Tax incentives and the California economy Statement by Lenny Goldberg, Executive Director, California Tax Reform Association, to Joint Hearing of the Senate and Assembly Committees on Revenue and Taxation, January 20, 1993 It used to be that liberals were accused of throwing money at social problems. Now, in a time where the economy is the paramount issue, the favored approach seems to be to throw tax breaks at economic problems. However well-intentioned the effort, it's at best a waste of tax dollars--there is no bang to the buck. At worst, it's special interest politics exploiting and benefiting from our economic troubles. My comments will address three broad areas: First, the argument that state business tax incentives are ineffective and wasteful economic policy is straightforward. It is covered well in the Q&A done by the Senate Revenue and Taxation Committee and in the excellent article by Harley Duncan. I will expand on some of these points and add a few of my own. Second, if scattering tax breaks throughout the landscape without accountability or targeting is ineffective, what is the alternative? We argue that public investment cannot be ignored, and, if the goal is to stimulate economic activity, the same amount of money can be much better spent than on diffuse tax breaks. Third, we cannot look at the issue of taxes and growth and not address Proposition 13. The inability to pay for infrastructure, environmental mitigation, local services, and quality of life improvements, plus the unfair taxation of developers through fees, is anti-growth. Counter to the tax-cutting perspectives, and counter-intuitively for many people, there is a strong argument that Prop. 13 reform which increases business taxation-- if done right--will improve the economic climate of California. I. The ineffectiveness of state tax incentives a. Total state and local taxes account for less than 2% of the cost of doing business, and are in many cases closer to 1%. Thus even large changes in tax law--which raise or lower taxes by 20% --amount to about 2 tenths of one percent of costs. A New York State study showed that labor costs were 53 times tax costs--so a few pennies worth of productivity improvements or labor saving (including, certainly, payroll costs such as workers' compensation) far overshadow any potential tax breaks. b. Tax incentives reward activity which would otherwise take place. At the Little Rock economic summit, the CEO of Zenith Corp. said that an investment tax credit will never make a bad investment into a good one--and that's based on a much higher federal tax rate. (For commercial real estate in the mid-1980's, that dictum probably did not hold). Business starts with the calculation of what's a good investment. Extra tax benefits become a bonus on the top, particularly in light of the fact that taxes are such a small part of costs. Even if some small percent of investments were stimulated at the margin by a tax incentive-- a big if--, it is hard to imagine the legislature approving an expenditure which was 95% ineffective. But we do so for tax breaks. c. There is no accountability or disclosure whatsoever. For even the most popular and targeted of tax breaks--the research and development tax credit--we have little idea what we're buying. We know that it goes to manufacturing companies, but what new jobs have been created? Have companies actually expanded r&d in California or have they changed their accounting procedures to take advantage of the credit? How much of their activities would take place anyway, since r&d is a requirement for survival in many industries? At the federal level for multinationals, we allow domestic write-off of considerable r&d even when it supports expansion of manufacturing abroad. Which California r&d, ostensibly stimulated by the credit, leads to other California jobs, and which spins off jobs in Mexico and Taiwan? We know none of these answers for this. I use r&d as an example because it is one of the more targeted incentives. For such broad breaks as investment tax credits, the problem becomes even worse. And for unitary reform, we have no data on the results, but we certainly have a down economy despite many promised jobs. Once again, it's hard to imagine the Legislature approving such major expenditures without knowing what it was buying, but we do it for tax expenditures. d. Regional and state economies have extensive leakages. It is far more likely that a cut in taxes for a multinational corporation will take dollars out of California than it will increase in-state expenditures. A $5 million California tax cut for a multi-billion dollar foreign corporation will show up on the balance sheet of the multi-national as a gain. How much of that money will stay in California, and how much will be distributed to foreign shareholders, increase executive salaries, be paid in foreign or federal taxes (as some of it will be) or be reinvested elsewhere? If we collect it as revenues, we know it stays in California. If we give the tax break to a company which does 10% of its worldwide business in-state, it's far more likely to go out-of-state, since any re-investment will be based on market forces of many other considerations, not tax policy. This same approach is applicable to virtually all companies. By what logic will the benefit of the tax break be reinvested instead of distributed to shareholders or increase executive salaries, among many other options. This approach, by the way, makes it clear how absurd the Governor's Office of Planning and Research study is. For example, it shows a job loss when lottery winnings are taxed, or when the rich are taxed, despite the fact that the newly rich or very rich will certainly spend their money on trips to Europe or foreign imports, or will invest in national capital markets, not California. e. Tax breaks are untargeted and not connected to economic development or job development strategies. Most views of economic development seek to promote high value-added activities which become part of an export base. But tax benefits fall equally on