State Tax Loopholes Run From Odd to Enormous : Revenue: Reforming the web of contradictions could raise billions. But powerful interests oppose change.

California taxes the catheter used to clean your arteries during surgery but not the one used to drain your bladder afterward. It taxes fertilizer for flowers but not fertilizer for vegetables. It taxes the movie you rent from the neighborhood video store but not the movie an exhibitor rents to show at the neighborhood theater.

These are just a few of the loopholes that have left California with what one expert calls a tax code that “looks like Swiss cheese.”

Some of the breaks written into law are broad-based, costly and immensely popular, such as the $2.5 billion claimed by homeowners in mortgage interest deductions each year and the sales tax exemption for food, which saves shoppers $1.6 billion annually.

But others benefit only a narrow segment of taxpayers, among them the state’s most politically powerful industries.

Etched into law when many of the industries were fledgling or in need, these breaks have assumed the status of birthrights that business has been able to preserve--even as the state is devastated by huge budget shortfalls.

“If we closed loopholes . . . we would have more than enough money to meet our obligations--and we would be able to handle the next hit, which will be (military) base closures,” said Sen. Leroy Greene (D-Carmichael), chairman of the Senate Revenue and Taxation Committee. “There’s a very big chunk of money here. It’s in the billions.”

Actually, it’s in the hundreds of billions.

Over the last 15 years, Californians have enjoyed tax breaks worth at least $320 billion, according to an estimate by Greene’s committee. By comparison, about $608 billion was collected in sales, property and income taxes during the same period, according to the State Board of Equalization.

By far the biggest relief has been through Proposition 13, which has lowered property taxes by an estimated $195 billion since its passage in 1978. What with Proposition 13 and the myriad other exemptions for business, renters, heirs and senior citizens, California grants tax breaks amounting to about $40 billion a year--compared to an annual state budget of $52.1 billion.

Some examples:

* Hollywood has received a number of major tax breaks, including the right to lease its movies tax-free to California theaters. That exemption alone saves the industry $21 million a year--taxes that film officials say would drive up ticket prices, discouraging attendance by teen-agers and low-income patrons.

The movie industry secured another major break in 1988 when lawmakers exempted the studios from paying sales tax on the purchase of movie sets, sound effects tapes and other goods produced by independent contractors.

And for years, studios have enjoyed a big property tax break on their film libraries--which are assessed as depreciated rolls of used celluloid rather than as products that can be marketed over and over.

Hollywood’s influence has also made California one of the few major tourism destinations that does not impose a state admission tax on movies, sporting events or amusement parks, such as Disneyland.

* California’s banks benefit from a Depression-era constitutional amendment that prohibits cities from imposing the same kinds of taxes on financial institutions that they levy on other businesses.

Instead, banks are assessed a state “in lieu” tax that the Franchise Tax Board estimated yields $100 million to $190 million a year less than if they were to pay local business franchise and other corporate taxes.

Banking representatives say they do not believe those figures, adding that it is the purpose of the in lieu tax to make sure the industry pays its fair share.

* Overall, the alcoholic beverage industry has enjoyed such low rates of taxation that a 1990 national survey--the most recent available--ranked California 49th in the nation, ahead of only Wyoming, in the amount of tax assessed per thousand dollars of personal income, a widely used standard for comparing state taxes.

A ballot initiative aimed at raising taxes on wine in particular failed in 1990. But the proposition prompted vintners to volunteer for a 1,900% increase during the 1991 state budget crisis. California’s new tax rate is still the lowest among the 43 states that impose a tax on wine sales.

* Petroleum producers have long benefited from the fact that California is the only major oil-producing state without a severance tax on each barrel of crude pumped from native soil. Several attempts to impose a tax have been repulsed by the powerful oil lobby.

In theory, government should try to keep tax levels low by spreading taxation over the widest spectrum of people and businesses, experts say. Loopholes defeat this purpose by cutting taxpayers out of the base and indirectly raising the burden on those left behind to pay for schools, prisons, welfare and other government programs.

The origins of California’s honeycomb of loopholes are varied.

Voters have cut their own taxes through ballot initiatives such as Proposition 13 and last year’s measure repealing the so-called snack tax on crackers, chips and candy. The Legislature has passed dozens of special-interest tax bills. Court decisions have opened other loopholes.

The most obscure breaks, however, are those shaped through regulation. The guidelines implementing tax law are debated and approved--largely out of public view--by the state’s two taxing agencies, the Franchise Tax Board and the Board of Equalization. Both powerful and secretive, they make decisions worth thousands--if not millions--of dollars to the affected taxpayers.

