BILL ANALYSIS                                                                                                                                                                                                    




            aSENATE REVENUE & TAXATION COMMITTEE

            Senator Michael J. Machado, Chair

                                             SB 1291 - Alquist

                                              Amended: As introduced

                                                                       

            Hearing: April 26, 2006    Tax Levy      Fiscal: YES


            SUBJECT:  Sales and Use Tax: Exemption for personal  
                      property purchased by manufacturers and other  
                      taxpayers

                 EXISTING LAW requires entities engaged in  
            manufacturing, research & development, telecommunications,  
            software production, printing, biotechnology or  
            pharmaceuticals that purchase, lease or rent equipment and  
            other supplies to pay sales or use tax on their purchases  
            of tangible personal property. But purchases of tangible  
            personal property that become ingredients of an item to be  
            resold are exempt from tax. 

                 THIS BILL, starting in 2006, would grant a sales tax  
            exemption to "qualified persons" (manufacturers and  
            entities engaged in research and development) for purchase,  
            lease or rental of (1) property that will become an  
            ingredient or component part of property manufactured,  
            processed, fabricated or used in research activities; (2)  
            tangible property directly used or consumed in or during  
            actual manufacturing, processing, research, and causes a  
            chemical or physical change to the product being (a)  
            manufactured, processed, fabricated, or used for research,  
            or (b) an intermediate or preliminary product that will  
            become part of the product being manufactured, processed,  
            etc.; (3) various listed switches, semiconductors,  
            transformers, fuel, devices and equipment used for  
            pollution control, lubricants, chemicals, gasses; (4)  
            tangible personal property used for quality control; (5)  
            personal property use of which is essential in compliance  
            with public health requirements; (6) personal property  








                                                                        

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            installed to conserve or recycle water; (7) clean rooms and  
            related equipment (defined by the bill in detail).

                 The bill specifies that newspaper publishers are  
            manufacturers. It also provides that computer software  
            manufacturing begins with the design and writing of the  
            code for the software, and includes testing and  
            demonstration of the software.

                 In order to receive this exemption, the purchaser must  
            provide the retailer with an exemption certificate  
            (completed in accordance with Board rules), and the  
            retailer must furnish the Board a copy of each certificate.

                 The exemption would apply to the state sales and use  
            tax only, and NOT to local sales or transactions and use  
            taxes, or the taxes levied for the Local Revenue Fund or  
            the Local Public Safety Fund.

                 The exemption would not apply to any property that,  
            within one year of purchase, is removed from California, or  
            converted from an exempt use to another use not qualified  
            for the exemption. And if the purchaser certifies to the  
            seller that the property will be 




























                                                                        

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            used for an exempt purpose, and within one year the  
            property is used in a manner not qualified for the  
            exemption, the purchaser must pay the sales tax. (Note -  
            this "claw-back" provision would not apply if the purchaser  
            did not certify to the retailer that the property would be  
            used for exempt purposes.  The "exemption certificate"  
            would need to contain detailed certification that the  
            property would be used for the exempt purpose.) 

                 The exemption would not apply to sales or transactions  
            and use taxes levied by local governments, nor to taxes  
            deposited in the Local Revenue Fund.


            FISCAL EFFECT: 

                 Based on Board of Equalization data, estimated state  
            revenue loss from the bill would be about $1.75billion  
            annually starting in 2006.  (As the exemption begins with  
            purchases made in January 2006 and thereafter, it would  
            appear to have retroactive effect.) 

                 The Department of Finance has developed a "dynamic"  
            revenue estimating model, which attempts to capture the  
            full effects of tax changes as they work their way through  
            the economy.  Based on past estimates of tax changes using  
            that model, it is estimated that after three to five years  
            the net revenue effect, after taking dynamic effects into  
            account would reduce the "static" revenue loss by about  
            10%.  So the net revenue, after dynamic effects, would be  
            about $1.6 billion.  (Note that the relatively small  
            difference between static and dynamic estimates is largely  
            due to the fact that the Finance model takes account of  
            reduced economic activity attributable to reduced  
            governmental spending resulting from the revenue loss.)


            COMMENTS:


            A.   Purpose of the bill

                 The author indicates that the bill would help  
            California compete with other states for jobs. California  








                                                                        

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            needs to be competitive to retain manufacturing jobs.  
            Forty-two other states offer some version of this economic  
            stimulus. Without the exemption, incumbent California job  
            providers have no reason to stay in the state. Furthermore,  
            the bill provides job providers with the certainty they'll  
            need to make major decisions regarding the creation of new  
            facilities - directly resulting in new jobs.

            B.   Jobs in California and Outsourcing.

                 Proponents of this measure note that California lost  
            18 percent of its manufacturing jobs since January, 2001.   
            In order to retain and grow manufacturing employment,  
            proponents state that the state must remove competitive  
            boundaries to hiring and making new investments in  
            California.  

                 Opponents, however, note that there is little evidence  
            that this exemption would make a difference in terms of  
            location decisions.  

