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BNA: Debate Heats Up Over Governor’s Proposal To End California Enterprise Zone Tax Credit

The following is BNA’s Daily Tax Report comprehensive review of the current debate over the Governor’s proposal to eliminate Enterprise Zones by Laura Mahoney.

Reproduced with permission from Daily Tax Report, 32 DTR GG-1 (Feb. 16, 2011). Copyright 2011 by The Bureau of National Affairs, Inc. (800)-372-1033

Debate Heats Up Over Governor’s Proposal To End California Enterprise Zone Tax Credit

SACRAMENTO, Calif.—Lawmakers weighing whether to eliminate tax credits for businesses in the state’s 42 enterprise zones have to decide whether to take the advice of their fiscal advisers who say the program is an ineffective luxury the state cannot afford, or heed the words of a lawyer for the zone’s supporters who says the idea would amount to an unprecedented, unconstitutional theft of tax credits held by California businesses.

At issue is Gov. Jerry Brown’s (D) proposal to eliminate state tax credits now available to businesses operating in the 42 zones around the state, for savings of $924 million over the next 18 months. Under his proposal, businesses would no longer be able to earn and claim new credits, and they would forfeit credits they have earned in past years but have not yet claimed on their tax returns.

At a legislative hearing on the proposal Feb. 7, administration officials stressed to lawmakers that in the face of a $25.4 billion deficit, they can only maintain programs that are most core to state government and most effective. California’s EZ program has not fulfilled its promise as a tool for economic development, and should not remain in place, they said.

Brown Administration: EZs a Luxury

Jay Chamberlain, chief of financial research with the governor’s Department of Finance, said the primary outcome of the EZ program has not been to spur new business activity, but to shift economic activity from some areas of the state to others.

“There will always be businesses who are strongly influenced by the program, and others who are not influenced by it,” Chamberlain told a subcommittee of the Assembly Budget Committee. “A non-trivial amount of money is going to businesses whose behavior is not at all affected by enterprise zones … This program is a luxury that the Legislature and California cannot afford.”

In the weeks since the governor made his budget proposal Jan. 10, two coalitions have formed to launch an assault on the plan, called Californians for Jobs and Safe Communities and Communities to Save Enterprise Zones. Coalition members, mainly local officials from the zones, consulting firms that help companies claim the credits, and businesses that have benefitted from the program, filled the hearing room to capacity and lined up in the hallways to tell lawmakers to save the state’s enterprise zones.

EZ Supporters: Proposal Is Unconstitutional

Leading the charge was Donald M. Griswold, an attorney with ReedSmith in Washington D.C., who was brought in to provide legal advice to the coalitions by one of the law firm’s clients, California Credits Group. CCG is one of the largest consulting firms in the state that focuses on helping businesses claim credits available in enterprise zones. CCG also has been a party to key enterprise zone tax credit cases that have been settled by the State Board of Equalization, and has made significant campaign contributions to the elected SBOE members, based on a recent BNA analysis of complex cases argued before the board (164 DTR S-27, 8/26/10 ).

Griswold told legislators the proposal to eliminate state EZ credits is bad public policy, and would violate the Due Process Clause and Contracts Clause of the U.S. Constitution. Most problematic is the governor’s plan to take away the credits retroactively, meaning companies that have earned credits but not yet claimed them would lose them beginning with the 2011 tax year.

Griswold told BNA the retroactive elimination of outstanding credits would be an unprecedented move.

“I’m not aware of any other state that has been so bald faced,” he said.

History of EZs in California

California created the EZ program in 1984, and currently has 42 zones around the state. Each of the zones is authorized for 15 years, and is located in an area that typically has high unemployment rates and depressed economic activity.

Under the program, employers that operate in the zones can claim credits of up to $37,440 for each qualified employee hired, and those credits can be carried forward for five years. Qualified employees fall into several categories, such as those who have been on public assistance, are disabled, or long-term unemployed.

Businesses also may carry forward up to 100 percent of net operating losses for 15 years, earn sales tax credits on up to $20 million in annual purchases of qualified manufacturing equipment, and benefit from favorable expensing rules for depreciable property. Lenders can deduct the interest paid by businesses in the zones.
Supporters of EZs want to preserve all the tax benefits of the zones, but most of the attention and controversy is focused on the hiring credit, which is the most lucrative. Under the governor’s proposal, a company that has qualified for the credit could lose all or part of it before being able to claim it. For example, an employer that has already claimed part of the $37,440 hiring credit for two years, but still has three years in which to carry forward the remainder and claim it, would lose the amount it planned to carry forward as of Jan. 1, 2011. In addition, employers would no longer be able to earn new hiring credits.