Case in point: the state’s ostrich farmers, who failed three years ago to get a bill through the Legislature declaring the birds fit for human consumption--and thereby exempt from sales tax, like other farm livestock.

Undeterred, the farmers recently approached Board of Equalization member Ernest J. Dronenburg of San Diego, asking the board to accomplish the same thing by inserting “ostriches” into the regulation that lists the farm animals covered by the tax break.

Dronenburg said he agreed to help because the U.S. Food and Drug Administration recently approved ostrich meat as fit for the nation’s dinner tables.

Yet the move ruffled the feathers of some lawmakers, who viewed it as a political end run that would cost the state $3 million a year.

“It is difficult to imagine ostriches being used for food when 3-month-old birds are sold for $8,000 to $9,000 per pair,” Greene wrote to the board in May. “Even ostrich breeders admit that their commercial slaughter of ostriches for food is at least several years away.”

The board has put the tax break on hold.

Even loopholes opened with the best intentions can be confusing.

In 1962, the Legislature sought to ease the financial sting of human suffering by exempting prescription medicine from the sales tax.

Since then, the loophole has been amended 13 times to include wheelchairs, crutches, mammary prostheses, bone screws, artificial limbs, insulin syringes and vehicle modifications for people with disabilities.

Last December, the Board of Equalization widened the exemption again after an attorney representing the manufacturer of iron lung-type breathing devices wheeled two patients into a hearing and pleaded for the same tax treatment given oxygen masks. As the machines pumped away noisily, the board voted its approval.

Such piecemeal expansion has begotten taxing contradictions.

For instance, the sales tax law specifically exempts catheters that remove body waste but is silent on those used for other purposes. Thus, hospitals pay sales tax on tubing used during heart catheterizations but no taxes on similar tubing used to drain bladders.

There are similar dichotomies in the taxing of food-related goods. State law imposes no sales tax on fertilizer used for vegetables, a break used mostly by farmers but available to every consumer who knows to claim it. Yet sales tax is collected on the same fertilizer if it is used for inedible flowers.

Still, some tax experts say loopholes are useful. They can help the disadvantaged, promote societal aims, reward groups such as veterans, provide incentives to change behavior and make sure that the broad sweep of the tax code does not have unintended effects.

“The purpose of exemptions is to fine-tune the tax structure for social purposes . . . or for economic effects,” said David Doerr, a lobbyist for the pro-business California Taxpayers Assn. who helped write many tax breaks during his 24 years as an aide to the Assembly Revenue and Taxation Committee. “If you impose a tax and people can beat you 10 ways to one and you lose money, then it’s stupid.”

Doerr and others point to what happened after lawmakers in 1991 repealed the longstanding sales tax exemption for bunker fuel, the heavy oil sold to ships at deep-water ports. The Legislature had to beat a hasty retreat and restore the loophole a year later when the number of ships refueling in California dropped sharply and portside businesses suffered, he said.

So bunker fuel rejoined airline jet fuel as a tax-free energy source in California. Other transportation industry tax breaks include property tax exemptions for airliners under repair or grounded and for ships with a carrying capacity of more than 50 tons. In addition, trailers, semi-trailers and certain cargo containers are not taxed if they are sold to out-of-state buyers.

Some analysts and policy-makers are suspicious that many tax breaks amount to freebies for businesses that say they need incentives but would have made the targeted investments anyway.

One example, according to Assemblyman Johan Klehs (D-San Leandro), is the 40% tax credit for the purchase of recycling equipment.

The Legislature approved the credit as an inducement for firms to get into the recycling business, he said. But a recent study by the Integrated Waste Management Board found that two-thirds of the firms claiming the credit did not even know it existed before making their purchases.

Adds Board of Equalization Chairman Brad Sherman: “I’m in favor of negotiated tax breaks . . . with polygraphs. You bring in the entire board of directors, you hook them up and give them the tax breaks that only really matter.”

Even as it argued against raising taxes, Gov. Pete Wilson’s Office of Planning and Research noted in a 1992 paper that tax breaks distort the economy. “If any favoritism is shown in the tax code, it should be not toward specific companies or industries but toward activities . . . that will allow incomes to grow,” the report said.

Yet within the last month, Wilson has signed a number of bills giving sales tax breaks to manufacturers, poultry farmers and a company that hopes to launch commercial rockets.

Under California’s political structure, Klehs said, “interest groups basically rule” the tax system.

He cites two reasons. First, Proposition 13 requires a two-thirds vote of the Legislature to raise state taxes, but only a simple majority to lower them.

That allows special interests to stop any threats to their loopholes simply by organizing the support of a minority of lawmakers in either house of the Legislature, Klehs said. “And to open a new loophole . . . the interest group just goes out and gets a majority of both houses to do it and you’re stuck.”

