State and Local Tax Considerations in Electric Industry Restructuring

Transcription

1 RESEARCH TRIANGLE INSTITUTE September 1999 State and Local Tax Considerations in Electric Industry Restructuring Volume 1 Task 3 Final Report Prepared for Legislative Study Commission on the Future of Electric Service in North Carolina 300 N. Salisbury Street Suite 545 Raleigh, NC Prepared by Research Triangle Institute Center for Economics Research Research Triangle Park, NC RTI Project Number Cornwallis Road Post Office Box Research Triangle Park, North Carolina USA

2 RTI Project Number State and Local Tax Considerations in Electric Industry Restructuring Volume 1 Task 3 Final Report September 1999 Prepared for Legislative Study Commission on the Future of Electric Service in North Carolina 300 N. Salisbury Street Suite 545 Raleigh, NC Prepared by Research Triangle Institute Center for Economics Research Research Triangle Park, NC 27709

3 Acknowledgments Robert L. Peace, Professor of Accounting, Charles R. Knoeber, Professor of Economics, at North Carolina State University, and Allen K. Miedema and W. Brad Eccles at Research Triangle Institute (RTI) were primary contributors to this report. Tax experts at the Research Division and Fiscal Research Division of the Legislative Services Office of the North Carolina General Assembly, the North Carolina Department of Revenue, the North Carolina League of Municipalities, the North Carolina Association of County Commissioners, and the electric utilities provided critical tax data and commentary on tax issues. Steven J. Rose and Esther E. Manheimer of the Study Commission provided substantial guidance on legal issues and careful editorial review. Other contributors at RTI were Sheryl C. Cates, Stephen A. Johnston, and Tikku Verghese. iii

4 Contents Executive Summary E-1 1. Introduction Taxes Paid by North Carolina s Electric Utilities Corporate Income Tax Property Tax Gross Receipts Tax Sales Tax on Electricity Sales and Use Tax on Purchases Summary Issues Affecting Future North Carolina Tax Revenues Future Electricity Prices Stranded Costs Nexus Other Issues Method of Stranded Cost Recovery Competition Start Date Length of Transition Period Writeoff of Regulatory Assets Tax Discount Rate v

5 4. Potential Impacts on Tax Revenues: Quantitative Estimates Tax Policy Options Option 1: No Change Option 2: Allow Stranded Cost Recovery Option 3: Change Tax Rates Option 4: Restructure Existing Taxes Conclusions References R-1 Reports... R-1 Books and Articles... R-1 Personal Sources... R-3 Cases and Statutes... R-5 vi

6 Figures Figure 2-1 Figure 2-2 Figure 2-3 Summary of 1997 (CY) Electric Utility Tax Remittances in North Carolina, By Type of Tax Summary of 1997 (CY) Electric Utility Tax Remittances in North Carolina, By Source North Carolina Counties with the Highest Percentage of Tax Receipts from Electric Utility Property Taxes in 1997 (CY) Figure 4-1 Figure 4-2 Figure 4-3 Figure 4-4 Figure 4-5 Changes in Aggregate North Carolina Tax Remittances by Electric Utilities under Alternative Policies Changes in North Carolina Sales and Gross Receipts Tax Remittances by Electric Utilities under Alternative Policies Changes in North Carolina Income Tax Remittances by Electric Utilities under Alternative Policies Changes in North Carolina Property Tax Remittances by Electric Utilities under Alternative Policies Changes in Tax Remittances During and After the 5-Year Transition Period: Retail Competition for the Period vii

7 Tables Table 2-1 Sources of North Carolina Tax Remittances Table 2-2 Recipients of North Carolina Taxes Table 2-3 Summary of 1997 (CY) Electric Utility Tax Remittances in North Carolina ($million) Table 2-4 Distribution of 1997 (CY) Electric Utility Tax Remittances to North Carolina Government Entities ($million/%) Table 2-5 Percentage Share of 1997 (CY) North Carolina Tax Receipts Derived from Electric Utility Tax Remittances Table 4-1 Table 4-2 Table 4-3 Table 4-4 Changes in North Carolina Taxes Remitted by Electric Utilities: Retail Competition for the Period Percentage Changes in North Carolina Taxes Remitted by Electric Utilities: Retail Competition for the Period Changes in Total Tax Receipts, By Government Entity: Retail Competition for the Period ($million) Percentage Changes in Total Tax Receipts, By Government Entity: Retail Competition for the Period viii

8 Executive Summary This report describes how retail competition in the electricity industry may affect the tax revenues of state and local government in North Carolina. In particular, we examine the potential effects of retail competition on North Carolina tax revenues for each of the following four taxes: Z corporate income tax, Z property tax, Z gross receipts tax, and Z sales tax. Altogether, remittances of these four taxes by electricity suppliers accounted for about $634 million in 1997 tax revenues in North Carolina. Roughly one-third of this total was from the gross receipts tax, slightly less than one-third was from the sales tax, and about one-sixth each was from property and corporate income taxes. Those revenues are ultimately spent by all three levels of North Carolina government, accounting for about 3.25 percent of total state tax revenues, 2.25 percent of county tax revenues, and 6.9 percent of municipal tax revenues. In Volume 1, we review all North Carolina taxes that may be affected by retail competition and provide our quantitative estimates of potential changes in tax revenues for the same set of assumptions that we used in our companion reports on stranded costs and benefits and detriments. We refer to this set of assumptions as the reference case, and this is consistent with other RTI reports to the Legislative Study Commission on the Future E-1

