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.

Introduction

Californians need quality public health and schools, access to affordable housing and clean water, and safe roads and neighborhoods along with many more services to live and thrive – no matter one’s zip code. Accordingly, the state’s tax and revenue system must raise adequate revenue to cover the services provided by state and local governments and make ongoing investments to meet the needs of Californians. However, policy choices of the past and present shape whether revenues are equitably raised and who is contributing a fair share of their income to California’s revenue. State policymakers can make the tax and revenue system more equitable by strengthening taxation of Californians with high incomes and wealth while providing more support to Californians with low incomes and Californians of color who have been blocked from income- and wealth-building opportunities.

This 5 Facts explains main concepts associated with tax equity and illustrates how elements of California’s tax and revenue system further or impede the goals of economic and racial equity for households, communities, and the state.

1. Taxes Can Be Progressive, Proportional, or Regressive — Depending on How They Impact People Across Income Levels 

A key aspect to tax equity is how a tax — or a tax system as a whole — impacts households across income levels. One way to measure this is by comparing effective tax rates —meaning the share of one’s income paid in a tax — of people in different income groups. A tax is considered progressive when households with higher incomes have higher effective tax rates than those with lower incomes. The opposite of a progressive tax is a regressive tax. With regressive taxes, people with lower incomes have higher effective tax rates than people with higher incomes. Finally, a tax is considered proportional when people at all income levels have the same effective rates. Progressive taxes are the most equitable taxes, since they ask the most from people who have the most ability to pay.

People with lower incomes must spend larger shares of their income just to meet their basic needs, leaving them with less ability to pay taxes. For example, almost 6 in 10 low-income California households spend more than half of their income on housing alone, compared to just 2% of high-income California households.¹Aureo Mesquita and Sara Kimberlin, Staying Home During California’s Housing Affordability Crisis (California Budget & Policy Center, July 2020), https://calbudgetcenter.org/resources/staying-home-during-californias-housing-affordability-crisis/. Data are for 2018. “Low-income California household” is defined as a household with income below 200% of the federal poverty threshold — roughly $51,000 for a family of four in 2018 — and “high-income California household” is defined as a household with income of at least four times the federal poverty threshold — roughly $102,000 for a family of four in 2018. In other words, after covering the basics, Californians with lower incomes have much smaller portions of their total incomes available to pay taxes than higher-income Californians. It follows that a fair tax system should take a smaller fraction of the income of low-income households.

2. California’s Personal Income Tax Is Highly Progressive, Asking the Most from Those with the Highest Ability to Pay

Californians with higher incomes pay a larger percentage of their income in personal income taxes than people with lower incomes because higher portions of income are subject to higher tax rates.²California’s personal income tax rates range from 1% to 13.3%. The top rate for each tax bracket, or range of income, is only applied to the amount of income that exceeds the income threshold for that bracket. In other words, high-income people face the highest effective tax rates with regard to the personal income tax. Additionally, the state has two refundable tax credits, the California Earned Income Tax Credit (CalEITC) and the Young Child Tax Credit, that provide refunds to families with very low incomes, creating a negative effective tax rate for them. The personal income tax is the state’s largest revenue source.

The progressive structure of the personal income tax also improves racial equity, since Latinx and Black Californians have lower average incomes than white Californians due to racist policies and practices in employment, education, and every other facet of society.³Carl Davis, Marco Guzman, and Jessica Schieder, State Income Taxes and Racial Equity: Narrowing Racial Income and Wealth Gaps with State Personal Income Taxes (Institute on Taxation and Economic Policy, October 2021), 11, https://itep.sfo2.digitaloceanspaces.com/State-Income-Taxes-and-Racial-Equity_ITEP_October2021.pdf; Adriana Ramos-Yamamoto and Monica Davalos, Confronting Racism, Overcoming COVID-19, and Advancing Health Equity (California Budget and Policy Center, February 2021), https://calbudgetcenter.org/resources/confronting-racism-overcoming-covid19-advancing-health-equity/. As a result, the effective state personal income tax rate is lower on average for Latinx and Black families (3.6% and 4.0%, respectively) than for white families (5.0%).⁴Davis, Guzman, and Schieder, State Income Taxes and Racial Equity, 11-12. Tax agencies do not collect racial or ethnic information, so the Institution on Taxation & Economic Policy estimates effective tax rates by race/ethnicity by combining tax data and US Census Bureau American Community Survey data using a methodology explained here: https://itep.org/itep-tax-model/iteps-approach-to-modeling-taxes-by-race-and-ethnicity.

