Hardly socialist, California offers the mother of all corporate tax breaks

Tax break image

California boasts the highest state marginal corporate tax rate in the country. For this reason, critics say the state is a bad place to do business.

But at least by one measure, California is the mother of all corporate welfare states. For years, the state has heaped billions of dollars of research and development tax credits on already cash-rich tech giants that neither need them nor even use them.

Normally, company must use their tax credits for that fiscal year or lose them. But under California’s scheme, the R&D tax credits never expire.

So if Apple earned $10 million in R&D credits for fiscal year 2019, the company can theoretically use that $10 million to trim its 2050 state tax bill.

Instead of using the credit, however, companies have only been stockpiling them. According to a report by the California State Auditor, companies held about $14 billion in unused R&D tax credits as of 2012. That’s more than the entire economies of Nicaragua, Mongolia, and Rwanda.

California’s tax credit bonanza shows how a program meant to stimulate innovation and create high paying jobs has essentially morphed into a huge corporate tax giveaway that only grows bigger and bigger every year. Yet we have no idea whether it really stimulates innovation or creates jobs in California. We don’t even know the identities of the companies that claim the credits or how much they get because the state refuses to release this information.

However, I was able to identify 5 major corporations in California (Alphabet, Nvidia, Salesforce, VMWare, and Edwards Lifescience) that claim but don’t use the California credit by analyzing documents filed with the Securities and Exchange Commission.

In 2018, Alphabet, the parent company of Google, reported it held an astonishing $2.4 billion in unused credits, about 5 times the number of credits it held 5 years ago.

“Alphabet has this get out of jail free card, this billion dollars of credit that it can apply in any year in which all of the other tax maneuvers don’t work out and they’re stuck with a big tax liability,” said Daniel Wilson, a researcher with the Federal Reserve Bank in San Francisco.

Moreover, Alphabet said in its filings that it probably will never use the credit, probably because it doesn’t need the money: last year, Alphabet generated $30.74  billion in profits.

Nvidia, which makes graphics chips, reported $687 million in unused credits last year, compared to $358 million in 2013. In that same period, Salesforce’s unused credits rose to $281 million from $68.1 million.

VMWare’s unused credits increased to nearly $200 million from $79 million in 2014. Edwards Lifescience saw its credits jump to $106 million last year versus $46.6 million in 2013.

Unused credits still have big impact– for both company and taxpayers

Even if the companies don’t use their credits, they still carry significant value. Shareholders like tax credits because they see them as financial assets— the more assets a company has, the more valuable they become. In other words, it’s always better to have tax credits than not. There’s no downside, only upside.

Accumulating tax credits at least gives the appearance that the company is, in fact, innovating. Presumably, companies must document and justify the R&D expenditures to the state’s Franchise Tax Board. But companies generally don’t publicly disclose state tax data because they have successfully argued that such information is confidential and proprietary.

For the state, however, those unused tax credits still represent a massive financial liability on its books.

In any case, plenty of companies use them: the program cost taxpayers about $1.5 billion in 2012, the largest corporate tax break in California.

Yet we have absolutely no idea if the program is working.

“Because no state entities oversee or regularly evaluate the R&D credit, we found insufficient evidence to determine whether these tax expenditures are fulfilling their purposes,” the state’s auditor report said.

How did we get to this point?

Misguided attempt to stimulate innovation

In 1981, Congress passed the Economic Recovery Tax Act, which contained a tax credit to encourage companies to conduct research and development. At the time, the country was suffering the worst economic downturn since the Great Depression. The unemployment rate soared to as high as 11 percent. Goods producers, including manufacturers like auto makers, accounted for 90 percent of all job losses in 1982.

Congress concluded that a big tax credit could “overcome the reluctance of many ongoing companies to bear the significant costs of staffing and supplies, and certain equipment expenses such as computer charges, which must be incurred to initiate or expand research programs in a trade or business,” according to the recovery act.

Following Congress’ lead, California passed its own tax credit in 1987 specifically for companies to conduct R&D in the state.

Here’s where things start to go awry. The economy has changed a lot since the 1980s, from one that relied heavily on manufacturing to today’s focus on technology and services.

Manufacturing is an expensive business since companies must spent a lot of money on big capital purchases like building a plant or buying machines. Computers were very expensive 40 years ago and not very common. Therefore, it made sense to craft a tax credit that would help companies recoup some of their costs in order for them to expand into new markets.

But advances in computing and the emergence of the Internet in the late 1990s meant companies could expand at much lower costs because creating and updating software is inherently much cheaper than buying and maintaining machines.

Entrepreneurs in Silicon Valley like Mark Zuckerberg of Facebook and Sergey Brin and Larry Page at Google could launch startups that have rapidly become the most valuable companies in the world, worth several hundreds of billions of dollars each.

At the same time, companies have moved their manufacturing operations overseas to developing countries with lower labor costs. But even as manufacturing declined in the United States, the R&D tax credit continued to grow, this time with large technology firms like Apple, Oracle, Hewlett-Packard, and Alphabet joining the fray.

Over the past three decades, California has made its R&D tax credit more and more generous. Today, companies can take a 15 percent credit against “qualified research” compared to 8 percent in 1987.

“The state is losing tax revenue on something that companies don’t even need or use,” said Gonzalo Freixes, a professor of accounting and associate dean of executive MBA programs at UCLA Anderson School of Management.

But the program shows something more fundamentally wrong with our country. We seem to think that giving corporations more money, rather than pay teachers, invest in libraries and higher education, and upgrade our highways and bridges, will jump start the economy and promote innovation.

In fact, President Trump touted his $1.1 trillion tax cut, which includes a sizable reduction to corporate tax rates and a generous federal research and development tax credit, would induce companies to invest in technology and people. So far, companies have used their windfalls to pay out dividends and buy back stock.

Better ways to use the money

So instead of giving $14 billion in R&D tax credits to companies that don’t even use them, why not give $14 billion to fixing highways or bridges? Or provide additional support to the University of California system, which has seen its share of the state’s general fund fall from 5.09 percent in 1980 to 2.76 percent in 2011? Investment in infrastructure improvements and education will do a lot more to promote innovation in the long run than corporate tax breaks.

“What is something that’s more effective, that will give us a better return?” said Annette Nellen, a professor of accounting and director of the Master’s degree program in taxation at San Jose State University.

However, I’d also argue that this corporate largess has hurt innovation by making companies fat and complacent. After all, when you know your R&D tax credits will never expire, why work with any sort of urgency or take any risks?

According to a recent report by CB Insights research firm, 78 percent of corporate innovation portfolios focus on incremental innovation instead of disruptive risks.

“Despite deep fear and talk of disruptive, companies invest in the small stuff,” the report said. “Continuous innovation — iterating on the status quo rather than on disruptive risks — is the primary type of innovation companies pursue. This includes enhancing existing products/services, cutting costs, and efforts focused on productivity.”

In other words, the kind of innovation that will boost quarterly results instead of change the industry.

Anne Marie Knott, a professor of strategy at Washington University’s Olin School of Business in St. Louis, recently analyzed the performance of publicly traded companies since 1972, measuring productivity by comparing increases in R&D spending with increases in annual revenue.

She found that corporate returns on R&D spending actually declined 65 percent.

So even as states shower companies with tax goodies, they don’t seem to getting a lot of bang for our bucks.

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