9 State and Local Tax Considerations in Electric Industry Restructuring of Electric Service in North Carolina ( Study Commission ). The key elements of the reference case are as follows: Z start date of retail competition = January 1, 2004 Z benchmark market-clearing price of power under competition = intermediate estimate as reported in Stranded Cost Estimates for a Restructured Electric Utility Industry in North Carolina, Volume 3 Task 4 (RTI, 1999) Z discount rate = cost of equity for investor-owned utilities (IOUs), cost of debt for other utilities used to compute the discounted present value of annual stranded costs Z capital additions to preserve capacity and efficiency ratings of existing generation are included as potential stranded costs All projections of tax revenues in this report cover the period from the assumed start date for competition through The Executive Summary of Volume 2 presents an intuitive summary of the modeling techniques and assumptions used in our projections of tax revenue changes; the remainder of Volume 2 describes our modeling approach at a more technical level that requires familiarity with the logic and algebra of microeconomic theory. To avoid confusion and to keep our presentation simple, we have presented quantitative results only for the reference case. However, our model is capable of producing a full set of alternative tax projections for a wide variety of alternative assumptions. Throughout this report we have focused solely on the prospective changes in tax revenues from electricity suppliers due to retail competition. We have not attempted to estimate changes in taxes that could be attributed to changes in the number and type of jobs or facilities in North Carolina due to changes in electricity prices. These secondary effects would tend to reduce our estimates of tax losses. Certain restructuring options could also affect tax revenues. For example, in our report, Policy Options for North Carolina s Municipal Power Agencies (RTI, 1999), we discussed Divestiture and Dissolution options. Both would involve the transfer of assets from entities that are exempt from certain taxes to others that may not be exempt. For example, IOUs could acquire properties now held by the municipal power agencies (MPAs) and begin paying taxes that are not paid by the power agencies. Such a transfer E-2

10 Executive Summary could reduce the tax losses discussed in this report, since we assume no ownership changes for this analysis. E.1 ISSUES AFFECTING FUTURE NORTH CAROLINA TAX REVENUES The two most important policy decisions affecting North Carolina tax revenues are those relating to the recovery of stranded costs and the establishment of nexus. Therefore, we have considered tax revenue consequences under all four possible outcomes regarding these issues. These outcomes constitute the four policy cases that we review in this report and detail for our modeling approach in Volume 2: Z Case 1: No Nexus, No Recovery of Stranded Costs Z Case 2: Nexus, No Recovery of Stranded Costs Z Case 3: No Nexus, Recovery of Stranded Costs Z Case 4: Nexus, Recovery of Stranded Costs All projections of tax revenues in this report assume that tax policies in North Carolina remain unchanged, except for the establishment of nexus. However, as discussed further below, several tax policy changes could be implemented to offset any tax losses. Stranded cost recovery decisions can affect North Carolina tax revenues in three significant ways. First, the aggregate amount of stranded costs significantly affects the difference between current electricity prices and competitive prices, so the amount of stranded costs affects the amount of potential price reductions under competition. Those price changes significantly affect electricity revenues and, hence, revenue-based tax proceeds. Second, stranded costs may affect property tax revenue because of the way in which utility property is appraised for tax purposes, as discussed in Section 2.2. Third, the state s decision on the recovery of stranded costs would have critical tax revenue implications, because stranded cost recovery payments are presumed to be taxable. Therefore, recovery of stranded costs would automatically offset part of the tax losses that would otherwise occur during the transition period. E-3

11 State and Local Tax Considerations in Electric Industry Restructuring Retail competition would likely introduce new electricity suppliers to North Carolina, some of them located in other states. Whether these out-of-state providers will be liable to pay North Carolina taxes remains an issue, generally described as the nexus issue. Nexus refers to the authority of a state to levy taxes on any out-ofstate seller, historically based on physical presence (that is, an outof-state provider s having sufficient property, employees, or other presence in a state to justify taxation). However, an exact legal definition of physical presence has not been established for the purpose of taxing electricity sales. As detailed in Volume 2, the existence of nexus would affect the competitive price of electricity and, therefore, the amount of stranded costs. As a result, revenues from the gross receipts tax, sales tax on electricity, and corporate income tax would be higher with nexus than without it. Therefore, North Carolina has an obvious incentive to establish nexus or to implement alternative tax policies that have the same effect as nexus. Table E-1 summarizes the potential impact of retail competition on North Carolina tax revenues for each of the four cases we considered in this report. We assume that stranded cost recovery payments are taxable, so income taxes and sales and gross receipts taxes increase when stranded costs are recovered. For all taxes, the smallest negative effects occur when both nexus and stranded cost recovery are assumed to exist. Table E-1. Percentage Change in North Carolina Taxes Remitted by Electric Utilities: Retail Competition for the Period a Potential Change in Tax Remittances (%) Case b Gross Receipts Tax Sales Tax on Electricity Corporate Income Tax Property Tax Total Case 1: No Nexus, No Recovery 18.22% 18.22% 30.3% 10.71% 18.7% Case 2: Nexus, No Recovery 10.88% 10.88% 10.97% 2.71% 8.95% Case 3: No Nexus, Recovery 9.98% 9.98% 9.39% 10.71% 10.01% Case 4: Nexus, Recovery 6.14% 6.14% 5.66% 2.71% 4.82% a Percentage changes in the discounted present value of annual tax remittances. b Recovery refers to stranded cost recovery. E-4

