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 SB 1291 - Alquist Page 4 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 SB 1291 - Alquist Page 4 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 SB 1291 - Alquist Page 4 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 SB 1291 - Alquist Page 4 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. SB 1291 - Alquist Page 4 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 SB 1291 - Alquist Page 4 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 ---------------------------------------------------- Consultant: Martin Helmke & Gayle Miller