Our state needs revenue for essential social programs and its education system. With the failure of tax measures on last fall's ballot, attention has shifted to numerous tax breaks benefiting private entities that drain state funds.
Breaks — aka: preferences, privileges, incentives, subsidies, and loopholes — take several forms: exemptions, deductions, deferrals, credits, exclusions, and differential rates. They have a long history that started when Washington was still a territory. Many were enacted in the 1930s when much of the state's current tax structure was established.
Some are constitutionally protected. Sales to the federal government and sales involving out-of-state delivery are exempt. Other exemptions, such as those for food and prescription drugs and the senior citizen property tax program, were enacted via ballot measures.
A myriad of breaks, now numbering in the hundreds, have been legislatively enacted in recent decades. Most have a relatively small revenue impact, but some cause a substantial expenditure of state revenues. Many were premised on important economic goals.
Since the mid-1960s, tax incentives have been used to bolster and diversify the state's manufacturing base and create family-wage jobs. The performance of these incentives is in itself an important story, but best left for another day. As is the question whether, in addition to tax policy, there are alternative tools available to state government that would increase long-term economic development and job creation? And what is the federal government's role — can it stimulate economic development in ways that do not cause one state to expend scarce resources competing with other states?
One large tax break was not even contemplated when the sales tax code was written in 1935; personal and professional services were not included in the definition of retail sales that focused on producer goods. This reflected the small share that services (business, consumer, medical, financial, etc.) were in the state economy at that time. Services are now a major share, with a value approximately twice that of manufactured goods. The Department of Revenue estimates that services receive a $2 billion annual exemption.
And the breaks keep coming. Last year a new sales tax exemption for electric power infrastructure and equipment used in data centers located in rural counties was created. And more breaks are in the pipeline. For example, the governor's Higher Education Funding Task Force this month recommended a 50 cent tax credit for every dollar in businesses's donations to a new scholarship fund.
The Department of Revenue has summarized the history, purpose, and revenue impact of each of the gamut of breaks. Many were enacted to take the sting out of the sales and B&O taxes, the two largest sources of state revenue.
The legislature has begun an effort to get control of breaks through the bipartisan Joint Legislative Audit and Review Committee (JLARC). And in 2006, it created the Citizen Commission for Performance Measurement of Tax Preferences. The commission is tasked with assisting the committee by formulating a schedule for the systematic review of preferences, and to comment on reviews, including whether they should be continued, revoked, or modified. Individual preferences are to be reviewed at least once every ten years, starting with the oldest first.
Another supporting effort was initiated in 2010 when the Legislature created the public-private sector Task Force on Tax Preference Reform. Their report submitted to the governor and legislature last November, recommended that the Citizen Commission be given more flexibility for scheduling reviews, such as grouping preferences by type of industry or policy focus. This is important since different breaks can have common policy goals.
In the past four years the JLARC, in reviews of 95 breaks spread over 1,500 pages, has recommended that the legislature continue 62 and terminate or allow to expire 12. The committee recommended that the legislature re-examine another 21. The breaks recommended for termination or sunsetting have a total estimated annual cost of $37 million. And the commission has adopted a schedule for review of the remaining 550 breaks over the next 10 years. These have an estimated total annual cost of $36 billion.
Given the low revenue impact of the reviews to date, the immediate imperative is to identify breaks that if eliminated or modified could help fill the current shortfall in state funding for social services. The review process needs to be quickly expedited with the clear purpose of generating 2011-13 biennium revenue. Revenue needs are significant but not huge if the goal is to save the most essential programs. For example, the governor's proposed budget would eliminate the Basic Health Plan ($230 million) and the Disability Lifeline Medical Program ($147 million).
Several groups have begun to target breaks that are the most problematic. The Economic Opportunity Institute has produced a list that includes interest earned on real estate loans, income earned by in-state freight haulers, agricultural producer’s income, and sales of customized software. Mortgage income, Viagra prescriptions, and a number of professional services, including cosmetic surgery, and have been red-flagged by the Washington State Budget and Policy Center as nonessential breaks.
The Washington State Labor Council takes a broad approach by advocating a 2- to 3-year moratorium on a "significant set" of exemptions in the $3 billion-plus range coupled with a sunset review and public referendum. It also suggests that exemptions for the purpose of creating or retaining jobs should be evaluated frequently, and if job goals are not met, taxes should be repaid.
I have scrutinized breaks that benefit the high-tech industries. One is a 1994 sales tax exemption for investments in buildings and equipment used for research and development (R & D), which can lead to high-wage jobs.
While 500 companies have participated, most of the pay-out has benefited a few large companies including Microsoft, Immunex (Amgen), Intel, and RBS Shell LLC.) Microsoft, the largest single beneficiary, has received an estimated $100 million from the state. Other major recipients include Immunex (Amgen), Intel, and RBS Shell LLC. These companies typically have large cash reserves available for investment. In 2009, Microsoft reported a cash balance of $37 billion and Amgen reported $18 billion.
Although this generous program has been routinely inventoried by the Department of Revenue, it does not have to demonstrate cost-effectiveness. One modification would be to require a showing by firms of actual financial need. A needs-test would align tax expenditures with the requirement placed on most social safety net programs. An example is the income requirement for the Apple Health for Kids program. It limits eligible families to those below 200 percent of the federal poverty level ($36,620 for family of three). At least one Republican budget writer in Olympia has talked about adding an asset limit.
Summing up: Tax breaks use revenues from all taxpayers to benefit favored economic groups. They involve expenditures similar to those for other state programs and thus should be given comparable scrutiny for need and effectiveness. This is especially important as their number and monetary costs have increased over the years.
Since the state is now facing a deeper and more prolonged economic crisis than earlier anticipated, the legislature should speed up the reviews and eliminate or modify breaks that are obviously ineffective, before axing essential programs.
Revenue being diverted to unproductive tax breaks could fund basic health care for many low-income citizens. It could educate and train the next generation of high-tech workers. Local governments would gain needed revenue. And reforming tax breaks would be a significant step toward broader tax system reform.
The first hurdle for reformers will come when bills are introduced and run up against the Eyman test: a two-thirds vote in both houses, or a simple majority vote and then referral to voters. Alternatively, reform measures could be framed as initiatives to the people. Whatever direction these efforts take, they should include a measure that asks voters to decide whether the elimination of a tax break should require the same majority vote of the legislature that it takes to create one.
And pushback from the folks who directly benefit from breaks can be expected. It's already begun. Writing in the Association of Washington Business blog, AWB President Donald Brunnell warns that repealing exemptions "would be a colossal mistake!" He says that it would cause businesses to move out of state.
The public takes a somewhat different view. Among respondents to a recent statewide Elway Poll who were asked how the legislature should proceed, the largest fraction, 39 percent, chose "close tax loopholes first, then cut spending."
It’s clearly time for a thorough, informed, and productive debate on tax breaks.