12 Executive Summary The effect of competition on the aggregate revenue from all four types of taxes will likely vary significantly from one policy case to another, although we project that total tax revenues will decline in all cases. Without nexus or stranded cost recovery (Case 1), total North Carolina tax revenues from electric utilities may decline by nearly 19 percent; with nexus and stranded cost recovery (Case 4), tax revenue losses are substantially reduced (to about 5 percent). Because sales and gross receipts taxes account for almost two-thirds of taxes remitted by electric utilities, they also account for most of the projected tax losses. They account for 70 to 90 percent of the projected aggregate tax revenue losses depending on the policy scenario. The projected percentage losses are identical for these taxes because both are collected as a percentage of electricity revenues. The projected percentage changes in tax revenues from one policy to another are greatest for the corporate income and property taxes. In fact, establishing both retail competition and nexus may increase property tax revenues as shown in Table E-1. Essentially, this increase would be due to increases in the market value of existing North Carolina generating plants, as competitive electricity prices begin to rise above the plant costs that utilities could otherwise recover in the prices charged under regulation. Table E-2 summarizes the potential impact of retail competition on North Carolina tax revenues by government entity. As shown in Table E-2, municipalities are likely to suffer the highest proportionate tax revenue losses under retail competition because of the impact on property taxes and municipal proceeds of gross receipts tax collections. In this model, projected changes in county tax revenues are strictly dependent on changes in property tax proceeds, and thus (like property taxes themselves), are assumed to be unaffected by stranded cost recovery. Any county-level tax revenue impacts from property tax reassessments will be widespread. Counties that depend more heavily on utility property taxes, especially counties that have a large apportionment of the assessed value of utility properties, and counties that are served by utilities with large stranded costs, may experience much greater than average effects due to these reassessments. Finally, tax revenues to the state of North Carolina are projected to decline by E-5

13 State and Local Tax Considerations in Electric Industry Restructuring Table E-2. Percentage Change in Total Tax Receipts, By Government Entity: Retail Competition for the Period a Case b Municipal County State Case 1: No Nexus, No Recovery 1.17% 0.24% 0.75% Case 2: Nexus, No Recovery 0.59% 0.06% 0.38% Case 3: No Nexus, Recovery 0.70% 0.24% 0.34% Case 4: Nexus, Recovery 0.32% 0.06% 0.21% a Percentage changes in the discounted present value of annual tax receipts. b Recovery refers to stranded cost recovery. about 0.8 percent, 0.4 percent, 0.3 percent, and 0.2 percent for Cases 1 through 4, respectively. E.2 TAX POLICY OPTIONS If retail competition reduces electricity prices in North Carolina and there are no changes in tax policies, there will be commensurate reductions in state and local tax bases. Several tax policy options are available to lawmakers: Z no change, Z allow stranded cost recovery, Z change tax rates, and Z restructure existing taxes. The relative attractiveness among these options depends on the resolution of the nexus issue. We have projected that average electricity prices are likely to decline under retail competition. Unless the state implements offsetting tax policies, revenues from electricity-related taxes are also projected to decline due to the loss of dollar sales (see Section 4). Thus, even though the state does have the option of leaving current tax policies in place, the likely consequence is that state, county, and municipal governments would experience tax revenue shortfalls unless some policies are changed. One option for policy change is to allow stranded cost recovery a decision that has critical implications for mitigating tax shortfalls that may be created by retail competition. Tax law suggests that E-6

14 Executive Summary revenue from stranded cost recovery surcharges would be taxed just like any other component of electric utility revenues. Thus, gross receipts and sales taxes would be levied on recovery surcharges. In addition, revenue from stranded cost recovery would contribute to the utilities income, and any resulting profits would be subject to the state income tax. Therefore, stranded cost recovery would have the effect of mitigating some tax revenue losses during the transition period. This is the case, whether nexus is established or not, since recovery surcharges are applied to all customers regardless of whether they buy power from in-state or out-of-state generators. The state could also offset projected tax losses by increasing the rates of one or more of the taxes considered in this report. But this option is practical only if nexus is established. Because gross receipts and sales tax on electricity account for the largest share of tax revenue, these tax rates would likely be the most prominent candidates for change. Tax restructuring options include introducing an entirely new tax or applying a surcharge on an existing tax. Two of the most promising options for offsetting potential revenue losses are (1) a consumption tax, also referred to as an excise tax; and (2) an electricity surcharge, which is a tax based on dollar sales. However, as is the case for changes in tax rates, an electricity surcharge is practical only if nexus is established. A consumption (excise) tax is a new tax that is designed to recover equivalent tax revenues under retail competition, but in a more uniform way than is possible with sales or gross receipts taxes. This tax would be levied on kilowatt hours instead of dollar sales and would be collected by the North Carolina entities that sell electricity at the retail level (i.e., distributors). It would be collected regardless of whether those distributors purchase their bulk power from in-state or out-of-state generation companies. In summary, our analysis suggests that if the state can establish nexus and ensures full recovery of stranded costs, losses of total tax revenues related to electricity will be fairly modest, about 5 percent. This would amount to an overall loss of about 0.2 percent in total tax receipts in North Carolina. If nexus is established (Cases 2 and 4), the most promising tax option for offsetting potential tax revenue losses may be to change existing tax E-7

