Three Ways State Policymakers Can Raise Revenues to Advance California’s Priorities

As millions of people struggle with the high costs of living and recovery from the health and economic effects of the pandemic, corporate profits have surged to historic new highs in recent years. However, corporations now pay just about half of what they did in the early 1980s in California taxes as a share of their income. This decline is a result of cuts to the corporate tax rate and the creation and expansion of corporate tax breaks. In addition, corporations were granted significant federal tax cuts as part of the “Tax Cuts and Jobs Act” of 2017, and some corporations even manage to pay nothing in federal taxes.

Policymakers have many options to ensure that profitable corporations are adequately contributing to California’s tax revenues and supporting the services that we all benefit from. These options include — but are not limited to — increasing tax rates for the most profitable corporations, ensuring that all profitable corporations pay a minimum level of taxes, and combating corporate tax avoidance. Increasing tax rates and limiting tax breaks for corporations only affects those corporations that make profits in California, so these actions will not harm struggling businesses that are operating in the red.

Increasing corporate tax revenues would provide more resources to support solutions to the most significant challenges facing Californians, such as unaffordable housing, child care, and health care costs.

1. Raise Corporate Tax Rates for the Most Profitable Corporations

When individuals and families pay their taxes, higher levels of income are subject to higher tax rates. This is not the case for corporations, which generally pay the same official tax rate regardless of the size of their profits.¹Some types of corporations are subject to different rates, such as banks and other financial institutions, which pay an additional 2% in state tax because they are exempt from local taxes that other businesses pay. Corporations that are organized under Subchapter S pay only a 1.5% rate, but their shareholders pay personal income taxes on their shares of the business’ income. Additionally, the effective tax rate — the share of overall income paid in tax — varies from corporation to corporation based on the extent to which they are able to take advantage of corporate tax breaks. Just as a small share of households receive an outsized share of total income in the state, a small share of corporations earn the majority of profits in California. Corporations with California profits of more than $10 million represented 0.3% of corporations operating in the state but made 62% of all statewide corporate profits in 2019, according to Franchise Tax Board data.²Franchise Tax Board, Corporation Tax Annual Report, Tax Year 2019, Table C-8, https://data.ftb.ca.gov/California-Corporation-Tax/CORP-Annual-Report-2020/6mcf-cr69 Adding a surtax — a higher tax rate — on just these corporations could raise substantial revenues without affecting the vast majority of businesses.³Jonathan Kaplan, Why Aren’t Large Corporations Paying Their Fair Share of Taxes and What Can California Policymakers Do About It?, (California Budget & Policy Center, April 2021), 6, https://calbudgetcenter.org/app/uploads/2021/03/IB-FP-Corporate-Taxes.pdf.

Of course, policymakers could set the threshold for a surtax lower than $10 million, or move to a graduated corporate tax structure where higher increments of profits are subject to higher rates. Several states already have graduated corporate tax structures and a few states have enacted temporary surtaxes on highly profitable corporations. Asking those corporations that are immensely profitable to contribute more to support state services would improve tax fairness and protect small and struggling businesses.

2. Ensure That Corporations Pay an Adequate Minimum Level of State Taxes

Based on the premise that corporations that take advantage of certain tax preferences should still pay a minimum level of taxes, the state put into place different rules to compute tax liability for these corporations.⁴This alternative minimum tax system is in addition to the $800 “minimum franchise tax” that must be paid by all corporations incorporated in, registered in, or doing business in California. However, state law still allows corporations to use many tax credits to reduce the minimum tax they would owe under these rules. This includes the research and development credit — the state’s largest credit, representing about 4 in 5 dollars of the total cost of California’s corporate tax credits.⁵Franchise Tax Board, Corporation Tax Annual Report, Tax Year 2019, Table C-7. As a result, California does not actually ensure that profitable corporations pay an adequate minimum level of tax. Policymakers could strengthen the minimum tax by not allowing credits to reduce a corporation’s tax liability below the minimum tax.⁶Specifically, credits could not be allowed to reduce taxes owed below the “tentative minimum tax,” which is the amount resulting by applying a 6.65% tax rate (or 8.65% for financial institutions) to an alternative income calculation which removes certain tax preferences. Credits could also not be allowed to reduce the “alternative minimum tax,” which is the additional amount that a corporation generally must pay when their tentative minimum tax exceeds their regular tax liability.

