State Budget

Governor’s Proposal Would Limit Use of NOLs for All Tax Years, Budget Committee Told

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Governor Gavin Newsom’s budget proposal to increase business taxes by limiting the utilization of net operating loss deductions is more extensive than described in the governor’s budget summary and would limit utilization for all tax years, according to testimony from the Department of Finance and the Legislative Analyst’s Office during a January 23 hearing of the Senate Budget and Fiscal Review Committee.

Detailed language of the proposal has not been released, so the public relied on the administration’s budget summary, which stated that the NOL change would “conform state law to federal law by limiting NOLs that are carried forward from prior years to 80 percent of any subsequent year’s net income, joining the majority of states in restricting NOL usage to 80 percent or less of taxable income.”

Legislative Analyst Gabe Petek, however, characterized the proposal as limiting taxpayer utilization of NOLs carried forward for years before The Tax Cuts and Jobs Act, suggesting that the proposal is not in true conformity with federal law.

During the committee hearing, Senator Roger Niello asked a representative from the Department of Finance for clarification.

“With regard to the net operating loss carryover proposal, is that in any way intended to be retroactive, or will it be effective in the budget year, meaning 2023, 2024, and beyond?” Niello asked.

Department of Finance representative Colby White responded that the proposal “is not retroactive in any way.”

“It is effective for taxable years beginning on or after January 1, 2024,” White said. “So, when a corporation files their tax return for 2024 or later, NOLs they had earned or any NOLs they earned in the past, they can use all their NOLs but only up to 80 percent of their taxable income, so they can’t fully offset.”

“Senator Niello, regarding your question, you mentioned the net operating loss proposal, which the administration describes as conformity to the federal law,” Petek said. “That’s true to an extent. But one thing we do point out is that under the federal law, those net operating losses that accrue began after 2017 are eligible for this. But the administration’s proposal is to encompass all the net operating losses from years before 2017. So, in that sense, it is not conforming strictly with federal law.” (CalTax: Under the Tax Cuts and Jobs Act, NOLs accrued before 2018 were not affected, but TCJA applied to those from 2018 and beyond.)

The language for the governor’s NOL proposal and the rest of his budget has not yet been released. The language will be subject to negotiation and changes as it moves through the Legislature.

The Assembly Budget Committee and Senate Budget and Fiscal Review Committee both held no-vote hearings January 23 to discuss Newsom’s budget proposal and take testimony from administration representatives and the legislative analyst. During the hearings, several lawmakers expressed concern over spending reductions, and some advocated for tax increases.

The governor’s budget, released January 10, proposes state spending of $291.5 billion, down 6.2 percent from the $310.8 billion budget enacted last summer. The governor projected a $37.9 billion deficit for the 2024-25 fiscal year – significantly lower than the $68 billion projected by the legislative analyst – and proposed bridging this gap through fund shifts, spending delays, withdrawals from state reserves, and a relatively small amount of targeted tax increases, including the NOL proposal and elimination of bad-debt deductions for non-retail lenders.

“I have concerns about some of the strategies proposed in the governor’s January budget,” Assembly Member Jesse Gabriel, newly appointed chair of the Assembly Budget Committee, said. “Particularly cuts that could undermine our ability to meaningfully address California’s housing and homelessness crisis.”

Republican members of the committees urged their colleagues to express restraint when crafting this year’s budget, noting that spending has grown exponentially over the last four years.

“Whether the deficit is $40 billion or $68 billion, California has a massive deficit, and we have our work cut out for us,” Assembly Member Vince Fong stated. “Such a massive deficit demands prudence and accountability. Unfortunately, in my opinion, the governor’s proposal does not rein in spending adequately.”

Erika Li, chief deputy director at the Department of Finance, testified to both committees that the governor’s proposal represents a “normalization to revenue patterns in line with pre-pandemic revenue years.” Li testified that spending would be $19.3 billion lower than last year’s enacted budget, primarily driven by deferring spending into future years, as opposed to cutting the spending entirely.

Fong expressed concern over the spending delays.

“There is about $37.9 billion of action to address the deficit, but in my reading, there is only $1.2 billion in actual spending reductions,” Fong said. “The rest comes from tapping the rainy day fund, one-time borrowing, deferrals, and other cost shifts.”

Li said Fong’s assessment is correct, but the administration will consider permanent spending reductions if revenue collections continue to fall short of projections.

Li remarked that the difference in deficit estimates between the Department of Finance and Legislative Analyst’s Office is attributable primarily to differing short-term revenue projections. Both agencies project that the state will face a deficit of around $30 billion annually for the next three fiscal years.

Petek urged lawmakers to remain cautious about approving new spending, because revenue collections remain weaker than the governor’s projections.

“The Department of Finance anticipates that general fund revenues will increase 8 percent in the current fiscal year, but we do not see a basis for that,” Petek said. “Historically, that is not what happens. Historically, when you see a large decline in revenues, it will persist, and you will see some stagnation for a year or two after. … In addition to that historical experience, that is not what cash collections are telling us so far this fiscal year. So far, cash collections are lining up with a lower trajectory than what the department estimates.”

Petek remarked that the Legislature should consider rejecting spending delays because they would exacerbate deficits in future fiscal years.

“We have $30 billion of deficits in each of the subsequent three years, so the budget challenges are not just the upcoming year, but the years ahead,” Petek said.

Assembly Member Alex Lee said that rather than reducing spending, the state should increase taxes on high-income residents and corporations, including a “wealth tax on billionaires, restoring the corporate tax rate before Trump, or other tax breaks where we are shelling out money to corporations and rich people, because those things still exist in this budget.”

Senator Brian Dahle asked whether the departure of businesses and high-income earners from the state is having an effect on California’s revenue.

“Businesses are leaving the state,” Dahle said. “We have seen Hewlett Packard, Oracle, they’re leaving. Those are high-wage companies, and they’re leaving the state …,” Dahle commented. “We’re not going to get out of this anytime soon unless we figure out how to keep businesses here that pay taxes, and high-income earners that pay taxes.”

Petek responded that his agency has noticed a trend in high-income residents leaving California, but he doesn’t know how much of an effect this has on revenue. The analyst said lawmakers shouldn’t dismiss the concern over the departures.

Budget subcommittees will begin to hold oversight hearings on individual spending items in late February or early March, according to Senator Nancy Skinner, chair of the Senate Budget and Fiscal Review Committee.

Budget negotiations typically accelerate after the governor releases a revised budget in mid-May, although Newsom and legislative leaders have approved several “early action items” in recent budgets.