            C.   Offshoring 

                 It is unclear whether any incentive could make a  
            difference in job growth in the manufacturing sectors of  
            the economy due to the macroeconomic trend of outsourcing.   
            Manufacturing firms have long used foreign labor, either by  
            importing inputs made by unrelated companies, or by setting  
            up their own companies overseas to produce these inputs<1>.  
             Many economists agree that offshoring, as a form of  
            international trade, is generally good for the economy and  
            will increase overall productivity.  

                 Therefore, since these jobs are generally offshored to  
            other countries (not within the United States), it is  
            important to consider whether any incentive would be able  
            to affect this trend, as it is true for the nation as well  
            as the state.  


            D.   Is this a jobs bill?

            ------------------------

            <1> PPIC report: "Services Offshoring," by Jon Haveman and  
            Howard Shatz







                                                                        

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                 This bill's predecessor, the Manufacturers Investment  
            Credit, offered a 6% income tax credit for purchases of  
            manufacturing equipment for use in California. There is  
            little evidence that this credit actually created many new  
            jobs, especially since most manufacturing equipment is in  
            effect "labor-saving."  However, it may have had a marginal  
            impact of holding jobs in California or bringing other jobs  
            to California. And the MIC's sunset provision, based on  
            growth in jobs, eventually allowed the MIC to sunset due to  
            too few new jobs. 

            E.   Or is it just good tax policy?

                 Almost all respectable economists who study government  
            finance and taxation agree that inputs to business (e.g.,  
            business equipment, research costs, raw materials, etc.)  
            should be exempt from sales tax, because generally the  
            outputs from business are subject to sales tax, and to tax  
            both business inputs and business outputs results in double  
            taxation. In fact, the Value Added Tax (VAT), used to  
            finance most European governments, is economically  
            equivalent to a sales tax with a broad exemption for  
            business inputs. Most economists would agree that this bill  
            would move California's sales tax in the direction of a  
            VAT, and that would be considered a good thing from an  
            economist's perspective. Indeed, this bill probably should  
            not be looked upon as a "tax expenditure" with the intent  
            of stimulating the economy, so much as a fundamental reform  
            of the tax structure to one more closely akin to a VAT.

                 However, this bill would be added to a system of  
            credits, expenditures and exemptions and would not be  
            allowed to operate as a true VAT.  Before passing a measure  
            like this one which is arguably good tax policy, the  
            committee may wish to consider it in the context of the  
            existing tax structure.

                 Furthermore, in most countries that use a VAT system,  
            the system includes some taxation of services (although not  
            as inputs to businesses).  Therefore, before California  
            could move in this direction, it would also need to  
            consider which services-in addition to goods-should be  
            taxed.








                                                                        

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            F.   No sunset date specified

                 The exemption offered by this bill begins on January  
            1, 2006. And the bill does not contain a sunset date - it  
            would be a permanent change in our sales tax structure. 


            G.   Much broader coverage than prior MIC

                 This bill's predecessor, the Manufacturing Investment  
            Credit, generally applied only to those manufacturing  
            activities described in specific codes of the Standard  
            Industrial Classification manual.  And the credit only  
            applied to equipment used by manufacturers. This bill  
            applies to manufacturers and entities engaged in research  
            and development. And the definitions in the bill are much  
            broader and less detailed that those in the old MIC. The  
            bill is focused on tangible property involved or included  
            in the manufacturing or research and development process,  
            rather than just manufacturing equipment used by  
            manufacturers.


            H.   Revenue sharing with federal government

                 The sales tax exemption granted by this bill is  
            approximately 5.25% of the cost of equipment and other  
            items qualified for the exemption. However, purchasers of  
            these items are eligible to deduct the cost of these  
            purchases for both federal and state income tax. The  
            exemption provided by the bill will thus reduce by 5.25%  
            the federal and state income tax deductions that eligible  
            companies may claim for purchases subject to the exemption.  
            This so-called "income tax interaction" will thus reduce  
            the after-tax benefit to the taxpayer by roughly one-third  
            (from $1.75 billion to about $1.16 billion), with the  
            federal government becoming richer by the about $500  
            million federal income tax increase (due to reduced income  
            tax deductions by California taxpayers).


            I.   Broad definitions leave much room for interpretation








                                                                        

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                 The definitions contained in the prior Manufacturing  
            Investment Credit were fairly precisely drafted and limited  
            to businesses described by the federal SIC manual. The  
            definitions used in this bill are much more broad and far  
            less precise. Even with the reasonably clear definitions  
            used by the MIC, the definition of "manufacturer" was  
            stretched to include a grocery store bakery, for example.  
            The definitions in this bill would likely lend themselves  
            to very broad interpretation by the administering agency,  
            thus increasing the potential revenue loss well beyond that  
            envisioned by the Legislature.


            Support and Opposition

                 Support:  Silicon Valley Leadership Group (sponsor)

                                    AeA (American Electronics  
                 Association)
                           California Chamber of Commerce
                           California Grocers Association
                           Auto Supply Company
                           L. A. Envelope Inc.
                           Milpitas Chamber of Commerce 
                           Lockheed Martin Space Systems
                           California Manufacturers & Technology  
                 Association 

                        Oppose: California Tax Reform Association 


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            Consultant: Martin Helmke & Gayle Miller