Another approach would be to simply limit the extent to which a corporation can use tax credits to reduce their tax bill in any given year. For example, California temporarily prohibited businesses from using more than $5 million in tax credits — excluding the low-income housing credit — to reduce their tax liability in 2020 after the COVID-19 pandemic hit when the state’s finances were expected to suffer. Policymakers could institute such a limit on a permanent basis, or limit the credits that can be claimed in a given year to a specific percentage of the tax that a corporation would otherwise owe. For example, credits could be limited to one-half of a corporation’s pre-credit tax liability in any given tax year.

3. Limit the Ability of Corporations to Avoid State Taxes by Using Tax Havens

Corporations doing business in multiple countries can minimize or even eliminate the taxes they owe to the US federal and state governments by shifting their profits into subsidiaries in jurisdictions with low or zero tax rates, known as tax havens. One recent estimate suggests that about one-quarter of the profits of US multinational corporations are booked abroad, and that about half of these foreign profits are booked in tax havens.⁷The authors also estimate that around 13-15% of the total worldwide profits of US corporations were booked in tax havens across 2015-2020, which they note represents a historically high level. Javier Garcia-Bernardo, Petr Janský, and Gabriel Zucman, Did The Tax Cuts And Jobs Act Reduce Profit Shifting By US Multinational Companies? (National Bureau of Economic Research, Working Paper 30086, May 2022), 3, https://www.nber.org/system/files/working_papers/w30086/w30086.pdf. Much of these shifted profits are not actually earned in these foreign jurisdictions, but have been artificially shifted out of the United States using creative accounting techniques.⁸One such technique is transferring intellectual property rights — such as patents and trademarks — to their foreign subsidiaries, which can then charge the US parent company for the use of that intellectual property. See, for example, Ana Maria Santacreu and Jesse LaBelle, “Profit Shifting Through Intellectual Property,” Federal Reserve Bank of St. Louis, Economic Synopses, no. 22 (July 2022), https://doi.org/10.20955/es.2022.22.

California and many other states allow corporations to take advantage of a loophole known as the water’s edge election, which enables this type of tax avoidance. This provision allows corporations to choose whether or not to include the income held by their foreign subsidiaries in their overall income when calculating the share that is taxable in California.⁹Generally, corporations determine the share of their total income that is taxable in California based on the share of their total sales that are made to California customers. This gives these corporations an incentive to shift profits abroad to avoid state taxes, and also gives them the option of choosing whichever of the two methods will result in the lowest tax liability. The water’s edge election is projected to cost the state an estimated $4.4 billion in 2022-23.¹⁰Department of Finance, Tax Expenditure Report 2022-23, 11, https://dof.ca.gov/wp-content/uploads/sites/352/Forecasting/Revenue_and_Taxation/TaxExpenditureReport.pdf.

The most comprehensive option to address this type of tax avoidance would be to eliminate the water’s edge election and require corporations to include their worldwide income as a starting point when calculating the share of their income subject to California taxes. This approach is known as “worldwide combined reporting,” and was used by California and other states in the past.¹¹See, for example, Darien Shanske, White Paper on Eliminating the Water’s Edge Election and Moving to Mandatory Worldwide Combined Reporting (August 2, 2018), https://dx.doi.org/10.2139/ssrn.3225310. There are also less comprehensive measures that policymakers could consider. One approach that some other states have taken is requiring corporations to just include the profits they have booked in known tax havens for the purpose of computing their state taxes.¹²See Richard Phillips and Nathan Proctor, A Simple Fix for a $17 Billion Loophole How States Can Reclaim Revenue Lost to Tax Havens (Institution on Taxation and Economic Policy, U.S. PIRG Education Fund, SalesFactor, and American Sustainable Business Council, January 17, 2019), 7-8 and 11-13, https://itep.org/a-simple-fix-for-a-17-billion-loophole/. Another is to explore following the approach that the federal government adopted in 2017 of taxing  “global intangible low-taxed income” or “GILTI.”¹³See Darien Shanske and David Gamage, “Why States Should Tax the GILTI,” State Tax Notes (March 4, 2019), https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3374987; and Darien Shanske and David Gamage, “Why States Can Tax the GILTI,” State Tax Notes (March 18, 2019), https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3374991. The GILTI regime is, however, complex and imperfect, so this option requires careful consideration and potential modifications to ensure the policy is effective and legally permissible.

