Analysis of the 2007-08 Budget Bill: Perspectives and Issues

The Governor’s Tax Proposals

Should the Legislature Adopt the Governor’s Proposed Tax Changes Involving the Teachers’ Retention Tax Credit and the Taxation of Out-of-State Purchases of Vessels, Vehicles, and Aircraft?

Summary

The budget contains two tax-change proposals. The first is to permanently repeal the existing teacher retention tax credit, which was adopted in 2000 but was temporarily suspended in four of the past six years. The second is to make permanent a temporary change made in 2004 to extend, from 90 days to one year, the time that vessels, vehicles, and aircraft recently purchased out of state must be kept outside of California in order to avoid the state’s use tax. We provide background on these two proposals, discuss their economic and fiscal impacts, and identify issues associated with them. Based on our review, we recommend that the Legislature adopt both proposals.

Proposal to Eliminate the Teacher Retention Tax Credit

Background

Off-and-on since January 1, 2000, California has made available a teacher retention tax credit (TRTC) providing benefits to those teaching in kindergarten through 12th grade (K-12) classes. The stated intent of the TRTC is to encourage the state’s experienced K-12 teachers to remain in the profession, as well as compensate teachers for their unreimbursed expenses related to professional development and classroom instruction.

The credit is available to any qualifying teacher and is not associated with their actual expenses incurred. Rather, the amount of the credit is based upon years of service as a credentialed teacher at a qualifying institution in California. The California TRTC increases from $250 for teachers with four or five years of service to a maximum of $1,500 for teachers with 20 years of service. California’s credit is offered in addition to a federal “above the line” deduction of $250 for qualified out-of-pocket expenses. Also, educators with out-of-pocket expenses larger than the allowable California credit or federal above-the-line deduction may claim expenses over these amounts as a miscellaneous itemized deduction. The TRTC is nonrefundable, which means that a claimant cannot receive more in credits than his or her tax liability. In addition, any unused credit cannot be carried forward and used to offset liabilities in future tax years.

Credit Features and Eligibility

In order to qualify for the credit, an individual must: (1) hold a California preliminary or professional teaching credential, (2) teach K-12 in an educational institution located in California, and (3) have completed at least four years of service as a fully credentialed teacher at a public or private educational institution (services performed as a credentialed teacher in another state may also count toward determining the years of service).

The credit amount is limited to the lesser of 50 percent of the total tax imposed on the individual’s wages and salaries for services as a credentialed teacher or:

• $250 for at least four years but less than six years of service.

• $500 for at least 6 years but less than 11 years of service.

• $1,000 for at least 11 years but less than 20 years of service.

• $1,500 for 20 years or more of service.

Use of the TRTC

Figure 1 shows the use of the credit since its inception in 2000—including tax years 2000, 2001, and 2003 (the credit was suspended for tax years 2002, 2004, 2005, and 2006, due to budgetary considerations). As shown, the credit has been claimed by over 200,000 teachers each year, with a revenue loss of over $150 million annually. The figure also shows that the number of taxpayers claiming the credit fell somewhat in 2003, which may be attributed to the inconsistent availability of the credit to taxpayers. The average claim during the period shown increased from $737 in 2000 to $773 in 2001, and then fell to $748 in 2003.

The use of the TRTC by income class in 2003 is shown in Figure 2. About 9 percent of total taxpayers claiming the credit earned more than $150,000, and these claims accounted for 15 percent of the total cost to the state of the credit. The figure also shows that 87 percent of the teachers that claimed the credit in 2003 had incomes greater than $50,000, and that 94 percent of the cost of the credit is attributable to claims by these taxpayers. (As a reference point, in 2004 the median adjusted gross income in California was about $35,000.)

What Has the Credit Accomplished?

The state has spent almost $500 million on the TRTC since its inception. A key consideration for the Legislature is whether it has accomplished its intent. For that reason, our review focuses on two questions:

• First, has the program resulted in fewer or later retirements or job shifts on the part of teachers?

• Second, has the program effectively and efficiently reimbursed teachers for out-of-pocket classroom expenditures?

Effects on Retention Hard to Identify but Likely Are Limited

Unfortunately, it is difficult to provide hard evidence as to the program’s effects on work-related decisions made by TRTC beneficiaries. There is some basis, however, for concluding that these effects likely have been limited.

