lower-income taxpayers.

Exclusion/Exemption:

Employer Contributions to Pension Plans

Description

This program excludes employer contributions to qualified retirement plans and simplified employee pension plans (SEPs) from the gross income of employees, subject to certain conditions. (Employees do, however, eventually have to pay tax on that portion of the retirement benefits they receive which was funded through employer contributions.) In general, for defined contribution plans, the allowable annual addition to a participant's account that can be excluded from gross income is limited to the lesser of 25 percent of the taxpayer's compensation, or $30,000.

Rationale

This program provides tax relief to persons who receive income in the form of employer contributions to their pension plans. This tax relief is in the form of a tax deferral, since these persons eventually are subject to paying taxes on the retirement benefits they receive. The underlying rationale for the program is the view that employees should not have to pay taxes on income until this income actually is received by the employee.

Distribution of Benefits

Generally, the tax benefits associated with this program are distributed over a wide range of income classes, excluding the very lowest. As shown in the accompanying table, almost one-third of the claims are by taxpayers with annual earnings of $80,000 or less, with over half going to those earning $150,000 or less. Those taxpayers earning more than $500,000 annually receive almost one-quarter of the exclusions, however, even though they constitute fewer than one percent of returns.

Employer Contributions to Pension Plans Exclusion
1998 Tax Year (Dollars In Millions)
Adjusted Gross Income ($000)	Total Amount Claimed	Percent of Total
$0-20	$29	1.1%
20-40	196	7.5
40-60	306	11.7
60-80	287	11.0
80-100	243	9.3
100-150	345	13.2
150-200	185	7.1
200-250	201	7.7
250-500	194	7.4
Over 500	623	23.9

Comments

In the long run, the tax deferral provided by this program has a net cost to the state. This is because most persons are in lower marginal income tax brackets after retirement, compared to their marginal income tax brackets during their working years when their employers were contributing to their retirement plans. In addition, the "present value" of the deferred taxes paid in later years is less than the value of the taxes that the state would have received if they had been paid at the time the employer contributions were made, due to such factors as inflation. Generally, the structure of retirement programs, especially arrangements in which employers "match" the contributions made by employees, encourage a greater rate of participation and contributions than would have otherwise occurred.

Exclusion/Exemption:

Social Security and Railroad Retirement Benefits

Description

This program exempts social security benefits and federal railroad retirement benefits from the recipient's gross income for tax purposes.

Rationale

This program provides tax relief to social security and railroad retirement recipients. The apparent rationale is a desire to protect the retirement income of elderly or disabled individuals who may have high living expenses due to illness or infirmity.

Comments

Federal law under Internal Revenue Code Sections 72(r), 86, and 105(h), provides for the partial taxation of social security and railroad retirement benefits. For most taxpayers, the amount of these benefits that must be reported as income for federal tax purposes equals the lesser of one-half of the benefits received, or one-half of the excess of the taxpayer's combined income (as defined) over a specified base amount. For 1998, the base amount is $32,000 for married taxpayers filing jointly. However, for high income taxpayers, up to 85 percent of social security and railroad retirement benefits may be included as income.

The partial taxation of these benefits at the federal level was adopted to put social security benefits more on a par with other types of pension benefits, which are taxable only to the extent that the annuity or pension received exceeds a taxpayer's own direct pension-related contributions.

Because a given dollar exclusion of social security benefits from state income for tax purposes is worth more to taxpayers as their marginal income tax rates rise, social security recipients with higher amounts of taxable income from other sources realize disproportionate benefits from this state program.

Exclusion/Exemption:

Employer Contributions for Life Insurance

Description

This program exempts from an employee's gross income that portion of the employer's contributions to his/her group term life insurance policy associated with the first $50,000 in individual coverage. Also exempt are contributions to life insurance policies which specify that the beneficiary is no longer employed by the employer providing coverage and is disabled, or the beneficiary is the employer or a charitable organization. In addition, insurance contributions under a qualified pension or profit-sharing plan are tax exempt.

Rationale

This program, by subsidizing the cost of life insurance, provides tax relief to policyholders and an incentive for employees and employers to incorporate life insurance coverage into their compensation packages. According to federal reports, the original rationale for the federal program (to which California conforms) was two-fold. First, it was believed that there were difficulties in properly apportioning group life insurance premium costs among individual employees, since premium costs depend on such factors as age, health, and related mortality factors. Second, it was believed that life insurance benefits would help keep family units intact upon death of the primary wage earner.

