Legislative Analyst's Office, February 1999

California's
Tax Expenditure Programs

Income Tax Programs--Part 2


Exclusion/Exemption:

Scholarshare Trust Income

Program Characteristics   Estimated Revenue Reduction
Tax Type: Personal Income Tax (PIT).

Authorization: California Revenue and Taxation Code Sections 17140, 23735, 24306, and 24328.

(In Millions)
Fiscal Year PIT
1996-97 --
1997-98 Minor
1998-99 $1

Description

The Golden State Scholarshare Trust program was established by the state to encourage families to save for the post-secondary education expenses of their children. Contributions under a Scholarshare Trust Account are not included for state tax purposes in gross income. Earnings on contributions under the Scholarshare Trust Account are not taxable when earned, but rather included in the beneficiaries' gross income upon distribution for educational purposes.

Contributions to and earnings on the trust must be used for qualified higher education expenses at a public or private post-secondary institution, including the following: tuition, fees, books, supplies, and (in most cases) room and board. Maximum contributions to the Scholarshare Trust Account are limited to estimated qualified expenses that can be incurred for a designated beneficiary to obtain a baccalaureate degree at an institution of higher education in California within four years.

Rationale

This program is one of several incorporated into state law that makes it financially easier for families to afford to send their children to colleges, universities, or other post-secondary educational institutions. The underlying rationale is that higher education is worthy of public financial support.

Comments

While the major thrust of this program is to make it easier for households to pay for post-secondary education, there are broader issues associated with this program. In particular, if there exist social benefits to post-secondary education in addition to private benefits, a less-than-optimal amount of education may result in the absence of programs like this. Since the after-tax price of post-secondary education is lowered through this program, it would typically be expected to result in an increase in the amount of education undertaken.



Some argue that sufficient public support for higher education already occurs and that programs such as this may actually stimulate consumption in excess of the appropriate amount.



Exclusion/Exemption:

Capital Gains on Small Business Stock

Program Characteristics   Estimated Revenue Reduction
Tax Type: Personal Income Tax (PIT).

Authorization: California Revenue and Taxation Code Section 18152.5, which partially conforms to Internal Revenue Code Section 1202.

(In Millions)
Fiscal Year PIT
1996-97 --
1997-98 --
1998-99 $15

Description

This program provides a PIT exclusion for 50 percent of the gain from the sale or exchange of qualified small business stock that is held for more than five years. The amount of the exclusion may not exceed the greater of the following (for a married couple filing a joint return) (1) $10 million, or (2) ten times the amount of the qualified small business stock under specified conditions. These amounts are halved for single taxpayers. The stock must be issued by a C corporation between January 1, 1993 and January 1, 1999 in order to qualify for the exclusion.

Qualified stock must be issued by a corporation with less than $50 million in total gross assets (before and after the stock issuance), and 80 percent of its total dollar payroll must be attributable to employment in California. "Qualified businesses" are those where at least 80 percent of the business assets are used to conduct qualified business or trade activities. Qualified business, in general, does not include professional or financial services or the hospitality industry. The measure was designed primarily to promote startup operations in manufacturing and related activities.

Rationale

The program was conceived of as a means by which small businesses in particular industries could gain access to the capital markets more easily than they otherwise would. Small, new or expanding businesses may face more substantial hurdles in raising funds for growth than large business entities. This program represents an effort to reduce the costs of access to required financial capital.

Comments

The federal government also has a PIT exclusion for 50 percent of small business stock gains held for five years or more. The design of the state's provision was largely based on the federal law but does not incorporate certain of its provisions including the rollover of capital gains.

The small business stock exclusion, which results in a reduction in capital costs, represents an attempt to address what are perceived as multiple issues relating to small businesses. These issues may stem from market failure of some type, but may also relate to the achievement of other social goals. For example, some argue that small businesses and industries face a capital shortage; that, for some reason, insufficient funds are being channeled to small businesses. This may be due to insufficient or inaccurate information, or an aversion to perceived high-risk ventures. Some feel that by increasing the return to investors, additional capital can be channeled into the small business sector.

Other proponents suggest that the cost of capital itself is the problem, and that a subsidy is necessary for small business start-ups and expansions to be viable. Finally, some supporters take the view that small businesses are worthy of special support, perhaps because they may be more labor intensive than larger businesses, or because small businesses tend to be a substantial source of product development and innovation.

Economists differ, and empirical evidence is inconclusive, regarding the validity of some of the claims regarding the positive aspects of small business activities or the existence of capital shortage for this sector. Even if the justifications given for the program are accurate, there may exist alternative ways to assist small business enterprise.



Adjustment:

Contributions to Individual Retirement Accounts

Program Characteristics   Estimated Revenue Reduction
Tax Type: Personal Income Tax (PIT).

Authorization: California Revenue and Taxation Code Sections 17085, 17201, 17203, 17210.6, 17501, 17504 through 17509, 17551, and 17554, which largely conform to Internal Revenue Code Sections 219 and 408.

(In Millions)
  Fiscal Year PIT
  1996-97 $51
  1997-98 57
  1998-99 62

Description

This program allows a deduction when computing adjusted gross income (AGI) for contributions to a taxpayer's Individual Retirement Account (IRA). The annual maximum deduction permitted is the lesser of $2,000 or 100 percent of the individual's compensation. A nonworking spouse may make a deductible IRA contribution of up to $2,000. The maximum aggregate contribution for a married couple is the lesser of $4,000 or 100 percent of their combined compensation.

