Building a Responsible Budget for Washington State

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1 03/28/13 Building a Responsible Budget for Washington State Washington s legislature must adopt a budget for the two year period beginning in July Our elected leaders can improve K-12 education, expand access to early learning and higher education, and protect basic public health and safety by: 1. Raising the Business and Occupation tax rate for services from 1.5% to 2.5%, and 2. Ending tax breaks that are outmoded or of lesser priority than educational opportunity. Since the Great Recession began in 2008, Washington has cut billions in funding for public services, damaging lives and constraining future opportunities. Class sizes are larger, fewer children are enrolled in quality early learning, young adults pay sharply higher tuition, and vulnerable elderly and disabled citizens have less ability to maintain healthy, independent lives. Now the state faces an additional shortfall of over $1 billion between projected revenue and the amount needed to maintain this reduced level of services for the state s growing population. On top of that, the Washington Supreme Court has ordered the legislature to fund public schools at a significantly higher level. Meanwhile, special tax breaks drained an estimated $29 billion from the state General Fund budget during the biennium nearly as much as the state collected in public revenue. 1 The legislature and public have no systematic way to evaluate tax breaks against investments that support economic opportunity, social mobility, and public health. 2 Eliminating even the most egregious loophole requires passing special legislation in the face of determined lobbying by corporate interests. As a result, some of the world s most profitable corporations continue to receive tax breaks many of them passed long ago for different purposes. And over 200 new tax preferences have been enacted just since the year Legislators can ensure more equitable treatment of businesses and individuals, and promote investment in public priorities that create educational opportunities, promote small business growth, and protect residents health and safety, by: Raising the business tax on services, as a first step toward a more fair and sustainable way to fund public services in a modern economy. Closing tax breaks that do not benefit the majority of Washingtonians or serve important public interests; Establishing a systematic way to evaluate and prioritize tax breaks and automatically end those that are not more important than the state s paramount duty: K-12 education. As outlined below, taking these steps this year will create in $1.8 billion in new revenue, and save an additional $1.03 billion in tax expenditures, yielding $2.8 billion in the biennium. Return B&O Service Tax Rate to 2.5% Value: $1.8 billion ( biennium) Over the past half century, the U.S. economy has shifted from goods-based to service-based. Yet Washington continues to rely on the retail sales tax mostly on goods for fully half its General Fund budget, while taxing the burgeoning service sector including attorneys, consultants, software engineering, and personal services far

2 more lightly. This disparity between our economy and tax structure is one of the reasons it is such a struggle for the state to adequately fund education, from early learning through college. In May 2010, the Business and Occupation tax rate on services temporarily rose from 1.5% to 1.8%. Without legislative action, the rate will revert to 1.5% on July 1, From 1993 to 1998, the service rate was even higher, with business services paying 2.5% from July 1993 to January 1996, then 2% until July Both during the 1990s and over the past 3 years, job growth in business and professional services has substantially outpaced job growth in the state overall. 4 Close Unneeded and Outdated Tax Breaks Value: $1.03 billion ( biennium) Examples of tax breaks to end High tech R&D Extracted fuel Comments These breaks primarily benefit highly profitable corporations or publically supported organizations - Microsoft, Immunex, UW, WSU. Oil refiners including Conoco Phillips, Tesoro, U.S. Oil, Shell and BP are the main beneficiaries, accounting for 98% of the value of the tax break, which was originally created in 1949 for the timber industry. Revenue (millions) $114 $63 Investments of nonfinancial firms Most states tax this type of income. $342 Instate portion of interstate transportation 3 tax breaks were enacted in the 1930s, based on an outdated understanding of the Commerce Clause of the U.S. Constitution. $107 Out-of-state residents Repeal would also generate revenue for local governments. $63.7 Insurance agents Precious metal and bullion Stevedoring & international charter & freight brokers Custom software Agricultural producers Insurance professionals pay 0.484% in B&O taxes, while similarly placed professionals pay 1.8% (1.5% in FY2014). Buyers pay no sales tax and sellers pay B&O tax only on commissions, not gross receipts or profits. JLARC could not establish whether the lower rate makes Washington s ports more competitive, and could find no public policy purpose for including charter and freight brokers in the preferential rate of 0.275%. 27 states apply sales tax to modifications of canned programs and 11 to custom programs. Also generates local revenue. This revenue projection includes continuing the exemption for farms with gross annual income below $200,000. Only 2 other states exempt farms from business taxes. $35.6 $42.2 $26.4 $78.6 $64 Non-organic fertilizers and sprays Would also generate revenue for local governments. $92.3 Total Value $1,028.8