Comments

Higher-income taxpayers benefit disproportionately under this program, both because of their higher marginal income tax rates and because employer-paid life insurance is most commonly provided for more highly compensated management-level employees.

Life insurance proceeds themselves are not taxed (see "Proceeds from Life Insurance and Annuity Contracts"). Thus, the provision of life insurance as a fringe benefit is completely tax exempt for many individuals. However, life insurance purchased by self-employed individuals, or by individuals whose employers do not make premium contributions, receive no tax break comparable to this program.

Exclusion/Exemption:

Proceeds from Life Insurance And Annuity Contracts

Description

This program generally allows an exclusion from gross income for proceeds received by a beneficiary from the life insurance policy of a deceased person. (Any interest component of such proceeds received as installments is taxable, however, and must be included in the recipient's gross income.) If the proceeds are received under circumstances other than death, then only the actual investment in the contract (for example, the aggregate premium and any other consideration paid) is excludable from gross income.

Beginning in 1991, Chapter 1387, Statutes of 1990 (AB 2663, Peace), makes amounts received under a "living benefits" contract excludable from gross income. These types of contract arrangements involve situations in which the insured, under a life insurance policy, has a catastrophic or life-threatening illness or condition. In such an event, the policy owner can give up or transfer the right to receive death benefits under the policy in exchange for compensation amounting to less than the death benefits.

Rationale

This program provides tax relief to persons who have been designated as beneficiaries of deceased persons' life insurance policies. To the extent that these beneficiaries were financially dependent on the deceased, the program helps to stabilize their economic situations. The program also provides financial relief to individuals receiving accelerated benefits due to catastrophic or life threatening illness, thereby helping them cope with the financial hardships that often are associated with such illnesses.

Comments

Higher-income individuals are likely to benefit disproportionately from this program, since insurance coverage tends to be positively correlated with income, and high-income taxpayers are in the highest marginal income tax brackets.

Due to a developing market involving the "sale" of insurance policies to investors, the rationale related to financial dependence of beneficiaries has been weakened. The sale of insurance policies generally requires that the investor pay the remaining premiums in exchange for being named the beneficiary of the policy. Proceeds received pursuant to the sale of an insurance policy would be subject to taxation.

With few exceptions, California has been in conformity with federal law since 1987.

Exclusion/Exemption:

Interest on Government Debt Obligations

Description

This program exempts from gross income the interest income earned on certain debt obligations issued by the U.S. government, territories of the United States, Puerto Rico, certain federal agencies, and California state and local government entities. The interest received from a mutual fund also is tax exempt if government obligations (those of California state and local governments and the federal government) comprise 50 percent or more of the fund's portfolio or of a series of assets within the portfolio. While the interest on qualifying debt obligations is tax exempt, any capital gains on the sale of such tax-exempt obligations must be reported as income.

The program applies to both PIT and the corporate income tax, but not to the corporate franchise tax.

Rationale

This program subsidizes the costs of governmental borrowing, by providing tax relief to investors who purchase qualifying debt obligations issued by California governments or by the federal government. This tax relief encourages investors to accept lower interest returns on these obligations which, in turn, reduces the debt-servicing costs of these debt-issuing governmental entities. In addition, the program provides an incentive for certain investors to purchase more government-issued debt than they otherwise would. As a result of these factors, governments are able to finance public outlays at lower costs than would otherwise prevail.

Distribution of Benefits

As shown in the accompanying table (see next page), the benefits from the program accrue disproportionately to high-income taxpayers. Over one-third of the claimed amount goes to the small fraction of the taxpayers earning in excess of $500,000 annually, and over one-half go to those earning more than $200,000. The average amount claimed for those in the highest income category is in excess of ten times that claimed by taxpayers in any of the lowest three income categories.

Comments

The revenue figures shown above only include reductions due to outstanding California state and local obligations, and mutual fund pass-through interest dividends. No revenue-reduction amounts are included for federal debt obligations since, pursuant to the principle of "reciprocal immunity," states are prevented from taxing the interest on U.S. government debt obligations.