If a taxpayer is a participant in an employer-sponsored retirement plan, the above deduction limitation is gradually reduced and then eliminated at a certain point. For the 1998 tax year, taxpayers who belong to employer-established pension programs can claim the full deduction, provided their AGI is below $30,000 for single filers, and $50,000 for married joint-return filers. For incomes above these amounts, the deduction is gradually phased-out, and then eliminated altogether for taxpayers whose AGI exceeds $40,000 for single filers and $60,000 for married joint-return filers.

Rationale

This program provides an incentive for taxpayers to save for retirement. It does this by permitting taxpayers to defer taxes on IRA contributions until they are withdrawn (after age 59), thereby increasing the investment earnings on such monies.



In addition, the program provides tax relief to IRA account owners, to the extent that their marginal income tax rates are lower when they retire compared to when they are working.

Comments

California has generally been in conformity with federal law regarding deductions for IRA account contributions since 1987. The state incorporated changes made at the federal level for tax years beginning in 1996 regarding maximum deductible contributions.



Adjustment:

Contributions to Self-Employed Retirement Plans

Program Characteristics   Estimated Revenue Reduction
Tax Type: Personal Income Tax (PIT).

Authorization: California Revenue and Taxation Code Sections 17501, 17504, 17506, and 17507, which generally conform to Internal Revenue Code Sections 219, 401 through 404, 408, and 415.

(In Millions)
Fiscal Year PIT
1996-97 $145
1997-98 155
1998-99 170

Description

This program allows a deduction when computing adjusted gross income (AGI) for a taxpayer's contributions to a self-employed retirement plan (these plans are usually referred to as "Keogh" plans).

For defined contribution plans, the deduction is limited to the lesser of $30,000 or 25 percent of earned income. For defined benefit plans, the annual normal retirement benefit limitation is the lesser of $90,000 or 100 percent of average compensation for the highest three consecutive years of active plan participation. The $90,000 limitation is adjusted annually based on the cost of living; for 1998, this adjusted figure was $130,000. California law requires that amounts used as earned income for federal income tax purposes must also be used for state income tax calculations.

Rationale

This program provides self-employed individuals an incentive to save for retirement, by granting them the same basic type of tax deferral that is available to individuals who are covered by employer-established retirement programs.

Distribution of Benefits

The accompanying table indicates that taxpayers receiving benefits from this program are broadly distributed across the income spectrum. However, the majority of benefits accrue to those in the upper-income categories, with almost 80 percent of amounts claimed by taxpayers earning more than $100,000. Average benefits also increase as income increases throughout most of the income spectrum.
Contributions to Self-Employed Retirement Plans Adjustment
1998 Tax Year
Adjusted Gross Income

($000)

Percent of Average Amount Claimed
Total Taxpayers Benefitting Total Amount Claimed
$0-20 1.6% 0.1% NA
20-40 6.3 1.2 $167
40-60 11.0 4.1 333
60-80 14.1 8.1 519
80-100 11.5 7.5 591
100-150 19.9 18.5 842
150-200 11.0 16.2 1,333
200-250 6.3 12.1 1,750
250-500 12.6 23.1 1,667
Over 500 5.8 9.3 1,455

Comments

In general, no distinction is made between (1) pension, profit-sharing, and other retirement plans, including simplified employee pension plans established by corporations; and (2) plans established by self-employed individuals and partnerships. In addition, contributions and deductions for a self-employed participant in a qualified plan are limited in the same way as those of an employee participant. California has been largely in conformity with federal law in this area since 1987.



Adjustment:

Contributions to Education Individual Retirement Accounts

Program Characteristics   Estimated Revenue Reduction
Tax Type: Personal Income Tax (PIT).

Authorization: California Revenue and Taxation Code Sections 17085, 17201, 17210.6, 17501, and 17505 through 17509, which generally conform to Internal Revenue Code Sections 219 and 408.

(In Millions)
Fiscal Year PIT
1996-97 --
1997-98 $1
1998-99 7

Description

This program allows for an exclusion from gross income when computing adjusted gross income (AGI) for earnings on contributions to an Individual Retirement Account (IRA) established for the purpose of funding a child's post-secondary educational expenses. Under the program, up to $500 per child, per year may be contributed to an educational IRA, effective for tax years beginning after 1997. Earnings on contributions are distributed tax-free provided that they are used for the purposes of the child's qualified post-secondary education expenses.

Qualified expenses include tuition, fees, books, supplies, equipment, and (in most cases) room and board. The program is available for taxpayers with modified AGI of up to $150,000 (joint returns) and $95,000 (single taxpayers). The program is phased out for filers with modified AGI between $150,000 and $160,000 (joint returns) and $95,000 and $110,000 (single taxpayers).

Rationale

This program provides favorable tax treatment of investment earnings specifically set aside for a child's post-secondary education. Although contributions to the education IRA themselves are not deductible from income, the incentive to earmark savings for educational purposes involves recognition of the high costs of education and the necessity of post-secondary education for many careers. Proponents argue that encouraging such behavior is deserving of public support.

Comments

California generally conforms to federal tax law with regard to education IRAs.



Adjustment:

Medical Savings Accounts

Program Characteristics   Estimated Revenue Reduction
Tax Type: Personal Income Tax (PIT).

Bank and Corporation Tax (BCT).

Authorization: California Revenue and Taxation Code Sections 17201, 17215, and 24343.3, which generally conform to Internal Revenue Code Sections 106, 138, and 220.

