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A Basic Reform to theBusiness & Occupation Tax

Prepared by

Alan Harvey

and

Donald Hopps, Ph.D.

for

The Institute for Washingtons Future

March 2005

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Table of Contents

Executive Summary

Part 1: Shortcomings of the Current B&O Tax ................................................................................ 3

Part 2: The Reform ............................................................................................................................. 6Proposed Structure: ....................................................................................................................... 6Uniform 2% Rate ....................................................................................................................... 6$100,000 Standard Deduction.................................................................................................... 7Complete Deductibility of Capital Investment ......................................................................... 7Deduction of Purchases from Other Taxpaying Entities.......................................................... 7Treatment of Current Exemptions, Special Rules Defining Other Taxpaying Entities ...... 8

Economic Attributes of the Reform ............................................................................................... 9

Part 3: Effect on Specific Business Types ........................................................................................ 12Nominal v. Effective Rate ............................................................................................................ 12

Specific Business Situations ......................................................................................................... 13Example 1: A Small Manufacturer ......................................................................................... 13Example 2: Startup Espresso-Pastry Store vs. Starbucks' Expanding by One Location ..... 13Example 3: Service Businesses ................................................................................................ 14Example 4: Grocery Stores ...................................................................................................... 14Example 5: Wal-Mart .............................................................................................................. 15

Part 4: Compliance and Transition Issues ....................................................................................... 16Compliance ................................................................................................................................... 16Transition ..................................................................................................................................... 17

Capital Expenditures ............................................................................................................... 17

Part 5: Toward Systemic Reform: Adequacy & Balance ............................................................... 18Adequacy ............................................................................................ Error! Bookmark not defined.Historical Context ........................................................................................................................ 18Nature and Magnitude of the Shortfall ....................................................................................... 19The Relevance of the B&O Tax ................................................................................................... 20Balance ......................................................................................................................................... 20

Endnotes ................................................................................................... Error! Bookmark not defined.

Appendix A: A Measure of Pyramiding of the B&O Tax

Appendix B: Calculation of the Rate and YieldAppendix C: The Break-Even PointAppendix D: B&O Taxpayers by Address

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A Basic Reform to the Business and Occupation Tax*

Executive Summary

One of the most important issues facing Washington is the state of our current tax system. While taxes onindividuals and tax relief measures have dominated the debate in Washington for the past decade, the morepressing issue is the need for genuine tax reform. Judged by credible observers for years to be grosslyinequitable, recent changes have made our system even more inequitableand less adequate. The State TaxStructure Study Committees report of 2002 makes the case for comprehensive reform to produce a moreadequate and equitable tax system. It recommended replacing the B&O tax with a subtraction-method,value-added tax (VAT).

The need for business tax reform is just as important as reforming taxes on individuals. Creating a taxsystem that treats businesses fairly and transparently, while producing adequate revenue, requires that weaddress the structure of our Business & Occupation tax and the myriad business tax exemptions we havecreated

We believe B&O reform can produce a more equitable tax for businesses, spur economic growth inWashington, and lead more naturally to a more accountable and beneficial approach to granting business taxexemptions.

Problem

Washingtons B&O tax has been a stable source of revenue through our economic cycles. Its strengths lie inits stability, low tax rates and manageability. But its unique base of gross receipts produces a tax that violatesprinciples of equity and neutrality. The B&O tax:

Places a relatively higher burden on new and expanding businesses,

Places a relatively higher burden on small and non-vertically integrated businesses due to pyramiding ofthe B&O tax,

Favors out-of-state businesses, and

Ignores a taxpayers fundamental economic status by ignoring the costs of doing business.

Reform Proposal

* This paper was prepared by independent economist Alan Harvey and Donald Hopps, Ph.D., Director of the Institute forWashingtons Future, with the critical assistance of Kristin Pula, coordinator of the Institutes Public Finance ReformProject.

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B&O reform can reverse these biases. Our proposed reform would reduce taxes on small and start-upbusinesses, encourage capital investments, eliminate the problem of pyramiding, and rectify the current biasfavoring vertically integrated and out-of-state firms. The reform would achieve these goals through:

A generous standard deduction for all firms (proposed at $100,000).

Complete deductability of capital purchases and investments. Deductability of purchasesmaterials and servicesfrom firms paying the B&O tax.

Replacement of a half dozen nominal ratesand widely divergent effective rateswith a single rate thatis economically consistent from small to large firms and from sector to sector.

Advantages to Reform

This reform corrects the grave imbalances created by our gross-receipts base B&O tax, and creates instead amore equitable and neutral B&O tax. The advantages of reform include:

It is fairer to small, start-up, and low-profit margin firms, while removing the current B&Os advantagesfor large, vertically-integrated firms.

It helps stimulate the economy by taking business costs into account and encouraging businessinvestments.

It does not create a new tax, but reforms the existing tax to allow for deductions of some inputs.

By creating a fairer tax, the reform eliminates the need for many of the special tax exemptions andpreferences currently in the tax code.

While increasing reporting requirements, the reform decreases the total number of taxedand thus,reportingbusinesses.

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Part 1:

Shortcomings of the Current B&O Tax

A 2002 study by the Washington business group Washington Policy Center found that small businessregards the B&O tax to be the most burdensome of all state taxes. In the written survey and inroundtable discussions small business owners identified the Business and Operating [sic] (B&O) tax ashaving the heaviest single impact among all taxes. The tax imposes a significant burden on businessesstruggling to reach profitability. The B&O tax is levied on all revenue above the minimum, even if thebusiness is operating at a net loss. Newly started businesses and those that are working through tougheconomic times are the hardest hit.1 The reformed B&O tax proposed here brings rationality to the taxbase used in determining the tax, introduces fairness for all companies, and promotes and supportsWashington-based businesses.

The defects of a gross receipts tax such as the B&O tax begin with the base. Gross receipts is a quantitynot relating to income or another measure reflecting ability to pay. The defects are amplified by the

phenomenon of pyramiding. Because the tax is collected on the full value of each transaction, itmultiplies as a product goes up through the production process and supply chain. This compounds theinequities inherent in the base. The B&O tax becomes a tax with innumerable effective rates, one whichis applied more leniently on large, vertically integrated corporations and out-of-state suppliers. Bothvertical and horizontal equity are violated. Under appropriate taxation, all companies would be taxed atthe same rate, no matter how large and no matter what sector of the economy they lie in. The differencein effective rates is sometimes a factor of two, three, four or more. This has led industries to seek andlegislators to grant, numerous special tax exemptions, further contributing to the complexity andunevenness in the application of the tax.

Taxing gross receipts, pyramiding, and levying multiple rates leads to significant problems. They are:

The current B&O tax violates principles of horizontal equity. Appendix A to this report replicates atable produced for the Tax Structure Study.2 The first column displays the B&O taxs effective rate onvalue added by industry sector. Value added is the most fundamental measure of a companys earnedincome. The table reveals the wide variance of effective taxation between sectors. The range in thistable is produced solely by the inappropriate base of the current B&O tax. Since the tax falls on aquantity that includes both income and costs, the effective tax on income, obviously, is greater or lesserdepending on the proportion of that income to the total.

The many nominal rates of the current B&O tax reflect in part an effort to provide a rough equity acrossclassifications. The divergent effective rates displayed in Appendix A demonstrate that this effort hasnot proven out. For example, the 1.5% nominal rate for Services is more than three times that for

Manufacturing, yet the effective rate is in the middle to low end of all classes. This follows directlyfrom the gross receipts base. Since services do not, in general, involve significant intermediate goods,

1 Washington Policy Center, The Small Business Climate in Washington State, Eric Montague, March 2002, p.6, http://www.washingtonpolicy.org/SmallBusiness/PBMontagueSmallBusinessClimate.html.

2Washington State Tax Structure Study Final Report, 2002, Table 9-7.

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the proportion of value added in the gross sales of the firm is much higher than for many manufacturingactivities.

This inequitable taxation can be further exacerbated by the pyramiding of the tax, since the intermediategoods purchased by a manufacturing company may well carry B&O taxes with them. This additionalB&O tax burden is not reflected in Appendix A.

The current B&O tax violates principles of vertical equity. The weight of pyramiding depends onthe number of steps in the production process and whether these steps have been subject to B&Otaxation. For example, if a widget is constructed and sold in Washington state, it bears an increment ofB&O tax for each transaction in the production process and for wholesaling and retailing as well. Awidget produced in Oregon bears the B&O tax only at the final wholesaling and retailing steps. TheWashington widget carries a higher effective B&O tax than the Oregon version, even if the productionprocess is identical, because of pyramiding.