Interest on Government Debt Obligations Exclusion
1998 Tax Year
Adjusted Gross Income ($000)	Percent of		Average Amount Claimed
	Total Taxpayers Benefitting	Total Amount Claimed
$0-20	9.6%	4.5%	$463
20-40	16.3	7.1	435
40-60	16.0	8.7	525
60-80	13.4	7.1	527
80-100	9.6	5.8	601
100-150	13.4	10.0	724
150-200	5.2	6.3	1,198
200-250	3.4	3.7	1,053
250-500	6.7	10.0	1,448
Over 500	6.5	36.8	5,614

The benefits of the tax exemption are worth proportionately more to taxpayers in higher tax brackets than those in lower tax brackets. This distinction is based on the notion of a taxable yield equivalent, or the effective (after tax) yield to the investor of an investment in tax-exempt securities. The taxable equivalent yield for a California municipal bond with an interest rate of 7 percent for a taxpayer in the 9 percent tax bracket would be 7.7 percent. For a taxpayer in the 2 percent bracket, however, the taxable yield equivalent would be only 7.1 percent. The greater benefits to higher-income taxpayers are even more pronounced at the federal level because of its higher marginal tax rates.

Despite the widespread use and long history of tax-exempt financing for government-issued debt, considerable controversy amongst public finance experts surrounds the continued broad-based use of programs like this. One reason for this involves the use of subsidized debt to finance projects which are not strictly "governmental" in nature, such as industrial projects and home purchases. In addition, many analysts view tax-exempt borrowing as an inequitable means of subsidizing governmental projects, since a disproportionate share of the foregone tax revenues flows to high-income investors. Finally, in order to generate sufficient market demand for the debt obligations, the interest rate on such debt is higher than the minimum required to ensure the participation of high-income taxpayers; consequently, many economists would argue that a more efficient means of aiding local governments is through various grant and loan programs. For a discussion of these and other related issues regarding this program, see The Use of Tax-Exempt Bonds in California: Policy Issues and Recommendations, Legislative Analyst's Office, State of California, December 1982.

Exclusion/Exemption:

Compensation for Injuries or Sickness

Description

This program allows taxpayers to exclude from their gross income the compensation they receive from workers' compensation, accident insurance, and health insurance, due to injuries or sickness. The exemption also covers the amount of any compensatory damages awarded for injury or sickness, regardless of whether the award is made under an in-court or out-of-court settlement, or whether the taxpayer receives a lump-sum award or installment payments. Punitive damages, however, are taxable. In addition, certain amounts paid by an employer to reimburse an employee for expenses incurred for the care of the employee, the employee's spouse, or the employee's dependents are excluded from taxation.

Rationale

This program provides tax relief to qualified taxpayers on the grounds that injuries or sickness often impose significant economic hardship, and can limit the ability of individuals to pay for such basic necessities as housing, food, and clothing. Under these conditions, taxes on compensation for injuries or sickness are viewed as a particularly onerous burden.

Comments

This program covers the disability benefits received under state statute, but does not apply to amounts received as reimbursement for medical expenses claimed as income tax deductions in prior years.

Exclusion/Exemption:

Employee Death Benefits

Description

This program allows tax-exempt treatment for the qualified employer-provided death benefits of employees deceased prior to August 21, 1996, by allowing beneficiaries to exclude from their income for tax purposes up to $5,000 of noninterest-related death benefits they receive. Formerly, certain noninterest-related amounts paid by an employer to an employee's beneficiaries on account of the employee's death were nontaxable up to a total amount of $5,000, regardless of the number of employers involved. This $5,000 exclusion, however, was repealed in 1997 for both California and federal tax purposes for deaths occurring after August 20, 1996. The exclusion program continues for survivor benefits paid under certain circumstances (see "Comments").

Rationale

This program provides tax relief to a qualified decedent's beneficiaries with the original rationale apparently being that death benefits often are used by such individuals to adjust to the economic hardships caused by the death of decedents, and/or to cover the death-related expenses they may face (such as burial costs). However, the fact that the program no longer applies to new decedents (except as noted below), suggests that this original rationale is no longer viewed as sufficient to justify the program.

Comments

Federal changes embodied in the Taxpayer Relief Act of 1997 included a provision that excludes from gross income certain survivor benefits paid as an annuity to the immediate family of a public safety officer killed in the line of duty. California incorporated this provision as a federal conformity measure through Chapter 322, Statutes of 1998 (AB 2797, Cardoza), with an effective date of January 1, 1998.