(In Millions)
Fiscal Year PIT BCT
1996-97 $4 NA
1997-98 8 NA
1998-99 10 NA

Description

This program allows small business employers and self-employed individuals to create tax-favored Medical Savings Accounts. In general, employer or employee contributions are limited to 65 percent of the annual health insurance deductible for taxpayers with individual insurance coverage. The comparable limitation for taxpayers with family coverage is 75 percent.

Employer contributions are excluded, and employee contributions deductible, from the employee's income for tax purposes. Any earnings accumulated in the Medical Savings Account are tax-free. Contributions and earnings placed in this account may be withdrawn for medical purposes without penalty. Withdrawals made for other purposes may be subject to tax, as well as a penalty, under certain circumstances.

Rationale

This program provides an incentive for taxpayers to save for medical treatment and emergencies. It does this by permitting taxpayers to defer taxes on their Medical Savings Account contributions and for employers, to deduct contributions made to employee accounts.

Comments

This program provides a "double" tax incentive. First, it lowers the adjusted gross income of taxpayers by exempting from income all of the contributions they make towards their Medical Savings Account. Second, it does not tax earnings accumulated or withdrawals made for medical purposes.



Adjustment:

Moving Expenses

Program Characteristics   Estimated Revenue Reduction
Tax Type: Personal Income Tax (PIT).

Authorization: California Revenue and Taxation Code Sections 17072, 17076, 17084, 17134.5, 17201, and 17218, which conform to

Internal Revenue Code Sections 62, 67, 82, 132, and 217.

(In Millions)
Fiscal Year PIT
1996-97 $20
1997-98 20
1998-99 20

Description

This program allows taxpayers an above-the-line deduction when computing their adjusted gross income (AGI) for the qualified moving expenses they incur, associated with beginning a new job in a new location. Only those expenses that are not paid or reimbursed by the employer are deductible. The allowable expenses taken as a deduction in calculating AGI are those direct expenses associated with relocation, but specifically excluding: (1) meals consumed while traveling and living in temporary quarters near the location of new employment; (2) preliminary house-hunting travel prior to the move; (3) temporary living expenses for up to 30 days in the general location of new employment; and (4) lease expenses associated with the new or old residence.



In order for the taxpayer to claim the deduction, the move must meet two basic tests--a distance test and a time test. The distance test requires that the taxpayer's new employment must be at least 50 miles further from the taxpayer's old residence than the former place of employment was from the taxpayer's old residence. The time test requires that the taxpayer be employed on a full-time basis at the new location for at least 39 weeks during the 12-month period following the move. Self-employed individuals must work in the new location for at least 78 weeks during the two years following the move in order to claim the deduction.

Rationale

This program provides tax relief to individuals whose employment requires that they relocate. The basic rationale is that such moving expenses actually are a type of employee business expense that is necessary in order to earn income, and that employees often have little control over incurring such expenses.



Exclusion/Exemption:

Recycled or Redeemed Beverage Container Redemption Payments

Program Characteristics   Estimated Revenue Reduction
Tax Type: Personal Income Tax (PIT).

Bank and Corporation Tax (BCT).

Authorization: California Revenue and Taxation Code Sections 17153.5 and 24315.

(In Millions)
Fiscal Year PIT BCT
1996-97 NA NA
1997-98 NA NA
1998-99 NA NA

Description

This program allows taxpayers to exclude from gross income the amounts they receive for returning recyclable beverage containers to state-designated recycling centers.

Rationale

This program provides an incentive for taxpayers to return beverage containers to recycling centers. The program's underlying rationale is that resource conservation and litter reduction are worthy of public financial support.

Comments

This program was enacted by Chapter 1290, Statutes of 1986 (AB 2020, Margolin), which established a statewide recycling program for certain types of beverage containers. The program's exclusion covers the amounts that a taxpayer receives as a refund/redemption value. The term "refund value" refers to the minimum refundable value established by the California Department of Conservation (DOC) for each type of beverage container. Generally, the current refund value is 2.5 cents per container.

Exclusion/Exemption:

Benefits Provided Under Cafeteria Plans

Program Characteristics Estimated Revenue Reduction
Tax Type: Personal Income Tax (PIT).

Authorization: California Revenue and Taxation Code Section 17131, which generally conforms to Internal Revenue Code Section 125.

(In Millions)
Fiscal Year PIT
1996-97 $170
1997-98 195
1998-99 220

Description

This program allows employees to exclude from their gross income benefits received from cafeteria plans. Such cafeteria plans are employer-sponsored benefit packages that offer employees a choice between taking monetary compensation or qualified benefits. The employee is allowed to choose among the "qualified benefits" that a particular employer's plan offers, which can include such benefits as accident and health coverage, group-term life insurance coverage, or child and dependent care benefits. Qualified benefits cannot include deferred compensation plans, except for certain plans maintained by educational institutions. If the employee chooses to take monetary compensation instead of the qualified benefits, the monetary compensation must be included in gross income subject to taxation.

Rationale

This program creates an incentive for employers to provide, and employees to accept, contributions made to benefit plans in lieu of monetary compensation. This is because a given contribution amount to such a program is worth more to employees on an after-tax basis than an equivalent amount of taxable income. In addition, the program provides both employers and employees with an incentive to make these types of benefits a standard part of the employees' compensation package. The rationale advanced for the program is that it furthers a desirable social goal, because it improves workers' income security and reduces the need for governments to provide these benefit programs themselves.

Comments

California has been largely in conformity with federal law regarding cafeteria plan benefits since 1987.



Exclusion/Exemption:

Water's-Edge Election

Program Characteristics Estimated Revenue Reduction
Tax Type: Bank and Corporation Tax (BCT).

Authorization: California Revenue and Taxation Code Sections 25110 through 25112.