3 High Technology R&D Tax Incentives $114 million ( biennium) In 1994, the legislature created two incentives for high tech research and investment, a B&O tax credit and a sales tax deferral/waiver. Both were renewed in 2004 and are now set to expire on January 1, Since 2004, firms benefitting have been required to file annual surveys reporting the number and quality of jobs created. These incentives were reviewed by JLARC in Based on that review, the Citizens Commission for Performance Measurement of Tax Preferences determined these incentives were not meeting standards for performance and quality, and recommended these preferences be allowed to expire. 5 B&O credit $51.8 million ( biennium) Qualifying firms can claim a tax credit of up to $2 million annually. Over 500 firms each year claim the credit, costing the state on average $20.5 million per year. In 2010, three firms claimed the maximum Microsoft, Battelle, and CH2M Hill. Microsoft has claimed the maximum in every year public disclosure has been required. 6 An econometric study commissioned by JLARC in 2012 based on data concluded the tax break was responsible for just 484 additional jobs in The study estimated each new job cost taxpayers about $45,000 annually, while producing only $25,000 in new earnings per job in the state. 7 Sales tax deferral/waiver $62.2 million ( biennium) Firms can receive a sales tax deferral when they invest in new or renovated facilities, machinery, and equipment. After 8 years of qualified use, the deferral becomes an outright waiver. Twenty five firms claimed $31 million in new sales tax breaks in From 1995 to 2009, this tax break cost the state a cumulative total of $574.6 million, and local governments $188.2 million (mostly in King County). 9 Because firms continue to report total deferred taxes for a particular project over 8 years, published figures for this incentive are difficult to analyze. In 2011, Microsoft claimed $145.6 million 58% of the cumulative total reported by all firms for projects at some point in their eight-year reporting cycle. The University of Washington and Immunex Corporation each claimed nearly $30 million, Washington State University and Children s Hospital claimed $8 million, and eight additional firms exceeded $1 million in claims. 10 Other claimants reported much smaller amounts. Because relatively few firms claim this tax break, the economists commissioned by JLARC to evaluate the high tech tax breaks concluded there was insufficient data to estimate an impact on jobs. 11 Extracted Fuel Exemption $63 million ( biennium) Most companies pay a use tax on property they produce and consume for commercial purposes, but in 1949 the legislature exempted fuel produced and used by a manufacturer after a timber company lawsuit. Five oil refineries constructed in the 1950s and later now account for an estimated 98% of the value of the tax break. JLARC was able to identify only one other state that provided a similar tax break, Alabama. Local governments in Whatcom, Skagit, and Pierce county would also gain about $22.4 million during the biennium. 12 B&O Tax Exemption for Investments by Nonfinancial Firms $342 million ( biennium) 13 Most states tax all the income of firms, but Washington s B&O tax on gross receipts exempts income from investments earned by nonfinancial firms. JLARC s analysis of IRS corporate tax returns concluded that manufacturing, real estate, and information firms receive approximately 6% of their income from investments. JLARC s 2009 study concluded that if this tax break were repealed, some businesses could avoid paying B&O tax on this income by forming a subsidiary in a state with no corporate or personal income tax, such as Nevada. 14