3. California’s Sales and Excise Taxes Are Regressive, Asking the Most from Those with the Least Ability to Pay

In contrast to the personal income tax, the sales and use tax is regressive. This is because people with lower incomes need to spend larger shares of their income to cover basic needs, so sales taxes take up larger shares of low-income households’ budgets. The sales and use tax is the state’s second-largest revenue source.

Excise taxes, which are taxes on specific goods including gasoline, alcohol, and tobacco, are also highly regressive. Like sales taxes, excise taxes hit people with lower incomes hardest since any money they spend on items subject to excises taxes will generally make up a larger share of their overall budgets compared to high-income people. In addition, since excise taxes are generally based on the volume of the purchase rather than the price, people at all income levels pay the same tax on a given amount of a product, whether they buy an economical brand or a more expensive brand.⁵Meg Wiehe et al., Who Pays: A Distributional Analysis of the Tax Systems in All Fifty States (Institute on Taxation and Economic Policy, October 2018), 19-20, https://itep.sfo2.digitaloceanspaces.com/whopays-ITEP-2018.pdf. 

The 20% of California families with the lowest incomes pay 7.4% of their incomes in combined state and local sales and excise taxes, compared to 0.8% for the richest 1%. Again, because Black, Latinx, and many other Californians of color are more likely to have low incomes than white Californians, regressive taxes like sales and excise taxes exacerbate racial inequity. 

4. California’s State and Local Tax System Could Be More Progressive

The overall impact of the state and local tax system on Californians is determined by the combination of the progressive personal income tax and regressive sales and excise taxes, as well as other taxes levied by the state and localities — most notably local property taxes and corporate income taxes. The combined impact is a state and local tax system that is regressive for people with lower incomes and progressive for people with very high incomes. The richest 1% of California tax filers pay the largest share of their income in state and local taxes (12.3%), but the 20% of filers with the lowest incomes pay the next highest share (11.4%). While the richest Californians pay a smaller portion of their income in sales, excise, and property taxes than any other group, it is made up for by the larger share of their income that goes to income taxes. Conversely, while the bottom 20% of Californians on average get money back from the personal income tax system via refundable tax credits, this is not enough to make up for paying larger shares of their income in sales, excise, and property taxes.

5. California’s Tax System Rewards Wealth but Doesn’t Tax Wealth

Wealth inequality is even more pronounced than income inequality, and racial wealth gaps are larger than racial income gaps. Many state tax policies contribute to wealth inequality and racial wealth gaps by providing substantial tax benefits to families who have assets like homes and retirement plans — such as the deductions for mortgage interest and property taxes, the partial tax exemption on the proceeds of home sales, and tax-privileged retirement accounts. Black, Latinx, and other people of color receive less of these tax benefits because — due to structural racism and discrimination — they are less likely to be homeowners, to be in jobs with access to employer-sponsored retirement plans, and to have the financial means to save or invest in assets.⁶Kayla Kitson, Promoting Racial Equity Through California’s Tax and Revenue Policies (California Budget & Policy Center, April 2021), 5, https://calbudgetcenter.org/resources/promoting-racial-equity-through-californias-tax-and-revenue-policies; Kayla Kitson, Tax Breaks: California’s $60 Billion Loss (California Budget & Policy Center, January 2020), 6-8, 10-11, https://calbudgetcenter.org/resources/tax-breaks-californias-60-billion-loss. At the same time, accumulated or inherited wealth is not taxed in California. Policymakers can eliminate or limit tax benefits that most advantage wealthy families and explore other options to better tax Californians who have amassed large amounts of wealth. The resulting revenues could then be directed to investments that help families who have been shut out from wealth-building opportunities achieve economic security and build wealth.

Conclusion

There are many dimensions to ensuring that a tax system equitably generates the revenue needed for Californians to care for their families, build healthy communities, and contribute to a strong economy. Policymakers need to consider how any tax policy could have disparate effects on Californians by income, wealth, and race/ethnicity — as well as other factors not discussed in this fact sheet, such as gender, family structure, and income source.

The state’s current tax and revenue system is not fair for all Californians. People with the lowest incomes should not be paying larger shares of their incomes in state and local taxes than most other income groups, and the state’s tax policies should work to narrow racial wealth gaps, not widen them.

California policymakers can make the tax and revenue system more equitable. This includes ensuring that Californians with high incomes and wealth pay their fair share to support critical state services, providing further support for Californians with low incomes — such as by increasing and expanding refundable tax credits and making other tax credits refundable to benefit more low-income households — and eliminating or reforming tax benefits that primarily help wealthy Californians. Moving toward more robust taxation of Californians with higher income and wealth would also generate revenues that can be spent equitably to help more low-income households and Californians of color live and thrive, and expand opportunities to build wealth for themselves, their children, and their communities.