(In Millions)
Fiscal Year BCT
1996-97 $335
1997-98 340
1998-99 355

Description

This program gives a unitary multinational corporation the option of computing its California taxable income on a "water's-edge" basis, which means the company's tax liability is determined on the basis of its United States income only, instead of on the basis of its worldwide income. (That is, nondomestic income may be excluded for tax-computation purposes.)

A qualifying water's-edge corporation is also allowed to deduct a percentage of its foreign dividends. Corporations electing to file on a water's-edge basis must do so for a seven-year period following the year of election.

Rationale

This program provides tax relief to multinational corporations by allowing them to compute their taxes using an alternative method. The net effect is that they are allowed to exclude the activities of foreign operations for the purposes of calculating California tax liabilities under BCT. One rationale for the program is that it is burdensome for some multinationals to keep track of all their worldwide income sources and amounts for the sole purpose of computing California's tax liability. The water's-edge election provides these corporations with an alternative that makes it easier and less costly for them to comply with California's tax laws, because it relies on the same information now required for federal tax purposes.

It also is argued by proponents that the worldwide method could result in an unfairly high allocation of income for California tax purposes, and that the water's-edge method reduces this distortion.

Distribution of Benefits

As shown in Figure 1, the benefits of the water's-edge election are claimed by a broadspectrum of businesses, based on total receipts. However, total benefits accrue disproportionately to larger corporations. This is due to the fact that corporations with world-wide operations who can benefit from a water's-edge election tend to be large entities.
Figure 1
Water's-Edge Election

Tax Benefits by Receipt

1998 Income Year
Total

Receipts

(In Millions)

Percent of
Total

Taxpayers

Benefitting

Total

Amount

Claimed

Under $1 13.3% 0.1%
1-10 26.7 0.1
10-50 25.3 0.1
50-100 6.0 0.5
100-500 16.5 4.2
500-1,000 5.1 7.8
Over 1,000 7.2 87.4


Figure 2 indicates that the total benefits associated with the program accrue largely to manufacturing and to finance, real estate, and insurance enterprises.

Figure 2
Water's-Edge Election

Tax Benefits by Industry

1998 Income Year
Industry Type Percent of
Gross State Product Total Taxpayers Benefitting Total Amount Claimed
Agriculture, Forestry & Fishery 3.0% 0.9% 0.1%
Construction 3.8 0.8 0.1
Manufacturing 15.9 20.6 50.9
Services 25.1 13.1 0.2
Trade 18.2 45.1 1.1
Finance, Real Estate & Insurance 25.9 17.0 30.7
Utilities & Transportation 8.2 2.5 17.1

Comments

This program was enacted by Chapter 660, Statutes of 1986 (SB 85, Alquist), and is applicable for tax years beginning in 1988.



Exclusion/Exemption:

Limited Partnership Investment Source Rules

Program Characteristics Estimated Revenue Reduction
Tax Type: Personal Income Tax (PIT).

Authorization: California Revenue and Taxation Code Section 17955.

(In Millions)
Fiscal Year PIT
1996-97 $10
1997-98 10
1998-99 10

Description

This program exempts from taxation dividends, interest, or gains and losses from qualifying investment securities of limited partnership members who reside outside of California, and whose only contact with this state is through a broker, dealer, or investment advisor located in the state. "Qualified investment securities" include, but are not limited to, common stock, bonds, and mortgage-based or asset-backed securities.

Rationale

This program provides tax relief to members of limited partnerships residing outside of California that make use of investment services within the state, on the grounds that such activity does not constitute "doing business" in the state.

Comments

Prior to this program, members of limited partnerships were subject to taxation on investment income because they were deemed to be "doing business" within the state, even though they did not physically reside in California. This increased the cost of using investment services in California, placing this industry at a comparative disadvantage in California relative to other states such as New York and Massachusetts, which had rules exempting limited partnership investment source-income from taxation.



Exclusion/Exemption:

Credit Union Treatment

Program Characteristics   Estimated Revenue Reduction
Tax Type: Bank and Corporation Tax (BCT).

Authorization: California Revenue and Taxation Code Section 23153.

(In Millions)
Fiscal Year BCT
1996-97 $13
1997-98 13
1998-99 13

Description

This program exempts credit unions and nonprofit cooperative associations from the state minimum franchise tax. This is the amount that a corporation must pay, regardless of income. It is currently $800 for most corporations, although new, small corporations pay a lower minimum franchise tax.

Rationale

This program provides tax relief to credit unions and nonprofit cooperative associations, based on the rationale that the primary goal of these organizations is to provide low-cost financial services to members who might not otherwise have access to such services.

Comments

While credit unions and nonprofit cooperative associations are exempt from any minimum franchise tax, credit unions must prepay a tax of $25 when they incorporate under the laws of California, or when they qualify to transact business in California.



Exclusion/Exemption:

Small Business Alternative Minimum Tax

Program Characteristics Estimated Revenue Reduction
Tax Type: Personal Income Tax (PIT).

Bank and Corporation Tax (BCT).

Authorization: California Revenue and Taxation Code Sections 17062,17309, 23036, 23453, 23455 through 23457, and 23459, which generally conform to Internal Revenue Code Sections 55 through 59.

(In Millions)
Fiscal Year PIT BCT
1996-97 NA NA
1997-98 NA NA
1998-99 NA NA

Description

For certain businesses and individuals which have large amounts of deductions, credits, exemptions, and exclusions, the Alternative Minimum Tax (AMT) may limit the amount of these "tax preference" items that may be claimed, or may impose an additional tax or limit tax credits receivable to ensure that these taxpayers are not receiving more than a "reasonable" amount of benefits from these preference items. This program exempts certain small businesses from the state AMT.