Because a transaction (a sale) is necessary for the application of the B&O tax, companies which avoidtransactions avoid taxation. Large companies can do this by vertical integration, a type of monopoly

structure, which brings several steps of the production process in under a single roof. For example,mining, smelting, fabricating, coating, engineering, forming, stamping, labeling , wholesaling,transporting, and retailing could each be the province of a single competitive firm. If so, the B&O taxwould be applied eleven times. But if all of these are performed within the context of a single company,the B&O tax is applied only once. Thus smaller and non vertically integrated companies bear a largerload.

The current B&O tax ignores a firms ability to pay. The corollary to this violation of horizontal andvertical equity is that the B&O tax is also blind with regard to a firms ability to pay. Businessesstruggling due to external factors, such as high energy costs, market weaknesses, or competition fromoutside the state, still have to pay their B&O taxes based on sales. The current B&O tax ignores the

bottom line (net income) in favor of taxing the line at the top (gross sales). This is bad tax policy.

Worse is when this focus on the gross revenue ignores a firms business capital investment and attemptsto grow. These are precisely the firms Washington should be nurturing and protecting, but in the B&Otax this valuable enterprise is ignored. The reform proposed here explicitly encourages businessexpansion and development by including complete deductibility of all capital investment.

Complexity in the Tax System.

Of course, legislators are not insensitive to the need to help developing businesses. The most commonmechanism used, in fact, is the tax code, which is riddled with exemptions and credits focused on

specific businesses, sectors, or geographical areas. The Reform proposes targeting the valued activity investmentrather than picking individual actors. The exemptions and special preferences of the taxcode may be effective for a time, but lead to awkwardness and suspicion that it is not the activity of thecompany, but its access to power in Olympia that leads to its being favored.3

3Washingtons tax code currently has 503 tax exemptions, and the number grows every biennium. Businessesreceive 210 of these preferences and exemptions, for activities including economic development, hightechnology research and development, agricultural production, and small business support. Of these, 133 areexemptions from the B&O tax. There is currently no public disclosure or reporting of these exemptions. An

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Other General Shortcomings

The above are the major issues with the current B&O, and they are all connected to its base of grossreceipts. Additional problems may exist as companies attempt to avoid the tax via phony purchasingagent arrangements, partnership agreements, or by moving centers of activity into essentially dummycorporations out of state. Avoidance like this could arise under any system, and the reform would not be

immune. Compliance and enforcement are considered briefly in Part 4.

A final weakness of the current B&O is that its arcane construction and built-in inequities maydiscourage legislators from looking to it as a revenue tool, since the imbalances of the gross receiptsB&O are amplified at higher rates. Ironically, it may be this weakness which has allowed the tax tosurvive so long. (The acute problem of tax adequacy is considered in Part 5.)

additional improvement to tax administration would be stronger reporting requirements, so all tax breaks can beevaluated on the criteria of public benefits.

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Part 2:The Reform

The reform put forward in this paper creates from the current B&O tax structure a tax which is sturdyand stable, one from which the citizens of the state can expect a vigorous contribution, and a tax whichprotects small businesses as it improves the competitive position of Washington-based businesses. Theproposed structure offers investment incentives to all, rather than limiting them to specific industries orbusinesses.

Past adjustments to the B&O tax have attempted to calibrate its many rates for different types of

business activity (e.g., wholesaling, services, manufacturing, retailing) to arrive at a pretense of roughequity across classes. This has never worked and never can work, because the flaw with regard to equitylies in the B&O tax's base of gross receipts, not in the rate schedule. By simply allowing businesses todeduct the costs of doing business, subject to some rules, the reform eliminates the mares nest ofproblems in the current B&O tax. It replaces the several different rates with a single rate. The rulesensure fairness and protect businesses at vulnerable stages in their development.

Proposed Structure:

A uniform 2% rate

A $100,000 standard deduction for all firms

Complete deductibility of capital purchases and investment Deductibility of purchases from other taxpaying entities

Retention of current exemptions for agriculture, some forestry and fishing activities, rental ofreal estate, and activities which fall under one of the B&O taxs sister taxes.

Replacement of many special exemptions with deductions for all firms, targetingeconomically desirable activities rather than individual actors.

Uniform 2% Rate

A 2% rate on net receipts replaces the several rates on gross receipts of the current B&O tax. Currentrates range from 0.471% for retailing to 3.3% for disposal of low level radioactive waste. Comparing

nominal or statutory rates is not helpful at all in judging the impact of the reform, as we have noted,because the reforms rate applies to a different baseto net receipts rather than gross receipts.

As an example, suppose a business buys stock for $90 which it sells for $100. The reformed tax is 2% ofthe difference between the purchase price and sale price, or 20 cents. The current B&O tax is 47 cents,even though the nominal rate is only 0.471% on retailing, less than a quarter of the reforms rate. Theapparently low tax rate is applied to a far larger base, the entire $100 of sales. The reform tax rate of 2%is applied only to a base of $10 in net receipts.

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The rate of 2% has been chosen because it will generate $800 million to $1 billion per year in criticallyneeded revenue for state services, and at the same time will allow room for the $100,000 standarddeduction and the economically important deduction for all capital investment. The need for newrevenue is the subject of Part 5. Appendix B provides an overview and spreadsheet detailing the researchand analysis which informed the choice of the 2% rate. It should be noted that the tax rate could be

readily adjusted to achieve various policy goals. One value of a single rate is that it clarifies andsimplifies such adjustments.

$100,000 Standard Deduction

The reform proposes a generous standard deduction of $100,000 from the base of net receipts. Thisdeduction protects small and startup businesses. This standard deduction replaces the small businesscredit in the current B&O tax, which applies a variable credit to taxes owed. The maximum value of thecurrent credit is $421, and it is available only to a small number of taxpayers. The value of the newstandard deduction is $2,000 (2% of $100,000). It is available to all taxpayers.

Complete Deductibility of Capital Investment

Under the reform all capital purchases will be deductible. The full value of capital investments may bededucted immediately, which will front-load the tax benefits. This deductibility of capital purchases willhelp all start-ups and expanding businesses, and provides a major new incentive for businesses toexpand and develop in Washington. The deduction of capital is focused on a desirable business activity,not on specific businesses. As discussed below, the rationale for many of the special exemptions isremoved by the elimination of B&O taxation on capital purchases and investments.

Deduction of Purchases from Other Taxpaying Entities

It is by allowing the deduction of purchases of necessary intermediate goods that the tax base of theB&O tax is changed from one of gross receipts to one of net receipts. Thus this component executes thecrux of the reform. Deductibility must be limited to purchases from other taxpaying entities in order to

ensure that each product or service is taxed at precisely the same rate, whether it is produced inWashington, California, or China.A uniform rate of taxation is guaranteed because the deductibility isoffered only to those products and services that have already been taxed. This is the mechanism of asubtraction method value added tax such as that which was highly recommended by the 2002Washington State Tax Structure Study Committee.4 Items or services which have not been taxed are notdeductible. Understanding the rationale for this is understanding the strength and logic of the reform.

The allowable deductions of purchases are those which are made from other taxpaying entities. (Otherenterprises are defined as taxpaying under the special rules below.) Again, this equalizes the tax rateon every product and service sold or produced in Washington. Out-of-state products will be subject tothe same tax rate as in-state products, as they should be. The current B&O tax penalizes companies

4 Ibid., p. v.. This was the Committees first recommendation, even before the highly publicized call for apersonal income tax. The structure of a subtraction method VAT is discussed in the section beginning on theStudys p. 39. The vote of 9-2 in favor is reported in Appendix H. The subtraction method is more rare thantwo other methods of a VAT. An addition method adds the components of firm and employee income toproduce value added. An invoice method involves credits for taxes paid which are passed up the supply chain.The latter method is different only in a minor accounting sense from the subtraction method.

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buying and selling within the state by pyramiding the tax, adding an increment on each sale. Activitiesoutside the state are ignored until they are imported.

Treatment of Current Exemptions, Special Rules Defining Other Taxpaying Entities

Many classifications of business are exempted from paying the current B&O tax. These fall into

basically two categoriesthose that the legislature wanted to spare from taxation for economic reasonsand those that are taxed under the tax code with a similar type of tax. The reform contemplatescontinuing many of the exemptions as-is. However, in the first, or economic category, onetroublesome area of exemptions is proposed for elimination. This economic category is composed ofbasically two groups: (1) special targets like research and development or investment by new businesses,which want stimulus, and (2) activities such as agriculture and fisheries, which need protection orspecial consideration.