Exclusion/Exemption:

Meals and Lodging Furnished by an Employer

Description

This program allows the exclusion from gross income of the value of meals and lodging furnished by an employer (other than the military) to an employee, spouse, or dependent. To qualify for the exemption, the meals or lodging must be provided at the employer's place of business and for the convenience of the employer. In addition, for the value of lodging to be exempt, the taxpayer must be required to accept the employer- provided lodging as a condition of employment. This means that the taxpayer must accept the lodging in order to fulfill the requirements of the job.

Rationale

This program provides tax relief to taxpayers who are required to live in or eat at facilities which are owned by their employers. The primary rationale for the program is to simplify tax administration. For example, the value to an employee of employer-provided meals or lodging is often difficult to establish. In addition, the lodging provided by an employer may simply duplicate rather than substitute for private quarters, in which case its value to the employee could be negligible.

Comments

In some cases, such as a live-in housekeeper or resident apartment manager, employer- furnished meals and lodging may represent a large portion of the employee's total compensation. To the extent that the employee's regular wages are lower as a result of this program, the government ends up subsidizing occupations that are characterized by such forms of compensation.

The program also provides an incentive for employers and employees to rely more than they otherwise would on such nonwage compensation, since the after-tax value of a dollar of this form of nonwage income is greater than that of a dollar of regular taxable wage income.

Exclusion/Exemption:

Miscellaneous Fringe Benefits

Description

This program provides a tax exemption to employees for specified types of employer-paid fringe benefits that they may be receiving. These benefits include: (1) special services provided to employees at no direct cost to them (such as free stand-by flights provided by airlines to their employees); (2) employee discounts for products and services sold by the employer; (3) use of company equipment (such as a company car); and (4) "de minimis" fringe benefits (such as personal use of an employer's copying machine or use of on-premises eating or gymnasium facilities).

Rationale

The rationale for this program depends on the type of fringe benefit involved. For instance, program supporters argue that the exemption for employer-provided gymnasium facilities is intended to provide employers with an incentive to improve the well being and productivity of their employees. The rationale for the exemption of certain other benefits often appears to be based primarily on administrative considerations, such as the difficulty of determining the value to individual employees of the specific benefit involved.

Exclusion/Exemption:

Scholarships, Fellowships, and Grants

Description

This program allows taxpayers to exclude from gross income any qualifying scholarships, fellowships, and tuition grants or reductions they receive that are used for qualified educational expenses. This includes tuition and fees for enrollment and attendance at an educational institution, as well as fees, books, supplies, and equipment required for educational courses. The exclusion does not, however, apply to the portion of the scholarships, fellowships, and grants which is used to pay for room and board.

Rationale

The rationale for the tax relief that this program provides to the recipients of scholarships, fellowships and grants appears to relate to the problem of uniformity in the treatment of different taxpayers. According to federal sources, the related federal tax-exclusion program (to which California's program conforms) initially required that all scholarship, fellowship and grant income be included as gross income, unless the taxpayer could show that it was a gift (this is because gifts are nontaxable, as specified). However, when the Internal Revenue Code of 1954 was enacted, the present program was adopted on the grounds that it would treat all taxpayers consistently and uniformly, and eliminate the need to determine whether a "gift" was involved. Thus, the rationale for the program is that it provides equity among different taxpayers and is administratively convenient.

Another rationale offered by the program's proponents is that recipients of scholarships, fellowships and grants often are students who have limited economic resources of their own. Thus, the program helps relieve some of the economic difficulties they face and thereby encourages increased educational attainments in our society.

Comments

The program applies to amounts received for such incidental expenses as travel, research, clerical assistance, and equipment, but does not apply to amounts received for teaching, research work, or similar services. In many cases the value of scholarships, fellowships, and grants is small enough that the recipients, who frequently are students with only limited outside income, would have little or no tax liabilities in the program's absence.

Exclusion/Exemption:

State Lottery Winnings

Description

This program exempts from gross income any winnings from the California State Lottery.

Rationale

This program presumably was intended to provide a tax incentive for individuals to participate in the state lottery. It does this by increasing the "take-home" value of winnings from lottery wagering.

Comments

This program was established in November 1984 by Proposition 37, which enacted the California State Lottery Act of 1984.

State lottery winnings are subject to federal income taxation, to the extent that they exceed lottery wagering losses. Gambling winnings other than lottery winnings are subject to both state and federal income taxation, to the extent that they exceed gambling losses.