To qualify for this treatment, the taxpayer must (1) own or have ownership interest in a trade or business, and (2) have aggregate adjusted gross receipts of less than $1 million from these trades or businesses. Proportionate interest in a partnership, regulated investment company, real estate investment trust, and real estate mortgage investment conduit are includable in the gross receipt totals.

Rationale

This program provides tax relief to qualified small businesses, thereby increasing their economic viability. The rationale is based on the belief that encouraging the development of small business helps the vitality of state and local economies.



Exclusion/Exemption:

Tuition Reduction or Waiver

Program Characteristics Estimated Revenue Reduction
Tax Type: Personal Income Tax (PIT).

Authorization: California Revenue and Taxation Code Section 17131, which conforms to

Internal Revenue Code Section 117(d).

(In Millions)
Fiscal Year PIT
1996-97 NA
1997-98 NA
1998-99 NA

Description

This program allows an exclusion from gross income for tuition reductions or waivers received by an employee of a qualified educational institution for undergraduate education provided to the employee, the employee's spouse, or dependent children. It also provides tuition reductions or waivers for graduate education of the employee, who must be engaged in teaching or research activities for the qualifying educational institution.

The educational institution may provide the tax-exempt tuition reduction or waiver only if it does not discriminate in favor of highly compensated employees. A qualified educational institution must maintain a regular faculty and curriculum, and have a regularly enrolled student body in attendance at the institution.

Rationale

This program provides tax relief to university and college employees based on the rationale that individuals in these occupations should be provided additional public support for their activities and because of the perceived importance of education. Schools have argued for the exemption as an added benefit to attract and maintain highly sought-after employees, who otherwise might be hired at other universities or by private sector companies. (This reasoning, however, does not provide a rationale for public financial support of this program.)

Comments

On several occasions in the late 1970s and early 1980s, the Internal Revenue Service (IRS) and some Members of Congress attempted to review or repeal this program, but met with strong resistance. As a method of curbing its use, the federal government restricted the use of the tax-exempt tuition reduction to undergraduate education only, except in the case of an employee who is concurrently attending graduate school.

Due to rising costs in recent years, some universities have limited the amount of tuition reduction to new employees as a means of cutting costs; however, many still provide a full tuition waiver.



Adjustment:

Health Insurance Premiums

Program Characteristics Estimated Revenue Reduction
Tax Type: Personal Income Tax (PIT).

Authorization: California Revenue and Taxation Code Sections 17201, 17270, and 17273,

which partially conform to Internal

Revenue Code Section 162.

(In Millions)
Fiscal Year PIT
1996-97 $34
1997-98 46
1998-99 50

Description

Under this program, self-employed taxpayers are allowed to deduct a percentage of the costs they incur for health insurance premiums for themselves and their families, not to exceed the taxpayer's earned income from his/her trade or business. California law allows self-employed taxpayers to deduct 40 percent of their costs for health insurance premiums. This deduction may be taken regardless of whether the taxpayer itemizes deductions.

Rationale

The purpose of this program is to encourage taxpayers to provide health insurance for themselves and their families. The program's rationale reflects the view that self-employed individuals incur these business-related expenses which can be treated in the same fashion as business-related expenses incurred by larger corporations.

Comments

Federal tax law increased the deductible percentage for health insurance premiums from 25 percent to 30 percent for tax years beginning after 1994. The percentage deduction for federal purposes increases to 40 percent for the 1997 tax year and then increases further at fairly regular intervals thereafter until the deductible percentage reaches 100 percent for tax years beginning after 2006.

For tax year 1997, the California deductible percentage was 40 percent, with the amount scheduled to decline to 25 percent for subsequent tax years. However, under Chapter 322, Statutes of 1998 (AB 2797, Cardoza) and Chapter 323, Statutes of 1998 (AB 2798, Machado), the 40 percent deductibility is scheduled to continue.

Adjustment:

Employee Contributions to Qualified Retirement and Salary Reduction Plans

Program Characteristics Estimated Revenue Reduction
Tax Type: Personal Income Tax (PIT).

Authorization: California Revenue and Taxation Code Section 17501, which conforms to Internal Revenue Code Sections 401 through 404a, 408, and 457.

(In Millions)
Fiscal Year PIT
1996-97 --
1997-98 --
1998-99 --

Description

This program allows an exclusion from gross income for a taxpayer's contributions to a qualified employer-sponsored retirement plan, a simplified employee pension plan (SEP), or a cash or defined-arrangement plan (CODA) such as a 401(k), 403(b), or 457 plan. Taxpayer contributions to a CODA are limited annually and vary by type of plan.

Rationale

This program provides individuals with an incentive to participate in employer-sponsored retirement plans and salary reduction plans, by permitting them to defer taxes on their contributions until they are "withdrawn" as benefits after retirement. This deferral reduces the cost of funding a specified level of retirement benefits, because the present value of taxes paid upon the withdrawal of benefits is less than the present value of the taxes that would be paid when the contributions are made, due to such factors as inflation. In addition, the program provides a further tax reduction to such individuals to the extent that their marginal income tax rates are lower when they retire and receive retirement distributions compared to when they made the contributions.

Comments

The revenue effects of this program are included in those for the program "Employer Contributions to Pension Plans." California has generally been in conformity with federal law since 1987. See comments under "Employer Contributions to Pension Plans."

Deduction:

Standard Deduction

Program Characteristics Estimated Revenue Reduction
Tax Type: Personal Income Tax (PIT).