15 State and Local Tax Considerations in Electric Industry Restructuring rates. In all cases, tax revenue losses will be decreased if the state allows stranded cost recovery whether or not nexus can be established. If North Carolina cannot establish nexus, a consumption or excise tax appears to be the preferred option for offsetting potential tax revenue losses. The recent adoption of a consumption tax on natural gas in North Carolina provides an important precedent, suggesting that in the absence of nexus such a tax will be an effective measure for offsetting other tax losses due to retail competition. E-8

16 1 Introduction This report describes how retail competition in the electricity industry may affect the tax revenues of state and local governments in North Carolina. We have considered the effects of possible future tax and regulatory policies as required by our contract with the Legislative Study Commission on the Future of Electric Service in North Carolina ( Study Commission ). In particular, we examine the potential effects of retail competition on North Carolina tax revenues for each of the four following taxes: Z corporate income tax, Z property tax, Z gross receipts tax, and Z sales tax. Section 2 provides an overview of each of these taxes remitted by North Carolina electric utilities. Section 3 discusses the three major issues that are likely to affect tax revenues if retail competition occurs in North Carolina. Section 4 presents quantitative estimates of the potential impacts of retail competition on North Carolina tax revenues. The impact estimates are called potential because they depend on several policy and market outcomes. Finally, Section 5 identifies potential options for offsetting tax losses due to retail competition. To prepare this report, we collected and reviewed the academic and professional literature on the impact of retail competition on tax revenues. In addition, we assembled a portfolio of court decisions and legislation on this topic. Finally, we conducted inperson and telephone interviews with 1-1

17 State and Local Tax Considerations in Electric Industry Restructuring Z tax executives from electric utilities in North Carolina; Z North Carolina government officials from state offices, including the X Research Division of the Legislative Services Office of the North Carolina General Assembly, X Fiscal Research Division of the Legislative Services Office of the North Carolina General Assembly, X North Carolina Office of State Budget and Management, X Public Staff of the North Carolina Public Utilities Commission, X North Carolina Department of Revenue s Income Tax Division, X North Carolina Department of Revenue s Franchise Tax Division, and X North Carolina Department of Revenue s Ad Valorem Tax Division; and Z state revenue officials, utility tax executives, and other tax professionals in California, Illinois, Iowa, Maine, Minnesota, Montana, Nevada, New Jersey, Pennsylvania, and Rhode Island. The Reference section lists articles and books reviewed, cases and statutes studied, and individuals interviewed as part of this study. Throughout this report we have focused solely on the prospective changes in tax revenues from electricity suppliers due to retail competition. We have not attempted to estimate changes in taxes that could be attributed to changes in the number and type of jobs or facilities in North Carolina due to changes in electricity prices. These secondary effects would tend to reduce our estimates of tax losses. Certain restructuring options could also affect tax revenues. For example, in our report, Policy Options for North Carolina s Municipal Power Agencies (RTI, 1999), we discussed Divestiture and Dissolution options. Both would involve the transfer of assets from entities that are exempt from certain taxes to others that may not be exempt. For example, IOUs could acquire properties now held by the MPAs, and begin paying taxes that are not paid by the power agencies. Such a transfer could reduce the tax losses discussed in this report, since we assume no ownership changes for this analysis. 1-2

18 Section 1 Introduction Restructuring with retail competition could also bring about fundamental changes in the way electric utilities are organized and operated. They may develop new markets and services and alter their cost structures. There may also be changes in the value of intangible assets held by electric utilities. All of these changes could eventually have some tax revenue implications. However, these changes are extremely difficult to anticipate and, therefore, constitute other types of secondary market effects that we have not attempted to model. We have divided this report into two volumes. In Volume 1, we review all North Carolina taxes that may be affected by retail competition and provide our quantitative estimates of potential changes in tax revenues for the same set of assumptions that we used in our companion reports on stranded costs and benefits and detriments. We refer to this set of assumptions as the reference case. The Executive Summary of Volume 2 presents an intuitive summary of the modeling techniques and assumptions used in our projections of tax revenue changes. The remainder of Volume 2 describes our modeling approach at a more technical level that requires familiarity with the logic and algebra of microeconomic theory. Volume 2 will be most helpful to experts who wish to examine the details of our model. To avoid confusion and to keep our presentation simple, we have presented quantitative results only for the reference case. However, our model is capable of producing a full set of alternative tax projections for a wide variety of alternative assumptions. 1-3

