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Strategies to Improve Maternal Mental Health in California

May 2019 | By Adriana Ramos-Yamamoto

Today marks World Maternal Mental Health Day and the start of Mental Health Awareness Month. Maternal mental health (MMH) is vital to the health and well-being of children and families. When mothers feel emotionally healthy and well supported, they are better able to develop strong bonds with their children, which promote children’s physical, mental, and emotional development. Conversely, when mothers experience mental health conditions during pregnancy or after giving birth and do not receive treatment, their health and that of their children, families, and communities are negatively impacted. This blog post discusses the impacts of untreated MMH conditions and highlights strategies to improve outcomes in California.

Untreated Anxiety and/or Depression During Pregnancy and After Childbirth Can Negatively Impact Mothers and Their Children

In California, 1 in 5 women experience pregnancy-related depression — the most common MMH disorder — during pregnancy or the first year following childbirth. That’s about 100,000 women every year. MMH disorders encompass a range of mental health conditions, including depression, anxiety, and postpartum psychosis, although many studies related to MMH disorders focus on depression. Substance use is not included in the definition of MMH disorders, but they sometimes occur together. Research suggests that depression during pregnancy is associated with substance use and that new mothers with postpartum depression may be at a higher risk for substance use. Given this overlap and the limited research on MMH disorders more broadly, this blog post focuses on maternal depression and substance use.

Untreated MMH disorders negatively impact the short- and long-term health outcomes of women and their children and often lead to:

  • adverse birth outcomes;
  • impaired maternal-infant bonding;
  • poor infant growth; and
  • childhood emotional and behavioral problems.

In addition, untreated MMH disorders have significant medical and economic costs. The cost of untreated maternal depression is estimated to be $22,500 per mother in lost income and productivity along with associated health costs. With 100,000 California mothers experiencing a MMH disorder every year, “the annual cost of untreated maternal depression in California is estimated at $2.25 billion,” according to the California Task Force on the Status of Maternal Mental Health Care.

All women are at risk of MMH disorders, but the risk is higher for some women. Socioeconomic status, race and ethnicity, neighborhood, and access to quality health care can impact the likelihood of both experiencing MMH disorders and seeking treatment. One study in California found that women who are black or Latinx and women with low incomes are more likely to have depressive symptoms before and after giving birth. Women who have experienced childhood adversity and stressors during pregnancy are more likely to have depressive symptoms as well. Addressing these factors would help to improve MMH outcomes. Strategies include increasing and improving home visiting services, bolstering income support programs, and improving mental health services and treatment.

Home Visiting Programs Can Help to Improve Maternal Mental Health Outcomes, But There Are Opportunities to Improve the Model

Home visiting programs involve regular visits to expecting parents and parents of young children, typically by a nurse or social worker. These professionals offer training and other assistance aimed at improving maternal and child health and helping parents achieve their education and employment goals. Home visiting programs help to reduce parental stress as well as encourage positive parenting and help to improve child development. Research suggests that home visiting programs have positive effects on MMH and substance use. A study of one home visiting program showed a positive impact on participants’ mental health and coping. An evaluation of a nurse home visitation program showed a decrease in prenatal and postpartum cigarette smoking.

Home visiting programs could do even more to improve MMH. One approach is to integrate mental health supports into home visiting programs. A recent systematic review revealed that 29% to 61% percent of mothers enrolled in home visiting programs across the US experienced depression. Yet, many home visitors do not have adequate training to identify and address the mental health issues experienced by the families they serve. Integrating mental health specialists into the home visiting process would help to address this gap. An evaluation of one home visiting program that incorporated a cognitive-behavioral intervention found that participating mothers showed significantly lower depressive symptoms than those in a control group. Where mental health integration is not possible, community linkages and referral systems could be strengthened to ensure that families receive timely community-based mental health services.

Anti-Poverty Strategies Can Improve Maternal Mental Health Outcomes

Given that poverty is strongly associated with higher levels of depression, one of the most effective anti-depression strategies is an anti-poverty strategy. Poverty is known to heighten exposure to negative life events, job loss, poor housing, dangerous neighborhoods, and conflict with partners, all of which contribute to depressive symptoms. Furthermore, depression is the most common mental health condition among mothers living in poverty, and depression may, in fact, be a result of the hardships mothers experience trying to make ends meet with few resources.

Research on the impact of income support programs on MMH and substance use is limited, but promising. For instance, one study found that working mothers with two or more children whose incomes increased due to the federal Earned Income Tax Credit (EITC) reported better overall physical and mental health compared with similar mothers with only one child, who received lower EITC payments. Another study of the 1990 expansion of the federal EITC suggests increasing the EITC may improve mental health for mothers, particularly for married mothers. Results from a more recent analysis using the Behavioral Risk Factor Surveillance System also suggest that the EITC expansion improved self-reported mental health for mothers. Researchers have also found that mothers who received the largest EITC under the 1993 expansion were less likely to drink and smoke during pregnancy.

Anti-poverty strategies such as bolstering the federal EITC and the Child Tax Credit (CTC) help to lift families out of poverty and thereby address the psychological distress that is associated with poverty. In California, these two credits lifted nearly 1.3 million people — including 643,000 children — out of poverty each year, on average, between 2015 and 2017, according to a Center on Budget and Policy Priorities analysis based on the Supplemental Poverty Measure. Increasing the scope and the size of these income support programs could help to mitigate and prevent MMH disorders. Expanding immigrant mothers’ access to these programs would further improve MMH outcomes, particularly because these mothers may be at an increased risk of experiencing MMH disorders due to fear and stress related to heightened immigration enforcement activities.

Current State Budget and Policy Proposals May Also Improve Maternal Mental Health Outcomes

Last year, Governor Brown signed bills into law that aim to increase MMH screenings, which are not routine across health systems, and clinical training to improve MMH treatment. This year, there are new proposals to further improve detection, assessment, and treatment of MMH disorders as well as to reduce racial and ethnic disparities in MMH outcomes, including:

  • AB 577 (Eggman) — Medi-Cal: Maternal Mental Health. This bill would extend the duration of Medi-Cal eligibility for postpartum care for an individual who is diagnosed with a MMH condition to one year after giving birth. Currently, Medi-Cal provides coverage for a 60-day period beginning on the last day of pregnancy.
  • SB 464 (Mitchell) — California Dignity in Pregnancy and Childbirth Act. This bill would require hospitals and birth centers to implement an implicit bias program for all health care providers who care for expectant and new mothers and their children. By addressing implicit bias among providers, this bill aims to prepare providers to better care for mothers and reduce preventable pregnancy-related deaths. It would also require the Department of Public Health to track and publish data on maternal death and diseases or illnesses.
  • AB 1676 (Maienschein) — Tele-Psychiatry. This bill would require health plans and insurers to establish a telehealth consultation program. Telehealth is the use of electronic information and telecommunication technologies to support the delivery of care at a distance. This program would allow providers who treat expectant and new mothers and their children to consult a psychiatrist in real-time regarding the diagnosis and treatment of mental illnesses.