The second reason, he said, is that the long shadow of Proposition 13 has made lawmakers quick to curry favor through tax cuts, especially for interest groups in their own districts.

One such example is Assemblywoman Andrea Seastrand’s measure intended help McDonnell Douglas win a contract to launch commercial telecommunications satellites from Vandenberg Air Force Base, located in her Santa Barbara County district.

To help McDonnell compete with the Russians, the Chinese and the French, the Republican legislator won approval for a bill exempting from sales tax the material used to build the company’s booster rockets--a saving for the firm of $1 million per launch.

California’s business community, one of the more powerful statewide interest groups, has won several major tax advantages since the mid-1980s:

* Multinational corporations helped change California’s controversial unitary tax, which based income taxes on a firm’s worldwide income. Now, companies can choose to pay taxes only on their U.S. activities--an option that lowers corporate tax payment by $340 million a year.

* Efforts in 1986 to reconcile state and federal tax law gave shareholders in private “Subchapter S” companies the ability to count business losses against personal income--producing savings, or a loss of state revenue, of more than $500 million annually.

The conformity efforts also allowed corporations to carry forward 50% of their operating losses. That provision is worth another $470 million annually in tax savings, but it has been suspended during the last two years because of budget constraints.

In crafting the operating-loss provision, the Legislature heeded requests from the Silicon Valley’s high-tech industry to make the tax change retroactive to 1985. That allowed computer firms such as Intel Corp. to take full tax advantage of large losses suffered at the hands of Japanese competitors.

Legislative deference to the tax preferences of favored industries long predates Proposition 13’s voting rules, said Jim Mills, Senate president pro tem in the 1970s and now chairman of the San Diego Metropolitan Transit District.

The state’s wine industry, Mills said, was protected from tax increases through the 1960s and ‘70s by the epicurean largess of its longtime lobbyist, a former assemblyman named Jefferson Peyser. A small, dapper man, Peyser would invite key lawmakers to his hotel suite across from the Capitol each night for a gourmet meal prepared by his personal chef. The repast, of course, always included California wines, which were ceremoniously poured for the grateful pols.

“It was money well spent,” said Mills. “They had the same message as now: California wines are in a competitive market, and if you raise the price, you will destroy this wonderful industry.”

The petroleum industry also had enormous clout, he said, because it lavished money on political campaigns and employed such lobbyists as Al Shults, who played poker and went hunting with key lawmakers while he represented major oil companies between 1955 and 1986.

Former Gov. Edmund G. (Pat) Brown ran into the oil industry’s political buzz saw when he proposed a 2% severance tax as part of his historic 1959 tax package to build up California’s freeway, university and water systems.

Everything passed the Legislature--except the oil severance tax.

Calling it a “temporary victory over the people,” Brown issued a blistering statement predicting that the industry’s arrogance would backfire.

“I wonder whether the oil industry really feels that it can continue to pay less than its proper share of the costs of state government while everyone else is taking on an added burden,” Brown said. “I wonder how the oil industry thinks the rest of us in California react to so selfish an attitude. . . . I predict that the oil industry’s lobbyists have won a minor victory that is the forerunner of a series of major defeats.”

He was wrong. The industry repulsed another severance tax measure in the early 1980s. Currently, it is fighting what appears to be a successful battle against a bill by Assemblyman Burt Margolin (D-Los Angeles) to impose a 6% severance fee--a tax that would yield about $100 million a year.

Texas charges a 4.6% severance tax, Alaska 15% and Louisiana 12.5%. But industry officials say there are good reasons why California should remain the only petroleum-producing state without a tax.

Other corporate taxes in California, they say, are higher. And the crude pumped from the Golden State is heavier and costly to refine, with costs ranging up to $10 a barrel compared to $4 for the same amount of West Texas crude, they say.

Among those fighting the tax is Atlantic Richfield Co., the Los Angeles-based oil giant regarded by many as a dominant player in state tax politics.

Arco flexed its muscle last year when it led all companies by contributing $643,600 to help trounce Proposition 167, the so-called tax the rich initiative that sought to close major corporate loopholes and raise taxes on business real estate and income. Opponents argued that tax hikes were the last thing California needed during a deep, enduring recession.

Among the measure’s provisions? An oil severance tax.

Following Arco’s lead, oil companies gave 25% of the $10.5 million that the business community raised to defeat the measure--the most spent by any one side on a November ballot measure, according to secretary of state records.

“Taxes are an important part of our legislative agenda, because we are the second-largest corporation in the state and they can adversely affect us in a substantial way,” said Doug Elmets, Arco’s manager of California government relations.

Smaller industries have won tax benefits, too.