those industries which are local market-oriented or low value-added. For example, the claim is that net operating loss carry-forward is necessary to help small business start-ups or new capital investment. Yet much of the NOL goes to banking, retailing and other market-oriented services. Does the bank in- lieu tax break encourage banking in California? Hardly. Regulatory policies and powerful market determinants for banking services will determine bank investments. With regard to jobs, since unitary reform we have sold a lot of real estate and assets to foreign-based multinationals, but the job creation has been highly questionable. However, in keeping with our analytical framework that tax breaks don't matter, foreign exchange rates and the condition of foreign economies were most influential in this case. f. Locational advantages and disadvantages are many and overwhelm state tax costs. According to traditional location theory, businesses have different and powerful imperatives with regard to location. Access to markets, transportation costs, quality and availability of the labor force, quality of life, location of similar industries, land costs--all are key location factors, depending on the industry. What about small business, which is the chief generator of new job growth? Entrepreneurship grows in diverse economies, with vibrant local markets, skilled labor, access to capital, and fluid social and economic structure. California has always ranked very high as an entrepreneurial state, and the potential gains to an entrepreneur are large. State tax incentives have nothing to do with the generation of an entrepreneurial climate-- in fact, our entrepreneurial climate is far more likely to be the result of our higher education system and our diverse immigrant population. The Corporation for Enterprise Development ranks state business climates on many factors, including both private and public concerns. They look at balance in the tax system, tax fairness, and fiscal equalization, and California ranked number one by those criteria. Beyond that, CFED looks at a broad range of indicators: California comes out high in % of college educated people, in science and technology indicators, in financial and technology resources, and some infrastructure issues. We do badly in illiteracy, health care, measures of inequality, high crime, high air pollution and high energy and housing costs. g. There is no apparent correlation between high-tax and low- growth, low income states--in fact, the reverse appears to be true. Minnesota is one of the highest tax states with one of the strongest economies. Prior to the 1980's, California was a high- tax and high-growth state. It is now a middle-tax and low-growth state. The "Massachusetts miracle" coincided with the "Taxachusetts" moniker. Meanwhile, very low-tax states such as Louisiana have continued to languish, and Bill Clinton's efforts to help the Arkansas economy included raising taxes. Those low tax states get appropriate industries: low-wage, unskilled industries which seek very low costs. The higher tax states get the high-tech, high-skilled, high productivity jobs. h. California has given business significant tax benefits in recent years, with little apparent reward in jobs. Since 1987, corporate taxes are about $1 billion below where they would have been based on normal economic growth. Our property tax is about the lowest in the country as a percent of market value--.6 percent compared a median of about 1.6 percent. Multinationals have had their taxes cut and the ability of foreign-based multinationals to avoid federal taxes--well-documented by the House Ways and Means Committee--now spills over to California. If business taxes matter as a determinant of economic health, we should be growing rapidly. Obviously the state of the national and world economy has had much more to do with the investment of multinational corporations than unitary reform and other tax breaks, and the powerful forces of the market have overwhelmed our generous incentives. II. If tax incentives do not work, what might be better? In the face of a stagnant economy, the urge to "do something" is strong. Economists are divided between those who are activist and interventionist and those who argue that little can be done. Our perspective is that the total package--fiscal policy, not just tax policy--matters, as follows: a. A healthy public sector provides the infrastructure needed for economic growth. Perpetual gridlock and budgetary crisis, the inability to finance public improvements, and the deterioration of vitally important services which took a generation to build and a very few years to run down most threatens California's economy. California should follow the lead of Clintonomics, which recognizes the vital link between public sector investment and private sector growth, and its own successful history, in which public sector investment went hand-in-hand with economic growth. There can be little economic advantage in cutting local government services, many of which provide the infrastructure for a healthy business environment; cutting higher education which provides the vital skilled labor force necessary for innovation; cutting schools which provide the basis of the future work force; controlling crime and urban decay which makes doing business unattractive; allowing the quality of life to decline; and allowing the transportation system to become more congested. With regard to the high technology sector, it's no accident that r&d grows up around universities and pools of technical skills-- Route 128 in Massachusetts, Research Triangle, North Carolina, Austin, Texas, and of course Silicon Valley. The East Bay appears to be an attractive location for bio-technology because the University of California has many patents of interest and many highly skilled researchers. We could not do worse than to run down our higher education system. b. The tax system should be stable, predictable, free of special- interest benefits, and loophole-free. The theory of the 1986 tax reform (1987 in California) was