In addition, Governor Newsom’s proposed budget includes expansive proposals that would benefit the health and well-being of mothers and their families. The Governor’s budget proposes to:

  • Expand home visiting programs;
  • Extend the California Earned Income Tax Credit (CalEITC) to an estimated 1 million additional tax filers (bringing the total to an estimated 3 million);
  • Increase the size of the CalEITC credit for many filers who currently qualify for small credits;
  • Boost California Work Opportunity and Responsibility to Kids grants (CalWORKs provides modest cash assistance to about 755,000 low-income children while helping parents overcome barriers to employment and find jobs); and
  • Increase participation in the Black Infant Health Program, which aims to improve African-American infant and maternal health through group support services and case management.

California Thrives When Mothers Thrive

Addressing the upstream factors that prevent the development of maternal mental health disorders, as well as improving early detection and treatment of these disorders, are critical to improving the health and well-being of mothers and children throughout the state. Improving mental health outcomes is the shared responsibility of multiple stakeholders — health insurers, hospitals, home visitors, community health workers, policymakers, and others. The health of California depends on the health of communities, which thrive when mothers thrive.

Support for this resource was provided by First 5 California.

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Introduction

Unaffordable housing costs are one of California’s most pressing challenges. The high cost of housing is one of the primary drivers of California’s high poverty rate — ranked first among the 50 states — under the Supplemental Poverty Measure, which accounts for differences in the local cost of living.[1] The lack of affordable housing increases economic insecurity among California families and also creates challenges for California employers striving to retain and recruit workers. Housing affordability is a problem throughout the state when housing costs are compared to incomes, and the Californians who are most affected by the housing affordability crisis are renters and households with the lowest incomes.  Policy solutions that particularly target these households represent a promising approach to tackling the state’s housing crisis strategically, with a focus on those most deeply affected.

Renters Are Especially Likely to Have Unaffordable Housing Costs, While Homeowners Without Mortgages Are Least Affected

Determining whether housing is affordable requires considering both housing costs and household incomes. For renters, housing costs include monthly rent payments, plus the cost of utilities if not included in the rent. Housing costs for homeowners include monthly mortgage principal and interest payments, plus property tax, property insurance, utilities, and condo or mobile home fees (if applicable). To understand California’s housing affordability challenges, it is important to consider these housing costs relative to incomes. If high housing costs are matched by high incomes, then expensive housing may be affordable to many households. At the same time, even relatively low housing costs may be unaffordable if local incomes are also low.

For housing costs to be considered affordable, a household’s total housing costs should not exceed 30 percent of household income, according to the US Department of Housing and Urban Development. Households paying more than 30% of income toward housing are considered housing “cost-burdened,” and those with housing costs that exceed half of their income are considered “severely cost-burdened.” By these standards, more than 4 in 10 households statewide had unaffordable housing costs in 2017. Furthermore, 1 in 5 households across California faced severe housing cost burdens, spending more than half of their income toward housing expenses.

California’s renters are substantially more likely to struggle with housing affordability than homeowners in California. More than half of renter households paid over 30% of income toward housing in 2017, and more than a quarter were severely cost-burdened, paying more than half of household income toward housing costs. California homeowners generally struggle less to afford their housing, though more than a third of homeowners with mortgages were housing cost-burdened in 2017. Owners without mortgages are least likely to face high housing burdens in California. Besides not having the monthly expense of a mortgage, many of these homeowners have been in their homes for decades and therefore benefit from relatively low property taxes due to Proposition 13’s limitation on property tax increases.

Low-Income Households Are Particularly Affected by Unaffordable Housing

Households with the lowest incomes are by far the most likely to have housing costs that are unaffordable. Eight in 10 households with low incomes (those with incomes of less than 200% of the federal poverty line) were housing cost-burdened in 2017, and more than half of these households spent more than half their income on housing. At the same time, only about 16% of high-income households (with incomes of 400% or more of the federal poverty line) were housing cost-burdened in 2017, and less than 3% were severely cost-burdened.

Housing Affordability Is a Problem in All Regions of California, and Many of Those Affected Are People of Color

Housing costs vary substantially throughout California, with the highest costs in coastal urban areas and the lowest costs in inland rural areas. But incomes also vary regionally, and areas with relatively lower housing costs also tend to have lower typical incomes. The result is that housing affordability is clearly a problem throughout the state when housing costs are compared to incomes. Across every region of California, from the high-cost San Francisco Bay Area and Los Angeles and South Coast to the lower-cost Central Valley and Far North, at least a third of households spent more than 30% of their incomes toward housing in 2017, and more than 1 in 6 spent more than half of their incomes on housing costs.

Throughout the state, many of the individuals affected by unaffordable housing costs are people of color. Among all Californians living in households paying more than 30% of income toward housing costs in 2017, more than two-thirds were people of color, and about 45% were Latinx.

High Housing Cost Burdens Call for Policies Designed to Help Those Who Are Most Affected

What problems arise when households struggle to afford housing? Unaffordable housing costs can force families to spend less on other basic necessities like health care or food, to cut costs by seeking lower-quality child care, and to under-invest in important long-term assets like education or retirement savings. Unaffordable housing costs can also force families and individuals to accept substandard housing or live in neighborhoods that lack basic safety and offer limited opportunities. In the most serious cases, unaffordable housing can push households into homelessness. All of these consequences can have cascading effects on health and can shape both short-term well-being and long-term outcomes for affected individuals.[2]

Given the challenges of housing affordability across all regions of California — especially for renters, households with the lowest incomes, and people of color — strategies to increase affordability are urgently needed, particularly for the most-affected Californians. Housing affordability policy solutions can focus on protection of affordability for current residents, preservation of existing affordable housing, and production of more housing, particularly homes targeted to the households that struggle most to find and retain affordable housing, including renters and those with the lowest incomes. Specific policy solutions that can make a difference include tenant protections against excessive rent increases, funding to support affordable housing construction and preservation, and policies that increase local incentives and local accountability for accommodating more housing development, particularly for housing affordable to low-income households. Moreover, policies outside of the housing arena that help families make ends meet — by reducing costs for child care, food, health care, or other necessities, or by supplementing incomes — represent another important approach to helping Californians who are struggling to afford the cost of housing.

As state leaders craft budget and policy proposals, it is important to acknowledge that a mix of policies is needed to address California’s housing affordability challenges and that doing so is particularly important for California’s renters, low-income households, and people of color.

[1]Sara Kimberlin and Esi Hutchful, New Census Figures Show That California Has 7.5 Million Residents Living in Poverty — More Than Any Other State (California Budget & Policy Center: September 2018).

[2]Adriana Ramos-Yamamoto, Advancing Health Equity: How State Policymakers Can Increase Opportunities for All Californians to Be Healthy (California Budget & Policy Center: March 18, 2019).

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Introduction

The 2017 federal Tax Cuts and Jobs Act (TCJA) included a provision creating a new program designed to encourage private investments in economically distressed communities. The Opportunity Zones program provides federal tax incentives for investments in areas that meet certain criteria and have been designated as Opportunity Zones (OZs). Additionally, Governor Gavin Newsom’s 2019-20 budget proposal would provide state-level tax incentives for investments in OZs. There are 879 designated OZs in California, located in nearly all of the state’s counties. More than 4 million Californians live in these areas and will be potentially impacted by new investments eligible for Opportunity Zones tax incentives. The Opportunity Zones program has the potential to encourage new investments in eligible communities that improve the lives of residents with low incomes. However, the vast majority of the tax benefits will be realized by wealthy investors, and the program may accelerate gentrification in some areas or subsidize investments that offer little or no benefit to community residents.

