“Tax Entitlements” on the California Ballot

The California ballot this November 2 features Proposition 24 along with eight other voter initiatives. Prop 24 cancels a package of California business tax breaks that were legislated in 2008 and 2009 as part of negotiations to close budget deficits. In short, the provisions allow for the the reduction in taxable income using three methods:

   1. Net operating losses could be applied against tax liabilities incurred in the previous two years (“carry back”, currently disallowed) or future profits (“carry forward”) more flexibly than current law allows. Carry forwards could be applied up to 20 years forward instead of the current 10 years.
   2. Multi-state companies would have more flexibility in what sales-based formula they use to determine their taxable income
   3. Business “groups” would get more options on how they share tax credits among members

The state legislative analyst estimates full enactment by 2012-2013 would reduce annual state revenues by $1.3 billion.

The composition of the two sides in the election holds few surprises. The opponents are “pro business” groups that are labeling Prop 24 a job killing tax hike (It’s actually the repeal of a tax reduction). Proponents include those under threat by the cuts necessary to shrink the $18 billion deficit: public employee, recipients of government services and their advocates.

The job-killer description for Prop 24 is in sync with the many-decade narrative which tags California as a high tax anti-business environment. On closer examination California doesn’t seem to have an exceptionally hostile tax code. A Los Angeles Times article of October 25 included a list of California tax features that challenge the anti-business reputation, at least as far as taxes are concerned:

   1. According to a study by the Council on State Taxation, the state’s tax share of  gross state product (gsp) is 4.7%, which is also the national average. Maybe surprisingly, the California rate is lower than for New York (5.5%) and Texas (4.9%). Two of the states usually held up as magnets for disgruntled California employers have higher rates: Arizona (4.8%); Nevada (4.9%).
   2. California’s research and development tax credit provision (15% of R&D expenditures over a specific base level) is considerably more generous than the national median of 6.5%.
   3. The well known Proposition 13 (1978) that caps real estate tax rates and annual increases favors business taxation since business ownership of commercial real estate changes far less often than for residential properties and is therefore less exposed the full tax adjustment triggered when deeds change hands. As a result, the business share of property taxes has declined steadily. In Los Angeles County, the residential share has climbed from 53% in 1975 to a current 69%.

More generally, the business share of California and federal income tax revenues has declined for decades. Business taxation rates expressed as a fraction of either profit or state or national gross product has not been increasing, this is particularly true for larger corporations. Through tax credits and other favorable “tax entitlement” the tax burden has steadily shifted to individuals and smaller businesses.

The tax and revenue systems of our respective states are complex and largely unfamiliar to citizens and journalists alike. So it would seem reasonable to make public the favors dispensed by the government. In California’s case such disclosure should be a prime candidate for the recently installed but seriously underused transparency-in-government efforts.

In California, Assembly Bill 2666 was passed by the state legislature and finally vetoed by the governor this summer. In the words of the legislative floor summary AB 2666 “requires the Franchise Tax Board (FTB) to compile information on tax expenditures claimed and reported by publicly traded companies and requires the State Chief Information Officer (CIO) to publish this information on the Reporting Transparency in
Government Internet (RTG) Web site.”

Tax expenditures, or what I prefer to call tax entitlements, are shrinking the tax base, shifting the burden to those who don’t have the political wherewithal to extract favors from their respective legislative bodies. This continuing trend restricts the deficit debate to a choice between cutting government spending and raising “job destroying” tax rates.

In California’s case, none of the tax breaks referred to in Prop 24 are aimed at or justified on the basis of job creation - except in the claims of the campaign literature. However, they clearly enhance after-tax income.

The California decision on Prop 24 distills the abstract national debate over whether cutting business taxes creates job down to a yes/no vote on a single proposition. The contexts are different but the question is really the same.

In testimony (Policies for Increasing Economic Growth and Employment in the Short Term) before congress in February 23, 2010, CBO Director Douglas W. Elmendorf offered the following: “increasing the after-tax income of businesses typically does not create much incentive for them to hire more workers in order to produce more, because production depends principally on their ability to sell their products.”

The Culture of Poverty versus the Culture of Poverty Studies

Recently, (October 18, 2010) a New York Times article   covered the resurgence of scholarly interest in the “culture of poverty”. The reporter focused on academic meetings and a congressional briefing linked to a special issue of The Annals, the Journal of the American Academy of Political and Social Science.

The article probably overstates the academic withdrawal resulting from association between “culture of poverty” and “blame the victim” established by the early 1970s. Research of the 1980s and 1990s focused on the new term “urban underclass” but continued to provide a rationale for ignoring pleas for anti-poverty efforts from the federal government.  Nevertheless, the recent interests does seem to represent a heightened participation by researchers and their funders.

