On November 7th, California passed Proposition 39, a controversial change to California’s corporate tax code. Since 2009, corporations have been offered a choice between two formulas. Formula A based corporate tax on a corporation’s sales, in-state property, and employees, while formula B was based solely upon in-state corporate sales. Initially, the choice-of-formula system benefitted the numerous and growing technology companies headquartered in California (electing to use Formula A, tech companies without numerous properties or large workforces decreased their liabilities). However, others suggested that the true beneficiaries of the 2009 change were out-of-state companies, who were electing to be assessed under Formula A, yet had no or little property in-state. They submitted that the ability to elect gave “tax breaks to companies who ship jobs out of state,” gave the out-of-state companies a competitive edge over in-state companies, and disincentivized infrastructure growth within California.
As a result of the controversy, Proposition 39 found its way onto the California ballot and won with 60.1% of the vote. The proposition requires out-of-state businesses to calculate their California income tax liability based on the percentage of their sales in California, repeals the choice-of-formula system, and dedicates $550 million per annum for 5 years from the initiative’s anticipated increase in revenue in order to fund projects that “create energy efficiency and clean energy jobs.”
Leading up to November 7th, the “Yes on Proposition 39” campaign found itself financially unopposed. The campaign received $23.1 million in contributions, with $21.9 million of that total invested by millionaire hedge fund owner Tom Steyer. In stark comparison, the “No on Proposition 39” campaign received $45,000, the brunt of which was donated by General Motors and the Kimberley-Clark Corporation.
Supporters of the proposition hail it as “the start of a California comeback.” The California Franchise Tax Board estimates that Prop 39 will raise ~$1 billion per annum in tax revenue for cash-strapped California. That total will predominantly fund “green” energy projects in-state, while giving the difference to CA public schools and community colleges. Supporters also argue that Proposition 39 will encourage corporations to hire and expand in California, because a bigger workforce would no longer result in a bigger tax bill. Finally, proponents of Proposition 39 suggest that in-state corporations will be more competitive now that the out-of-state corporations are taxed in the same manner.
Critics, while less outspoken, have voiced their concerns over several aspects of the proposition. They advise that the sales-based formula will “enable firms to avoid paying for the roads, universities and other state services they use and note that some tax-avoidance schemes, such as shifting of income into shell companies” may follow. They also accuse the Proposition 39 writers of “ballot box budgeting,” suggesting that the $550 million for “green” energy was put on the ballot mainly to gain support and votes for the proposition, rather than after a qualitative assessment of the funding’s positive effect on California’s economy. Additionally, critics accuse Steyer of buying the election for personal gain: “Mr. Steyer’s firm, Farallon Capital, has millions of dollars invested in alternative-energy projects,” projects that will receive multi-million dollar contracts when the new tax revenue is allocated (It should be noted, however, that Mr. Steyer denies he would benefit financially from Proposition 39). Finally, critics point out that the cost of doing business is passed on to the Californian consumer – out-of-state corporations formerly using Formula A will experience an aggregate billion dollar tax hike, necessitating increased corporate revenue, requiring increased sales prices.
California is in need of serious reform when it comes to attracting businesses in-state. According to a report from the Tax Foundation, California’s business tax climate ranks 48th out of the 50 states of the Union. Additionally, it has one of the highest corporate tax rates in the country and levies heavy regulatory burdens on in-state corporations. But is a standardized sales- based tax the right way to go? Unfortunately, the answer likely is no. The fundamental problem is that while Proposition 39’s aim is to incentivize infrastructure growth within California, it will end up strangling growth instead. Those companies with little infrastructure in-state will receive tax hikes when switched over to the sales-based formula- a tax hike that proponents gleefully report will amount to an additional $1 billion per year. Long before the companies can consider growth in California, they will have to find a way to correct the balance sheet for the increased liabilities. The typical options for achieving that goal are: pass the costs of new taxes onto the Californian consumer, reduce sales presence in California, and/or reduce infrastructure costs. In a state with an unemployment rate above 10%, none of these options should be acceptable. In addition, the estimated billion dollars in tax revenue fails to consider that in-state revenues likely will drop as prices are hiked and sales presence is reduced. Reduction of in-state revenue for corporations disincentivizes further presence in-state and further contravenes the proposition’s purported goal. Ultimately, the proposition likely will only speed up the exodus of private capital from California to neighboring Nevada and Arizona.