Exclusion/Exemption:

Income from Investments in Economically Depressed Areas

Description

This program exempts from gross income the interest received from investments made in state-designated economically depressed areas, including Enterprise Zones and the Los Angeles Revitalization Zone (LARZ). For example, the interest income from a loan to a business that expands its operations in an Enterprise Zone area is tax-exempt. The loan must be used solely in connection with activities within an Enterprise Zone or LARZ, and the taxpayer must have no equity or ownership interest in the business(es) involved.

Rationale

This program provides an incentive for investments to be made in economically depressed areas of the state, by increasing the after-tax investment return that taxpayers can earn on loans to businesses which are located in such areas. Proponents argue that this increased rate of return may be necessary to induce investments in areas where such investments are perceived to face higher-than-average financial risks.

Comments

In recent years, over two-thirds of all states have enacted some form of tax incentives for businesses operating in economically depressed areas. These incentives differ widely in their purpose and coverage. Some of the tax incentives currently made available by states include tax exemptions for businesses investing capital within a designated geographic area or zone, income tax credits based on the number of eligible employees hired by businesses in these locales, and property tax abatement programs for land and structures in such areas.

The problems of economically disadvantaged areas can take many forms, including a declining or stagnant base of economic activities, an inadequately trained or skilled labor force, a dilapidated public infrastructure involving poor-quality educational and transportation facilities, and a depressed private infrastructure involving run-down business and residential structures.

Arguments in Support. Supporters of this program argue that, given such factors, these geographic areas are worthy of financial subsidies, at least to "put them on track" to eliminate these adverse conditions. In addition, supporters argue that there often is evidence of some type of "market failure" that makes it especially difficult for these areas to deal with their problems--including imperfect information among investors about the positive investment opportunities that these areas may offer. Thus, supporters argue, government should "get involved" to help to correct these areas' problems. They note that the benefits to be realized from such involvement include both private-sector economic gains and public-sector improvements, such as reduced crime.

Other supporters argue that, while market failures may be important to address, the program can be justified on equity grounds alone. According to this view, government-provided incentives to businesses in depressed areas can result in greater economic opportunities for the people residing in them, thereby benefitting both individual residents and the public generally.

Arguments Against. Critics of this program argue that it is an ineffective and inefficient means of stimulating new economic activity, and that it simply encourages relocation of existing businesses to the designated areas as opposed to the creating of truly "new" enterprises. This view holds that a "zero-sum" game is involved, with such tax incentives benefitting certain localities at the expense of others. Some critics go even further, arguing that the tax incentives represent such a small part of the cost calculation for a business that they simply constitute a "windfall benefit" for business behavior that would have occurred anyway.

Given the above, the controversy about the program's merits seems to largely revolve around the geographic scope of the program's evaluation, for example, whether the focus is on the economic effect on the targeted impact area alone or the change in the level of economic activity for the state or a region as a whole. Supporters argue that even if the program does not increase economic activity for the state generally, it still is justified on distributional grounds if it benefits a particular disadvantaged area. They also note that there may be efficiency gains resulting from relocating investment from high-employment labor markets to low-employment labor markets, as otherwise under-utilized resources are tapped.

Empirical Evidence. Empirical evidence is mixed as to the efficiency and effectiveness of this and similar programs. For example, in What Do We Know About Enterprise Zones? (Tax Policy and the Economy, Volume 7, National Bureau of Economic Research, 1993), evidence is presented of increased investment and reduced unemployment claims within enterprise zones in Indiana. Also, a report prepared for the New Jersey Department of Commerce that surveyed firms receiving such tax incentives found that about one-third said they were the sole or major factor in their investment decision (see Rubin and Armstrong, The New Jersey Enterprise Program: An Evaluation, 1989). However, data from the U.S. Census Bureau indicates that the economic well-being of enterprise zone residents has not significantly improved since the zones were established.

The California Bureau of State Audits (BSA) conducted a review of the effectiveness of the employment and economic incentives of California enterprise zones and program areas (a former state program). Based on statistics provided by the California Employment Development Department, the BSA found that business and job growth in the enterprise zones and program areas generally exceeded the growth in the counties in which they were located. However, the BSA was unable to determine whether this growth was the result of tax incentive programs per se versus other factors (see California Trade and Commerce Agency, The Effectiveness of the Employment and Economic Incentive and Enterprise Zone Programs Cannot Be Determined, November 1995).

Exclusion/Exemption:

Foster Care Payments

Description

This program allows taxpayers to exclude from gross income the payments they receive from state, local, and nonprofit agencies as reimbursement for the costs of taking care of a foster child. To qualify, a foster child must live in the taxpayer's home.

