This section provides information on tax expenditure programs (TEPs) associated with the income tax liabilities of individuals and businesses. These programs affect the amount of General Fund revenues raised by the state's first and third largest taxes--the Personal Income Tax (PIT) and the Bank and Corporation Tax (BCT), respectively. Both of these taxes are administered by the California Franchise Tax Board (FTB). The following provides a brief summary of the PIT and BCT.
The PIT is paid by all California residents and nonresidents who receive income from sources in the state. Estates and trusts are also required to pay personal income taxes. The largest sources of taxable income under PIT include wages and salaries, interest, dividends, rents and royalties, net capital gains, and net business income. Business income includes the distribution of profits from partnerships, sole proprietorships, and Subchapter S corporations to shareholders or partners. Subchapter S corporations are also subject to an entity-level corporate tax on their net taxable income.
California's PIT law conforms to federal PIT law in many areas, which helps simplify both the calculations of tax liabilities for taxpayers, as well as the administration and enforcement activities of the FTB. Filing under California's PIT system, for example, builds upon preliminary steps carried out for the calculation of federal PIT liabilities.
Basic Calculation of State Income Tax Liabilities. Figure 1 provides a flowchart of how California's PIT liabilities are calculated. For the purposes of calculating PIT, there are four basic steps involved:
Taxpayers are then allowed to deduct from their California AGI the larger of either a fixed dollar amount (called the "standard deduction") or the total amount of their allowable itemized expenditures of specified types (called "itemized deductions"), to arrive at California taxable income (TI).
Marginal Tax Rates and Income Tax Brackets. The tax rates used to calculate state PIT liabilities depend on both the filing status and taxable income of the taxpayer. California has five filing statuses: single, married filing jointly, married filing separately, head of household, and surviving spouse with dependents. A different tax rate schedule is used for each filing status. In general, taxpayers must use the same filing status on both their federal and state tax returns. Over 84 percent of all California tax returns filed are from taxpayers selecting the married filing jointly or the single filing statuses.
| Figure 2 | |||||
| Personal Income Tax Rate Schedules for 1998 | |||||
| If the taxable income is: | Computed Tax Is | Of The Amount Over | |||
| Over | But Not Over | ||||
| Married Filing Jointly and Surviving Spouses with Dependents | |||||
| $0 | $10,262 | $0.00 | + | 1.0% | $0 |
| 10,262 | 24,322 | 102.62 | + | 2.0 | 10,262 |
| 24,322 | 38,386 | 383.82 | + | 4.0 | 24,322 |
| 38,386 | 53,288 | 946.38 | + | 6.0 | 38,386 |
| 53,288 | 67,346 | 1,840.50 | + | 8.0 | 53,288 |
| 67,346 | and over | 2,965.14 | + | 9.3 | 67,346 |
| Single and Married Filing Separate | |||||
| $0 | $5,131 | $0.00 | + | 1.0% | $0 |
| 5,131 | 12,161 | 51.31 | + | 2.0 | 5,131 |
| 12,161 | 19,193 | 191.91 | + | 4.0 | 12,161 |
| 19,193 | 26,644 | 473.19 | + | 6.0 | 19,193 |
| 26,644 | 33,673 | 920.25 | + | 8.0 | 26,644 |
| 33,673 | and over | 1,482.57 | + | 9.3 | 33,673 |
| Head of Household | |||||
| $0 | $10,264 | $0.00 | + | 1.0% | $0 |
| 10,264 | 24,323 | 102.64 | + | 2.0 | 10,264 |
| 24,323 | 31,353 | 383.82 | + | 4.0 | 24,323 |
| 31,353 | 38,803 | 665.02 | + | 6.0 | 31,353 |
| 38,803 | 45,833 | 1,112.02 | + | 8.0 | 38,803 |
| 45,833 | and over | 1,674.42 | + | 9.3 | 45,833 |
| Source: Franchise Tax Board. | |||||
As noted above, each filing status has a corresponding tax rate schedule. Figure 2 provides tax rate schedules by filing status for the 1998 tax year. As Figure 2 shows, under California's progressive income tax rate structure, taxpayers at higher income levels pay a larger share of their income in taxes than do taxpayers at lower income levels. In 1998, marginal tax rates ranged from 1 percent to 9.3 percent, with an AMT rate of 7 percent. To calculate their state tax liability before credits, taxpayers use the tax rate schedule that corresponds to their appropriate filing status. For example, a single taxpayer with taxable income of $28,500 would have a state tax liability of $920.25 + (8 percent x $1,856.00), or $1,068.73. California indexes its PIT brackets annually for inflation using the June- (of the prior year) to-June (of the current year) increase in the California Consumer Price Index. California's standard deduction and personal and dependent credits also are indexed for inflation.
Because the tax brackets for single persons are divided at levels that are exactly half of their married-filing-joint counterparts, California's income tax bracket structure generally does not result in a "marriage penalty." (At the federal level, this penalty can occur when two single taxpayers with equal incomes are subject to lower tax liabilities than are two similar taxpayers who are married.) California's tax system results in either marriage neutrality or, for many taxpayers, actual marriage bonuses.
Effect of Different Marginal Tax Rates. In many of the reviews of TEPs relating to PIT, we indicate that the program results in disproportionate benefits to higher-income taxpayers due to their higher marginal tax rates. It is important to note why this happens, since its occurrence is so frequent in TEPs which result in either deductions or exclusions from income.