19 Taxes Paid by 2 North Carolina s Electric Utilities This section describes the North Carolina taxes that are paid by electricity suppliers or their customers. These taxes provide revenue to the state, county, and municipal governments of North Carolina. Table 2-1 shows each of the four North Carolina taxes we considered and indicates which suppliers remit each type of tax. Table 2-2 shows the recipients of each type of tax. We briefly describe each type of tax below. Table 2-1. Sources of North Carolina Tax Remittances Corporate Income Tax Property Tax Gross Receipts Tax Sales Tax Investor-Owned Utilities (IOUs) Municipal Power Agencies (MPAs) MPA Member Cities North Carolina Electric Membership Corporation (NCEMC) Electric Membership Cooperatives Table 2-2. Recipients of North Carolina Taxes Corporate Income Tax Property Tax Gross Receipts Tax Sales Tax State County Municipal 2-1

20 State and Local Tax Considerations in Electric Industry Restructuring 2.1 CORPORATE INCOME TAX Like all for-profit corporations located in North Carolina, the investor-owned utilities (IOUs) pay corporate income tax. Suppliers affiliated with the municipalities and rural electric cooperatives are not-for-profit and therefore are not subject to the corporate income tax. 1 The corporate income tax is levied by the state of North Carolina and is calculated in two steps. In the first step, utilities must apportion their taxable business income between North Carolina and other states in their service territory based on sales in each state. For example, North Carolina utilities serving customers in South Carolina apportion some of their income to South Carolina for taxation there. Likewise, an out-of-state provider selling electricity in North Carolina might have some of its taxable income apportioned to North Carolina provided that company has nexus with North Carolina that is, provided the company has sufficient property, employees, or other presence in the state to enable North Carolina authorities to levy state and local taxes on it. In the second step, the North Carolina portion of taxable income is multiplied by the North Carolina income tax rate to yield the total amount of income taxes due. The tax rate is as follows: Z In % Z In % Z In % 2.2 PROPERTY TAX Property tax is paid on generation, transmission, distribution, and other affected property owned by each electric utility. As shown in Table 2-1, member cities do not pay property taxes on their electric systems because they are municipal properties. 2 The value of the property comprising the entire system owned by each taxable electric utility is appraised each tax year by tax officials at the North Carolina Department of Revenue. Each utility s total system value is then 1 Technically this is true for electric cooperatives only so long as they derive 85 percent or more of their income from their members. Generally, all municipal and cooperative electricity suppliers must observe certain restrictions on their commercial activities to avoid jeopardizing their tax-exempt status. We assume throughout this report that they do observe those restrictions and remain tax exempt. 2 However, North Carolina Local Government Commission (LGC) guidelines suggest that MPA member cities electric funds may contribute to the state s general fund in lieu of property taxes. 2-2

21 Section 2 Taxes Paid by North Carolina s Electric Utilities allocated to county and local taxing jurisdictions where tax rates are applied and a tax bill is rendered to the utility by the county or municipality. For example, suppose that the appraised value of a utility s total system is $6 billion. If the system property located within the jurisdiction of a particular county was installed at an original cost of $200 million and the original cost of the entire system was $8 billion, that county s allocation of system property will be ($200 million/$8 billion) x $6 billion = $150 million. North Carolina tax officials consider two factors in appraising system property: (1) average system property cost net of depreciation (the cost factor approach), and (2) the system s income-earning capacity, derived by capitalizing a utility s income stream (the capitalized income factor approach). Tax officials have discretion under law (see In re Southern Railway, 59 N.C. App. 119 [1985]) in determining their emphasis on either the cost factor or the capitalized income factor when establishing a system s appraised value. Local government authorities such as county commissioners and city councils establish property tax rates. These rates are multiplied by the appraised values to determine the total amount of property tax revenue in each jurisdiction. As shown in Table 2-2, both county and municipal tax authorities collect property taxes. In some cases, the county collects the tax for some or all of the municipalities in the county and then distributes the funds. Counties and municipalities use property tax revenues primarily to operate schools and to pay for services provided by local government, including health care, police protection, fire protection, public libraries, and waste disposal. Property tax revenues are more uncertain than other tax revenues under retail competition for two main reasons: (1) the method of appraising utility properties incorporates a substantial degree of judgment on the part of North Carolina tax authorities, who make an administrative determination on the relative influence of the cost factor and capitalized income factor approaches; and (2) the influence of stranded cost recovery payments on utility property values has not yet been determined by North Carolina tax authorities. 2-3