This Issue Brief, the first in a series of Budget Center publications exploring the Opportunity Zones program, explains the structure of the program, its tax incentives, and how California’s communities may be affected.

The Basics: Opportunity Zones, Qualified Opportunity Funds, and Qualified Opportunity Zone Businesses

The TCJA allowed governors to nominate census tracts for OZ designation following certain federal criteria.[1] To qualify, census tracts must generally be low-income communities, defined as having a poverty rate of at least 20% or a median family income of 80% or less of the metropolitan area or state median family income.[2] States were also permitted to select a limited number of “contiguous tracts” that are not low-income communities but border a qualified low-income community and have a median family income that does not exceed 125% of that of the adjacent qualified low-income tract. Contiguous tracts may not comprise more than 5% of a state’s total selected OZs. Each state was permitted to nominate a total number of OZs not exceeding one-quarter of all eligible low-income tracts. In California, Governor Jerry Brown’s administration nominated 879 census tracts to become OZs, and the US Treasury Department certified all of them. One-tenth of California’s population (10.7%), nearly 4.2 million residents, live in OZ census tracts.[3] These designations will remain in effect for 10 years.

Individuals and corporations that invest in a Qualified Opportunity Fund (QOF) — an entity that in turn makes investments in OZs — are eligible for several tax benefits, discussed below. To be a QOF, at least 90% of the fund’s assets must be invested in “Qualified Opportunity Zone Property,” which may include either a stock or partnership interest in a “Qualified Opportunity Zone Business” that holds tangible property — such as buildings and equipment — in an OZ (known as “Qualified Opportunity Zone Business Property”) or direct holdings of such business property (Figure 1). A QOF, which may be a corporation or partnership, does not need to apply for QOF designation and may self-certify with the Internal Revenue Service (IRS).

Figure 1

The TCJA statute is vague about how much of a QOF’s or Qualified Opportunity Zone Business’ property must be located in an OZ, but the IRS has issued proposed regulations that seek to clarify this issue. If these proposed regulations go into effect, a QOF could have less than half of its assets in use within an OZ and its investors would still be eligible for the full tax benefit.[4]

The law also specifies that, if the original use of the Qualified Opportunity Zone Business Property does not start with the QOF investment, the property must be “substantially improved” — requiring the QOF to spend at least as much to improve the property as it spent to acquire it. Ostensibly, this requirement aims to prevent investors from getting tax benefits by simply buying property in an OZ without adding any value for the community. The IRS’ proposed regulations would make this requirement more flexible, which could increase the likelihood that tax subsidies will go to investments that provide few community benefits.[5]

The broad definitions in the law and the flexibility offered in the proposed regulations mean there will likely be few limitations on the types of investments that will qualify for preferred tax treatment. For example, investments in startup businesses, expansions of existing businesses, construction or substantial rehabilitation of residential or commercial properties, and infrastructure improvements are all likely to qualify. The only businesses explicitly prohibited from receiving Opportunity Zone tax benefits are so-called “sin businesses” including liquor stores, gambling facilities, golf courses, country clubs, tanning facilities, and massage parlors.

The regulations for the Opportunity Zones program have not been finalized at the time of this publication, and the IRS will issue further proposed regulations to clarify other aspects of the law in the coming months. The final regulations will impact the degree to which tax-privileged investments substantively benefit OZ residents and the generosity of the tax benefits for investors.

Tax Incentives for Investors Can Be Lucrative

The Opportunity Zones program attempts to promote investments in OZ census tracts by providing several tax breaks on capital gains that are reinvested into a QOF. A capital gain results when a taxpayer sells or exchanges an asset — such as corporate stock shares or real estate — at a price higher than its purchase price.[6] For federal tax purposes, the short-term capital gains tax rate, which applies to gains on assets held for one year or less, is equal to the taxpayer’s ordinary income tax rate, with a maximum rate of 37%. Lower federal rates apply to long-term capital gains on assets held for more than one year. The maximum rate for long-term capital gains is 20% plus a 3.8% surtax related to the Affordable Care Act.[7] Under the Opportunity Zones program, taxpayers reinvesting capital gains into a QOF within 180 days of the sale or exchange of the original investment are eligible for three federal tax benefits:

  • Deferral of tax on the capital gain on the original investment until 2026 (or the time the QOF investment is disposed of, if earlier) — allowing the reinvestment of the entire capital gain into a QOF with the potential benefit of a higher return.
  • Reduction of tax on the capital gain on the original investment if the QOF investment is held long enough (the taxable value of the capital gain — and thus the tax liability — is reduced by 10% if the QOF investment is held for five years and by 15% if the QOF investment is held for seven years).
  • Elimination of tax on the capital gain on the QOF investment if it is held for 10 years.

There is no upper limit on the tax benefits any QOF investor can receive, nor on the overall cost to the federal government in foregone tax revenues. (See text box for an example of the potential tax benefits from investing in a QOF.)

Wealthiest Investors Will Reap Greatest Share of Tax Savings While Community Benefits Are Uncertain

Taxpayers with holdings of appreciated assets will be the direct beneficiaries of Opportunity Zones tax incentives. Most of these benefits will accrue to very well-off investors, who hold a disproportionate share of such assets. Only 9.2% of all taxpayers report realizing any long-term capital gains, according to estimates from the Urban-Brookings Tax Policy Center.[8] In addition, capital gains are highly concentrated at the top of the income distribution. The top 20% receive 90.2% of all reported long-term capital gains, with the top 1% collecting 68.7% of these gains (Figure 2). Thus, very few low- or middle-income families will receive any tax benefits from the Opportunity Zones incentives.

Figure 2

While the benefits to wealthy investors are clear, there is no guarantee that the subsidized investments will positively impact current residents of designated OZs. The Opportunity Zones program is not the first attempt to bring investment and employment into areas that lack financial resources and jobs. A variety of federal and state programs have provided tax incentives and other benefits to attract business and capital investment and to increase employment in such areas, including Empowerment Zones, Enterprise Communities, Renewal Communities, New Market Tax Credits, and state-level enterprise zones. Research on the community impacts of these programs has reached mixed conclusions. Some studies have found increases in employment and wages and reductions in poverty in designated zones relative to similar communities where these incentives were unavailable, while others have found little evidence that the incentives led to statistically significant community improvements.[9] The inconclusiveness of the research exploring the connection between economic development tax incentives and community outcomes suggests that the costs of such incentives may outweigh the benefits.

A primary concern is investors may be drawn to projects or businesses in areas already in the process of gentrification, as these investments will likely yield the highest returns.[10] If investors do prioritize projects in gentrifying areas, a large portion of the tax-preferred investments could flow into communities that have fewer challenges attracting capital, meaning US taxpayers would be unnecessarily subsidizing investments that likely would have occurred without the incentives. The extent to which this occurs will partially depend on which census tracts states designated as OZs. (The next publication in this series will examine California’s selection of OZs, including the share of selected areas showing signs of gentrification.)