Evaluation of the credit’s ability to achieve the goal of improved retention (particularly among more experienced teachers) involves such steps as: (1) examining retirement patterns of teachers in years when the credit was available as compared to years when the credit was not available, and (2) examining retention of all staff—not just those of retirement age.

Minimal Effect on Retirements. While no data on the credit’s particular impact on retirements is available, examination of retirement rates in years that the credit was available suggests that the credit had no significant positive effect on retention among the most experienced teachers—that is, those teachers eligible for retirement. This finding is not surprising given that the credit is such a small amount relative to a teacher’s total annual compensation. A more direct way to affect retention rates of experienced teachers is through the retirement system. In fact, the state recently took such actions:

• In 2001, the state provided increased benefits (known as the "longevity bonus") to members retiring with 30 or more years of service earned by 2011.

• Also beginning in 2001, retirees with 25 or more years of service became eligible for a benefit based on their highest 12 consecutive months of salary, instead of the highest 36 months used for members with fewer years of service.

Minimal Effect on Teacher Retention Rates. Figure 3, which shows the retention of all public teaching staff in the state over recent years, suggests that the TRTC has had little to no effect on overall retention of teachers. The figure shows that the average number of years teaching and the average years in a particular district has remained virtually flat over the period.

Issues Concerning Reimbursement of Classroom Expenditures

Credit Not Tied to Actual Out-of-Pocket Expenditures. The TRTC’s stated intent is, in part, to reimburse certain teachers for out-of-pocket classroom expenses. However, as currently structured, the amount of the credit is dependent only upon years of credentialed service as a teacher, rather than actual out-of-pocket expenses incurred. Hence, rather than a reimbursement for expenses, the program represents a direct wage subsidy for certain teachers. Because of this disconnect, there is no data available on the amount of instructional materials actually reimbursed through this credit.

Credit Does Not Reimburse Expenses of Many Teachers. New teachers are excluded from the current program since they do not have at least four years of credentialed teaching. This is so even though newer teachers may arguably incur the greatest out-of-pocket expenses for gathering supplies for their students, since these new teachers do not have supplies accumulated from years past. The same argument applies to preschool teachers, who are not currently eligible for the TRTC.

State Provides Significant Direct Instructional Materials Spending. The budget includes significant funds for instructional materials in classrooms. Specifically, for 2007-08, it sets aside $419 million in an instructional materials block grant and $109 million in an arts and music block grant. Lottery moneys from Proposition 20, which usually amount to between $150 million and $200 million each year, are also available for instructional materials. Taken together, the administration proposes more than $680 million for instructional materials in the budget year. This is a significant increase in targeted state funding on instruction materials compared to the start of the decade. This increased spending may have reduced significantly the level of unreimbursed spending by teachers.

LAO Bottom Line

As noted above, we find there to be a lack of evidence that the TRTC has materially encouraged teacher retention. Rather than use the tax system, we think it is much more appropriate and effective for the state and school districts to use their pay and retirement systems to address any retention concerns. We also were unable to identify evidence that the TRTC materially affects the amount of instructional materials and supplies that teachers contribute to their classrooms. This is not surprising given that the credit is not linked to teacher spending on these materials. For these reasons, we recommend that the Legislature adopt the Governor’s proposal to eliminate the TRTC on the grounds that it is not an effective and cost-efficient means of achieving its stated objectives. Elimination of the credit would result in annual savings to the state of $165 million beginning in 2007-08 and increasing amounts thereafter.

Proposal Involving Out-of-State Purchases of Vessels, Vehicles, and Aircraft

Background

California imposes a sales and use tax (SUT) on the final sale of tangible personal property, where the term “final sale” applies when the purchaser is determined to be a property’s ultimate consumer. The main component of the SUT is the sales tax, which is collected by retailers on most purchases made in California. The second component, the use tax, is applied to nonretail sales occurring inside of California, as well as to purchases made outside of California involving goods which are then brought into California for storage or use in this state. The SUT is administered by the California State Board of Equalization (BOE).

The Key Issue—What Does “Use” Mean?

The single most important issue involved in administering the use tax when out-of-state purchases are involved is: What criteria should be employed to determine whether an item has been purchased for use in California versus for out-of-state usage, and thus whether it is or is not subject to California taxation.