Authorization: California Revenue and Taxation Code Sections 17041, 17073, and 17073.5.

(In Millions)
Fiscal Year PIT
1996-97 $840
1997-98 910
1998-99 950

Description

This program allows taxpayers who do not itemize their income tax deductions to claim a standard deduction. The deduction amount for the 1998 income year was $2,642 for single-return taxpayers and $5,284 for joint-return taxpayers. The standard deduction is indexed annually for inflation, as measured by the percent change in the California Consumer Price Index for June of the tax year compared to June of the preceding year.

Rationale

This program is intended to simplify state tax administration and the tax-computation process for taxpayers who have less than a specified level of itemized tax deductions.

Distribution of Benefits

As shown in the accompanying table, the standard deduction is a program which is used heavily by lower-to-moderate income taxpayers. Almost 75 percent of the taxpayers claiming the standard deduction have $40,000 or less in annual income, and over three-quarters of all deductions go to taxpayers earning $60,000 or less annually. For the lowest income class, the great majority of benefits (in excess of 90 percent) go to single taxpayers or married taxpayers filing separately. Average claims for this deduction decline in the higher income categories due to the increased prevalence of the use of itemized deductions.
Standard Deduction
1998 Tax Year
Adjusted Gross Income ($000) Percent of Average Amount Claimed
Total Taxpayers Benefitting Total Amount Claimed
$0-20 39.6% 13.8% $57
20-40 33.9 35.8 174
40-60 15.9 28.3 294
60-80 5.5 12.2 367
80-100 2.1 4.7 364
100-150 1.6 3.3 341
150-200 0.5 0.8 280
200-250 0.2 0.4 308
250-500 0.5 0.7 240
Over 500 0.3 0.2 143

Comments

Considerable disagreement exists regarding how the tax expenditure associated with the standard deduction should be defined and measured. The revenue reduction amounts shown above represent the amounts the state would gain if the standard deduction were eliminated altogether, and those taxpayers who would otherwise claim it were instead left with itemizing their deductions. Thus, for a single taxpayer with itemizable deductions of $1,000, the revenue reduction for this program would be based on an increased deduction of $1,642 (reflecting the excess of the standard deduction over the taxpayer's itemizable deductions).

However, alternative ways of defining and computing the tax expenditure amount have been suggested which can lead to significantly different revenue effects. For example:



Deduction:

Casualty Losses

Program Characteristics   Estimated Revenue Reduction
Tax Type: Personal Income Tax (PIT).

Bank and Corporation Tax (BCT).

Authorization: California Revenue and Taxation Code Sections 17131, 17207, and 24347.5 which largely conform to Internal Revenue Code Section 165.

(In Millions)
Fiscal Year PIT BCT
1996-97 $15 $1
1997-98 20 1
1998-99 20 1

Description

This program allows as a deduction from gross income any qualifying casualty losses that exceed 10 percent of federal adjusted gross income (AGI), to the extent that these losses are not compensated for by insurance or other means. In addition, the program allows that subgroup of casualty losses associated with certain officially designated disasters (as proclaimed by the President or the Governor) to be (1) carried back as a deduction against income for the prior year, and/or (2) carried forward as a deduction against future income for up to five years. Fifty percent of the amount of any such loss remaining after five years may be carried forward for the next ten taxable years.

The term "casualty loss" includes losses arising from fire, storm, shipwreck, floods, and other such casualties, or from theft. Each separate casualty or theft loss is deductible only to the extent that it exceeds $100, and the total of all individual losses is deductible only to the extent that it exceeds 10 percent of federal AGI.

California law incorporates federal law allowing a deduction for corporate losses sustained and not compensated by insurance proceeds or other means. The corporate provisions regarding the deduction and carryover of disaster losses are the same as the provisions under the PIT.

Rationale

This program provides tax relief to those individuals, businesses, and corporate entities which suffer large casualty losses, have a tax liability, and (in the case of PIT) are able to itemize deductions. The most commonly cited rationale for the program is that it helps to relieve the hardships that these losses can impose on such individuals and firms.

Comments

This program has a number of important side effects and tax-equity considerations. First, because the program shifts part of the cost of a taxpayer's property losses to the general taxpayer, it serves as a form of indirect property insurance. As such, it reduces the costs of not having insurance and gives taxpayers an incentive to purchase less private insurance than they otherwise might. Insurance can result in a phenomenon known as "moral hazard," whereby an insured individual behaves in a manner which results in increased risk since the full costs of such behavior are not directly borne by the taxpayer. Private insurers attempt to control these tendencies by instituting experience-adjusted insurance premiums and deductibles. This tax program can be perceived as a supplemental insurance policy, but without such protective devices.

Second, depending on the size of a casualty loss and a taxpayer's income level, different taxpayers sustaining identical casualty losses can be provided different amounts of tax relief, due to such factors as the 10 percent threshold, the $100 minimum-loss requirement, and differences in marginal income tax rates. For example, a high-income taxpayer may not be able to claim any deduction for a $5,000 casualty loss due to the 10 percent threshold, whereas a low-income taxpayer would qualify for a large deduction. Conversely, the dollar amount of tax relief provided for a given dollar amount of casualty loss in excess of the 10 percent threshold will be greater for a higher-income taxpayer than for a lower-income taxpayer, due to the difference in their marginal tax rates.

The estimated revenue amounts shown above are for revenue reductions associated only with the deduction for casualty losses. The revenue reduction estimates for disaster-related losses depend on the type and scope of the disaster, and reflect larger carryback/carryforward deduction allowances.