22 State and Local Tax Considerations in Electric Industry Restructuring To maintain simplicity in our tax projection model, we have incorporated the following assumptions with respect to these issues: Z the income factor approach will be the sole approach to determining utility property valuation, and Z recovery of stranded costs will have no effect on utility property valuations. With regard to our first assumption, we anticipate that tax authorities will ultimately be more likely to emphasize the income factor approach for appraisal since the accounting or book value of some generating plants may seriously overstate their market value in a competitive environment. With regard to our second assumption, we assume that property tax appraisers would not attribute income from stranded cost payments to individual power plants for the purpose of tax valuation. The process of subdividing stranded cost recovery payments and imputing payment shares to individual plants may be unduly complex. Both of these assumptions are contestable and subject to final determination by the North Carolina Department of Revenue. However, the effect of both assumptions is to lower property tax projections, thereby yielding conservative estimates of property tax revenue losses under retail competition. A more detailed explanation of these assumptions is provided in Volume GROSS RECEIPTS TAX All utilities (i.e., electric, gas, water) located in North Carolina are required to pay a gross receipts tax. The gross receipts tax is a franchise or privilege tax on utilities that is imposed in lieu of any other franchise privilege or license tax. Currently, the tax is applied at a rate of 3.22 percent to the gross receipts derived from sales within North Carolina. The tax is not applied to wholesale power sales (i.e., electricity that is resold for example, electricity purchased by a municipal power system for resale to its customers). Utilities remit the tax proceeds to the North Carolina Department of Revenue each month and file tax returns quarterly. On its tax return each taxpaying utility shows the amount of the tax that is due to each municipality within its service territory. That amount is calculated as the product of the gross revenues derived within each municipality s corporate limits times a tax rate of 3.09 percent. The Department of Revenue distributes most of the revenue collections 2-4

23 Section 2 Taxes Paid by North Carolina s Electric Utilities back to the cities where the power was purchased. The balance of funds remaining after distribution to the municipalities goes into the North Carolina General Fund. The gross receipts tax is a transaction tax similar to a sales tax. North Carolina cannot impose taxes on the gross receipts of out-of-state providers unless nexus is established as detailed in Section SALES TAX ON ELECTRICITY Electricity distributors collect sales tax from customers and remit it to the state. As shown in Table 2-1, these distributors include IOUs, electric cooperatives, and member cities that own their distribution systems. The sales tax on electricity in North Carolina is imposed on all sales of electricity and applies to all customer charges related to providing electricity. Some buyers of electricity are exempt from the sales tax on electricity. Exempt buyers include suppliers who resell electricity, federal government agencies, and the North Carolina Department of Transportation. Two different sales tax rates are applied depending on the specific electricity use: a tax rate of 2.83 percent is applied to electricity sales related to specified farming, manufacturing, and commercial applications, while a tax rate of 3 percent is applied to all other retail electricity sales. Sales tax revenues are used to support public school systems and other state government needs. Because the sales tax is a transaction tax (like the gross receipts tax), the nexus requirements for taxing out-of-state providers also apply to this tax. 2.5 SALES AND USE TAX ON PURCHASES Sales tax on purchases is a tax on tangible personal property sold within the state for use within the state. Use tax is a tax on tangible personal property purchased outside North Carolina but used within North Carolina. The tax rate in both cases is 6 percent, but certain items are taxed at a lower rate. For example, machinery used directly in the process of producing electricity and in pollution control facilities is subject to a 1 percent tax rate with a maximum of $80 per single article. The sales and use tax on purchases is separate from the sales tax on electricity and does not apply to sales of electric services. 2-5

24 State and Local Tax Considerations in Electric Industry Restructuring Because it is unlikely that retail competition will have any effect on the sales and use tax on purchases, we do not include this tax in our analysis. 2.6 SUMMARY North Carolina IOUs (Carolina Power & Light [CP&L], Duke Power, and Virginia Electric Power Company) remit corporate income taxes and sales taxes on electricity to the state of North Carolina and property taxes to the county and municipal governments in North Carolina. In addition, they remit gross receipts taxes to the state of North Carolina, a portion of which is shared with North Carolina municipalities. Publicly-owned utilities (the MPAs and municipal systems) and customer-owned utilities (electric cooperatives and NCEMC) remit sales and gross receipts taxes. Both also pay property taxes, except that property tax is not levied on municipal distribution systems. Table 2-3 summarizes the tax remittances of all electric utilities for calendar year (CY) Altogether, the tax remittances from electric utilities totaled approximately $634 million in As shown in Figure 2-1, taxes related to electricity sales are dominated by the gross receipts tax (35 percent) and the sales tax on electricity (30 percent). Duke Power and CP&L remit about 80 percent of the total taxes related to electricity supply (see Figure 2-2). Table 2-3. Summary of 1997 (CY) Electric Utility Tax Remittances in North Carolina ($million) Corporate Income Tax Property Tax Gross Receipts Tax Sales Tax on Electricity Sales and Use Tax on Purchases Total Carolina Power & Light $45.0 $34.0 $67.0 $58.0 $8.0 $212.0 Duke Power $56.0 $51.0 $92.0 $82.0 $12.0 $293.0 Virginia Electric Power Company $3.1 $2.7 $6.6 $5.8 $0.3 $18.5 MPAs and Member Cities N/A $5.0 $21.0 $19.5 a b $45.5 NCEMC and Rural Electric N/A $8.4 $29.3 $27.4 N/A $65.1 Cooperatives Totals $104.1 $101.1 $215.9 $192.7 $20.3 $634.1 NA = not applicable. a MPAs sales tax is collected by municipal electric utilities they serve. b The MPAs report that they paid about $128,000 in sales and use taxes in In addition, they paid these taxes through their ownership share of generation plant costs, even though the operating IOUs remitted the payments. Sources: Data provided by tax managers of all taxpaying entities and verified with 1997 revenue collection data from the North Carolina Office of State Budget and Management and the Fiscal Research Division of the Legislative Services Office of the North Carolina General Assembly. 2-6