Existing special purpose exemptions targeted to economic stimulus become largely obsolete under thereform. Exemptions for economic stimulus purposes will be available to all, not just a few, with the newinvestment deduction. The legislature will need to determine an equitable way of sunsetting the specialpurpose exemptions, but again, this should be easier for the fact that many will become redundant to thereforms provisions.

On the other hand, Agriculture and some other resource-based activities in forestry and fisheries havelong enjoyed exemption from the B&O tax, and the reform proposed in this paper maintains theseexemptions. Resource-based operations are a primary source for creating value added, and in themselvesthey comprise a very small proportion of total product. In contrast, the processing, packaging,distribution and retail functions garner a far bigger piece of the pie, and will continue to be subject toB&O taxation.

Agriculture operates in a very different context from other industries, which makes it difficult to treatfairly under a set of rules designed for all business enterprises. For example, farming operates under acontinuous cycle of short-term debt. Farmers seek loans to plant their crops, and pay off their debt withproceeds from the harvest. There is a long-term difference in the time between investment and payofffor this industry as compared to others. The loan activity is invisible to both the B&O tax and theproposed reform. The proposed reform continues the Agriculture exemption as a means of supportingsmaller operations and newer business models. (Note that unlike the exemptions discussed below,taxpayer status will not be granted to agriculture and other resource-based activities. Thus the value oftheir product sold or processed in-state will be subject to taxation at the next level.)

A second category of exemptions from the B&O tax is occasioned by the parallel, or sister, taxes to theB&O tax. Public utilities, insurance, and pari-mutuel racing pay the public utilities tax, the insurancepremiums tax, and the pari-mutuel racing tax, taxes which are roughly parallel to the B&O tax, thoughoften with higher nominal rates. Another classification is also proposed to be included as taxpaying

under these special rulesrental of real estate. This is an partly an effort to continue forward thecurrent exemption for rental of real estate, partly to acknowledge the effect of property taxes, but mostlyto concede the problematic nature of taxing this function and the fact that rental and leasehold costs are aprimary burden on new and struggling businesses.

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Economic Attributes of the Reform

The reform will generate substantial new revenue. Our estimate is that between $800 million and$1.0 billion per year will be added to the revenue stream. This amount is necessarily imprecise becausethe major part of allowable deductions derives from purchases from other taxpaying entities, and sincemuch of this amount is imported from out of state, it is not a part of the readily available data which isbased on state product and income. The reform generates new revenue by eliminating the currentadvantages enjoyed by large, vertically integrated corporations, while reducing the share of taxes paidby small and start-up businesses. Appendix B discusses the precision and reliability of the estimates.The spreadsheet included is quite informative in terms of illustrating the magnitude of each of thecomponents in terms of revenue loss or gain.

Most Washington businesses will pay less, even in nominal terms, under the reform. The U.S.Census Bureau counted approximately 140,000 firms in Washington with payroll.5 Rough estimatesderived from these payroll numbers and the break-even calculation summarized in Appendix C suggestthatat least 75 percent of these Washington businesses would pay the same or less under the reform .It is estimated that 60 percent of these Washington businesses would pay no tax at all. The Labor

Market and Economic Analysis branch of the States Employment Security Department counts 230,000total firms, 180,000 with employees.6 These figures do not include dollar values of payroll, but the samesort of result is apparent. (Reconciling these numbers has been difficult. Both the Census and LMEAhave been responsive, but unable to fully explain the differences.) The Department of Revenue countsroughly 260,000 active B&O taxpayers.7 This number and other data generally corroborating ourestimates is displayed in Appendix D. Caution should be used with the data on in-state and out-of-stateaddresses, as they may not fully represent the location of operations and employment.

It is impossible to know the proportion of total B&O taxpayers who will pay less under the reform, sinceaccurate data on these businesses do not exist. It may be safe to assume, however, that many or most ofthe out-of-state firms would pay more under the reform, not because of any selective targeting ordiscrimination against these firms, but because they benefit unfairly from the current B&O grossreceipts base.

The reform will increase the amount of Washingtons tax burden that is exported. Exporting astates tax burden means some of the load is paid by businesses or households outside the state. Theproposition that a portion of Washingtons tax load will be exported under the reform is not wishfulthinking, no matter which view of the incidence of the tax one may hold. The above discussion sharesthe common approach within the state that the B&O (and hence the proposed reform) is a tax borne bybusiness. As such, and because the reform equalizes the effective rate, the advantage enjoyed by out-of-state firms disappears, thus they pay more and in-state businesses pay less of the reformed B&O tax. Asecond approach holds that a gross receipts tax such as the B&O tax becomes attached to the product or

5 U.S. Census Bureau, Statistics of U.S. Businesses: 2000: All Industries: Washington: By detailed employmentsize, http://www.census.gov/epcd/susb/2000/wa/WA--.HTM.

6 Washington State Employment Security Department, Labor Market and Economic Analysis Branch, Size ofFirm by County Distribution for All Ownerships, Including Multiple Establishments, First Quarter, 2003,October 3, 2003.

7 Correspondence from Stephen D. Smith, Department of Revenue Research Division, December 13, 2004.

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service and is paid by the eventual purchaser as a sales tax, wherever that person may reside. In thisview, those products produced in Washington and shipped out of state carry the tax with them. Theburden is literally exported.

Our own view of tax incidence is less cut and dried. We see taxes as a cost faced by business like anyother cost, and thus, according to standard price theory, tax impacts depend on market factors, primarily

the strength of demand. In conditions of high demand, a tax will likely be borne by the purchaser. Inconditions of weak demand, the producer will likely bear the load. This may explain why complaintsfrom business over taxation become more vigorous during slumps in demand, either during a generaleconomic downturn, or for example, when a business is in the phase of building its customer base and isexperiencing specific demand weakness. (For this reason it is also important for the state to supportdemand by every means reasonable, including stable government spending levels during downturns.Cutting government spending only increases the stress on business.)

By whatever measure one chooses, a significant portion of the states tax burden will be exported underthis reform. This is a goal for all tax structures, as noted by the Washington State Tax Structure StudyCommittee.8 Out-of-state producers who are favored currently will no longer be favored. By exporting a

portion of the tax load, resources are released in the private sector and public services are financed in amore balanced way. The current B&O tax excessively focuses on activities within the state and failsmiserably in the goal of exporting the tax burden.

The reform is a business tax. While determining the incidence of taxation is not a precise science, theB&O is considered Washingtons business tax, and the reform ought to be seen in this same light. Assuch, it will be more likely to be appreciated as a measure which does not add to the share of taxes paidby families and individuals, as would, for example, an increase in the sales tax or a new personal incometax. The share of revenue expected by the federal government from corporations (particularly the largecorporations that would be most impacted by this reform) has fallen dramatically over the past decade.Our reform may provide some balance to that trend. This is not to dismiss the contribution by businessesto state programs. That contribution is by no means limited to the B&O tax, as it includes significant

employment taxes.

The proposed reform requires no new collection mechanisms or bureaucracy other than thatadditional capacity inherent in the alteration of the tax base, which will be more difficult to calculatethan the current gross receipts base. Implementation of the reform should require no extended transitionperiod. Current exemptions will be retained, for agriculture, rental of real estate, certain forestry andfishing activities, public utilities, and so on. The roll of taxpayers is identical under the reform. Part 4examines further the issues around transition.

This proposal conforms to many of the principles developed by the Washington State TaxStructure Study Committee, principles of neutrality, adequacy, fairness and stability, and movesmarkedly in the direction espoused by the Committee in terms of exporting the state's tax burden.9 Byexporting some of this load, the new tax will also improve the competitive position of in-state firms.

8Washington State Tax Structure Study Committee, op. cit., p. 5. The state should minimize the burden on statetaxpayers by choosing a tax system that maximizes the extent to which taxes can be exported(paid bynonresidents).

9 Ibid, pp. 3-5.

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The reform eliminates the major liabilities of a gross receipts tax. The weaknesses and inequitiesidentified in Part 1 substantially disappear under the reform. Adjusting the base in the manner describedwill eliminate the problem of pyramiding, because goods and services already subject to the B&O taxare deductible and thus will be counted only once. The bias toward large, vertically integratedbusinesses will disappear completely, because the same rate is applied to all value added. The invisible

but large effective tax rates that now eat at the bottom lines of small and independent companies willcrystallize into a single standard rate for all. The large company will not reduce its tax by reducing thenumber of transactions. The small company will not be penalized for buying its inputs from independentsuppliers. The large standard deduction offered in the reform, in fact, will reverse the bias to favor small,independent businesses. The inequity in effective taxation across business classes will alsocompletely disappear. A single effective rate will apply to all.