Since the professed goal of the Opportunity Zones program is to improve economically distressed communities, and not to give tax breaks to wealthy investors, the primary question should be whether the inflow of funds meaningfully improves the circumstances of residents in those communities. For instance, if the incentive results in more affordable housing or local businesses that create job opportunities for low-income residents, this would be considered a successful outcome — even if wealthy investors become wealthier in the process. However, given the few restrictions placed on the investments that can be made, and the laxness of some of the regulations proposed by the IRS, there is a real possibility that some of these new investments will contribute to the gentrification of communities. For example, QOFs may invest in luxury condominiums or companies that mostly employ high-skilled workers from outside the community. In fact, these types of investments may be more attractive than “social impact” investments due to potentially higher returns. This could put low-income residents at risk of facing increased costs of living or being displaced, harming the very people the incentive is intended to help. And since OZ census tracts have higher concentrations of black and Latinx residents than other communities, this could exacerbate existing racial and ethnic inequities.[11]

Some of the most disadvantaged communities may not see any new investment at all. These communities have a scarcity of assets to attract investors, present higher risks, and offer potentially lower returns. Therefore, investors are more likely to choose projects in areas that are already more advantaged or showing signs of revitalization over neighborhoods that have the greatest need for new resources.

Another consideration is the overall cost of the Opportunity Zones incentives in the form of foregone federal revenues from capital gains taxes. These lost revenues — mostly benefiting high-income investors — could instead help pay for other services that may have a greater impact on vulnerable communities in California and across the nation. The official cost estimate for the tax incentives is small relative to total cost of the TCJA — $1.6 billion over 10 years in a package of nearly $2 trillion in tax cuts.[12] However, the long-run costs could be much greater given that this estimate does not include revenue losses from the complete exclusion of gains on QOF investments held for 10 years, which fall outside the 10-year period for which budget estimates were made.

The high levels of flexibility for investors and uncertainty regarding the potential benefits and harms to OZ residents elevate the need for strong reporting and data collection requirements. The law does not include such requirements, but the US Treasury Department has the discretion to issue them in forthcoming regulations. Thus, until the final regulations are released, it is unknown whether there will be sufficient and transparent information available to determine how the tax incentives are being used and how subsidized investments are affecting the communities in which they are made.

What’s Next for California’s Opportunity Zones?

Now that the selection of OZ census tracts in California has been finalized, state and local leaders are contemplating how to encourage meaningful investments that will improve the lives of people in struggling communities. Policymakers are considering whether to provide state-level tax incentives to make QOF investments even more attractive, how to align existing state and local resources with those investments, and how to ensure transparency and accountability. Given that the federal tax benefits are heavily skewed toward wealthy investors (as would be state-level capital gains tax breaks) and that residents of affected communities may face affordability pressures and displacement risks, any state-level Opportunity Zones incentives should be structured to 1) provide greater opportunities for lower-income community members, 2) safeguard residents against displacement, and 3) avoid providing a windfall for the wealthy at the expense of the state’s finances. Finally, if state and local governments provide additional incentives to encourage investments in OZs, such incentives should be more narrowly targeted to investments likely to benefit current residents, and data collection and evaluation requirements should be established to enable an assessment of whether the incentives are achieving their intended purpose.

[1] The statute governing Opportunity Zones is found in the new Section 1400Z of the US Internal Revenue Code (26 US Code Section 1400Z).

[2] The definition of “low-income community” for the Opportunity Zones program comes from the statute governing the New Markets Tax Credit (26 US Code Section 45D(e)). For a census tract located in a metropolitan area to qualify, it must have a poverty rate of at least 20% or a median family income not exceeding 80% of the greater of the statewide median family income or the metropolitan area median family income. For a census tract not located in a metropolitan area to qualify, it must have a poverty rate of at least 20% or a median family income not exceeding 80% of the statewide median family income.

[3] Rebecca Lester, Cody Evans, and Hanna Tian, “Opportunity Zones: An Analysis of the Policy’s Implications,” State Tax Notes (October 15, 2018), Table 1.

[4] The TCJA requires that “substantially all” of a business’ tangible property be Qualified Opportunity Zone Business Property, “substantially all” of which is in use in an OZ. The law does not define “substantially all,” but the IRS’ proposed regulations would define it as 70% in both cases. This means a business would only need to have 49% of its tangible property in an OZ (70% times 70%). Since the law requires only 90% of a QOF’s assets to be Qualified Opportunity Zone Property, a QOF holding property through an operating business could have as little as 44.1% of its assets being used in an OZ. US Department of the Treasury, Internal Revenue Service, REG-120186-18: Investing in Qualified Opportunity Funds (April 17, 2019), pp. 77-78.

[5] The proposed regulations released in October 2018 specify that only the value of buildings, excluding the value of the underlying land, would be considered in the calculation to determine whether a property has been substantially improved, which would allow more real estate investments to meet this test. Brett Theodos, Steven M. Rosenthal, and Brady Meixell, The IRS Proposes Generous Rules for Opportunity Zone Investors but What Will They Mean for Communities? (Urban-Brookings Tax Policy Center: October 23, 2018). Additionally, proposed regulations released in April 2019 clarify that unimproved land does not need to be substantially improved, but that such land must be used in a trade or business and would not be considered Qualified Opportunity Zone Business Property if it were being held for investment. The IRS is seeking comments on whether additional rules are needed to prevent QOFs from acquiring land in an OZ without adding any value or economic activity. US Department of the Treasury, Internal Revenue Service, REG-120186-18: Investing in Qualified Opportunity Funds (April 17, 2019), pp. 12-14.

[6] Technically, a capital gain is the difference between an asset’s sale price and its “basis,” which equals the asset’s purchase price with some adjustments, such as the cost of commissions for stocks or the cost of improvements minus depreciation for real property.

[7] Thus, the maximum federal tax rate on long-term capital gains is 23.8%. This includes the top long-term capital gains rate of 20%, which for the 2019 tax year applies to taxpayers with incomes above $434,550 ($488,850 for married taxpayers filing jointly). An additional 3.8% surtax on net investment income, including capital gains, helps fund Affordable Care Act benefits. This surtax applies to single taxpayers with incomes over $200,000 ($250,000 for married taxpayers filing jointly). In contrast to federal law, California taxes all capital gains as ordinary income, at a maximum rate of 13.3%.

[8] Urban-Brookings Tax Policy Center, Table T18-0231: Distribution of Long-Term Capital Gains and Qualified Dividends by Expanded Cash Income Percentile, 2018  (November 16, 2018).

[9] See reviews of the literature in Congressional Research Service, Empowerment Zones, Enterprise Communities, and Renewal Communities: Comparative Overview and Analysis (February 14, 2011), pp. 17-18; David Neumark and Helen Simpson, Do Place-Based Policies Matter? (Federal Reserve Bank of San Francisco Economic Letter: March 2, 2015), pp. 2-3; and Rebecca Lester, Cody Evans, and Hanna Tian, “Opportunity Zones: An Analysis of the Policy’s Implications,” State Tax Notes (October 15, 2018), p. 226.

[10] As described by the Urban Displacement Project, gentrification is “a process of neighborhood change that includes economic change in a historically disinvested neighborhood — by means of real estate investment and new higher-income residents moving in — as well as demographic change — not only in terms of income level, but also in terms of changes in the education level or racial make-up of residents.” Gentrification can lead to displacement, meaning long-term community residents are no longer able to live in gentrified communities. See Miriam Zuk and Karen Chapple, “Gentrification Explained” (Urban Displacement Project: 2015).

[11] Brett Theodos, Brady Meixell, and Carl Hedman, Did States Maximize Their Opportunity Zone Selections? Analysis of the Opportunity Zone Designations (Urban Institute: May 2018, revised July 2018), Table 3.

