Federal Opportunity Zones Program: Implications for California Communities

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.

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.

The ongoing US trade war with China, initiated by the Trump Administration, shows little sign of ending soon. After months of escalating tit-for-tat tariffs, the US has now imposed tariffs on $263.1 billion of goods imported from China, and China has responded with retaliatory tariffs on $112.4 billion in goods exported from the US to China. President Trump has recently threatened to impose tariffs on all remaining Chinese imports — representing an estimated $257 billion in goods — by early December, if upcoming trade discussions are not successful. This action would likely trigger further tariffs from China on US goods and/or other retaliatory measures targeting US companies. Tariffs imposed in response to the Trump Administration’s actions are likely to affect businesses in every part of California, because China is a major export market for goods produced in every California congressional district (see maps and link to table below).

The US has legitimate concerns about unfair trade practices in China, including deliberately weak protection of intellectual property rights and restrictions on foreign investment and market access which disadvantage US companies. The US also imports far more goods from China than it exports to China, creating a bilateral trade deficit that is cited by President Trump as a key reason for trade actions against China, though economists disagree about the significance of this trade deficit. Many economists argue that trade deficits are not problematic, and that US consumers and businesses, and the overall US and global economies, benefit from global supply chains that allow countries to specialize in producing certain goods and global consumer markets that allow producers to sell their goods widely and consumers to access goods produced globally. Some economists, however, argue that the trade deficit with China is a problem because of evidence that the increased flow into the US of lower-cost manufactured goods imported from China has triggered a drop in the number and wages of US manufacturing jobs, limiting the job opportunities available to less-educated US workers and pushing a significant number of former manufacturing workers into lower-paying jobs or out of the labor force entirely. But economists on all sides of the debate about the core concerns about trade with China — from those who emphasize the need to protect jobs and wages for US workers or address the needs of workers and communities harmed by trade, to those who believe unfettered free trade promotes the best economic outcomes, to those who support open markets coupled with targeted protections — all oppose the untargeted, broad-based tariffs that the Trump Administration has imposed on China. They argue that these types of tariffs are an inappropriate and ineffective approach to addressing concerns about China’s unfair trade practices or the negative effects of trade with China, because they appear unlikely to lead to desired reforms in China or significantly more jobs in the US, while they cause US businesses and consumers to face higher prices as a result of both tariffs imposed by the US on Chinese goods and retaliatory tariffs imposed by China on US-produced goods.

As discussed in a prior Budget Center blog post, California companies and workers are likely to feel the effects of retaliatory tariffs imposed by China because China is a key export market for California businesses. This is true for businesses in all parts of California that export goods. In fact, as of 2016 China was one of the top five export destinations for goods produced in every one of California’s 53 congressional districts, with annual exports to China valued at more than $100 million in more than 90% of districts, according to figures produced by The Trade Partnership for the US-China Business Council, based on data from the US Census Bureau and US Department of Agriculture (see maps).

Download a table of the value of goods exported to China and rank of China as an export destination by congressional district.

This means that the Trump Administration’s tit-for-tat tariff war with China, with no end in sight, can be expected to disrupt operations and revenues of businesses throughout California that produce agricultural, industrial, and manufactured goods for export — with cascading effects on jobs, business profits, and state and local tax revenues. California workers and businesses need a different federal approach to trade policy with China — one that addresses legitimate concerns about unfair competition and the negative effects of trade on workers and communities, without punishing US workers, companies, and consumers through direct and retaliatory tariffs that do not lead to meaningful trade reform.