Corporate Tax Transparency, Corporate Tax Breaks, and Barriers to Raising Revenues

Beyond the three options discussed here, policymakers should also increase corporate tax transparency, scale back corporate tax breaks, and address barriers to raising revenues. These steps would help make the state’s corporate tax system — and the state’s revenue system as a whole — more fair and effective.

First, greater transparency is needed to shed light on the extent to which corporations are engaging in questionable tactics to minimize or wipe out their state liability. This includes stronger data reporting requirements, which can be structured to avoid jeopardizing taxpayer privacy. 

Policymakers should also examine the specific corporate tax breaks that already exist in the state’s tax code. These tax breaks should be regularly reviewed and subject to nonpartisan evaluation to determine if and how well they are achieving their policy goals, what types of corporations receive the most benefits, and whether they should be retained, reformed, or eliminated.

Finally, the state’s constitutional spending cap (the Gann Limit) poses challenges to any policy change that raises significant revenues, since substantial new revenues will push the state closer to or above the spending cap, and revenues above the cap are restricted to being spent in specific ways. This limits the ability of state leaders to use revenues to address the most pressing challenges faced by Californians. Policymakers could raise significant revenues and avoid this limitation by using the new revenues for tax benefits that improve the economic and social well-being of Californians with low and middle incomes — such as expanding the California Earned Income Tax Credit and Young Child Tax Credit. With this approach, revenues would not increase on net, allowing the state to avoid going over the spending cap and facing a restriction on how those revenues could be used. For policymakers to have more flexibility in spending significant new revenues — beyond investing them in tax benefits for people with low or moderate incomes — it will be necessary to reform the Gann Limit.

Governor Newsom proposed a “windfall tax” or “price gouging penalty” in fall 2022 to capture a share of the extraordinary recent profits of oil companies operating in the state and return it to Californians impacted by high gas prices. The governor has said that he will call a special session of the Legislature to take up this proposal. This Q&A discusses the concept of a windfall profits tax, why Governor Newsom is calling for such a tax on oil companies, and how it could impact Californians.

What is a windfall profits tax?

In general, a “windfall profits tax” or “excess profits tax” is intended to tax the portion of a corporation’s profits that exceed some specified “normal” level. Excess profits might represent advantages a corporation has due to market concentration and lack of competition or due to an external event like a war, natural disaster, or a pandemic — or a combination of these factors.

For example, during WWI, WWII, and the Korean War, the US put in place excess profits taxes that were intended to discourage some corporations, such as weapons manufacturers, from receiving outsized benefits due to war.

In the 1980s, the US instituted a “Crude Oil Windfall Profits Tax,” but it was not a true tax on excess profits. Instead, it was an excise tax on domestic oil production applied to the difference between the market price of a barrel of oil and a base price.

There have also been proposals by some academics, advocacy groups, and federal policymakers for windfall profits taxes on corporations that have seen record profits during COVID-19 while many Americans have suffered the health and economic consequences of the pandemic.

What is the difference between a windfall profits tax and a corporate income tax?

There are several ways to structure a windfall profits tax. But the main difference between a windfall profits tax and a corporate income tax is:

• A regular corporate income tax takes a percentage of a corporation’s total profits (revenues minus costs and other deductions allowed for tax purposes).
• A windfall or excess profits tax is designed to get at those profits above a normal rate of return on investment or above the average profits during a baseline period.

And while a corporate income tax is levied on corporations’ profits every year, a windfall profits tax is generally a temporary tax in place for a specified period of time such as during a war or a period of high oil prices.