The reform is not blind to a companys ability to pay. At least one eye will be opened. Deductions ofinvestment costs in equipment and facilities will be allowed, providing a great boon to start-ups andcompanies that must retool or modernize. Purchases of intermediate goods will also be deductible.Wages and salaries will not be deductible, however, so the cost of people can be avoided only by layingthem off. Significantly, however, the cost of training provided by outside vendors will be deductible

under the reform. Training and employee development are not now deductible.

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Part 3:Effect on Specific Business Types

The reform we propose may strike a chord with policy-makers interested in the goals of overall fairness,neutrality, and economic stimulus, as well as increased revenue, but it will be the financial impact onindividual business owners that will determine the strength of support and ultimately whether a reformcan be enacted. When we move from the academic to the actual, the business owner will want to knowfirst how it affects his or her specific operation, not how it applies across broad classifications. Thisshort section cannot offer more than a taste of the range of impacts, but even these few examples shouldgive depth to the discussion, suggest likely winners and losers, and pick out potential points of confusionwhich may arise in communicating the proposal to the public.

As noted in the last section, we estimate that 60 percent of Washington businesses will pay nothingunder the reform, and more than three-quarters will see their taxes stay the same or drop. These arenecessarily rough estimates, from the calculations detailed in Appendix C. This is possible while stillgenerating a marked increase in revenue. Under the reform, the tax burden will shift to out-of-stateenterprises and to larger companies that benefit most from the current inequities of a gross receipts tax.The amount of the tax which will be exported under the reform is very difficult to ascertain. It isconceivable that the proportion could rise from the neighborhood of 10 percent currently to as much asone-third under the reform, or possibly higher.10 And while the great majority of Washington firms willpay less in B&O tax, some at the top will pay more, and this is where the great preponderance of value

added is produced.

In summary, very small businesses will benefit greatly. Companies that invest in capital will do well.Service businesses may not be overly affected. On the other hand, companies that draw product andservices from outside Washington will have to absorb an increased burden. Larger, vertically integratedcompanies will see their advantages disappear.

Nominal v. Effective Rate

The discussion above and the examples which follow concentrate on the tax bills of individualcompanies, the size of the check they will write to the state. It is worth repeating at this point, however,that the burden of the current B&O tax is far larger than the dollar figure on the check. As Appendix A

indicates, the effective tax paid by Washington businesses can be up to six times the nominal rate andhigher, a consequence of the pyramiding inherent in a gross receipts tax. This is a real and onerousweight on those companies that cannot shield themselves from it. The tax rate in column 2 of AppendixA is similar to a revenue neutral rate that might be expected under terms like those of the reform. This

10 The increase suggested (30%) assumes that a large part of the wholesale category involves imports, the rate onwhich will be increased to the full 2%, an increase in the service sector will be at least partly attributable toimports, and that at least some currently untaxed imports will no longer be able to avoid taxation.

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column does not show the effect of the standard deduction, nor the full effect of the capital investmentdeduction. It also fails to show the variability of taxation within classifications, where larger firms tendto pay a lower rate and smaller firms a higher rate.

The removal of the pyramiding dynamic will be a competitive boost to smaller companies. Larger andmore established firms will lose this unfair leverage. Out-of-state competitors will also lose their

advantage, since their product will now be taxed at par with that of Washington businesses. Thus theReform is pro-competitive, a leveling of the competitive playing field. In this section, however, we willbe discussing the tax bills of typical hypothetical companies of specific business types, and thus will notbe dealing with the higher effective rate, but with the statutory, or nominal, rate. As the reform takeshold and the pyramiding process of the current tax subsides, it will be interesting to see how pricesnormalize over time.

And again, as we discussed in Part 2, the true incidence of taxation is a subject of considerable debate.The burden may not be determined simply by who writes the checks to the state and may be morerelated to market power, shifting in response to the market.

Specific Business Situations

Example 1: A Small Manufacturer

A small manufacturing business has a total of five employees. Their gross sales were $1.2 million 2002,but dropped to $865,000 in 2003. Staff attribute the decline to the current economic downturn. In 2003,the company rebuilt its principal machine tool at a cost of $200,000, and net sales were estimated at$294,000, or 34 percent of gross sales. The company purchases pipe stock, almost exclusively (95%)from in-state suppliers, and remanufactures it for commercial and residential use. Shipping is donethrough UPS or by independent flatbed haulers.

Under the current B&O tax, this companys 2003 tax bill would be $4,187 (0.484% on gross sales of$865,000). The company cannot take any deductions for their inputs or for their capital expenditures.Under the proposed B&O tax reform, this firm fares much better. First, it can deduct intermediate costsfrom other taxpaying firms, so its tax base is now net receipts of $294,000. Second, it receives thestandard deduction of $100,000 and third, it can deduct $200,000 for its capital investment. So, underthis reform, the company has no taxable receipts and pays no tax.

Example 2: Startup Espresso Store vs. Expansion of Established, Vertically Integrated CoffeeChain by One Location

Any small business that depends on independent suppliers is a victim of the B&O tax in its current formbecause of the pyramiding of its gross receipts tax base. Large vertically integrated enterprisesthose

which provide in-house the production and distribution of the products they retailescape B&Otaxation in the main. Start-up costs for a new single-store business may be significant for theentrepreneur. Under the current B&O tax, none of these costs are deductible, and the company is onlyeligible for a meager credit with a maximum value of $421. Add to this the higher effective rate oftaxation occasioned by pyramiding, and it becomes clear why the current B&O tax is the bane of smallbusinesses.

An established coffee chains competitive position is enhanced by economies of scale, but inWashington it also benefits from a lower effective tax rate, since many of the operations that go into its

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productdistribution, roasting, baking and even professional services like marketing and legalservicesmay be provided in-house. Obtaining goods and services from independent enterprises doesnot occur, the transactions that the B&O taxes do not occur, and so pyramiding does not occur. Underthe reform, the established chains lower effective rate will disappear, and the company will pay exactlythe same rate on taxable net sales as the startup.

Example 3: Service Businesses

Service businesses (almost by definition) are high value added businesses. But this does not mean thatthese enterprises will take a big hit under the proposed reform. Quite the contrary. The tax rate under thecurrent B&O tax is 1.5% on gross receipts. Under the reform it is 2.0% on net receipts. Since rent andthe first $100,000 of taxable receipts are deductible under the reformed B&O tax, thousands of smallservice businesses may see the effective share of their taxes drop.

While this ought to encourage support from this sector, a question of balance needs to be raised here.The reform is constructed to make the effective tax on value added uniform across business sectors, butthis is not true of the states tax system as a whole. The B&O tax and employment taxes are the onlydirect contributions expected from service businesses. Some voices have called for the retail sales tax to

be extended to service businesses to rectify this imbalance.11 These considerations are beyond the scopeof the present study. Suffice it to say that a sturdy, broad-based tax such as proposed in this reform couldsupplant reliance on the retail sales tax in the future, bringing this calculus more into line. Mitigatingthis imbalance is the fact that service businesses are (also almost by definition) jobs businesses.Favoring them in the tax system is not without merit.

Example 4: Grocery Stores

Grocery stores are low profit margin businesses, meaning that the profit obtained from the sale of goodsis a low percentage of total sales. Grocery stores and supermarkets often operate with a margin of onlyone to two percent. This contrasts with, for example, luxury merchandise businesses where the marginmay be 30 percent or more. Grocery stores are typically low-capital, high-volume businesses. Thisprofile will benefit or suffer under the proposed reform depending on the proportion of merchandise thatis deductible. The B&O tax reform allows deductions for goods purchased from other taxpaying entities,while goods imported from out-of-state or purchased from other non-taxpayer sources are notdeductible. While we have not made a thorough investigation of the comparable effects on this type ofbusiness, it seems likely that the smaller and more independent the enterprise, the lower will be itsexposure to tax increases under the reform.

It ought to be noted here that food and drugs have been exempted from the retail sales tax, so the B&Otax is the only significant contribution to the States General Fund from commerce in these twoimportant consumer sectors. Hence the overall tax share expected from activity in these areas would stillbe fairly low.

REWRITE BIG BOX RETAILERS

11 Economic Opportunity Institute,Extending the Retail Sales Tax to Services in Washington State, September2002, Jason Smith, http://www.econop.org/Taxes/TaxPolicy-RetailSalesToServices.htm.