Studies by Daniel Patrick Moynihan before he became a senator from New York and the anthropologist Oscar Lewis among others, described the urban black family as trapped in a “tangle of pathology” and moral deficiencies resulting in a community of welfare-dependent unmarried mothers. The underlying racial theme repelled many for decades, so the renewed interest in this subject is noteworthy. There is a careful avoidance of terms like pathology, and language that sounds like blame.

We know that this is not a purely academic exercise if for no other reason than the congressional briefing. The Times article highlights this connection directly:

“The topic has generated interest on Capitol Hill because so much of the research intersects with policy debates. Views of the cultural roots of poverty ‘play important roles in shaping how lawmakers choose to address poverty issues,’ Representative Lynn Woolsey, Democrat of California, noted at the briefing.”

But this current research is not so focused on distinguishing which cultural attributes cause or sustain poverty rather than being caused by poverty. Separating cause and effect is important. Marriage promotion has been advocated as an anti-poverty strategy because marriage appeared to be one of the striking differences between the poor and the non-poor. But is marriage a cause or the result of higher income?

Why is the focus on the behavior of the “losers” in the economic competition as opposed to all players? Pathologies of the rich would seem to be at least as interesting, but draw much less attention at universities where the research is conducted or the government
agencies and charitable foundations that hand out the research grants. Wouldn’t it be constructive to learn how and why middle class families are convinced to vote pathologically against their economic interests; or how the truly rich are able to separate their weekend religious beliefs from their profit generating weekday activities when in comes to interactions with other economic classes?

One of the arguments against aid to the poor is that it encourages a “culture of dependency”. Policy analysts don’t identify the same flaw in tax benefits and subsidized mortgage rates for middle class homeowners. Or at least it doesn’t seem to be of “cultural” interest.

When the sub prime mortgage collapse expanded into a banking crisis, some argued that not only was government intervention on behalf of low income homeownership bad for the poor, but that it could destroy capitalism for everyone. The diseases from the culture of poverty could escape quarantine even if poor people couldn’t. The pathology of the poor had transformed into a contagion infecting the rest of us.

Advocates for homeownership claim a list of benefits for society: increased satisfaction with their homes and neighborhoods; increased likelihood to participate in voluntary and political activities; and prolonged stays in their homes, contributing to neighborhood stability. But housing subsidies to the poor are devoid of any analogous self-empowerment – in other words, no means to accumulate wealth in the form of equity, or effective participation in the operation of the public housing project. As a result, many of the elements that contribute to the advantages of homeownership are “designed out” of low income housing subsidies.

Instead of focusing on culture, this blog advocates a focus on the federal and state government spending policies that unfortunately contribute to differences in economic opportunity.

This structural approach suggests a different set of questions than those emphasized by a focus on culture. What is it about the rules of the economic game that produces so many losers and could the game be made fairer? Why isn’t the poverty level a higher priority
target of economic performance along with growth in gross national product and the unemployment rate? In other words, isn’t a persistent, and now climbing, poverty level a sign of failure for fiscal/tax policy?

What about the Culture of Poverty Studies?

Unlike engineers or others involved in technology, social scientists are not expected to solve the problems they study. Although they as individuals may care about the fate of the poor, these researchers have a perverse incentive to keep poverty around.

If the focus on the poor is driven by a desire to solve the poverty problem, then I would expect more emphasis on solutions-oriented research. I would expect more emphasis on the structural obstacles to escape from the poverty trap. Instead, there is at least as much
interest in developing new theoretical frameworks, and applying novel experimental designs to examine poverty in fresh ways. In fact there doesn’t seem to be a high expectation of eliminating poverty through social science research.

It’s not as if solutions-oriented experts don’t exist: but they are not really asked to deliver them.

Besides the PhD. policy analysts at D.C. partisan and nonpartisan think tanks, there are government economists, statisticians and attorneys at the Federal Reserve, Office of Management and Budget (OMB), Congressional Budget Office (CBO), Commerce, Agriculture, Housing and Urban Development (HUD) and other agencies representing a staggering amount of intellectual and computational firepower who are never directly asked the question they have spent most of their careers fantasizing about: "How would you fix this poverty mess?”

In many cases, government policy analysts, e.g. CBO, are prohibited from giving recommendations, presumably to assure “objective, impartial analysis” of the policy under consideration. Instead they get to make diplomatic comments, analyses and forecasts about what congress is about to consider, and they are occasionally asked to comment on some tangential details in a congressional hearing. But wouldn’t we all like to know what they are muttering to themselves when they are asked everything else but “How would you fix this mess?”

At its simplistic core, solutions to poverty don’t require that much intellectual fire power. Once you set aside those who are physically or mentally incapable of holding a productive job and those who avoid working, the missing element is self-evident. There are not enough jobs at the appropriate skill level paying enough to keep job seekers above the poverty level. Aren’t there rich countries that have much lower levels of poverty? How do they do it?