Deduction:

Medical and Dental Expenses

Program Characteristics   Estimated Revenue Reduction
Tax Type: Personal Income Tax (PIT).

Authorization: California Revenue and Taxation Code Section 17201, which conforms to Internal Revenue Code Section 213.

(In Millions)
Fiscal Year PIT
1996-97 $110
1997-98 115
1998-99 120

Description

This program allows taxpayers to claim a deduction for specified medical and dental expenses related to treatment of the taxpayer, spouse, and dependents, to the extent that these expenses exceed 7.5 percent of federal adjusted gross income (AGI) and are not compensated for by insurance or other means.

Qualifying medical expenses include payments for diagnosis, cure, mitigation, treatment, or prevention of disease, including certain related travel costs and lodging expenses. They also include the costs of prescription drugs, plus nonprescription insulin. For tax years after 1996, the definition of medical care was expanded to include qualified long-term care and long-term care insurance premiums.

Rationale

This program provides tax relief to individuals who incur nonreimbursed medical expenses. The rationale for the program is that such expenses can impose extraordinary and involuntary financial burdens. In addition, the program provides some incentive for taxpayers to seek proper medical attention and preventive medical care, thereby improving the overall level of public health.

Distribution of Benefits

As shown in the table below, the number of taxpayers benefitting from medical and dental expense deductions is broadly distributed, but concentrated in the lower and moderate income categories. Total dollar deductions are also concentrated in the lower-to-middle income categories, with over 40 percent of the total deductions going to those taxpayers earning $60,000 annually or less. The average benefit from the program increases with income except in the highest income group.
Medical and Dental Expense Deduction
1998 Tax Year
Adjusted Income ($000) Percent of Average Amount

Claimed

Total Taxpayers Benefitting Total

Amount

Claimed

$0-20 12.2% 2.5% $51
20-40 33.3 16.8 124
40-60 25.6 21.0 202
60-80 15.3 17.7 284
80-100 6.0 12.6 517
100-150 5.4 14.3 654
150-200 1.2 7.6 1,500
200-250 0.4 2.5 1,500
250-500 0.6 4.2 1,667
Over 500 0.1 0.8 NA

Comments

Although the basic rationale for this program relates to the involuntary nature of many medical expenses, the deduction itself can be claimed for a variety of expenses that do not necessarily fall into this category. Such expenses include those for rest cures, and other basically "optional" expenses, many of which are not covered under medical insurance programs because insurers consider them to be discretionary.

This program gives rise to a number of economic side effects and tax-equity considerations. For example, because the program essentially shifts certain health-related expenses to the general taxpayer, it provides a form of indirect health insurance to individuals. Thus, it can give individuals an incentive to purchase less private health insurance than they otherwise might.

The tax subsidy given for a dollar of medical expenses also can differ under the program, depending on such factors as a taxpayer's income level and amount of total medical expenses. For instance, the tax subsidy for low dollar amounts of medical expenses can be greatest for certain low-income taxpayers, since the 7.5 percent threshold can disqualify higher-income taxpayers from claiming them. On the other hand, the tax subsidy for high dollar amounts of medical expenses can be greatest for higher-income taxpayers, due to their higher marginal income tax rates.

Deduction:

Certain Taxes Paid

Program Characteristics Estimated Revenue Reduction
Tax Type: Personal Income Tax (PIT).

Authorization: California Revenue and Taxation Code Sections 17201, 17220, and 17222, which partially conform to Internal Revenue Code Section 164.

(In Millions)
Fiscal Year PIT
1996-97 $658
1997-98 671
1998-99 706

Description

This program allows taxpayers to claim an itemized deduction for the amount of certain property taxes, vehicle taxes, and other taxes paid to the state and its local governments. Specifically, the program allows a deduction for: (1) state, local, and foreign real property taxes; (2) state and local personal property taxes (including only the portion of the state vehicle license fee that does not represent annual charges for vehicle registration and vehicle weight); (3) one-half of self-employ-ment taxes; and (4) other state, local, and foreign taxes relating to a trade or business, or to a property held for the production of income. Generally, California law is the same as federal law except that California specifically prohibits the deduction of state, local, and foreign income, war profits, and excess profits taxes.

Rationale

This program provides tax relief under the rationale that already-paid taxes reduce the amount of a taxpayer's net income, thereby reducing the taxpayer's ability to pay state income taxes. The program also has been justified on the grounds that income should not be subject to double taxation by California state and local governments.

Distribution of Benefits

The largest portion of taxes which is deductible under PIT is the local property tax. The income distribution of the deductibility of property taxes is shown in the accompanying table. The program largely benefits middle-income taxpayers, both in terms of the of number of taxpayers benefitting, as well as the distribution of total deductions. Average benefits increase along with income due to the high correlation between income and home values.
Real Property Taxes Deduction
1998 Tax Year
Adjusted

Gross

Income

($000)

Percent of Average

Amount

Claimed

Total

Taxpayers

Benefitting

Total

Amount

Claimed

$0-20 1.8% 0.2% $16
20-40 11.3 3.5 56
40-60 21.6 11.9 102
60-80 21.6 17.0 145
80-100 14.7 15.9 200
100-150 16.6 23.2 258
150-200 5.0 9.0 331
200-250 2.5 5.3 395
250-500 3.3 8.8 491
Over 500 1.7 5.3 586

Comments

This program is available only to taxpayers who claim itemized deductions on their state income tax returns. These taxpayers tend to fall disproportionately into moderate-income and higher-income brackets. Because of this tendency, along with both the state's graduated marginal tax bracket structure and the positive relationship between increases in the level of taxes paid and income, the tax relief provided by this program generally increases with income levels.