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Example 5: Big Box Retailers

Big Box retailing is a term applying to a spectrum of warehouse and large department storespurveying a wide range of goods. On one end of this spectrum is a company like Wal-Mart, whichtypically minimizes its capital investment and workforce costs and competes on the base of price, withgoods typically imported. On the other end of the spectrum are the mall department stores, which have a

substantial investment in their locations and compete both on quality and price.

Big Box retailers will likely pay a significantly larger share of B&O taxes under the reform proposedhere. The capital investment deduction will benefit some more than others, but the merchandise that isproduced out of state or out of the country and sold in these stores will be subject to the 2% rate,whereas it currently is liable to less than 0.5%.

This is a very short list of examples. By no means does it display all of the ramifications of a changefrom the current B&O tax to the reform proposal. In particular, restaurant businesses, with theirexposure to the retail sales tax and their relatively high labor input, will likely see an increase as they

grow out from under the umbrella of the $100,000 standard deduction.

The true effect on business of all types is ruled by the inequities of the current tax, the web ofpyramiding and its avoidance, and the unwise and unfair predicament in which it places start-ups andsmall and struggling business. It will be welcome to see a tax regime in which all enterprises are treatedequally and where the tax share is visible in simple, unconfused terms, rather than being variable andobscure. The considerable expertise of the Department of Revenue will be welcome in further exploringthe specific effects of this reform on specific businesses.

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Part 4:

Compliance and Transition Issues

We have so far concentrated on theoretical and hypothetical issues. What will happen when the Statemoves to apply the reform to real businesses? As a reform to an existing tax, our proposal does notrequire an effort of the scale and detail necessary to institute a new tax, a personal income tax, forexample. But while they will be markedly fewer than with a new tax, difficulties and differences willneed to be anticipated.

Compliance

There is no doubt that whatever the economic simplicity and fairness the reform brings with it,

compliance and enforcement of the reform will be more complex. Eliminating the tax on companieswith less than $100,000 in taxable receipts will simplify auditing and enforcement tasks. It is in thiscategory that the great preponderance of noncompliance problems occur with the current B&O tax.12 Onthe other hand, the reformed tax will require more in terms of preparation than the simple calculation ofrate multiplied by the bottom (or top) line. For those businesses that do pay, the $2,000 represented bythe standard deduction may be a fair compensation for their increased accounting.

Restricting deductibility to other taxpaying firms creates a challenging tracking problem. But preciselybecause deductibility depends on it, firms will likely be assiduous in reporting the sources of theirpurchases, creating a self-policing dynamic that will be helpful for auditors. It is our great good fortuneto have one of the best agencies of its kind in the nation in the Washington State Department of

Revenue.Governing

magazine gave the Department its highest rating, noting, "To their creditorsometimes to their embarrassmentWashington policy makers have plenty of good data to base theirdecisions on. The state has better analytic capacity than most. In fact, overall, tax administration inWashington is a model for other states...."13

The reform will not change the stipulation in the current B&O that the tax is a cost of doing business andmay not be invoiced to customers. A companys tax bill ought to be 2% of its contribution to the valueof its products and services. In cases where there are not-taxpaying suppliers, the company will be liablefor 2% of this value as well. Agriculture is one category of non-taxpaying suppliers. Exportationaccounts for 80 percent of agricultural production, and this amount will not be taxed. The remainingportion, which is sold or processed within the state, accumulates the B&O tax at the next step. Theremay be other suppliers whose product is now processed under the radar. These avoided sums will also

be taxed at the next step. In this way, the reform mechanism may collect taxes that are currently illegallyavoided.

12 Washington State Tax Structure Study Committee, op. cit. Appendix C-8, Table 3, Total Noncompliance bySize of Firm.

13 Governing.com, The Way We Tax, February 2003, http://www.governing.com/gpp/2003/gp3wasup.htm.

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Transition

Transition problems ought to be minimal in comparison with other tax reform proposals, since the roll oftaxpayers role is identical to that for the current B&O tax (though as above, a majority will be liable forno tax). The rules have changed fundamentally, but the mechanisms of collection and monitoring remainthe same.

Capital Expenditures

It will be necessary to adopt procedures to allow for appropriate treatment of recently purchased but notfully depreciated capital. It would be unfair for businesses that invest one year prior to the enactment ofthe reform to be deprived of the benefit of deductibility. And it would be quite unfortunate if businessesdelayed their investments while awaiting the outcome of the reform effort. Since accounting fordepreciation is an everyday part of business, particularly with respect to federal taxation, it ought to befairly simple to make an equitable arrangement by using extant depreciation schedules. Encouragingcapital investment should be one main attribute of a business tax. Investment in plant and equipmentbrings with it good jobs and committed corporate citizens.

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Part 5:

Toward Systemic Reform: Adequacy & Balance

The goal of tax reform is a fair, adequate, and balanced tax system. How does this proposed reform ofthe Business & Occupation tax meet this goal? Throughout this discussion, we have focused on the issueof the comparative equity of this proposed reform and the present tax. The foregoing analysis clearlydemonstrates that this reform would make the B&O tax itself eminently more fair by assessing it on arational basis, businesses net receiptsa base that factors in businesses ability to payandeliminating the advantages to out-of-state firms. This would make the tax system as a wholeconsiderably more fair by reducing the taxes of small business ownersa significant portion ofWashington's middle-income people. In and of itself, this would be a significant reform for the State ofWashington. The purpose of Part 5 is to show how the reform brings improvement to the systemic health

of the total tax structure in terms of improving adequacy and balance.

Does the current tax system in Washington provide revenue adequate to the need? There is no reason toargue the fine points of the budget to answer this question. A February 2003 study, The GovernmentPerformance Project: The Way We Tax,14 identified the most important shortcoming of Washington'stax system to be its inadequacy. The State earned the lowest rating due to its unwillingness to raisesufficient revenue. We are currently facing a $2.2 billion deficit for the 2005-2007 biennium, aftershortfalls in the two previous budget cycles.

Historical Context

Previous levels of revenue have deteriorated over the past five years. Statutory reductions have been led

by citizen initiatives. The low unemployment and high personal income growth of the '90s created short-term revenue surpluses for the state, which then became the rationale for long-term tax rollbacks. In2000, ratifying an initiative ruled illegal by the courts, the governor and legislature eliminated the motorvehicle excise tax (MVET). The MVET was responsible for 7 percent of State revenue, more than $800million per year. Voters subsequently capped property tax revenue increases at 1 percent per year. Non-statutory reductions in revenue accompanied the general economic decline which began in 2000. Theeconomic stagnation has eaten at retail sales, and hence the retail sales tax, the mainstay of the budget.

As its response to these events, the state has balanced its budget with a mixture of one-time fixes,wishful thinking, and cuts in services. The State sold rights to some of its tobacco settlement, adoptedbest case scenarios for federal funding, hiked sin taxes and, most importantly, cut spending. Thegovernor rejected any significant new revenues for 2003-05 and developed a budget that froze voter-

mandated cost-of-living increases for teachers, rejected voter-mandated class size reductions, frozevoter-mandated wage increases for home health care workers, cut higher education assistance, cut Statejobs, rolled back health coverage, and diminished support for other, mainly social support programs.15

14 ibid.

15 A more complete examination of the budget balancing can be found in The Washington Budget 2003,LeLoup, Lance T. and Grulke, Eric, Washington State University, July, 2003, presented in association with

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The apparent rationale behind these financial contortions is that the state's economic problems would beshort-lived and the cash flow of the 1990s would return, along with a relief from fiscal stress andrenewed revenue flows through the existing taxes which would make replacement of the MVETunnecessary. Unfortunately, the experience of state and local governments has not confirmed theperiodic announcements of an impending turnaround. Rather than a return to good times, Washingtonhas joined other states in a continual revenue squeeze.

Nature and Magnitude of the ShortfallWashingtons Office of Financial Management (OFM) prepares periodic predictions for the economyand for fiscal factors affecting the States mandated functions. The January 2004 Six-Year Outlook16identified three scenarios. The best case scenario projected a $382 million shortfall at the end of the2005-07 biennium. Its most likely case projected the number at $1.1 billion. The worst caseprojected a $1.8 billion gap at the end of 2007 (and an incredible $5.6 billion gap at the end of the 2009fiscal biennium). The 05-07 deficit--has surpassed these projections, hitting $2.2 billion after the statesupreme court invalidated the estate tax in February 2005. The State is constitutionally prohibited fromrunning deficits. Since very nearly half of the budgetbond payments, pension contributions, basic K-12 educationis immune to cuts, the other half, programs amounting to around $13 billion, must bearthe budget knife. Cuts of this magnitude mean more than a pound of flesh. The prospect is for sacrificeof muscle and bone.17

This adequacy problem stems largely, according to the authors ofThe Government PerformanceProject,from imbalance in the tax system, meaning its reliance almost exclusively on sales and propertytaxes. Inadequacy, again, was rated a more significant problem in Washington even than regressivity,and as pointed out in Part 1, the state has the most regressive tax system in the nation, according toITEP. It is pertinent to at least reflect on the possibility that the two issues may be connected. That is, atax regime which taxes low- and middle-income households much more heavily than higher-incomehouseholds can never be adequate without being too oppressive to the most vulnerable.