Instead of studying the “culture of poverty”, maybe we could disrupt the culture of poverty studies and give some “experts” a serious chance to solve problems using the proper incentives. It’s not an accident that the most successful advocates in Washington are the ones that are paid for winning – lobbyists and vendor/contractors.

Renewable Energy Tax Credit: Worthy Goal, But There is a Better (and Tried) Path

Tax cuts, in their various forms, have emerged as the fiscal instrument of choice for a variety of goals: stimulate the overall economic growth, create jobs, reduce unemployment and attract investment.

The Kennedy and Reagan Tax cuts are sentimental and bipartisan examples used as arguments for applying the same strategy today. Those episodes from recent history are subject to easy challenge as useful models because the contexts are so different and the cause/effect conclusions are never as tight as politically driven proponents would have us believe.

Even for a specifically targeted sector as opposed to general economy, tax cuts in the form of investment tax credits were chosen as an important vehicle in the 2009 economic stimulus package (ARRA). The Renewable Energy Tax Credit Program (RETC) uses tax credits to encourage the development of manufacturing facilities making “solar, wind, and geothermal energy equipment; fuel cells, microturbines, and batteries; electric cars; electric grids to support the transmission of renewable energy; energy conservation technologies; and equipment that captures and sequesters carbon dioxide or reduces greenhouse gas emissions.”
Quoting Energy Secretary Steven Chu:  "These tax credits will help create thousands of high quality manufacturing jobs in some of the highest growth segments of the economy.  This is an opportunity to develop our global leadership in clean energy manufacturing and build a secure, sustained base of jobs for America's workers."
(August 13, 2009 TG-262 Treasury, Energy Announce more than $2 Billion in Recovery Act Tax Credits for Energy Manufacturers http://www.treas.gov/press/releases/tg262.htm US Treasury)

The program provides a 30% credit for investments in new, expanded, or re-equipped advanced energy manufacturing projects. 
 

The credits are awarded in a process that is surprisingly devoid of market influence. Quoting from the Department of Energy description- “The Department of Energy (DOE) and the Internal Revenue Service (IRS) will review and make determinations on the eligibility and merit of MTC (Advanced Energy Manufacturing Tax Credit) applications.  Applicants will receive tax credits based on the expected commercial viability of their project and the ranking of their project relative to other projects.  Rankings based on: expected job creation, reduction of air pollutants and greenhouse gas emissions, technological innovation, and ability to have the project up and running quickly.  Technology, geographic & project size diversity, and regional economic development will also be considered when rating projects.” (http://www.energy.gov/recovery/48C.htm)
 

But using tax credits to encourage new ventures in new technologies can’t depend on nostalgia for support because there really isn’t any history to count on. 

Tax credits tend to be most useful to full tax payers. Enterprises that are in the product development stage and have not hit their stride in revenue or profits don’t have tax liabilities to offset. The written-in ability to use the credit over the next 20 years is better than nothing, but that’s not necessarily what that type of company most desperately needs. What they want is long term fixed revenue for their products or services. In other words, customers with deep pockets – like the federal government.

Such credits are most useful to established firms with current tax liabilities to erase. The credits won’t necessarily change their investment behavior, but it will enhance the after-tax income statement.

Why do companies in the renewable energy business need tax incentives at all? Why aren’t “market forces” sufficient. The risks of doing business in an emerging technology are several: risk of technical failure; uncertainty of demand volume; the pricing of competitive products, especially from existing technology. These are the risks examined by all involved, including potential investors. Occasionally the federal government tries to accelerate market progress either because it needs better products for its own purposes, such as military applications or because certain constituencies are not being served by unfettered capital such as what inspired federal sponsorship of rural electrification or universal telephone service. When these legacy supports or subsides outlive their original intent, they can become obstacles to emerging technological replacements.

Such is the case with renewable energy. The goal is to eventually replace the slowly dwindling supply of non-renewable, a.k.a. fossil fuel with renewable energy sources delivered through more efficient, adaptive and intelligent energy storage and distribution systems. Customers are reluctant to switch over to a new source if it is not predictably cheaper, and at least as reliable in the long run as oil and coal. Given that there are no new sources of fossil fuels, we already know that eventually the supply will run out and will be very expensive. We just don’t know the timetable.

Some of the uncertainty in timing comes from the current regime of subsidies for fossil fuels, both direct and indirect. The normal price fluctuations associated with the trading of energy commodities are further influenced by federal programs that: provide security at geo-politically challenging choke points such as shipping sea lanes from the Pentagon; standby fuel cleanup capacity; strategic fuel storage; carbon capture and storage, essentially none of which is incorporated into energy prices. Additional direct subsidies to the oil and gas industry are embedded in the tax code: produces are allowed to take deductions normally reserved for domestic manufacturing even though such production isn’t normally thought of as manufacturing; “intangible” costs like the use of machinery and materials that get consumed that are normally written off over the life of the gear, are allowed to be expensed immediately; special “percentage depletion” provisions allow for the cost of using up property as a percentage of gross revenues instead of actual costs over time until the asset is exhausted. All of these, plus several more, reduce the tax burden of producing fossil fuels.