An example of this is a married couple filing jointly with California taxable income (TI) of $75,000. Their marginal tax rate is 9.3 percent and tax liability before credits is $3,676.96. Now assume the couple has a deduction for mortgage interest payments of $5,000. This would result in TI of $70,000 and a tax liability of $3,211.96, or $465 less than their liability without the deduction.
Alternatively, a married couple filing jointly with a California TI of $50,000 has a marginal tax rate of 6 percent, and a pre-credit tax liability of $1,643.22. With a mortgage interest deduction of $5,000, their tax liability would drop to $1,343.22, or $300 less than their tax liability without the deduction.
Based on this example, in terms of taxes saved, the deduction is worth $165 more to the higher-income couple. A similar result occurs when income exclusions are involved.
Most corporations that earn income derived or attributable to California sources are subject to California's BCT. Some corporations, however, are either exempt or partially exempt from the tax. These include insurance companies (which are subject to a gross premiums tax in lieu of a tax on net income) and nonprofit organizations (which are only subject to the BCT for earned income that is unrelated to their tax-exempt status).
Types of Bank and Corporation Taxes. There are four basic categories of taxes levied under the BCT:
The franchise tax accounts for the majority of revenues raised under the BCT, and generally is the tax being referred to when the term "corporate income tax" is used (even though there is a separate smaller corporate income tax, as discussed below). As under PIT, corporate taxpayers who take advantage of certain tax preferences or special tax provisions must complete an AMT calculation and pay any resulting amount by which it exceeds the amount of the regular tax due. For 1998, the AMT tax rate is 6.65 percent.
Figure 3 provides a history of California BCT rates levied since the tax was created in 1929. As it shows, the current general franchise tax rate is at its lowest level since 1973. Other state corporate-related tax rates--such as for Subchapter S corporations, the corporate AMT, and banks and financial corporations--have generally declined in recent years as well. However, the corporate minimum tax has remained at $800 for most corporations since 1990.
| Figure 3 | ||
| Bank and Corporation Tax Rates | ||
| General Corporation Rate | MinimumTaxa | |
| 1929-34 | 2.00% | $25 |
| 1935-42 | 4.00 | 25 |
| 1943-49 | 3.40 | 25 |
| 1950-58 | 4.00 | 25 |
| 1959-66 | 5.50 | 100 |
| 1967-71 | 7.00 | 100 |
| 1972 | 7.60 | 200 |
| 1973 | 8.30 | 200 |
| 1974-79 | 9.00 | 200 |
| 1980-81 | 9.60 | 200 |
| 1982-86 | 9.60 | 200 |
| 1987-88 | 9.30 | 300 |
| 1989 | 9.30 | 600 |
| 1990-96 | 9.30 | 800 |
| 1997 to present | 8.84 | 800 |
| a Beginning in 1998, new small corporations pay a minimum tax below this amount. | ||
| Source: Franchise Tax Board. | ||
Calculation of Income for Multistate and Multinational Corporations. If a corporation derives all of its income from California sources, the entire nonexempt portion of income is used in the state BCT liability calculation described above. However, if the corporation has multistate or multinational operations and has business income attributable to non-California sources, then it must apportion the amount of its business income attributable to its California operations. Nonbusiness income, such as interest and royalties, is allocated to (1) the corporation's official state of residence, in the case of taxable income derived from intangibles, or (2) where relevant property is located, in the case of taxable income derived from real or personal property.
Before apportioning income, the corporate taxpayer must first identify the extent of its operations that are attributable to a corporation or group of corporations operating as one integrated business. This taxpayer may elect to combine either: (1) its worldwide income or, (2) its income within the U.S. and certain specified "tax havens." The former method is known as the "worldwide" basis and the latter as the "water's-edge" basis. Once this election is made, formula apportionment (see below) is used to determine the portion of income attributable to California for tax purposes.
Formula Apportionment. California's apportionment formula is based on looking at a firm's average ratio of its corporate activity in California to its total corporate activity (either on a worldwide basis or water's-edge basis, depending on the taxpayer's preference) for three factors: property, payroll, and sales. In California, the sales factor is double-weighted (except for mining and other extractive industries, agriculture, and banking and financial business activity). The average computed ratio is then multiplied by the total net corporate income (whether on a worldwide basis or water's-edge basis) to arrive at the amount of income attributable to California. This amount is then used in the calculation described above to arrive at corporate state tax liabilities.
Because the sales factor is weighted twice in computing the apportionment factor (versus the alternative approach of equally weighting all three factors), certain corporations are advantaged. Specifically, the formula provides relative benefits to those corporations that are based in California but conduct most of their sales outside of the state. This procedure serves to encourage and stimulate California-based development and production activities.
Calculation of Income Tax Liabilities. Corporations may choose to file their taxes based upon either a calendar-year or fiscal-year basis (which in the latter case, commences in any month other than January). Corporations calculate tax liabilities based upon a process similar to that described above for PIT filers. First, all income attributable or sourced to California must be added up, and then tax-exempt or excluded income is subtracted from this amount to arrive at gross income. Next, deductions are subtracted to arrive at a measure of corporate net income. For most corporations, the flat 8.84 percent tax rate is levied on this net income, yielding state BCT liabilities before tax credits. Certain tax credits may reduce corporate tax liabilities. However, as noted above, corporations are subject to the state's AMT, which serves to recapture some of those tax revenues that would otherwise be lost due to tax exemptions, exclusions, deductions, and credits.
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