Tax Incentives and the California Economy (L. Goldberg)
               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.