[12] US Joint Committee on Taxation, Estimated Budget Effects of the Conference Agreement for H.R.1, the “Tax Cuts and Jobs Act” (December 18, 2017); Congressional Budget Office, The Budget and Economic Outlook: 2018 to 2028 (April 2018), p. 106.

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Introduction

The California Work Opportunity and Responsibility to Kids (CalWORKs) program provides modest cash assistance to about 755,000 low-income children and their parents. It also helps parents overcome barriers to work and find jobs through key support services such as subsidized child care and transportation reimbursement.[1] As this Brief outlines, although Governor Newsom proposed new funding for CalWORKs grants in his 2019-20 budget proposal, the declining value of the earned-income disregard (EID) would reduce the economic impact of these investments, especially in the face of a rising state minimum wage.

A Fixed Earned-Income Disregard Does Not Serve CalWORKs Families

As parents who are participating in CalWORKs enter the workforce, the earned-income disregard allows families to continue to receive benefits while earning a paycheck — up to a certain limit. Specifically, the EID is the amount of a recipient’s gross monthly earnings that is overlooked when their grant levels are calculated. Since CalWORKs’ implementation in 1997-98, state law has exempted the first $225 of monthly earnings, then 50% of the remainder.[2]  As a family’s earnings increase, their grant amount decreases until they reach the CalWORKs income limit. The income limit, which is partly based on the maximum monthly grant and the earned-income disregard, determines when a family is no longer eligible for CalWORKs cash assistance. The greater the value of the disregard, the smaller the reduction in the monthly grant and the more parents can earn before losing eligibility. This allows for a smoother transition out of the CalWORKs program.

Unfortunately, the value of the EID has not changed in more than 20 years, leaving families with fewer resources (Figure 1). With the current $225 disregard, the annualized income limit in 2019-20 will be $23,772 (or $1,981 a month) for a family of three in a high-cost county. If policymakers had increased the disregard each year to account for inflation, the EID would have been $399 in 2019-20. Families would have had up to $25,858 in annual income (or $2,155 a month) before reaching the income limit. For working families who face rising rents and find it harder each year to keep a roof over their heads, that extra $174 a month is substantial.[3] In other words, policymakers’ failure to increase the disregard to keep up with the rising cost of goods and services has left already struggling families with even fewer resources to make ends meet in our state.

Figure 1

The Earned-Income Disregard Has Fallen Behind the State Minimum Wage

However, with a rising state minimum wage, policymakers would need to do more than adjust the EID for inflation if CalWORKs is to better support families pursuing employment (Figure 2). When CalWORKs was first implemented in 1997-98, a parent working a minimum wage job full-time and year-round earned $11,960 a year (or $5.75 an hour), well-below the annualized income limit of $16,020 (or $7.70 an hour). In 2019-20, that same parent would be ineligible for assistance because the annualized income limit of $23,772 (or $11.43 an hour) would be below minimum wage earnings of $27,040 (or $13.00 an hour). Even if the disregard had been adjusted for inflation, the annualized income limit would still fall short.[4] The gap between minimum wage earnings and the CalWORKs income limit is only projected to grow in the coming years. By 2021-22, when the minimum wage hits $15.00 an hour, working more than the required 30 hours a week at minimum wage could mean a single-parent family automatically loses support.[5]

Figure 2

State Policymakers Should Raise the CalWORKs Income Limit by Increasing the Earned-Income Disregard and Tying the Disregard to Inflation

During and after the Great Recession, state leaders made cuts to the CalWORKs program that undermined economic security for families with very low incomes. In recent years, policymakers have begun to reinvest in the program by boosting the value of CalWORKs grants. California’s leaders should continue to invest in CalWORKs by also increasing the earned-income disregard to better reflect changes made to the state minimum wage. An increase to the disregard would raise the income limit without penalizing parents for working more hours, especially for minimum-wage earners. Furthermore, to keep the disregard from losing value in the future, policymakers should ensure that the EID is increased annually to keep pace with inflation.

Esi Hutchful prepared this Issue Brief. The Budget Center was established in 1995 to provide Californians with a source of timely, objective, and accessible expertise on state fiscal and economic policy issues. The Budget Center engages in independent fiscal and policy analysis and public education with the goal of improving public policies affecting the economic and social well-being of low- and middle-income Californians. General operating support for the Budget Center is provided by foundation grants, subscriptions, and individual contributions. Support for this Issue Brief was provided by First 5 California.

[1]Legislative Analyst’s Office, The 2018-19 Budget: Analysis of the Health and Human Services Budget (February 16, 2018).

[2] For example, if a single mother with two children earns $500 a month, the first $225 she earned that month would not count towards the calculation of her grant, leaving $275. Then, half of that ($137.5) would be subtracted from the grant. The $225 disregard was reduced to $112 in 2011-12 but restored the year after. See Legislative Analyst’s Office, Review of CalWORKs Changes in the 2012-13 Budget (March 13, 2013), p. 7.

[3] Alissa Anderson and Esi Hutchful, CalWORKs Grants Continue to Fall Short as Rents Keep Rising (California Budget & Policy Center: March 2018).

[4] If the earned-income disregard had been adjusted for inflation each year since 1997-98, the annualized CalWORKs income limit would be $25,858 in 2019-20. The hourly wage equivalent would be $12.43 an hour.

[5] Unless otherwise exempt, single parents must spend on average 30 hours a week each month engaged in welfare-to-work activities if they have a child over age 6 or 20 hours per week each month if the child is under age 6. Welfare-to-work activities include unsubsidized and subsidized employment, job training, and other activities to help participants with employment.  See California Department of Social Services, CalWORKs Annual Summary: February 2018 (February 2018), p. xv.

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Executive Summary

California Budget Perspective is the Budget Center’s annual “chartbook” publication that takes a wide-ranging look at the Governor’s proposed state budget.

California Budget Perspective 2019-20 examines the social, economic, and policy context for this year’s budget; discusses key elements of — and priorities reflected in — the Governor’s proposal; and highlights issues to watch in the coming months.

Read California Budget Perspective 2019-20.

California Budget

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The California Earned Income Tax Credit (CalEITC) is a refundable state tax credit that helps people who earn little from their jobs to pay for basic necessities. The CalEITC builds on the proven success of the federal earned income tax credit (EITC), which reduces poverty and boosts employment, and may even improve children’s health and educational attainment.

A new California Budget & Policy Center guide, Expanding the CalEITC: A Smart Investment to Broaden Economic Security in California, provides an overview of how EITCs support families, children, and communities; examines key features of the CalEITC; and shows how Governor Gavin Newsom’s 2019-20 budget proposal to significantly expand the credit will impact state residents with low incomes. The guide also highlights several ways that the CalEITC could be further strengthened, including by extending the credit to working immigrants who pay taxes and to unpaid family caregivers.

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Poverty & Inequality
Taxes & Revenue

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View the Technical Appendix for this report.

View a presentation of this research.

Earlier estimates of this research were published in The Institute for College Access and Success’ (TICAS) compendium Designing Financial Aid for California’s Future.