However, an excess profits tax could be implemented on a permanent basis if designed to tax profits above a specific rate of return or profit margin. In this case, the intent would be to capture some of the extraordinary profit a business receives by virtue of having a high degree of market power, control of some natural resource, or some other advantage, rather than just capturing the windfall profits received due to some external event like a war, pandemic, or natural disaster. In fact, a permanent tax may be a more effective policy since it is less likely to discourage investment as it is more stable and predictable.

Why is Governor Newsom proposing a windfall profits tax now?

Governor Newsom has drawn attention to the fact that oil companies have seen record profits recently while many Californians are struggling with high gas prices. He has suggested that oil companies are using their market power to price-gouge Californians. To the extent that this is true, it may be sensible for policymakers to recapture some of the undue profits oil companies have made and return them to Californians.

If policymakers do enact a windfall profits tax, California would likely be the first state to do so. However, some European countries have recently enacted various versions of temporary windfall taxes targeted at energy companies in response to rising prices in that sector.

Should California policymakers adopt a windfall profits tax on oil companies?

In general, it’s reasonable to tax excessive profits a corporation receives due to monopoly power or taking advantage of a crisis. Corporate profit margins have been at or near long-time highs, and not just for the energy sector. And corporate profits have accounted for a significantly larger share of price increases over the past few years compared to the average over the previous four decades, while many corporate executives have recently discussed on investor calls how they have benefited from keeping prices high.

However, if policymakers choose to move forward with this proposal, they should be prudent when designing it to minimize unintended consequences that could harm Californians, such as reductions in supply leading to even higher prices. The “Crude Oil Windfall Profits Tax” that was in place in the US from 1980 to 1988 — which was actually a tax based on the price of a barrel of oil instead of oil company profits — was not very successful, raising significantly less revenue than projected and contributing to a reduction in domestic oil production and an increased reliance on foreign imports.

Policymakers have many options for ensuring that corporations making excessive profits — including but not limited to oil companies — are paying their fair share in state taxes. Since the early 1980s, the share of corporations’ California income that they pay in state taxes has fallen by about half. This significant drop is a result of factors including reductions in the official corporate tax rate in the 1980s and 1990s as well as the enactment of multiple corporate tax breaks which disproportionately advantage large and multinational corporations, have uncertain economic effects, and cost the state billions in revenues each year.

Policymakers can eliminate or limit some of these costly tax breaks and increase the corporate income tax rate on the most profitable corporations. State leaders could also explore adopting a permanent tax on oil and gas extraction — known as a “severance tax” — as many other states already have. The additional revenue raised from these measures could then be used to help ensure all Californians can thrive in their communities.

How should California use the revenues from a windfall profits tax or other corporate tax increases?

Californians have been hit by rising costs of almost everything this year — from gas to groceries to rent and more. These price increases are especially harmful to Californians with low incomes, who struggle to afford the basics even in times when inflation is low. About 2 in 3 California households with incomes below $35,000 reported having trouble paying for their usual expenses in September and October 2022, as did nearly half of those with incomes between $35,000 and $75,000.

People with low incomes are hit hardest by inflation because they need to spend larger shares of their income to meet their basic needs like food, housing, and transportation, which have been subject to large increases. They also have less ability to change their spending patterns to reduce the impact of inflation on their budgets, such as by switching to lower-cost versions of products, since they are likely already purchasing the lowest-cost versions. Black and Latinx households may also be disproportionately harmed by inflation as they are more likely to be renters than homeowners and rental inflation is generally higher than overall inflation.

Policymakers should keep these facts in mind when deciding how to distribute the revenue from a windfall tax — which likely would be much smaller than recent rounds of tax rebates for Californians — or other strategies to improve the taxation of profitable corporations. Additionally, as state leaders work to craft the state’s 2023-24 budget, they should avoid giving away tax breaks to corporations and prioritize the pressing needs of Californians who are struggling the most with the costs of living, such as by protecting and strengthening cash assistance and other supports to help families with the costs of child care, health care, and housing.