Past and Current Criteria

Past Criteria. California had a given set of rules in place for many years to make this determination regarding taxability. Prior to October 2004, any vessel, vehicle, or aircraft purchased out of state was generally subject to the SUT if it was either purchased in California or if it was brought into California within 90 days of its purchase date (the so-called “90-day test”). Property held outside of California for the initial 90-day period was presumed to have been purchased for out-of-state use, and thus was exempt from taxation. In addition, if the property was brought into California before the 90-day period was up, it could still be exempt if it was subsequently used and stored outside of California at least one-half of the time during the six-month period immediately following its initial entry into the state (the so-called “principal-use test”).

But Problems Emerged. Over time, the state increasingly found itself experiencing difficulties under these original rules in effectively enforcing the spirit of the law regarding the use taxation of out-of-state purchases of vessels, vehicles, and aircraft. What occurred was that a growing number of purchasers—particularly of yachts and recreational vehicles (RVs)—used the 90-day test to claim the out-of-state usage exemption. In the case of vessels, this often involved taking possession more than three miles offshore, sailing the vessel directly to Ensenada or other sites near the U.S. border, and then storing it for 90 days or more before returning to California. In the case of RVs, it often involved taking possession in Arizona, Nevada, or Oregon, then using or storing the vehicle outside of California for at least 90 days before returning to the state.

Current Criteria. These problems led to the enactment of Chapter 226, Statutes of 2004 (Senate Bill 1100, Committee on Budget and Fiscal Review), which temporarily tightened up on the rules. The enactment of Chapter 226 was in response to concerns about growing usage of the exemption and the belief that this involved assets that would subsequently be used on an ongoing basis in California instead of outside of the state. Figure 4 summarizes the changes temporarily made by Chapter 226 that the Governor’s proposal would make permanent. As shown, the main one is the “one-year test,” under which property is subject to the use tax if it is brought into California within one year after its purchase (except when this is done simply for repair, retrofit, or modification).

LAO Report Requirement

Chapter 227 also required the LAO to evaluate and report on the economic and fiscal effects of the new rules. In our report—Out-of-State Purchases: California’s Taxation of Vessels, Vehicles, and Aircraft (April 2006)—we concluded that it would be preferable to make these rule changes permanent, and this is what the Governor is proposing.

LAO Report Findings

General Approach and Considerations

By lengthening the time that purchasers need to keep vessels, vehicles, and aircraft out of state in order to fulfill the requirements for an out-of-state usage exemption, Chapter 226 was expected to result in fewer exempt sales and an increase in SUT revenues to California. At the same time, however, industry representatives asserted that the law changes would have negative impacts on California business activities and profitability. These concerns were most notable with respect to the yachting industry, where it was argued that Californians would be put at a competitive economic disadvantage with those in other yachting regions, such as the northwest and Florida. Given these concerns, our analysis focused first and foremost on the impacts of Chapter 226 on the yachting industry, although we also evaluated impacts on vehicles (mostly RVs) and aircraft.

In considering the impacts of Chapter 226, it was important to assess the extent to which its provisions can be avoided through the use of other tax code provisions. That is, can purchasers who no longer qualify for the out-of-state usage exemption still find other means to avoid the use tax? If this were to occur frequently, the added revenue from the limits placed on the out-of-state usage exemption by Chapter 226 might be largely or even entirely negated. This could potentially occur through two avenues: (1) the use of an alternative exemption or (2) utilizing certain other provisions of the tax law, such as changing the organizational form of a business.

Other Exemptions Available to Buyers of Vessels, Vehicles, and Aircraft. Altogether, there are 13 exemptions in the use tax law, including that for out-of-state usage and others ranging from purchases between family members to transfers between related businesses. In addition to the out-of-state usage exemption, there are three exemptions of major relevance to purchasers of vessels, vehicles, and aircraft. These are the exemptions for (1) commercial fishing, (2) interstate commerce, and (3) being a common carrier. We determined that there definitely is potential for taxpayers to substitute other exemptions for the out-of-state exemption in the case of aviation-related purchases, but less opportunity for substitution in the case of vessels and vehicles.

Economic and Fiscal Effects Involving Vessels

Our analysis of Chapter 226’s economic and fiscal effects was based on such factors as our assessment of the industry’s structure, the mix of vessels marketed to Californians, industry sales data, and assumptions about the likely mix of different behavioral responses of purchasers to the law change.