Introduction

Historically, the state paid most of the cost of higher education at California’s public institutions: the California Community Colleges (CCC), the California State University (CSU) and the University of California (UC). However, years of budget cuts and tuition hikes have shifted more of the cost to students and their families, especially at the state’s four-year institutions: the CSU and the UC. This cost-shift undermines California’s commitment — as outlined in the Master Plan for Higher Education — to ensuring that a quality higher education is accessible and affordable to all eligible Californians. It also means that more students are graduating with increasing amounts of student loan debt and working excessive hours that impact their ability to graduate on time while others are forgoing higher education altogether.[1] A well-educated workforce is critical to the state’s economic future. Yet, at current rates, California will not produce enough college graduates to meet the demands of the state’s economy in the years ahead.[2]

In order to meet the state’s workforce demands, reforms must be made to ensure all students have access to an affordable higher education that will prepare them to enter the workforce with the skills they need to be successful. One of the greatest challenges for students seeking a higher education, and one of the greatest opportunities for reform, is the design of the financial aid system. Most state and federal student financial aid is linked primarily to tuition and largely fails to assist students with other major costs of college attendance, including housing, food, and transportation. Understanding the full cost of college is essential for decision-makers, advocates, and others who seek to expand college opportunities for all Californians.

This analysis estimates the cost of implementing a state financial aid program designed to enable qualified Californians to pursue undergraduate study full time at any of the three public higher education sectors — the CCC, CSU and UC — eliminating the need for students to take out loans or work unmanageable hours. This analysis develops two models to estimate the cost of an affordable-college program in California. One model estimates the cost of a “shared responsibility” program, in which the state covers students’ remaining unmet financial need after taking into account selected federal grants, an expected parent contribution, an expected student contribution from work earnings, and any currently available state and institutional aid. The second model estimates the cost of a “government responsibility” program, in which the state covers students’ remaining unmet financial need after taking into account only selected federal grants and any currently available state and institutional aid, with no student or parent contribution.

These models are intended to show how the state might calculate the cost of reforms (see the “cost of college” and “paying for college” tables) as well as the total cost of any such changes (see the “total costs” tables). As a point of departure, both of these models assume that all qualified students — based on current estimated enrollment levels at the CCC, the CSU, and the UC during the 2018-19 academic year — would be eligible for new state assistance, regardless of family income. Of course, policymakers could pursue other options. For example, policymakers could choose to focus new state resources on low- and middle-income students, rather than all students, in which case total costs would be lower.

This analysis provides estimates on a per-student, per-sector, and statewide basis. The estimates regarding 1) the cost of college and 2) paying for college are based on the most recent data available from multiple sources. The “cost of college” category consists of institutional costs, such as tuition and fees, and living costs, such as housing and food. The “paying for college” category consists of financial aid as well as expected parent and student contributions (the latter of which are estimated only for the shared responsibility model). A full description of the methodology used to develop this analysis can be found in the Technical Appendix.

Cost of College

Students pursuing a college degree face two main costs: tuition and fees charged by the institution and student-related living expenses such as housing, food, transportation, and books and supplies (often referred to as “non-tuition and fees”). The following table estimates the per-student cost of attendance for each sector. These estimates are for California residents who attend full-time (12 units or more) as an undergraduate at one of the state’s public colleges. This analysis uses full-time enrollment to weight per-student costs by housing type (on-campus, off-campus, or with family), dependency status (dependent or independent), and income (low-income, middle-income, or high-income).

Paying for College

This analysis incorporates three financial resources that help students to cover the cost of college: an expected parent contribution, students’ earnings from work, and financial aid. Parent contribution refers to the amount a student’s parents are estimated to be able to contribute toward college expenses. Expected parent contributions vary by income level — the estimates displayed in the table below are average contributions weighted by family income level. The student earnings figures assume that all students work 15 hours per week at the California minimum wage ($11 per hour) during the academic year and 40 hours per week at the minimum wage during the summer, though some students may choose to make their contribution through borrowing or other means.[3]

The following table shows the average annual amount students and parents are estimated to contribute towards students’ total cost of attendance.

In addition to student and parent contributions, many students pay for college with assistance from federal financial aid. This analysis assumes that all eligible students receive some federal gift aid from the Pell Grant and the Federal Supplemental Educational Opportunity Grant (FSEOG). The following table shows average per-student federal award amounts.

California and its public institutions provide a generous amount of financial aid to students from families with low incomes, administering over $4 billion in need-based aid annually. However, most of this aid is targeted towards tuition and fees. Because the goal of this analysis is to estimate the cost of a new state financial aid program that covers any remaining unmet financial need for students’ total cost of attendance, state and institutional aid estimates are not provided on a per-student level.

Affordable College: Two Models

This analysis provides detailed cost estimates for a new state program that allows full-time resident undergraduate Californians to receive an affordable college education at one of the state’s public higher education institutions. This section presents two models for achieving this goal. Each model displays the estimated costs and unmet financial need per sector, based on 2018-19 full-time resident enrollment (430,000 at CCC; 370,000 at CSU; and 180,000 at UC).

Option #1: Shared Responsibility Model

Option #1 estimates the total unmet financial need for qualified students after accounting for an expected parent contribution, an expected student contribution, and existing federal, state, and institutional aid.

Option #2: Government Responsibility Model

Option #2 estimates the total unmet financial need for qualified students after accounting for existing federal, state, and institutional aid, with no parent or student contribution.

Total Costs

The following table displays the total unmet financial need for all three sectors combined, after accounting for existing state and institutional aid, federal aid, and — where applicable — parent and student contributions. The total estimated unmet financial need for the shared responsibility model is $1.8 billion ($411 million at CCC, $939 million at CSU, and $475 million at UC). The total estimated unmet financial need for the government responsibility model is $15 billion ($4.5 billion at CCC, $7 billion at CSU, and $3.5 billion at UC). Both sets of estimates are on top of existing need-based state and institutional aid.

The program costs associated with these two models rely on several assumptions and the best available data regarding costs and enrollment. Actual program costs could vary considerably — increasing or decreasing the estimates presented here. Costs could be higher if enrollment increased significantly due to the availability of additional state-funded financial aid; living costs increased significantly (or were adjusted to reflect regional cost variations); more students lived off-campus; tuition increased; or federal and institutional aid decreased. Alternatively, costs could be lower if more students applied for and received federal financial aid due to increased outreach efforts; the minimum wage increased; more campuses participated in the FSEOG program; parents’ contributions exceeded expectations; federal or institutional aid increased significantly; or the program were limited to students from low-income families.

Conclusion

Ensuring that higher education is accessible and affordable for all Californians who wish to pursue a college degree is a widely shared goal among policymakers. Even with state and institutional aid, students experience significant unmet financial needs that create a barrier to success. Understanding how the current system falls short in helping students to afford a college education is essential to addressing California’s college affordability challenges. This analysis provides two estimates of what an affordable-college program might cost California if the state were to cover unmet financial need for qualified students. While the path forward requires significant investments, California’s students and economy cannot afford to wait.

[1] Estimate based on California’s 2018 minimum wage for employers with 26 employees or more. For more information, see the Technical Appendix.

[2] Michael Mitchell, et al., Unkept Promises: State Cuts to Higher Education Threaten Access and Equity (Center on Budget Priorities: October 2018); and Lauren Dundes and Jeff Marx, Balancing Work and Academics in College: Why Do Students Working 10-19 Hours per Week Excel? (Journal of College Student Retention: May 2006).

[3] Hans Johnson, Marisol Cuellar Mejia, and Sarah Bohn, Will California Run Out of College Graduates? (Public Policy Institute of California: October 2015).