25 Section 2 Taxes Paid by North Carolina s Electric Utilities Figure 2-1. Summary of 1997 (CY) Electric Utility Tax Remittances in North Carolina, By Type of Tax 3% 16% 30% 16% Corporate Income Tax Property Tax Gross Receipts Tax Sales Tax on Electricity Sales Tax on Purchases 35% Sources: Data provided by tax managers of all taxpaying entities and verified with 1997 revenue collection data from the North Carolina Office of State Budget and Management and the Fiscal Research Division of the Legislative Services Office of the North Carolina General Assembly. Figure 2-2. Summary of 1997 (CY) Electric Utility Tax Remittances in North Carolina, By Source 10% 3% 7% 33% Carolina Power & Light Duke Power Virginia Electric Power Company Municipal Power Agencies Electric Cooperatives 47% Sources: Data provided by tax managers of all taxpaying entities and verified with 1997 revenue collection data from the North Carolina Office of State Budget and Management and the Fiscal Research Division of the Legislative Services Office of the North Carolina General Assembly. 2-7

26 State and Local Tax Considerations in Electric Industry Restructuring Table 2-4 shows the approximate distribution of 1997 tax remittances to state, county, and municipal governments. The state retains all corporate income and sales tax proceeds but only 39 percent of gross receipts tax proceeds and none of the property tax revenue. Table 2-4. Distribution of 1997 (CY) Electric Utility Tax Remittances to North Carolina Government Entities ($million/%) Corporate Income Tax Property Tax Gross Receipts Tax Sales Tax State $104.1 (100%) N/A $84.5 (39%) $192.7 (100%) County N/A $81.1 (80%) N/A N/A Municipal N/A $20.0 (20%) $131.3 (61%) NA Table 2-5 summarizes the percentage share of total state, county, and municipal tax receipts derived from electric utility tax remittances. These remittances account for 3.26 percent of state tax receipts, 2.26 percent of county tax receipts, and 6.91 percent of municipal tax receipts. Table 2-5. Percentage Share of 1997 (CY) North Carolina Tax Receipts Derived from Electric Utility Tax Remittances Revenue Share by Level of Government Tax Type State a County Municipal Corporate Income Tax 0.99% 0.00% 0.00% Property Tax 0.00% 2.26% 1.14% Gross Receipts Tax 0.63% 0.00% 5.77% Sales Tax 1.64% 0.00% 0.00% Total 3.26% 2.26% 6.91% a The percentages shown are for the state general fund; thus, they do not include the portion of gross receipts tax that is distributed back to the municipalities. Sources: Data provided by tax managers of all taxpaying entities and verified with 1997 revenue collection data from the North Carolina Office of State Budget and Management and the Fiscal Research Division of the Legislative Services Office of the North Carolina General Assembly and the North Carolina Department of Revenue, On average, counties obtain a relatively small share of their tax receipts from property taxes paid by electric utilities. However, some counties, particularly those with generating plants, rely 2-8

27 Section 2 Taxes Paid by North Carolina s Electric Utilities heavily on the property taxes paid by electric utilities to fund public services. Figure 2-3 shows the 10 North Carolina counties with the highest percentage of tax receipts from electric utility property taxes. The two counties with the highest percentage of tax revenues from electric utility property taxes Brunswick and Person had $42 million and $14 million, respectively, in total property tax revenue in Figure 2-3. North Carolina Counties with the Highest Percentage of Tax Receipts from Electric Utility Property Taxes in 1997 (CY) 25% 20% Percentage 15% 10% 5% 0% Person Brunswick Stokes Lincoln Northhampton Wake Mecklenburg Gaston Rutherford Chatham Source: North Carolina Department of Revenue,

28 Issues Affecting Future 3 North Carolina Tax Revenues Several issues will affect the potential impacts of retail competition on North Carolina tax revenues. In this section, we first discuss each of the three key issues: Z future electricity prices, Z stranded costs, and Z nexus. We then discuss other, less significant, issues affecting our tax projections. Volume 2 details how we modeled the potential effects of all these issues. 3.1 FUTURE ELECTRICITY PRICES Proponents of retail competition claim that future prices for electricity will decline after competition begins. In fact, our stranded cost report incorporates three different projections of those price changes (RTI, 1999) and details the sources and basis for our projected price series. All of the price series in our reports project that the competitive price for electricity will be lower on average than current electricity prices in the next few years. A substantial number of empirical studies have shown that when the price of any product or service declines the quantity purchased will typically increase. But for some products the amount purchased is not likely to increase very much. In fact, even though the amount purchased may increase, total dollar sales may 3-1