By allowing deductions for local taxes paid, this program makes it less expensive on an after-tax basis for individuals to consume a given level of publically provided services. It enables individuals living in communities with a high appetite for public services to avoid bearing the entire cost of the increase in taxes necessary to support such services, since a portion of the cost can be offset in the form of lower state income tax liabilities. This issue is less important at the state level than at the federal level, but still has ramifications for state fiscal policy.

The federal Budget Reconciliation Act of 1990 limited the aggregate amount of itemized deductions including this one, which can be claimed by taxpayers with adjusted gross income (AGI) over a certain amount, depending on the year involved. This amount was $124,500 in 1998 for joint-return filers and $62,250 for married, filing separately taxpayers. California law limits 1998 itemized deductions for taxpayers with AGI in excess of $116,777 for single-filers and married taxpayers filing separately, and $233,556 for joint-return filers.

Deduction:

Mortgage Interest Expenses

Program Characteristics Estimated Revenue Reduction
Tax Type: Personal Income Tax (PIT).

Authorization: California Revenue and Taxation Code Section 17201, which conforms to

Internal Revenue Code Section 163.

(In Millions)
Fiscal Year PIT
1996-97 $2,770
1997-98 2,880
1998-99 3,030

Description

This program generally allows taxpayers to deduct the amount of qualified mortgage interest expenses paid or accrued within a taxable year. Qualified mortgage interest includes interest on indebtedness secured by a taxpayer's residence, including interest incurred in acquiring, constructing, substantially improving, or refinancing the residence. Interest on indebtedness to purchase second homes and vacation homes, and interest on home-equity borrowing, also qualify for the deduction. The aggregate amount of indebtedness incurred to purchase, construct, or improve a home may not exceed $1 million (or $500,000 for a married individual filing a separate return). The total amount of interest on a home-equity loan generally may not exceed interest on indebtedness of more than $100,000 (or $50,000 for a married taxpayer filing a separate return).

Rationale

This program provides an incentive for home ownership. This is because most home purchases require mortgage financing, and this deduction reduces the net after-tax costs of such borrowing. It often is claimed that home ownership is worth encouraging on the grounds that it generates substantial public benefits, including neighborhood stability, promotion of civic responsibility, and encouragement of proper maintenance of residential structures by occupants.

Distribution of Benefits

The accompanying table indicates by income class the distribution of the mortgage interest deduction. The program provides a substantial proportion of benefits to middle and upper-middle income classes, with over 70 percent of total deductions accruing to taxpayers earning between $40,000 and $150,000 annually. The average benefit increases with income for all but the highest income class. The latter is due to a decline in the prevalence of mortgages in this income class, as well as the effect of limitations on itemized deductions.
Mortgage Interest Expense

Deduction

1998 Tax Year
Adjusted

Gross

Income

($000)

Percent of Average

Amount

Claimed

Total

Taxpayers

Benefitting

Total

Amount

Claimed

$0-20 2.2% 0.3% $104
20-40 12.7 3.9 266
40-60 22.9 12.8 481
60-80 21.0 18.2 745
80-100 14.2 16.7 1,020
100-150 15.7 23.8 1,307
150-200 4.7 8.9 1,642
200-250 2.3 5.1 1,925
250-500 3.0 7.6 2,179
Over 500 1.4 2.9 1,760

Comments

One of the side-effects of this program is that it encourages consumers to finance their homes and other purchases through borrowing, even if their income level is high enough to avoid the need to do so. In this sense, some might argue that the program provides some incentive for "over-borrowing." The program also encourages taxpayers to increase the amount they spend on housing because it reduces the after-tax costs of such expenditures. In addition, the program disproportionately benefits higher-income individuals, who are most likely to purchase their own homes. Higher-income individuals also realize greater tax savings for a given dollar amount of interest deductions due to their higher marginal income tax rates.

It should be noted that the federal Budget Reconciliation Act of 1990 placed additional limitations on the aggregate amount of itemized deductions (including this one) which can be claimed by a taxpayer with adjusted gross income (AGI) over a specified amount. California law also has limits on the aggregate amount of deductions which may be claimed by taxpayers. These limits are discussed under the program entitled, "Certain Taxes Paid."

We previously reviewed the economic and fiscal effects of this program (see Legislative Analyst's Report on the 1988-89 Tax Expenditure Budget: Overview and Selected Reviews, and The Personal Income Tax Itemized Deduction for Mortgage Interest Expenses). Our major findings, which we believe still are applicable, were that although the program is at least partially successful in enabling certain taxpayers to buy homes, it is relatively inefficient. For example, the interest rate subsidies made available under the program provide "windfall" benefits to many taxpayers who would have purchased homes in the absence of the program, and encourage certain individuals to over-consume housing by buying bigger and more expensive homes than they otherwise would. The result may be that this program, coupled with other programs granting housing preferential treatment, results in a misallocation of resources. Reducing, but not eliminating, subsidies for housing could result in a more efficient allocation of resources while still preserving the social benefits that result from home ownership.

Given these findings, we previously have recommended that the Legislature consider the following options: (1) limit the amount of mortgage interest which may be deducted, (2) eliminate or limit the deduction for second homes and nonhousing expenses, (3) convert the current deduction into a maximum tax credit that reduces the overall regressivity of the derived tax benefit from the program and potentially reduces its revenue effect, and (4) use the savings from "tightening up" eligibility under this program to provide additional subsidies targeted at low-income households and first-time home buyers.


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