‘Bait and Switch Taxation’

Griswold told lawmakers the governor’s proposal amounts to illegal “bait and switch taxation.” The state has targeted a specific group—businesses that operate or may operate in the zones—and induced them with the program’s tax credits to engage in specific actions such as buying equipment or hiring employees on the promise that those credits would exist for 15 years. Revoking the credits would illegitimately revoke the promise upon which the businesses relied, he said.

When the businesses hire workers, buy equipment and earn the credits, those actions are the “consideration” with which they accept the state’s offer of a binding contract, he said.

The EZ credits are different from other credits, such as net operating losses that can be carried forward, Griswold told BNA after the hearing. Taxpayers do not enter into a contract with the state to lose money so they can have NOLs to carry forward, nor do they obtain NOLs with reliance on government plans to keep the NOLs in existence.

The EZ credits, however, are vested property because they “were earned in exchange for specific, substantial actions that you deliberately induced,” Griswold said in written remarks submitted to lawmakers, “and because those credits can be sold to others for cash. That is, they have value as soon as they are earned.”

The credits can be “sold” in the sense that a company that is a member of a unitary group of companies can give the credit to another member of the group. The group member that is given the credit must also be located in the enterprise zone and earn its income in the zone.

Lawsuits are certain to be filed against the state if the governor’s proposal is enacted, Griswold told lawmakers. Those lawsuits would come from companies that lose their credits, and from local governments that enter into 15-year agreements to operate the zones.

With litigation a certainty, Griswold cautioned lawmakers that projected savings from the proposal would be wiped out, harming the state’s fiscal health and possibly its credit rating.

Administration Believes Move Is Legal

Chamberlain with the Department of Finance told BNA after the hearing that the Brown administration sought legal advice from the Franchise Tax Board and Legislative Counsel before making the proposal to eliminate state EZ credits. Based on legal advice, the administration is confident the proposal would withstand a constitutional challenge, he said.

If lawmakers enact a budget that amounts to a compromise, eliminating only state EZ credits prospectively and allowing those with unclaimed credits to claim them until they are exhausted or expire, the revenue savings would diminish significantly, according to Chamberlain. If carryover credits can be used, state revenue would increase by $145 million in the current fiscal year of 2010-11, instead of $343 million, and would increase by $250 million instead of $581 million in fiscal year 2011-12. In other words, allowing taxpayers to use earned credits leaves only 43 percent of the total revenue in the governor’s proposal, Chamberlain said.

The Legislative Analysts’ Office, the nonpartisan fiscal adviser to the Legislature, which has been a vocal critic of the EZ program for several years, questioned the governor’s plan to void unused credits in their briefing for lawmakers Feb. 7.

“Businesses made decisions under the assumption the state would meet its credit commitment,” LAO said. “Voiding unused credits not only raises concerns about the state’s treatment of businesses that have such credits; it also could weaken incentives provided by other credits.”

LAO suggested that instead of voiding unused credits, lawmakers could suspend their use temporarily or limit the amount of net income they could offset in a given year.

EZs Should Be on Top of List, LAO Says

Despite LAO’s reservations about voiding existing credits, the office is one of several voices engaged in a fundamental disagreement about whether the EZ program is working.

LAO has been telling lawmakers for several years that the program does not create a net increase in jobs and should be eliminated. Although use of the program has grown dramatically, LAO noted that use “is not the same thing as effectiveness.” In 2008, about half of the hiring and sales tax credits went to businesses that had more than $100 million in assets. About 40 percent of those credits went to businesses with more than $1 billion in assets.

“There doesn’t really seem to be strong evidence supporting it,” Jason Sisney, LAO director of state finance, told lawmakers Feb. 7. “You should probably put it on the top of your list” of programs to cut.

LAO’s take on EZs is bolstered by a June 2009 study released by the Public Policy Institute of California. PPIC Associate Director of Research Jed Kolko, who authored the study, told the Assembly committee Feb. 7 the zones do not spur job growth.