29 State and Local Tax Considerations in Electric Industry Restructuring sometimes fall. Many other empirical studies have shown that this is the case for electricity when the price of electricity declines, the quantity of electricity used typically increases at the same time that dollar sales decline. 1 Consequently, we project that electricity revenues would decline under retail competition, at least when we assume the future price series that we developed for our stranded cost study. Reductions in electricity revenues would have serious implications for North Carolina tax revenues. Unless the state implements offsetting tax policies, we would expect revenues from all revenuebased taxes to decline. Both sales and gross receipts taxes are levied directly on the dollar value of electricity sales, so revenues from those two taxes would clearly decline. In addition, electricity revenue losses may reduce property and income tax revenues depending on several factors discussed in Volume 2 of this report. 3.2 STRANDED COSTS As previously mentioned, retail competition would require competitive pricing of electricity. In other words, all electricity suppliers who wish to remain competitive in North Carolina would charge prices that are comparable to those offered by any outside supplier. As indicated in our report on stranded costs, that would require all electricity suppliers presently serving North Carolina retail customers to lower their prices (RTI, 1999). Yet the prices now charged by North Carolina suppliers are set at the levels needed to recover the costs of all their past investment expenditures incurred to serve their North Carolina customers. The costs of those investments that cannot be recovered when electricity is sold at competitive prices are known as stranded costs. Stranded costs are composed of three major types of investments that North Carolina utilities have undertaken during the past several years. The largest component of stranded costs in North Carolina is attributable to the nuclear generating facilities. Typically, the 1 A decline in dollar sales in conjunction with a price decrease will always occur when a parameter called the elasticity of demand for electricity has a value between zero and 1. Whenever the elasticity value is in that range we say that demand is inelastic. Our reference case assumes a demand parameter value of 0.25, as is commonly reported in the empirical literature on electricity demand (Bohi, 1981). 3-2

30 Section 3 Issues Affecting Future North Carolina Tax Revenues current market value of those plants is well below their current accounting value as stated on their owners balance sheets. Accounting value equals the difference between the facilities initial cost and the amount of that initial cost already charged to customers in past years. The difference between accounting values and market values for these assets is a significant part of stranded costs. A second component of stranded costs is associated with power purchase contracts. Some North Carolina providers are bound for several years by contracts to buy wholesale or bulk power at prices well above expected wholesale prices in a competitive market environment. The excess cost of those contracts above competitive prices is stranded. The third major component of stranded costs is known as regulatory assets. These are other utility expenses undertaken in past years but as yet not charged to customers, in many cases at the direction of regulatory authorities. Examples include the cost of energy conservation programs or electricity price discount programs for low-income customers. Stranded cost recovery decisions could affect North Carolina tax revenues in three significant ways. First, the aggregate amount of stranded costs significantly affects the difference between current electricity prices and competitive prices, so the amount of stranded costs affects the amount of potential price reductions under competition. Those price changes significantly affect electricity revenues and, hence, revenue-based tax proceeds. Second, stranded costs may reduce property tax revenue because of the manner in which utility property is appraised for tax purposes, as discussed in Section 2.2. Third, the state s decision on the recovery of stranded costs would have critical tax revenue implications, because stranded cost recovery payments are presumed to be taxable. 2 Therefore, recovery of stranded costs would automatically offset part of the tax losses that would otherwise occur during the transition period. 2 It may be necessary for the state to enact specific legislation to authorize taxes on stranded cost recovery payments. Our model assumes that the full amount of such payments is taxable for IOUs, but not for tax-exempt municipal or cooperative suppliers. 3-3

31 State and Local Tax Considerations in Electric Industry Restructuring 3.3 NEXUS Under retail competition any generating company would be free to sell electricity to North Carolina homes and businesses. As is already the case in states that have opened their markets to retail competition, this would likely introduce some new electricity suppliers to North Carolina who are located in other states. Whether those out-of-state companies will be liable to collect or pay North Carolina taxes remains an issue, generally described as the nexus issue. Nexus refers to the authority of a state to levy a tax on a transaction or a person, or to require a person to collect taxes the state levies. Traditionally this has been an issue with out-of-state mail-order sales and, more recently, with Internet sales. The courts have established a state s authority to impose its taxes based on substantial presence. Substantial presence depends on a taxpayer having sufficient property, employees, or other presence in a state to justify taxation. Nonetheless, the courts and legislatures have not yet provided an exact legal definition of nexus for the purpose of taxing electricity sales. 3 Therefore, we must consider the potential tax consequences that would occur if nexus is not established. As detailed in Volume 2, the existence of nexus would affect the competitive price of electricity and, therefore, the amount of stranded costs. With nexus, out-of-state suppliers would be forced to charge prices that adequately compensate for all their costs including the North Carolina taxes they must pay. Naturally their costs would be lower if they could avoid paying those taxes. In a competitive market environment without nexus this would typically affect enough out-of-state suppliers that they would all offer electricity to North Carolina buyers at lower prices reflecting the avoided cost of taxes. Consequently, revenues from the gross receipts tax, sales tax on electricity, and corporate income tax would be lower, and stranded costs would be higher without nexus 3 It should be noted that the U.S. Congress has the power to regulate interstate commerce and has been considering legislation to address interstate electricity sales. Thus, the Congress could enact legislation that would establish the method for states to levy taxes on interstate electricity sales. 3-4