Rather than paying conventional property taxes, racehorse owners are assessed a tax ranging from $12 for non-producing brood mares to $1,000 for stallions. The owners save millions of dollars each year; the tax has not been increased since 1972.

Times researcher Nona Yates contributed to this story.

A Loophole Lexicon

Incentive, loophole or tax “expenditure”?

All of these terms describe a tax break. The one you pick depends largely on whether you’re the beneficiary--or a critic. Here’s a guide for the perplexed:

* Tax Relief. A term favored by beneficiaries, who say tax breaks or reductions stimulate economic activity or prevent job loss.

* Incentive. A tax benefit designed to boost economic activity or aid business.

* Loophole. A term that emphasizes the idea that the beneficiary is escaping taxes others must pay.

* Tax Expenditure. A decision by government to forgo tax revenues in order to further some policy aim.

* Exclusions. Income taxpayers do not have to count when figuring their taxes.

* Exemptions. The amount of tax not paid on a transaction, sale or privileged economic activity.

* Deductions. Expenses tax payers can subtract from gross income when figuring their final tax bill.

* Credits. More valuable to poorer taxpayers, an amount the taxpayer can deduct directly from his final tax bill. Although this is typically smaller in size than a deduction, a credit has a more dramatic and direct effect.

Whatever the form, here are the biggest tax breaks among the $20.1 billion in annual tax expenditures, based on 1992-93 budget figures as outlined by the Commission on State Finance: Personal income tax deduction for home mortgage interest expense: $2.5 billion Personal income tax exemption for employer contributions to pension plans: $2.4 billion Personal income tax exemption for employer contributions to health plans: $1.8 billion Sales tax exemption for groceries: $1.6 billion Sales tax exemption for utility costs: $1.6 billion Standard income tax deduction for those who do not itemize deductions: $700 million Bank and corporation tax reduction for special partnerships: $700 million Capital gains exclusion on home sales: $600 million Income tax deduction for charitable contributions: $600 million Exemption of Social Security benefits from state personal income taxes: $600 million Tax Breaks or Growth Tonics?

Here are some of the more unusual loopholes in California’s tax code.

MEDICAL

* Sales tax is not charged on surgical stitches but it is charged on bandages.

* Medical clinics don’t have to pay property taxes on the blood or body parts they store.

* Oxygen masks used in the hospital are taxed but oxygen masks used by a patient at home are not.

* Heart pacemakers used for infants and hung nearby on their cribs are taxed, but those implanted directly in adults are not.

TECHNOLOGY / COMMUNICATION

* Sales of commercial satellites are tax free, since their transfer and use take place in outer space.

* Advertisers pay no sales tax on the junk mail they buy and have sent to homeowners.

* Custom computer programs, typically used by major corporations, are exempt from sales tax.

* UC San Diego’s Supercomputer Center pays no sales tax on purchases of its high-tech equipment.

MISCELLANEOUS

* Cemetery plots are not subject to property tax.

* Gold and silver bullion, as well as numismatic coins, can be sold tax free.

* The first $400 worth of foreign goods purchased abroad in a single month and hand-carried into California are tax free.

AGRICULTURE

* No sales tax is charged on livestock, feed, seeds for planting and fertilizer used for food production.

* Farmers and ranchers pay lower property taxes on land that might otherwise be assessed at higher rates because of development potential.

* No property tax can be assessed on newly planted vineyards or fruit groves.

ENTERTAINMENT

* Theaters don’t pay sales tax when they lease movies for exhibition.

* For property tax purposes, studio film libraries are assessed as depreciated rolls of used celluloid rather than on their value as prized assets that can be marketed indefinitely.

* Alone among major tourism states, California imposes no admission taxes at amusement parks.

* The recording industry pays no sales tax on the transfer of its master tapes.

FOOD AND DRINK

* There’s no sales tax imposed on airline meals.

* Breweries don’t have to pay alcohol tax on the beer their employees sample at work.

* Two-thirds of the money made by vending machines dispensing hot coffee, tea and hot chocolate is exempt from sales tax.

TRANSPORTATION AND SHIPPING

* No gas tax is charged on airline jet fuel.

* No property tax is charged on an airliner under repair or grounded.

* Ships with a carrying capacity of more than 50 tons are exempt from property tax.

* Trailers, semi-trailers and certain cargo containers are not taxed if sold to out of state buyers.

* Sightseeing buses from out of state don’t have to pay gas tax when refueling in California.

* No property tax is assessed for the days private railroad cars are down for repair.

RACEHORSES

* Owners are assessed a tax ranging from $12 for a non-producing brood mare to $1,000 for a stallion rather than paying conventional property tax on the market value of their prized horses.