Olympia: Breaking up with a tax favor is so hard to do

Despite the looming government shutdown, not much happened in Olympia over the weekend. Credit: Visitor7/Flickr

This is the second in a three-part series on tax reform in Washington state.

The state keeps tabs on more than 600 tax breaks that have been enacted over the years. In time, and with a few significant exceptions, each of these will come up for formal review. According to the Department of Revenue’s 2012 Tax Exemption Study, 113 fall into the business incentive category. And businesses will realize approximately $1.7 billion in tax “savings” in the current biennium.

Since the Great Recession began, there has been increasing interest in using tax incentives to enhance economic development. Numerous new and expanded incentives were the subject of bills introduced in the 2011-12 Legislature. And incentives have become a topic in the race for governor between Jay Inslee and Rob McKenna. Inslee has proposed new breaks to stimulate economic growth in green jobs. And both candidates would increase the tax credit available to small businesses.

The review process is in the hands of the Joint Legislative Audit and Review Committee (JLARC) ,which is assisted by the Citizen Commission for the Performance Measurement of Tax Preferences. The Commission schedules reviews and comments when they are completed. At its Aug. 24 meeting, the Citizen Commission adopted a 10-year review schedule that lists 569 preferences with a total biennial cost of $65 billion.

A JLARC review begins with a determination of the Legislature’s public policy objective in enacting a preference. The objective is expressed in an intent statement usually found in a brief preamble to a bill. However, the Legislature hasn’t been consistent in this regard, requiring a search of other records for its intent. Statutory factors, which can be objective metrics but are most often desirable outcomes stated in general terms, are then used to determine the efficacy of a preference.

On numerous occasions the intent has been to boost economic development. As early as 1972, when the state was in the throes of a minor recession, Senate Bill 92 was enacted that established an economic assistance authority and allowed it to grant sales tax deferrals on machinery, materials , labor, and services utilized in manufacturing. The intent section, which is similar to recent statements, reads:

It is declared to be the public policy of the state of Washington to direct financial resources of this state toward the fostering of economic development through the stimulation of investment and job opportunity in order that the general welfare of the inhabitants of the state is served. The legislature further finds that reducing unemployment as soon as possible is of major concern to the economic welfare of the state. It is further declared that such economic development should be fostered through provision of investment tax deferrals, construction of public facilities, the insurance of industrial mortgages, and technical assistance; that expenditures made for these purposes as authorized in this chapter are declared to be in the public interest.

In evaluating tax preferences, JLARC determines which of the factors (set forth under RCW 43.136.055) should be included in the review of a particular preference based on the factor's relevance. Several are directed at economic goals: to encourage business retention, growth, and attraction; to promote high-wage jobs; to positively impact the state economy; and to stabilize communities. However, all are stated in subjective language and the law generally does not provide clues as to how they should be evaluated.

JLARC is also directed to consider similar and competing tax preferences adopted by other states, and identify benefits that might be gained by incorporating corresponding provisions in our policies. This reflects the belief that the state must use tax breaks to compete with other states for businesses and jobs.

Senate Bill 5044 enacted in 2011 added an economic impact analysis to the list of factors to be considered by JLARC when reviewing tax preferences. It requires a comparison of the benefits produced by a tax expenditure to the benefits of a direct program expenditure in the same amount. For example, instead of granting R & D tax breaks to high-tech companies, state funding could be increased for more slots in university STEM (science, technology, engineering, and math) programs. But the legislation requires the use of a state’s input-output model that the Citizen Commission found to be lacking for this purpose.

SB 5044 failed to address four important issues: preferences that are exempt from review; how to best measure outcomes; whether there is a real need for a public subsidy; and direct expenditures by other state agencies to encourage economic development.

An example of the first is the sales tax exemption for manufacturing machinery, which the Legislature has forbidden JLARC from reviewing. Its cost to the state in the next (2013-15) biennium is projected to be $539 million. A review might indicate if some of that amount is used to buy automated equipment that actually replaces human workers.

A problematic aspect of the legislative intent (expressed in SB 5044 and other earlier legislation) is that tax preferences enacted for economic development purposes must demonstrate growth in full-time family wage or high wage jobs with health and retirement benefits. While laudable, the difficulty is to separate job growth that would have occurred without the preference. Also, firms taking the sales tax exemption for construction of R&D facilities or investments in rural counties must indicate the number of new products or research projects developed and the number of new patents, copyrights, and trademarks associated with the facility. Again, correlating these gains with the tax preference is a difficult exercise as companies restructure in an ever-changing business environment.

And, as pointed out in a previous article, a needs test is clearly called for when well-established companies can fund R & D and other investments with their own funds in lieu of a tax break. Finally, there may be redundancy in the state’s economic development efforts. The Washington Economic Development Commission has inventoried direct economic development expenditures in 128 programs across 32 state agencies but has made no comparative study of tax expenditures that serve similar purposes. These direct budgeted expenditures total more than $2 billion annually.

The final step in the review process is a JLARC report to the Legislature. JLARC must provide a recommendation as to whether the tax preference should be continued without modification, modified, scheduled for sunset review, or terminated immediately. And the committee may recommend “accountability standards” for the future review of a tax preference.

From 2007 through 2011 JLARC reviewed 120 preferences. It recommended that 70 should be continued, four should be continued with a modified expiration date, and 29 should be re-examined and the intent clarified. It recommended that 11 be allowed to expire on their sunset date. For just six tax preferences, the recommendation was termination. The Citizen Commission differed with only nine of the 120 reviews. It recommended that two additional preferences be terminated rather than continued or clarified, and another two should be re-examined rather than terminated.

The Legislature has not exactly embraced the recommendations from either JLARC or the Commission with enthusiasm. Of the 120 JLARC reviews, 27 were the subject of bills that were not enacted including four preferences for which termination was recommended. Only five were implemented. Eleven of the 120 preferences did end, including three for which the Legislature made a different policy choice and allowed them to expire.

In the nine cases for which the Commission adopted a different recommendation, only one was fully implemented. For the other eight, bills were introduced and either not enacted or no action was taken.

These results attest to the difficulty of undoing a tax preference once established. One person’s crucial incentive is another person’s worthless loophole. And almost everyone can think of at least one tax break they are unwilling to give up. Thus gridlock sets in.

The problem is compounded by the lack of objective metrics that reveal the real economic benefits of preferences compared to the costs, and also to the absence of a process that compares tax expenditures to the option of making direct program expenditures.

Part 3 will look at ways to improve the review of existing tax breaks and how new tax breaks should be evaluated before they are enacted, with a focus on business incentives.

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