Rationale

This program provides an incentive for individuals to take on the responsibilities of caring for foster children. The payments and tax exclusion are intended as compensation for and to cover expenses associated with foster care.

Comments

Supplemental payments made by the state or a tax-exempt child-placement agency as "difficulty-of-care payments," are also excludable from gross income for tax purposes. These are intended as compensation for the additional expense associated with the care of a foster child with a physical, mental, or emotional handicap.

Exclusion/Exemption:

Employee Ridesharing Benefits

Description

This program allows taxpayers to exclude from their gross income the compensation or any other benefits they receive from an employer for their costs of participating in a qualified ridesharing program. The exemption covers compensation or other benefits received for commuting in a third-party vanpool, private commuter bus, or subscription taxipool, and for monthly transit passes that are used by an employee or the employee's dependents. It also covers such benefits as carpooling, free or subsidized parking, bicycling, ferry use, travel to or from a telecommuting facility, and any alternative transportation method that reduces the use of motor vehicles in traveling to or from a place of employment.

Rationale

This program provides tax relief to employees who participate in ridesharing programs, and an incentive for employers to make ridesharing benefits a part of their employees' overall compensation. The program's underlying rationale is based on the view that state tax incentives are needed to encourage employees and employers to use ridesharing programs as a means of alleviating traffic congestion and reducing air pollution.

Comments

The exemption provided by this program originally was established by Chapter 25, Statutes of 1982 (AB 548, Ryan), and was allowed for income years 1981 through 1985. Chapter 1444, Statutes of 1986 (SB 1794, Beverly), which extended the exemption through 1990, was repealed in 1987. The current program was enacted by Chapter 1437, Statutes of 1988 (SB 1904, Morgan).

Exclusion/Exemption:

Employee Child and Dependent Care Benefits

Description

This program allows taxpayers to exclude from their gross income the compensation or other benefits they receive from an employer for qualified child and dependent care services. In addition to exempting these employer-provided benefits, an employee may exempt the amount of child and dependent care benefits received through a salary-reduction agreement entered into with an employer. In this case, the employee elects to receive a salary reduction in the amount of the additional employer-paid child or dependent care benefits.

Rationale

This program provides tax relief for employees who receive child and dependent care benefits through either of the methods above, and an incentive for employers to make such benefits a part of their employees' overall compensation package. The program's underlying rationale is that it benefits society as a whole in several ways. One of these ways, proponents argue, is through increased labor output and productivity, which occurs because the availability of child care enables more individuals to work and reduces employee absenteeism and turnover. Another cited benefit of the program is a reduction in the need for government-provided child care programs.

Comments

This program covers payments or services provided by the employer for child or dependent care services, which enable or assist the taxpayer to work. To qualify for the program, the assistance must be provided under a plan that does not discriminate in favor of officers, owners, or higher-paid employees, and which meets various other requirements.

Federal tax law, to which California conforms, limits the exclusion for employee child care benefits (both those paid by the employer and those provided through employee salary reductions) to $5,000 per year ($2,500 in the case of married individuals who file tax returns separately from their spouse), beginning in 1987. Individuals are allowed to use this income exclusion in conjunction with the tax credit for child and dependent care expenses.

Exclusion/Exemption:

Tax-Exempt Status for Qualifying Corporations

Description

This program allows an exemption from the BCT franchise and income taxes for the income of qualifying tax-exempt nonprofit and charitable organizations. (The BCT franchise tax is levied against all banks and corporations doing business in the state. In contrast, the BCT income tax is imposed on banks and corporations that do not do business in the state, but which have income from California sources, such as holding companies and firms engaged only in interstate commerce.)

This exemption extends to the minimum franchise tax imposed on corporations which otherwise would have a tax liability less than that amount. Qualifying organizations are still subject to taxes on "unrelated business income," which includes income associated with activities that are not directly related to their tax-exempt status. For example, a church would have to pay taxes on the income earned from the lease of its personal property to a business, even though its income from religious-related activities would be tax exempt.

Rationale

This program provides tax relief to organizations which are engaged in various charitable, or otherwise not-for-profit, activities. The tax-exempt status generally applies to nonprofit religious, charitable, educational, and scientific organizations. Certain homeowner-ship organizations, civic and business organizations, and financial cooperatives also qualify for tax-exempt status. The commonly cited rationale for exempting such organizations from taxation is that they provide social benefits which are worthy of indirect public financial support.

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