These federal interventions serve to distort the real value of vanishing energy supplies, encourage overuse, accelerate inevitable depletion, but most relevant here, and make an already difficult terrain for emerging technologies even more hazardous.

Over the last 100 years Federal roles have been prominent in the development of several industries and infrastructures
○    Nuclear technology
○    Modern pharmaceuticals
○    Interstate highway system
○    Rural electrification
○    Universal telephone service
○    Civil aviation
○    Information technology (IT) – (electronic computers, computer software, semiconductor based electronics/integrated circuits, and the Internet)
The last two are particularly applicable to the renewable energy sector.

Civil aviation fits, because it is an example where the federal government helped to spawn commercialization through its role as customer: as a shipper of airmail.

A much more comprehensive and useful example would be the IT industry. Both IT and energy are critical to national and economic security, and are industries where the federal government is a large, and in the case of the military, technologically demanding customer.

Rather than follow recent energy policy which, in addition to tax breaks, consists of
●    Direct and indirect subsidies to energy production (e.g., Synthetic Fuels Corporation)
●    Intermittent subsidies to consumer conservation efforts (1978 tax credits dismantled during the Reagan administration)
●    Mandated use of politically selected alternative fuels (e.g., ethanol),

we might adopt some lessons learned from the federal role in the development of the post World War II information technology (IT) sector.

Early federal participation in IT was characterized by:
●    Public funding of R&D, both academic and commercial leading to accelerated diffusion of technologies that otherwise might have been inhibited by monopolistic behavior on the part of patent holders
●    A procurement policy that importantly came during early stages of industrial development that, in many cases, required multiple suppliers which encouraged new industry entrants as well as larger established firms
●    Bipartisan cooperation brought on by the cold war/national security environment
●    Relative absence of mandated technology: instead mostly mandated performance specifications
●    Rapid commercialization: by the 1960s private industry’s requirements overtook the military influence in setting the IT industry agenda.

Against this backdrop, a more market-focused federal energy strategy might deliver widely accepted results.
Policy Objective: accelerate rather than substitute for market processes in developing new energy-related industry capabilities – products, providers and distributors
1.    Government should not defeat the proper role of the market by selecting specific technologies or individual, exclusive suppliers.
2.    It should not favor one side of the market (supply) as do current tax expenditures, but rather encourage demand for energy-efficient products including those for construction and transportation, through procurement policies.
3.    Develop intellectual property policies that allow relatively free flow of innovation (where the intellectual property belongs to the government) among suppliers and generally favor multiple suppliers for large orders. These practices will tend to discourage or eliminate monopolistic behavior and thereby improve market performance.
 

The federal role in financing research should not be underestimated. A recent article on the government role in new technology focused on a few illustrative examples including nanotechnology:
 

Scientific research in nanotechnology, much of which has important defense applications, may be an example of another field in which federal R&D funding could play an important role in the development of a general-purpose technology. .. Steve Jurvetson, recently characterized the role of private investment in the development of nanotechnology applications as follows: “ We [venture capitalists] have come in much later, after [something that] was an incredibly risky proposition bears some fruit in terms of a prototype of some products. That’s when we first invest…. Every one of our nanotech and related companies was first federally funded in a university setting or in a government lab” (from “The Federal Role In Financing Major Innovations: Information Technology during the Postwar Period”, Kira R. Fabrizio and David C. Mowery in Financing Innovation in the United States, 1870 to the Present, edited by Naomi R. Lamoreaux and Kenneth L, Sokoloff, MIT Press 2007)

Conclusion

Much of the criticism directed at the government participation in industrial development is the prospect of the government substituting for the market in picking winners and losers. However, when federal agencies use their purchase dollars to provide a minimum of demand based on performance specifications (rather than specific techniques or technologies and built-in advantages for existing large firms) and encourage multiple suppliers, then new sectors can be jump-started and induced to survive their most fragile formative stages.

New entrants, unencumbered by legacy technologies and manufacturing capacity need the promise of demand over extended production runs to achieve cost-effectiveness the ability to attract capital at a competitive rates.

One additional bonus to rapidly cranking up demand for the new products: the accelerated increase in steady demand will encourage investment in automated manufacturing, reducing the relative advantage of cheap foreign labor, and increase the relative cost of shipping the finished products from Asia. Otherwise the “green jobs” will be limited to installing the new imported devices and not manufacturing.

If affections for manipulating the tax code can’t be overcome, then use the IRS to encourage conversion to non-fossil fuels by subsidizing purchases from renewable supplies.