Our admittedly preliminary work with regard to identifying the "structural" characteristics of the tax

system, those which remain after corrections for population, inflation and unemployment, indicates that

Western Political Science Association, sponsored by the Center for Public Policy and Administration,http://www.cppa.utah.edu/westernstatesbudgets/WPSA02/wa_2002.pdf.

16 Washington State Office of Financial Management, Six Year Outlook,January 16, 2004,http://www.ofm.wa.gov/fiscal/outlook/index.htm. Subsequent revisions to Six Year Outlook were published inJune and September 2004 and include revised projections for each scenario. These numbers are not reflected inthe current paper. These later versions project markedly lowered oil prices, while in fact, oil prices have spikedupward.

17 Our view of the economic assumptions underlying OFM's projections suggest actual economic and fiscalconditions will be very close to the worst case scenario. OFM has differentiated its cases based on assumptionsfor population growth and health care inflation. Inflation is a term more aptly used for general price rises,rather than those of a single sector, but the significance of this factor is not debatable, particularly in an agingsociety. Were the federal government to accept a more significant role in financing health care for the generalpopulation, or even for the uninsured population, the great and growing weight on the states to deliver thoseservices could be relieved. In other words, health care reform at the national level is a potential boon for statefinances.

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even in the best economic circumstances, tax revenue from the current structure could not pay the bills.Real revenue per capita adjusted for employment is below the demands in real terms on that revenue.18

The Relevance of the B&O Tax

The proposed reform to the B&O tax turns this unfair, regressive, and economically complex tax intoone which is sturdy, stimulative and equitable. It will produce an estimated increase of $800 million to$1.0 billion per year. The tax base of the reformed B&O tax will rise in lock step with the economy as awhole.

Funding basic and necessary services and facilities is the fundamental object of the tax system. If it failsthis function, it has failed fundamentally. Removing the inequities between businesses and the biasagainst small and struggling businesses are valuable achievements for tax reform, but they are notenough. Even the most balanced, fair and progressive tax scheme is a failed scheme if it results incrumbling infrastructure, failing schools, and people forgotten in desperate conditions. If a water orsewer system were renovated, it would not matter what high-tech efficiencies and equipment wereinstalled. A system not adequate to serve existing or easily foreseen demand would be seen as nothingmore than a mistake. For tax reform, this means that the two aims of balance and adequacy must arrivein the same package.

Balance

Balance brings adequacy and fairness together by considering the composite effect of the various taxesthat form a tax system. It is a recognition that the whole is greater than the parts; that it is possible tohave a system whose individual taxes are fair and adequate, but when taken together as a whole can beunfair or inadequate. It is also recognition that the system is relative, particularly to the economy. Weonly have to look as far as Oregon to see the truth of this. Oregon is in the same fiscal trouble thatplagues Washington because Oregon relies far too much on its fair and, in a normal economy, adequateincome tax. The downside of an income tax is that it is notoriously sensitive to the economy. Aboom/bust cycle such as we have experienced in the Northwest during the last decade throws itcompletely out of kilter. One year it brings in too much revenue and generates taxpayer resentment. The

next year its revenues could drop off significantly, failing to bring in enough to meet needs.

The Oregon and Washington examples demonstrate that balance requires adequacy and fairness in asystem over time and varying conditions. Its measure is not just productivity, but consistentproductivity.

18 Interestingly, we find that population, employment and revenue per capita in real terms all vary in the samedirection. (The budget restrictions of Initiative 601 passed in the early 1990s do not recognize this connection,since they are keyed to population.) In other words, better times mean higher employment and higherpopulation growth and higher tax revenue per capita. In harder times, population increases are lower, as is therevenue per capita, but the strain on services may not decrease as unemployment may fuel need. A furtherexploration of this gap can be found inIts Not Just the Recession: The Budget Crisis and Washington StatesStructural Deficit, by Marilyn P. Watkins and Jason Smith, Economic Opportunity Institute (EOI), 2003,http://www.econop.org/Taxes/ StructuralDeficit.pdf. It should be noted that the definition of structural in theEOI discussion relates to the structure of the tax system, demands on it, and its ability to respond. The moretraditional structural definition has to do with the so-called full-employment budget, that is, measuringagainst a hypothetical good times economy. The EOI analysis of the trends in state revenue capacity anddemands on that revenue are persuasive in their argument for a state personal income tax and/or extension of thesales tax to services.

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The reformed B&O tax would be the fairest tax in our system and thus the best to use to addressadequacy, but this may raise an issue of imbalance if businesses are seen to carry too large a share of thestates taxes. In an ideal tax system, the rate of our B&O tax might be lower than that proposed here.The retail sales tax would also be considerably lower. These might be balanced by a personal incometax. As it is, however, the regressive sales tax cannot in good conscience be raised enough to fill therevenue gap. "Sin taxes" are even more regressive, and in any case, could never generate the level ofrevenue needed. Property taxes are limited by law. And the B&O tax as currently constituted is so unfairand counterproductive to economic growth that raising it is not a practical option

The reform proposed here creates fairness in the tax code and brings some balance and adequacy intothe system. Its enactment would create a sturdy, fair and fully functional business and make the weakestleg of the State's tax structure into the strongest.

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APPENDICES

Appendix A: A Measure of Pyramiding of the B&O Tax

Appendix B: Calculation of the Rate and Yield

Appendix C: The Break-Even Point

Appendix D: B&O Taxpayers by Address

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Appendix A

A Measure of Pyramiding of the B&O Tax

Tax Rate on Effective PyramidingSectors & SIC Codes Value Added B&O Rate Index4 MFG FOOD 20 2.0% 0.3 6.711 MFG PETROLEUM REFINING 29 3.1% 0.5 6.719 MFG AIRCRAFT & PARTS 372 2.6% 0.5 5.312 MFG RUBBER & PLASTICS 30 2.0% 0.5 4.315 MFG PRIMARY METAL 33 2.0% 0.5 4.15 MFG APPAREL & TEXTILES 22-23 2.0% 0.5 4.16 MFG LUMBER & WOOD PROD 24 1.9% 0.5 4.021 MFG PROF & SCIENTIFIC INSTR 38 1.8% 0.5 4.017 MFG IND/COMM/COMP M&E 35 1.9% 0.5 3.97 MFG FURN & FIXTURES 25 1.8% 0.5 3.720 MFG OTHER TRANS EQUIP 37 1.8% 0.5 3.7

8 MFG PAPER PROD 26 1.7% 0.5 3.714 MFG STONE/CLAY/GLASS 32 1.6% 0.5 3.410 MFG CHEMICAL PROD 28 1.5% 0.5 3.33 CONSTRUCTION 15-17 1.6% 0.5 3.318 MFG ELECT M&E (NOT COMP) 36 1.4% 0.5 2.813 MFG LEATHER ETC 31 1.4% 0.5 2.835 MOVIES/AMUSE/REC 78-79 2.2% 0.8 2.734 SVC MISC REPAIR 76 1.4% 0.5 2.722 MFG MISC MFG IND 39 1.2% 0.4 2.79 MFG PRINT & PUBLISHING 27 1.3% 0.5 2.623 TRANSPORTATION ETC 40-47 1.8% 0.7 2.52 MINING/QUARRY 10-14 1.2% 0.5 2.416 MFG FABRICATED METAL 34 1.1% 0.5 2.3

29 SVC LODGING 70 1.1% 0.5 2.230 SVC PERSONAL 72 2.0% 1.0 2.11 AG FOR FISHING 1-9 1.4% 0.7 2.033 SVC AUTO REPAIR, SERV&PARK 75 1.0% 0.5 2.024 COMMUNICATIONS 48 1.2% 0.6 1.926 WHOLESALE TRADE 50-51 0.9% 0.5 1.937 LEGAL/ENG/ACCT 81-89 2.1% 1.1 1.832 SVC BUSINESS 73 1.6% 0.9 1.727 RETAIL TRADE 52-59 0.8% 0.5 1.636 SVC MEDICAL & HEALTH 80 2.0% 1.2 1.628 FIRE 60-67 1.5% 1.0 1.625 ELECTRIC, GAS & OTHER UTIL 49 3.2% 2.1 1.531 SVC COMP/DATA/PROC SERVICES 737 1.3% 0.9 1.4

Statewide 1.5% 0.6 2.5

This table from Chapter 9 of the Washington State Tax Structure Study Committees report Tax Alternatives forWashington State: A Report to the Legislature. http://dor.wa.gov/content/statistics/WAtaxstudy/Chapter_9.pdf

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Appendix B

A Fundamental Reform to the Business & Occupation Tax

Rate and Yield

This appendix is a technical discussion of the likely rate and yield under the proposedreform to the B&O tax. We summarize the analysis which allowed us to estimate that a 2.0

percent rate applied to the reformed tax base will generate $800 million to $1.0 billion per yearin new revenue.