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At the end of 2017, President Trump signed into law the Tax Cuts and Jobs Act (TCJA), passed with solely Republican support in Congress. As the Budget Center has previously noted, the TCJA — the most extensive revision of the tax code since 1986 — primarily cuts taxes for the wealthy and corporations while increasing the federal deficit by $1.9 trillion over 10 years, putting at risk funding for services that support low- and middle-income families.

Given the severe deficiencies of the TCJA, Californians may be surprised to learn that the new federal tax law has some potential benefits for our state — if our policymakers choose to act. There is much in the TCJA for advocates of tax fairness to dislike, including the large cut in the corporate tax rate (from 35% to 21%), the new deduction for income from “pass-through businesses,” and the reduction in the top personal income tax rate. All of these changes will lead to massive federal revenue losses. However, the new law also includes some reasonable changes that raise federal tax revenue in order to partially offset these losses, including limiting federal tax breaks that are costly, unfair, or economically inefficient. California now has the opportunity to increase state revenue by adopting (or “conforming to”) some of these provisions.

Unlike many other states, California does not automatically conform to changes in the federal tax code. Instead, it selectively conforms to the Internal Revenue Code as of a fixed date, which is currently January 1, 2015, meaning most of the changes made by the TCJA are not in effect for the purposes of calculating state taxes for California taxpayers. Conforming to federal tax law increases simplicity for tax filers, but there are many provisions of the federal code that don’t align with the state’s policy goals. California practices “selective conformity,” allowing policymakers to conform to some federal tax provisions, but not others. Since the state sets its own tax rates on personal and corporate income, the reductions in federal rates do not apply to state-level taxes. Thus, California can end up with more income tax revenue by conforming to those TCJA provisions that limit tax deductions and exclusions while maintaining current state tax rates.

Corporations that have profits in California currently pay significantly less in state income taxes as a portion of their state profits than they did in the 1980s, partly reflecting the increase in the number and generosity of state tax breaks that have been created over the past few decades. The state can narrow some of these tax breaks by selectively conforming to federal law. While the state’s fiscal situation is currently very positive (the Legislative Analyst’s Office estimates that over $20 billion in discretionary resources is available to allocate through the 2019-20 budget process), Governor Newsom has proposed ambitious new investments that will require new ongoing expenditures, such as more than doubling the total amount of credits provided under the state’s Earned Income Tax Credit (CalEITC). The Governor proposes to offset revenue losses from the CalEITC expansion by conforming to certain federal tax law changes mainly affecting businesses. These include “flexibility for small businesses; capital gains deferrals and exclusions for Opportunity Zones; and limitations on fringe benefit deductions, like-kind exchanges, and losses for non-corporate taxpayers; among others.”

The three revenue-raisers in the Governor’s proposed conformity package — the limitations on fringe benefit deductions, like-kind exchanges, and non-corporate losses — would increase state revenue by $1.2 billion, according to recently-released estimates. The other two provisions noted would cost the state revenue and reduce the net gain to closer to $1 billion. Not mentioned in the budget proposal are two other business-related TCJA provisions that could together bring in another $1.3 billion, according to Franchise Tax Board (FTB) estimates: limitations on Net Operating Losses (NOLs) and business interest deductions. If California were to conform to these two provisions in addition to the three revenue-raisers included in the Governor’s budget proposal, the state treasury could see approximately $2.5 billion in increased annual revenue, which could be used to support investments that improve economic security and opportunity for Californians.

The remainder of this post examines these five revenue-raisers, the two revenue-losing provisions proposed by the Governor, and other revenue-losers in the TCJA that California should avoid adopting.

 

Revenue-Increasing Conformity Provisions

Limitations on Fringe Benefit Deductions

The TCJA places new restrictions on federal tax deductions employers may take for certain expenses, including entertainment-related activities, transportation benefits, and some meals. Under prior federal law, businesses could deduct 50% of the costs of activities “generally considered to constitute entertainment, amusement, or recreation” (for example, a sporting event or theater performance) as long as they were directly related to the active conduct of the taxpayer’s trade or business. The TCJA disallowed this deduction. The previous federal deduction for transportation-related fringe benefits, such as parking and commuter benefits, is also disallowed except to ensure an employee’s safety. Additionally, expenses related to meals provided to employees through certain on-site eating facilities or for the convenience of the employer, which were previously fully deductible, are now limited to 50% through 2025 and are not deductible in subsequent years. Taken together, conforming to these limitations would raise an estimated $160 million in state revenue.

Limitation on Like-Kind Exchanges

Generally, when taxpayers sell or exchange an asset and make a profit, they owe tax on that capital gain at the time of the transaction. Prior federal law (to which California currently conforms, with modifications) allowed taxpayers to defer taxes on gains from an exchange of a business or investment property (excluding inventory, stocks, bonds, and other securities, and other specified types of property) if it was exchanged for a similar (“like-kind”) property. The capital gain would only be recognized once the taxpayer sold or exchanged the new asset in a later taxable transaction. However, if the new asset was held until the taxpayer’s death and passed on to an heir, the capital gain would escape taxation completely. This is because the federal government and California do not levy capital gains taxes when an heir inherits property — the heir only owes tax on the increase in value between the time the property is inherited and the time it is sold.

Under post-TCJA federal tax law, only real estate properties are eligible for like-kind exchange deferrals. For instance, an exchange of a vehicle used in connection with a business is now taxable at the federal level, but not at the state level. If California conformed to this limitation, FTB estimates that the state could gain $200 million in revenue. FTB’s latest tax expenditure report estimates the total state cost of like-kind exchange deferrals (including real estate property) for 2019-20 to be nearly $1.2 billion, suggesting that the state could gain significantly more revenue by going beyond conforming to the new federal law and simply eliminating tax deferrals for all types of like-kind exchanges. As the FTB report notes, allowing tax deferral for exchanges of some types of property and not others can be economically inefficient because it may encourage unnecessary investment in properties eligible for favorable tax treatment. And let’s not forget that the real estate industry fared quite well in the TCJA (see here and here), being exempted from several restrictions in the new law.

Limitation on Business Interest Deductions

Prior to the TCJA, businesses were generally able to fully deduct business-related interest expense from their taxable income. The new law limits the federal deduction for net interest expense (that is, interest expense minus interest income) to 30% of the taxpayer’s “adjusted taxable income” in a given tax year. Adjusted taxable income is essentially defined as business-related income before taking into account interest expense, interest income, and certain other deductions. An exception is made for interest expense incurred by vehicle dealers who finance their inventory of vehicles held for sale, known as “floor plan financing interest,” which continues to be fully deductible. The TCJA also allows any federal business interest deduction that cannot be used in a taxable year to be carried forward indefinitely and used in future tax years. Special rules apply to partnerships and S corporations to prevent partners and shareholders from double-counting deductions. Businesses with less than $25 million in gross receipts (averaged over the previous three tax years) are exempt from the new limitations, as are certain public utilities. Additionally, real estate companies and farming businesses may opt out of the new limitation.

The major justification for limiting interest deductions is that doing so reduces the tax incentive for companies to take on excessive debt. Since deductions are allowed for interest expense but not for returns to equity (in the form of dividends and capital gains paid to shareholders), the tax code makes it more attractive for businesses to finance investments with debt rather than equity. Businesses that take on high levels of debt are more susceptible to bankruptcy, and this can have ripple effects throughout an entire economy. As discussed in an International Monetary Fund report, the bias toward debt financing likely exacerbated the global financial crisis of 2007-2008 by encouraging high debt levels. Although the TCJA’s limitation on interest deductions will not fully equalize the tax treatment of debt and equity, it will at least reduce the debt bias. Conforming to this provision can raise $650 million for California while further limiting the overall tax preference toward debt.