4 Exemption for In-State Portion of Interstate Transportation $107 million ( biennium) When Washington s basic tax code was adopted in the 1930s, drafters believed that the Commerce Clause of the U.S. constitution prohibited states from taxing any commercial transport that crossed out of the state. Since then, the U.S. Supreme Court has ruled that states are free to tax the instate portion of trips, but Washington still completely exempts companies that transport people or good across the state line. For example, companies now pay a public utility tax for transportation between Seattle and Vancouver, WA, but would pay no tax on transport between Seattle and Portland. There are 3 similar exemptions: Instate portion of interstate transportation: $59.7 million Applies to transportation of goods and passengers by truck, rail, and some water transportation. Transportation of through freight: $32.2 million Applies to goods that are transported within the state to store or process, then transported out of state. Shipments to ports: $15.2 million Applies to transport of commodities to a port, dock, etc. for shipment outside the state. Sales Tax Exemption for Out-Of-State Residents $63.7 million ( biennium) 15 Residents of states or provinces with less than 3% sales tax are not required to pay sales tax on Washington purchases. Repeal of this tax break would also generate revenue for local governments. Preferential B&O Tax Rate for Insurance Agents and Brokers $35.6 million ( biennium) Insurance agents and brokers and related professionals have had a preferential B&O tax rate since 1983, that was further reduced in 1998 to 0.484% as part of a simplification of B&O tax rates. The general service business rate is currently 1.8%, scheduled to reduce to 1.5% in July These insurance professionals are typically independent contractors or sub-contractors. Real estate agents and stock brokers operate in similar fashions, yet do not enjoy the same tax break. The 2012 JLARC analysis could find no clear rationale for this preference. At the 1.8% service rate, ending this tax break would yield $42.7 million in the biennium. 16 Tax Exemption for Precious Metal and Bullion $42.2 million ( biennium) A 1985 law exempts buyers of precious metal and bullion from paying sales tax. Sellers pay B&O tax at the service rate, but only on commissions, not on gross receipts or profits. The stated purpose of the sponsor of these tax breaks was to treat precious metal and bullion as investments, however seller of stocks and securities pay tax on markups and profits, as well as commissions. According to JLARC s evaluation of this tax preference, representatives of the coin and bullion industry claimed that Washington retailers were suffering from out-of- state competitors prior to 1985 and would again if the tax breaks were repealed, but JLARC could find no data to verify these claims. 17

5 Preferential B&O Rate for Stevedoring & International Charter & Freight Brokers $26.4 million ( biennium) A special B&O tax rate of 0.275% applies to stevedoring and other services related to loading or unloading cargo from vessels or barges used in interstate and foreign commerce, and to businesses that arrange international transportation of goods. When the B&O tax was created in 1935, stevedoring but not charter and freight broker services were considered exempt from taxation under the Commerce Clause of the U.S. Constitution. A 1978 Supreme Court case clarified that the state could tax these services. The legislature responded by adopting a preferential rate of 0.33% in 1979, and extending it to charter and freight broker services as well as stevedoring. The rate was further lowered in 1998 when several B&O rates were consolidated. JLARC could not establish whether or not the lower rate made Washington s deep water ports more competitive with other west coast ports, and could find no public policy purpose for including charter and freight brokers in the preferential rate. 18 Sales Tax Break for Custom Software $78.6 million ( biennium) 19 Custom software was recognized in state law as a service rather than retail sale in Washington, along with most states, applies retail sales tax to canned software. 20 According to a 2007 survey by the Federation of Tax Administrators, 27 states apply sales tax to modifications of canned programs and 11 to custom programs. 21 Repealing this tax break also generates local revenue. B&O Tax Exemption for Agricultural Producers $64 million ( biennium) Washington s B&O tax was adopted during the Great Depression of the 1930s when agriculture was in financial crisis and family farms dominated production. Since that time, farming has changed considerably. 22 A complete repeal of the B&O exemption (except for the general small business tax credit) would generate $68 million, while continuing to exempt farms with gross receipts below $200,000 would generate $64 million. 23 Exemption for Non-organic Fertilizers, Sprays and Washes $92.3 million ( biennium) Washington s exemption of fertilizers, sprays, and washes used in agriculture is generally consistent with the tax treatment of component parts of manufacturing processes. Most other states also exempt such agricultural inputs. 24 However, extending the tax to nonorganic products would incentivize farmers to switch to products that are less harmful to worker, public and environmental health. It would also expand the tax base in rural parts of the state with few other options to fund local public services.