The rules of the proposed reform, to review briefly, are as follows:

A $100,000 standard deduction for each enterprise subject to B&O taxation.

Deduction of all capital expenditures.

Deduction of all purchases from other B&O taxpaying enterprises.

Retention of all current exemptions.

Reduction of the several rates of the current tax to one rate of 2.0 percent.

Precision is wanting in this analysis because the available data are themselves not preciseand because there are several necessarily inexact, sometimes even crude, manipulations of thedata required to get to the desired end. At every step we have chosen the most conservativetreatment. While technical, the analysis is instructive as to the dynamics of the tax and is nottoo difficult to follow.

A summary table of the last several steps is provided Below (Table B-1), and a spreadsheetdetailing all the steps and data is provided at the end (Table B-2). An addendum to thespreadsheet provides an array of rates depending on the level of the standard deduction. Wehope that as this paper is reviewed by economists in the Department of Revenue andelsewhere, they will comment and criticize, and the analysis will move forward in precision andsophistication.

Developing the Rate and Yield

Data: State Gross Product by Industry

The object of the analysis is to find the applicable tax base for the reformed tax, thenincrease the revenue to meet the adequacy objective of the reform. We have used the fivefiscal years 1997 through 2001 to provide an array of rates. We developed estimates of thedollar impacts of the rules which define our reform and expanded or contracted the base asappropriate. (The spreadsheet then divides by the actual B&O collections at each step toprovide an informative interim report on the rate.)

The seven steps from beginning to end are:

1.Obtain appropriate gross product data for the classifications of industry which will be

taxable under the B&O and the reform.

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2.Convert data from calendar year to fiscal year, so the revenue data will be parallel to thetax base data.

3.Make certain ad hoc adjustments to keep the data consistent.

4.Convert from gross product data to net product to allow for the rule that capital purchasesare deductible.

5.Expand product data to reflect the limitation of deductibility to in-state firms to approachthe full tax base we are looking for.

6.Account for the cost of the universal $100,000 standard deduction.

7.Increase revenue requirements by 50 percent to address the chronic inadequacy of staterevenues.

Detailed Explanation of Steps

Data: The tax base we want is really one of net income to owners and workers. It is amirror image of value added to product. In a closed economy, product and income would beidentical. Washington state is very, very far from being a closed economy. The eventual tax

base under this reform will account for income from around the world, and in particular, fromother parts of the United States.

We began with state gross product data, because it is the most accessible, and in Step 6 weexpand this data to approximate the effect of an open economy. The data we have used comesfrom a special report published in the September2003 Washington Economic and RevenueForecast from the Office of Forecast Council. 19 The close relationship between product andincome becomes clearer with the comment in the report, In practice, GSP (gross state product)estimates are measured as the sum of distributions by industry of the components of grossdomestic income. The difference between GDP (gross domestic product) and gross domesticincome is the statistical discrepancy.20

Step 1: Obtain appropriate gross product data for the classifications of industry whichwill be taxable under the B&O and the reform. Not all industries are taxed under the B&O.Some categories, like government and nonprofits, are obvious. Others which are not taxed underthe B&O are utilities, transportation and insurance, because they come under other parts of thetax code. Agriculture, forestry, rental of real estate, and other special purposes are also exemptfrom the tax.

In the Washington State Tax Structure Study Final Report , a table is provided for thepurpose of estimating the effective tax on value added for different business classifications. Oneversion of that table was referenced earlier and provided in Appendix A. Another appears inAppendix C-12 of the Study.21 The table was used as a template to select the classifications for

19Washington State Gross Product by Industry, pages 65-74 in the September 2003Washington Economic and Revenue Forecast, Office of Forecast Council.

20Ibid, p. 65.

21Table 1, "Effective Tax rate on Value Added: Listed by Degree of Pyramiding," Washington

State Tax Structure Study Final Report, Appendices, p. 41.

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our analysis.22

The classifications obtained from these tables were first reduced by eliminating the class ofFIRE (finance, insurance and real estate), transportation and public utilities for the reason statedabove, they are taxed elsewhere. Rental of real estate for more than 30 days is exempt from theB&O, though no corresponding tax is paid. Finance is a problematic category for severalreasons.

Again, our special rules allow these to be deducted by businesses, and for the purposes ofthis tax the providers of these services are categorized as taxpaying entities. Eliminating theseentire categories from our calculations also injects a conservative bias to the tax base, as not allactivities will be exempt. Notice that the category of farming and some activities in forestry andfishing have not been eliminated, since these will accumulate at the next level of the supplychain.

Step 2: Convert data from calendar year to fiscal year, so the revenue data will beparallel to the tax base data. Tax revenues are reported by the Department of Revenue in byfiscal year,23 and in order to derive a legitimate rate, we need parallel data. To accomplish this

we simply (if crudely) add one-half of the first calendar year to one-half the second. This entailsdata from 1996 which is not displayed.

Step 3: Make some ad hoc adjustments to keep the data consistent. The categoriesdisplayed in the Tax Structure Studys final report were used as a template for taxablecategories. That table lumps services together as "legal/engineering/accounting." We could notdesegregate the OFC data, so we simply added an amount comparable to theStudys number.

Step 4: Convert from gross product data to net product to allow for the rule thatcapital purchases are deductible. With the rule that capital investments are deductible, wemove from gross product to net product. Net product is a figure adjusted for the consumption ofcapital. To obtain net product we simply reduced the gross product number by 10 percent.Capital consumption has averaged 8 to 10 percent as a whole in the postwar period. We haveused the higher end of the range and applied it to total gross product in order to inject anotherconservative bias to the analysis and to accommodate the proposal which allows outrightexpensing of capital purchases. The deductibility of capital can come in two forms, depreciation(which approximates the literal "consumption of capital") or in expensing outright. The latterwould be very helpful to start-ups and would strengthen the argument to eliminate other forms of

22We need to note here that we could not replicate the numbers in this table of the Study. The

table was created in part using the 1998 Washington State Implan Model, a proprietary input-outputmodel from the Minnesota Implan Group, Inc. The model may have generated the "Value Added" columnas a function of income. As noted below, our analysis begins with product data. A second clarification isalso in order. It would be tempting to use the "Total State" effective rate on value added identified in the

table (1.53%) as a surrogate for the revenue-neutral rate for this reform. In fact, the deductibility of capitalexpenditures is not clear from the table, and the reforms stipulation that purchases must be from othertaxpaying enterprises broadens the base significantly beyond that considered by the Study. Thesubtraction method VAT favored by the Study Commission in this context is very similar to the reformproposed here in some of its mechanics and somewhat similar in tax base, however, and we wouldexpect the nine Commission members who endorsed the tax alternative of Chapter 6 to also support thisproposal.

23Tax Reference Manual, Washington State Department of Revenue.

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business stimulus in the B&O structure. (The technical term for a tax, say a VAT, usingdepreciation is "an income VAT." If expensing were allowed, it would be "a consumptionVAT.")

Step 5: Expand product data to reflect the limitation of deductibility to in-state firms,thus expanding product data to the full tax base we are looking for. In the step that isprobably least precise of all the manipulations, we adjusted for the reforms proposal which

limits deductions of purchases to those from other taxpaying entities. This in effect adds to thetax base, as out-of-state firms products will not be deductible. The amount of this addition isunknowable. Import and export figures are available for Washington with regard to internationaltrade, but these are superfluous to our purposes. (Even these, because they are based on point ofshipment, not point of production, are not relevant). We suggest a reasonable estimate of thiscontribution to the tax base from out-of-state firms can be got by assuming that one-half of goodsand services taxable under Washingtons retail sales tax come from out -of-state suppliers. Thisfigure does not include food and drugs, which are exempt from the retail sales tax, nor manyservices, and thus by no means does it represent one-half of the value of all goods and services.

