Governor Gray Davis’ proposed two-year suspension of the net operating loss (NOL) deduction is an ill-advised change that would have a damaging effect on the California economy and should be rejected by the Legislature as a means for raising revenue to balance the state’s budget.

While initially thought to be a change in law requiring only a majority vote, and therefore a much easier road to raising revenues, the draft proposal has been keyed a two-thirds vote by the Legislative Counsel as required by the Constitution for changing state tax law for the purpose of raising revenues.

California businesses (both large and small) pay and report income tax based on an arbitrary 12-month period. Many businesses, however, experience wide swings in their income year-to-year for which a 12-month reporting period for paying taxes does not fairly correlate investment expense with return on that investment in the form of income. This is particularly true for start-ups, and in the high-tech and agriculture sectors, but true for most industries. Without recognition of a NOL deduction, a company that invests heavily one year (for example in plant and equipment, research and development, and/or employees) but doesn’t see a return on that investment until a year or years into the future will be penalized by a tax system that taxes only profits without recognition of those early years of investment. A tax structure without the NOL is imbalanced and actually penalizes and discourages risk and investment.

Without the NOL, when one business with a smooth history of income is compared with a like-sized business with large swings in gains and losses, it is clear that the business with wide swings in income pays more in tax than the business with consistent streams of income. Not having an NOL is not just unfair; it’s bad for the economy because it stifles risk and investment and punishes those companies struggling to earn a profit and contribute to our economic prosperity.

For example, Company A earns $1 million every year. Company B incurs a loss of $1 million in year one and earns $3 million in year two. Both companies have net income of $2 million over the two years. But if NOL carry-forward is not permitted, Company B pays tax on $3 million while Company A pays tax on only $2 million.

Under federal law, a taxpayer which incurs an NOL may carry-forward that loss to offset future income for 20 years and even carry-back that loss to two prior years. California, unfortunately, has never fully conformed to federal law on the NOL. Under California law, taxpayers are permitted to carry forward only a fraction of their losses (50% for years prior to 2002, 60% for 2002 and 2003 and 65% for 2002 and thereafter – called "the California haircut") and for only 10 years and cannot carry back at all (until recently only a 5 year carry-over was permitted). Repeated attempts by California taxpayers to at least conform to the carry-forward provisions of federal law have always been met with concerns over lost revenue (even during times of multibillion-dollar surpluses).

The NOL carry-forward is not a "tax break" or in any way an incentive for businesses to engage in a particular manner to boost economic activity. The NOL is an integral part of a fair tax system that treats fairly businesses that have cycles which exceed the artificial one-year tax reporting period. Suspending it, even for two years, means that California business who have incurred losses (thus already feeling the damaging effects of the down turn in the economy) will suddenly be faced in income tax liabilities where they once would not.

If the massive surpluses of the 1990s have taught us anything, it should be that an expanding California economy produces expanding revenues for the state of California. Promoting economic growth should be the goal. Suspending the NOL does just the opposite. It impairs companies trying to get off the ground. It discourages risk and investment. It makes doing business in California that much less attractive, not simply because it adds to the already exorbitant costs of operations here, but because it screams of unfairness and injustice to the methods by which California requires business to pay their taxes.

California is already alone among federal and state tax systems in allowing only a 60% carryover of a net operating loss. We should not enhance our anti-business distinction by suspending the NOL altogether.