6 Endnotes 1 Washington s Department of Revenue concludes that about 450 of the more than 600 existing tax breaks would result in additional revenue for the state if repealed. DOR, 2012 Tax Exemption Study: A Study of Tax Exemptions, Exclusions, Deductions, Deferrals, Differential Rates and Credits for Major Washington State and Local Taxes, Introduction and Summary of Findings, 2 A Citizen s Commission and the Joint Legislative Audit and Review Committee reviews most tax breaks on a 10 year cycle, but evaluation criteria are limited by statue and recommendations have no teeth. See the Citizen Commission for Performance Measurement of Tax Preferences, 3 The B&O rate for business services was 2.5% From July 1993 to January 1996, then 2% until July During those same periods, rates for financial services were 1.7% and 1.6%, and for all other services 2.09% and 1.83%. DOR, Comparative State and Local Taxes 2010, 2013, Chart 5. Historical Summary of Washington Taxes, 4 Business and professional service jobs in Washington increased 9.9% between May 2010 and February 2013, compared to overall nonfarm job growth of 4.5%. Washington Employment Security Department, Historical Employment Estimates, seasonally adjusted, 5 Joint Legislative Audit & Review Committee, 2012 Tax Preference Performance Reviews, JLARC Report 13-1, 6 Washington Department of Revenue, Tax Incentive Public Disclosure Reports, Timothy Bartik and Kevin Hollenbeck, An Analysis of the Employment Effects of the Washington High Technology Business and Occupation (B&O) Tax Credit, June 25, 2012, JLARC, 2012 Tax Preference Performance Reviews, Appendix 4. 8 JLARC, 2012 Tax Preference Performance Reviews. 9 Washington Department of Revenue, Evaluation of Tax Incentives: Analysis of High Technology Programs, December 2009, 10 Washington Department of Revenue data. 11 JLARC, 2012 Tax Preference Performance Reviews. 12 JLARC, 2011 Tax Preference Performance Reviews, Fiscal estimate from Gov. Gregoire s proposed budget. 13 Wealthy individuals could also be required to pay B&O tax if the exemption were completely repealed. The revenue estimate here assumes that individuals would continue to be exempt. Including wealthy individuals as well would raise the total for the biennium by $185 million. Washington Department of Revenue, A Study of Tax Exemptions, Exclusions, Deductions, Deferrals, Differential Rates and Credits for Major Washington State and Local Taxes, 2012, JLARC, 2009 Tax Preference Performance Reviews, 14 JLARC, 2009 Tax Preference Performance Reviews, 15 Gov. Jay Inslee Budget Priorities : 16 JLARC, 2012 Tax Preference Performance Reviews. 17 Senate Bill report 5395, 2010 legislative session, JLARC, 2012 Tax Preference Performance Reviews, p JLARC, 2012 Tax Preference Performance Reviews, p Revenue estimate from Department of Revenue, based on September 2012 Forecast. 20 Department of Revenue, A Study of Tax Exemptions, Exclusions, Deductions, Deferrals, Differential Rates and Credits for Major Washington State and Local Taxes, Federation of Tax Administrators, 2007 Survey of Service Taxation, 22 JLARC, 2008 Tax Preference Performance Reviews, 23 Department of Revenue estimates, based on September 2012 Forecast. 24 JLARC, 2010 Tax Preference Performance Reviews,

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