Step 6: Account for the cost of covering the universal $100,000 standard deduction.The tax base developed by these manipulations is further reduced by the impact of the standard

deduction of $100,000. The US Census Bureau in its "Statistics of US Businesses: 2000"provides a table estimating the number of businesses in Washington by size of enterprise interms of employment.24 This table identifies 138,228 total firms. The 82,500 firms with fewerthan 5 employees have an average payroll of under $50,000. Payroll will not be a stableproportion of taxable receipts across firms (see the next section), but it ought to be more or lessrelated. If we assume that an equivalent of 40,000 firms will be unable to take advantage of thestandard deduction of $100,000 by virtue of taxable receipts being below that figure, then weproduce a round number of 100,000 firms which take full advantage, resulting in an even $10billion reduction in the tax base from the standard deduction provision. (The same 40,000number would be obtained with the assumption that the equivalent of 80,000 firms could utilizeonly half the standard deduction or that utilization for the 80,000 firms was distributed evenly

between $0 and $100,000.)

Both the Census table and that from the States Labor Market and Economic Analysis datademonstrate a striking characteristic of the states employment it is top-heavy. Firmsemploying 500 or more comprise less than 2 percent of all enterprises in the Census data, yetaccount for 45 percent of employment and well more than half of annual payroll. The largestfirms, those employing more than 2,500 account for barely 1 percent of firms, but more than athird of employed workers and 45 percent of payroll.

Step 7: Increase revenue requirements by 50 percent to address the chronicinadequacy of state revenues. The sequence of steps to this point results in the "revenueneutral" rate. As discussed in Part 5, no reform will be successful or complete without

addressing the hole in the states fiscal foundation, the chronic and growing shortfall in revenues.24

US Census Bureau, "Statistics of US Business: 2000: Washington: All Industries by EmploymentSize of Enterprise," http;//www.census.gov/epcd/susb/2000/wa/WA--.HTM." The State of Washington,Employment Security Department, Labor Market and Economic Analysis, also provides an estimate ofsize of firm by number of employees, but the Census Bureaus count is more relevant, as it excludes firmswithout payroll and other categories which are not relevant to this issue e.g., governmentestablishments. See "Washington State, Employment Security Department, Labor Market and EconomicAnalysis, "Size of Firm by County Distribution," October 3, 2003,http;//www.workforceexplorer.com/publication.asp?PUBLICATIONID=1610.)

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The final step in our calculation is to compute an increase that will measurably improve thissituation. An increase of 50 percent, or $800 million to $1 billion generates the range of ratesdisplayed in the tables. Our target is the 2006 fiscal year, so we believe that this is animminently practicable goal with the rate of 2.0 percent.

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TABLE B-1

STEPS 3 THROUGH 7

Fiscal Year

1997 1998 1999 2000 2001

Simple Product Divided by Actual Collections

Applicable Tax Base (millions) 96,938 106,477 118,361 126,820 129,326Actual B&O Tax Collections (000s) 1,722,802 1,853,815 1,827,459 1,854,948 2,012,403

Implied B&O Reformed Tax Rate 1.78% 1.74% 1.54% 1.46% 1.56%

Step 3: Minor Adjustment for Continuity

Tax base Including $8 billion adjustment 104,938 114,477 126,361 134,820 137,326

for services discrepancy (millions)

Actual B&O Tax Collections (000s) 1,722,802 1,853,815 1,827,459 1,854,948 2,012,403

Implied B&O Reformed Tax Rate 1.64% 1.62% 1.45% 1.38% 1.47%

Step 4: Consumption of Fixed Capital at 10%

Consumption of Fixed Capital at 10% of GrossProduct (millions)

16,851 18,364 20,025 21,328 22,052

Revised Tax Base with Capital Consumption(millions)

88,086 96,113 106,335 113,492 115,274

Implied B&O Reformed Tax Rate 1.96% 1.93% 1.72% 1.63% 1.75%

Step 5: Accting for taxpayer-only deductibility *

Sales Tax Collections by Fiscal Year ($millions) 4,373 4,663 4,948 5,406 5,519

Divided by State Rate of 6.5% ($millions)

Equals Approximate Taxed Retail Sales 67,278 71,745 76,127 83,163 84,909

Tax Base w/ "taxpayers-only" ded. at 50% of RST

Retail *

121,725 131,985 144,399 155,073 157,728

Implied B&O Reformed Tax Rate 1.42% 1.40% 1.27% 1.20% 1.28%

Step 6: The Influence of the StandardDeduction at $100,000

Actual B&O Tax Collections (000s) 1,722,802 1,853,815 1,827,459 1,854,948 2,012,403

Tax Base reduction of $10 billion (millions) 111,725 121,985 134,399 145,073 147,728

Implied B&O Reformed Tax Rate 1.54% 1.52% 1.36% 1.28% 1.36%

Step 7: Calctg.the Rate for Enhanced Revenue

Actual B&O Tax Collections (000s) 1,722,802 1,853,815 1,827,459 1,854,948 2,012,403

Increasing Collections by 50 percent (000s) 861,401 926,908 913,730 927,474 1,006,202

Reformed Collections (000s) 2,584,203 2,780,723 2,741,189 2,782,422 3,018,605

Tax Base (millions) 111,725 121,985 134,399 145,073 147,728

Implied B&O Reformed Tax Rate 2.31% 2.28% 2.04% 1.92% 2.04%

* Assumes 50% of retail taxed under retail sales tax (RST) is not produced by Washingtontaxpayers.

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Appendix C

The Break-Even Point

The current B&O undertaxes larger, established, and vertically integrated businesses. Thereform adjusts the burden in favor of nurturing small businesses, promoting investments incapital equipment and facilities, and evening the load on users of in-state products. Can we finda break-even point so that an individual business owner can know whether he or she will dobetter on the tax return to the state under the current B&O or under the reform rules?25

The short answer to this question is No. We would be comparing gross sales to net sales, andas already discussed, the two may bear little resemblance to each other. We can get closer,

however, for some businesses. The tables below allow comparison for those who know whatthe percentage of allowable deductions is against their gross receipts.

Table C-1

Break-Even Point Between Current B&O and Reformed Taxat 2.0 Percent

Assuming Different Levels of Allowable Deductions26

.00484 Rate:Wholesaling,

Manufacturing70% 1,724,13860% 632,91150% 387,59740% 279,33030% 218,34120% 179,21110% 151,9760% 131,926

.00471 Rate:Retailing

70% 1,550,38860% 607,90350% 378,07240% 274,34830% 215,28520% 177,14810% 150,4890% 130,804

.015 Rate:Service and Other

Activities70% negative60% negative50% negative40% negative30% negative20% 2,000,00010% 666,6670% 400,000

25Effective vs. Nominal Tax Rate. A potential area of confusion arises from the calculation of theeffective rate on value added, as displayed in Table 9-7, Appendix A. This effective rate does notcorrespond to the nominal rate which we are discussing in this section, which is the amount whicha firm remits to the state at tax time. The effective rate earlier is no less burdensome andappropriate for consideration, but it is the nominal rate we are discussing here. This rate can beeasily grasped and its weight communicated to business owners, and this is the amount on thetax bill.

26Calculated by solving for the equation .022-[(x - deduction%)(x) - 100,000)] = (b&o rate)(x).

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This table indicates that a great many businesses in Washington state would pay less under thereform proposal. Department of Labor data identify firms by size of work force. Of the nearly140,000 total firms in Washington counted by the US Census Bureau in 2001, more than halfhad fewer than five employees and an average payroll below $50,000.27 The next cohortreported, those businesses with five to nine employees, comprised another 20 percent ofWashington businesses, and their average payroll amounted to $167,000. Value added, as

discussed more fully in Part 5, is comprised basically of payroll and returns to ownership. Thereformed tax is based on a value added concept, but the tax exposure of an individual businessmay or may not come close to economic value added because deductions allowed arerestricted to purchases from other taxpaying enterprises and to capital expenditures. In lieu of amore complete discussion, we suggest simply that 70 percent of Washington businesses wouldsee a lower tax bill under the reform. Notice, however, that by far the greater number of workerswill be in those enterprises with a higher bill. Companies employing twenty or more workersaccount for 80 percent of employment.

27Statistics of US Businesses 2000: All Industries: Washington: By Employment Size of

Enterprise, http://www.census.gov/ eped/susb/2000/wa/WA- -.HTM.