Regarding these behavior responses, individuals would be faced with four different options: (1) buying the same vessel and paying the use tax in California, (2) purchasing a smaller vessel and paying the use tax in California, (3) complying with the one-year test and keeping the vessel out of state so as to avoid the use tax, and (4) canceling their purchase altogether. At one extreme, if the great majority of buyers simply went ahead and purchased the vessel in California, then the measure would result in a large increase in revenues and a modest increase in economic activity. At the other extreme, if the main effect was a cancellation of buyer’s plans, then Chapter 226 would result in fewer revenues and reduced economic activity. The actual mix of behaviors would depend on such factors as the sensitivity of buyers and sellers to changes in after-tax vessel prices, and the mobility of buyers—that is, their ability to shift purchases and usage of a vessel from California to other regions.

The Evidence to Date. Based on the data available so far, it appears that the measure has resulted in major declines in the out-of-state usage exemption, an increase in sales subject to California’s SUT, and thus a roughly $20 million annual increase in SUT receipts from vessel-related purchases.

Overall Fiscal and Economic Effects

Fiscal Effects. After conducting similar analyses for vehicles and aircraft and combining the results with those for vessels, we estimated that the combined impact of Chapter 226 on SUT revenues was a revenue increase of about $45 million in 2005-06. The General Fund share of this total was about $28 million, with the remaining portion going to state special funds and localities.

Economic Effects. In terms of economic effects, we concluded that it is likely that the extended one-year test has had some adverse effects on California’s yachting and RV industries. In instances where the state is competing with other states and countries for business, the Chapter 226 changes could also have adverse effects on California’s competitiveness. The initial data we have observed, however, suggest that these effects have not been particularly large.

Legislative Issues and Considerations

In considering the Governor’s proposal to extend Chapter 226 permanently, the main question facing the Legislature is: Which tax test is most appropriate both from (1) a tax policy perspective and (2) in terms of making practical sense?

The One-Year Test Is Preferable

Determining the best approach from a tax policy perspective can be a complicated issue for vessels, vehicles, and aircraft, as they have long lives, are mobile, and thus may be used in numerous places over their lifetimes. While, in theory, use taxes could be apportioned to various different taxing jurisdictions over time based on where the assets are used, such a process would, in practice, be virtually impossible to administer and enforce by the state’s taxing agencies. It is for this reason that California, like other states, has adopted tests that are rough approximations for determining whether property that is being purchased is, in fact, for use in California. The basic tax policy question regarding Chapter 226 is thus whether the one-year test is a more appropriate measure for determining usage than the 90-day test. Although neither test is perfect, the striking decline in claims for the out-of-state usage exemption for vessels and RVs that occurred when the test was expanded to one year strongly suggests that the majority of the 90-day exemptions were made for assets that were purchased for use in this state. In this regard, we believe the one-year test is a better approximation of actual usage than is the 90-day test. As such, we recommend that the Legislature adopt the Governor’s proposal to make Chapter 226’s change permanent.

But Other Changes Also May Merit Consideration

If the Legislature does choose to permanently extend the one-year test, it may also wish to consider changes to Chapter 226 that we believe would address some legitimate concerns about the measure raised by the affected industries and which would not weaken the basic intent of Chapter 226. These changes involve:

• Connection of the Use Tax to the Property Tax Lien Date. Under Chapter 226, a nonresident owner of a vessel or aircraft is exempt from the use tax if the property is used outside of the state for more than six months during the first year. However, the vessel or aircraft is also presumed to be for use in California (and thus subject to the use tax) if it is subject to the property tax during the first 12 months of ownership. Thus, if a vessel owned by a nonresident is within a county on the January lien date, it would be subject to both the personal property tax and the use tax. While this linkage may help BOE establish use tax liabilities, we believe it creates a conflicting standard that could seriously disadvantage nonresidents that have fully met the out-of-state usage test, and yet find themselves subject to the use tax. Given this, the Legislature may wish to eliminate the provision in Chapter 226 which links the application of the use tax to the property tax.

• Exemption for Fueling and Emergencies. Chapter 226 includes an exemption from the use tax for vessels and aircraft for repair, retrofit, or modifications. The Legislature may wish to add similar exemptions for refueling and emergencies, since such activities do not necessarily imply regular usage in California.

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