“Enterprise zones on average do not increase employment,” Kolko said. In an examination of employment trends in the zones, PPIC found no difference in immediate or long-term job growth compared to similar areas without the zones.

Although some zones are more effective than others, the overall effect appears to only shift economic activity among different areas of the state, Kolko said.

Competing Study Says Zones Work

Countering PPIC and LAO is a November 2008 study by the University of Southern California and University of Maryland. Charles Swenson, professor at the USC Marshall School of Business and co-author of the study, told the Assembly committee that based on the study, EZs have several benefits: they create jobs, increase incomes, and reduce poverty and unemployment in the zones.

Swenson said his study shows EZs do not shift jobs, but that job creation is not the only measure of the success of EZs. Through the credits, companies have more money to invest in equipment, increase salaries of existing employees, and otherwise improve their business operations.

In addition to his position as a professor at USC, Swenson is a co-founder of the National Tax Credit Group, a consulting firm that helps companies claim credits available through state and federal programs such as the state EZ program.

Labor Unions Leading Opposition to EZs

Opponents of the zones are also becoming more vocal, to counter the business coalitions fighting to save the program. Labor unions, lead by the California Labor Federation and International Brotherhood of Teamsters, delivered “valentines” to lawmakers Feb. 14, calling on them to “Stop the Sweetheart Enterprise Zones.”

According to the unions, the incentives EZs provide to shift jobs from locations within California have resulted in the loss of union jobs.

Instead of creating jobs, the EZ program subsidizes “big, profitable corporations and a burgeoning industry of consultants who exploit the program for their own personal profit,” the unions said in a Feb. 14 news release.

The valentine to lawmakers included a sampling of marketing pitches on the web sites of various consulting firms that help employers claim EZ credits.

“You’d be surprised who qualifies for this program—the criterion is very diverse and not exclusive to any specific type of workforce,” stated The Enterprise Zone Company on its website. “In fact, top management positions can qualify as easily as manual laborers.”

“With the help of CTG, companies with no employees living in the Enterprise Zone are STILL eligible to recover thousands of tax dollars and gain the opportunity to offset some future liabilities as well,” claimed Cal Tax Group on its website.

“Enterprise Zones are the poster child for wasteful government spending,” California Labor Federation Executive Secretary-Treasurer Art Pulaski said in the Feb. 14 news release. “At a time when the state is considering devastating cuts to higher education and programs that are a lifeline for seniors and people with disabilities, eliminating this wasteful program should be a top priority.”

Lawmakers Expected to Act in Next Week

The Assembly and Senate budget committees are expected to take action on the governor’s budget proposals in the next week, with a goal of sending a final package to the floor of each house by early March. Brown is pushing lawmakers to enact his budget cuts by mid-March, to complement a ballot measure he is seeking on a special June ballot to extend three temporary tax hikes that are set to expire in July.

The fate of the EZ program is unclear, but a bipartisan list of lawmakers who represent districts that include EZs are strong supporters of the program. The legislators argue the program’s economic incentives are crucial to reviving the state’s weak economy.

Some lawmakers are working to shift the focus from eliminating EZs to reforming the rules for the program. Assemblyman V. Manuel Perez (D) has introduced three bills to reinvigorate debate about reforms to the program that were percolating in the 2010 legislative session but never reached the governor’s desk.

A.B. 231, A.B. 232, and A.B.X1 11, introduced Feb. 2, would make various changes to the program regarding their geographic boundaries, administration at the state and local level, and definition of qualified workers that would make employers eligible for the hiring credit. For example, A.B. 231 would eliminate from the hiring credit workers who qualified for the expired federal Job Training Partnership Act, or the state Greater Avenues for Independence Act of 1985. It would add recipients of Medi-Cal or Healthy Families, training services through the federal Workforce Investment Act, state welfare program, or federal Work Opportunity Tax Credit as newly hired employees who could trigger eligibility for the credit.

Assemblyman Luis Alejo (D), a co-author of the three bills, touted the EZ program and the need to shift the debate from elimination to reform of the program at a news conference Feb. 11 in the Salinas, Calif., zone.

“These bills that we have introduced are meant as a catalyst for changing the discussion from cutting the enterprise zone program to reforming it and making it more effective,” Alejo said.

Another hearing on the EZ program and other tax incentives is scheduled for Feb. 16 before the Senate Committee on Governance and Finance.

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