that the market, not the tax code, should determine investments, although there has been much divergence in practice from that view. Favoring one set of industries over another only diminishes support for the tax code. Two areas of manipulation include: the ability to "elect" either waters' edge or worldwide reporting--we should have one system for all, preferably worldwide; and the ability to structure changes of ownership so that no property tax reassessment takes place. The second affects primarily partnership transactions, since corporations are rarely reassessed and the 1% property tax consequences are irrelevant to true corporate buy-outs. c. Our most pressing economic problem is defense conversion, and our most effective economic policies will be in response. In 1982, a deep national recession coincided with a strategic defense build-up; now the recession coincides with a long-term defense build-down. Clinton Advisor Ann Markusen and Joel Yudken, in their book Dismantling the Defense Economy, call for a broad- based conversion program, involving government, business, and labor. If the $55 million in new tax credits proposed by the Governor were instead allocated--in various ways--to the defense conversion problem, we're virtually certain to get more bang for the buck than scattering that money throughout the landscape. d. Industrial strategies should use carefully targeted policy tools which make sure that results are achieved. There are a range of market-driven and regulatory issues which might be addressed: high land and housing costs, high energy costs, high workers' compensation costs, high environmental compliance costs. Very little happens when the broad, unaccountable brush of tax policy is thrown at a problem, while targeted tools can work. For example, a mitigation fund for environmental compliance can help the state negotiate and get something in return, whereas tax credits for environmental compliance are open-ended, with no guaranteed return. For r&d, we have suggested capped and allocated tax credits, based on real criteria and agreements, similar to the low-income housing tax credit; even if some of it is not well-spent, such a program would go further than the current approach. e. California should enact corporate tax disclosure provisions similar to Massachusetts as it reviews tax expenditures. It is impossible to know what the truth is about tax levels, the effects of tax incentives, and comparative tax burdens without disclosure. Federal 10-k forms require disclosure of corporate federal tax payments; disclosures that highly profitable corporations paid no taxes or received refunds led to the 1986 tax reform. Perhaps with disclosure we will find that California's burden is high; that specific tax preferences are well utilized; or, alternatively, we will find that loopholes are so extensive that many profitable corporations pay minimal tax. At minimum, we will be able to evaluate all these claims. III. Bad tax policy can be harmful: Proposition 13 as it affects the business climate (briefly). It is hard to imagine as anti-growth a tax policy as the property tax on commercial property. In brief: a. It puts the highest tax burden on the growth and development decision. New investors, whether buying, building, or adding property, pay taxes on the full market value of their investment, at a reasonable 1% rate. But, because property taxes are so low on those who hold property and benefit from the new investment, developers are hit with inordinate fees to pay for their costs and other infrastructure costs. b. It damages competition. New entrants into the market should be taxed on the same basis as its competitors. But under our assessment system government makes entry in the market more costly than for those already in the market. c. It leads to inflated land costs, encourages land speculation, and fails to promote highest and best use of land. Speculators can hold valuable land off the market without any real holding costs, so land will be used inefficiently. The property tax burden capitalizes into the value of land; with a declining real tax burden and land held off the market, land costs inevitably increase. The current systems increases the return to landholders and diminishes it to developers and investors. d. It fails to tax windfall gains. If a new office building or hotel moves in downtown, the holders of property all benefit from the increased use. Their incomes rise, but their taxes go down in real terms. The best tax policy--one that is completely neutral with regard to economic decision-making--is to tax economic rents which accrue not from ones own action but the action of others. Prop. 13 fails to do that. e. Worst, it leads to anti-growth politics. Localities see few benefits and many environmental and congestion costs from growth. It used to be that not only infrastructure, which is unseen, but also libraries, parks, museums and other amenities--real civic improvements--stemmed from growth. Now, the tax system is unresponsive to growth, and developer fees are mounted on top of investment costs just to pay for infrastructure. Those who seek environmental mitigation costs to be paid for the state should look instead into the roots of the problem in the property tax system. By amending Proposition 13 to say "Non-residential property shall be uniformly assessed at market value", we can in a stroke improve both the business climate and the tax climate. We would fund services where people want them, at the local level. Once again, the development decision would be popular instead of unpopular, because taxes would capture the windfall land value increases brought by the developers. For investors who are paying the full market value anyway, the marginally increased lifetime taxes would capitalize into lower land costs; and, of course, the excessive fee burden would be limited and environmental mitigation would be affordable. So a net tax increase on the order of $4 billion would--amazingly--lower land and development costs and greatly improve the economy of California.