Limitation on Net Operating Loss Deductions

A net operating loss occurs when a taxpayer’s total tax deductions exceed total income for the tax year. NOLs can be claimed by both corporate and individual taxpayers, but are usually related to losses from operating a business. Pass-through businesses like S corporations and partnerships cannot claim NOLs at the entity level, but their shareholders or partners can claim NOLs based on their respective shares of the businesses’ income and deductions. Before the TCJA, taxpayers were permitted to carry back these NOLs to offset federal taxable income, dollar-for-dollar, for up to two years prior to the year the NOL was incurred. In addition, they were able to carry forward NOLs to offset taxable income for up to 20 years into the future. As a simple example, if a corporation had an NOL of $500,000 in tax year 2017 (prior to the passage of the TCJA) and taxable income of $250,000 in each of the two previous tax years, it could file amended tax returns to claim a deduction of $250,000 in tax years 2015 and 2016, zeroing out its federal tax liability in both years. The corporation would then get a refund for previously paid taxes for those years. If it had no taxable income in the two prior years or if the NOL exceeded the corporation’s aggregate taxable income for those years, it could carry the remainder forward to reduce its tax bill in future years.

Under the TCJA, corporations and other taxpayers are no longer able to carry back their NOLs (with the exception of certain disaster-related farm losses) to offset federal taxable income. Additionally, NOL carryforward deductions are now limited to 80% of taxable income in any given year, but the 20-year limit has been removed so losses can be carried forward indefinitely. California generally conforms to pre-TCJA federal law at present, but in past years has had its own rules concerning NOLs. Prior to 2013, California had not allowed NOL carrybacks, and in certain years had limited or suspended NOL carryforwards.

There is a legitimate rationale for allowing businesses to average income over several years for tax purposes, given that businesses often incur losses in early years and during economic downturns. However, allowing NOL carrybacks can exacerbate state fiscal challenges during a recession, since it requires that the state refund tax revenues that have likely already been spent. Without NOL carrybacks, businesses may still reap the benefits of income averaging by claiming NOL carryforwards. Limiting carryforwards to a percentage of taxable income reflects the concept that even if a business isn’t profitable, it still benefits from public services like education and infrastructure and should thus be expected to pay some level of taxes. The new federal 80% limitation on NOL carryforwards ensures that corporations cannot use NOLs to entirely wipe out their tax liability in a given tax year. If California conforms to the new limits on NOL carrybacks and carryforwards, the state could bring in an additional $650 million annually in revenue.

Limitation on Losses for Non-Corporate Taxpayers

For taxpayers that have interests in so-called “pass-through businesses” such as S corporations, partnerships, limited liability companies, and sole proprietorships, the TCJA limits the federal deduction for business losses that can offset other income, such as salary and investment income. Prior to the TCJA, business losses could be used to reduce or even zero out federal tax liability, even for individuals with significant income from non-business sources. As with any tax deduction for individuals, higher-income taxpayers receive a larger tax benefit per dollar deducted because they are in higher tax brackets. Federal law now only allows taxpayers to deduct up to $250,000 in “excess business losses” (defined as the amount by which business-related deductions exceed business-related income). The threshold amount is $500,000 for married taxpayers filing joint returns. Any excess business losses above the threshold would have to be carried forward to offset income in future tax years as part of the taxpayer’s NOL. This limitation is scheduled to sunset after 2025 for federal tax purposes. FTB estimates that conforming to the excess business loss limitation would generate $850 million for California.

Revenue-Losing Conformity Provisions

The Governor also has indicated that he wants California to conform to two additional TCJA provisions that would result in state revenue losses – losses that would partially offset the increased revenues from the other conformity provisions. Specifically, the Governor is calling for “flexibility for small businesses,” which is likely a reference to the TCJA’s provision allowing more “small” businesses to use simplified accounting methods. Primarily, this provision increases the size threshold for small businesses that may use the cash method of accounting (rather than the accrual method) from $5 million in gross receipts to $25 million. Under the cash method, businesses recognize income when it is received and expenses when they are paid; under the accrual method, income and expenses are recognized when they are incurred. The cash method allows some businesses to defer taxes by recognizing more expenses in the current tax year and postponing income to the next year. As the Joint Committee on Taxation explains, the cash method is “administratively easy and provides the taxpayer flexibility in the timing of income recognition” while accrual methods “generally result in a more accurate measure of economic income.” Conforming to this provision would make filing taxes simpler for California businesses affected by the change in federal law, since it would be administratively burdensome to use different accounting methods for federal and state tax purposes. However, it would also reduce the revenue gains from enacting other conformity items by about $100 million (though this number would likely decrease over the next several years, consistent with the 10-year federal revenue estimates).

The Governor also proposes to conform — at least in part — to the new federal Opportunity Zone tax incentives, which allow individual and corporate investors to defer and reduce their capital gains taxes if they invest in economically distressed communities that meet certain federal criteria and have been designated by states as Opportunity Zones. The tax incentives are very generous to investors and come with few strings attached. Although the incentives may encourage increased investment in some underserved communities, there is also a risk that the subsidies may accelerate gentrification and displacement in some areas or be used for projects that have little benefit for current community residents. Conforming to these tax incentives would cost the state an estimated $37 million in the first year, rising to $70 million in the following year — but the long-term costs would be higher than suggested by the early year estimates since the tax incentives become more generous as Opportunity Zone investments are held longer. The Budget Center will explore these new incentives in more detail in future publications.

Beyond the items highlighted in the Governor’s budget, the TCJA contains some large new unnecessary federal tax breaks for businesses that would cost California significant revenue if the state were to adopt them. For instance, one set of provisions would repeal the federal corporate Alternative Minimum Tax (AMT) and temporarily allow corporations to claim a partially refundable tax credit for AMT paid in previous years. These provisions together would cost the state $300 million or more if adopted by California, according to FTB. Even more concerning is the new federal 20% deduction for pass-through business income, which would reduce state revenues by $2.6 billion per year if adopted. The pass-through deduction is as poorly designed as it is costly; an estimated three-fifths of the federal tax benefits will go to the richest 1%, and this tax break is vulnerable to myriad abuses by higher-income taxpayers. The Governor does not propose conforming to these poorly-conceived federal provisions, and the state should avoid adopting them as they would not enhance state tax fairness.

Looking Forward

Over the next several months, the Newsom Administration and the Legislature will need to carefully consider the various tax conformity options in terms of their effects on the state budget as well as the fairness and efficiency of the tax code. Adopting any provision that increases taxes on any state taxpayer will likely require a two-thirds vote in each house of the Legislature, which could be an uphill battle politically. Conforming to selected portions of the recent federal tax law offers policymakers an opportunity to raise revenues for new investments by limiting inefficient or unnecessary business tax breaks while resisting pressures to adopt new tax breaks that are not needed. Doing so would make California’s tax code fairer, offset some of the harmful and inequitable aspects of the TCJA, and make significant funding available to support state policy goals and invest in the low- and moderate-income Californians who have benefitted less from recent federal tax cuts.

Taxes & Revenue

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