Closing tax loopholes in Olympia could backfire

"No loopholes" is a good political rallying cry, but the reality is more complicated. Here's a short course through Washington state's tax maze, and how closing some loopholes would pinch consumers.

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"No loopholes" is a good political rallying cry, but the reality is more complicated. Here's a short course through Washington state's tax maze, and how closing some loopholes would pinch consumers.

Protesters in Olympia spent last week bouncing “no loophole” chants off the marble walls. Despite their venting, there will be no loophole fix for Washington’s multibillion-dollar budget gap. Such broad slogans also do little to illuminate the realities of the situation.

The state labor council’s “demand letter” sent to the governor and legislators last month sets out the complaint: “The state currently has 567 tax breaks on the books that cost taxpayers billions of dollars every year.  Instead of cutting vital services, the Legislature should be cutting the billions in wasteful corporate tax breaks.”

Let's start by using a more neutral term, “tax preferences,” as the Legislature did when it established the Citizen Commission for Performance Measurement of Tax Preferences in 2006. The estimate of 567 tax breaks comes from the revenue department’s quadrennial report on “tax exemptions, exclusions, deductions, deferrals, differential rates, and credits.” Unfortunately, the department’s inventory fails as a good framework for exemption review.

In 2008, the department reported an estimated potential savings for taxpayers of $98.5 billion from 567 preferences. The analysis then draws a good distinction between taxpayer savings and potential revenue collections. The department estimated that governments might realize about $14.8 billion from repeal, about 15 percent of the total.

The department's report has led to all kinds of mischief and exaggeration. Loophole closers regularly cite the misleadingly big numbers from the report, but they primarily target a handful of things they consider “wasteful corporate tax breaks.” They also mention, presumably for rhetorical effect, eliminating tax exemptions for “elective cosmetic surgery” and “private jets” — tiny amounts. And these advocates do not mention that hardly anyone is pushing the repeal of popular sales tax exemptions for groceries and pharmaceuticals, the Business and Occupation (B&O) tax exemption for employee wages and salaries, or property tax exemptions for nonprofits.

Underlying the agitation is the notion that Washington businesses are under taxed. In fact, Washington businesses bear among the nation’s heaviest tax burdens. The accounting firm Ernst & Young recently calculated that businesses paid Washington’s state and local governments $14.7 billion in taxes during the 2009 fiscal year. This was 51.2 percent of all taxes the governments received. The effective tax rate on business in the state (calculated as the ratio of taxes to private sector gross state product) is 5.3 percent, tied for 13th highest and significantly higher than the 4.7 percent national average.

The business burden would be much higher were it not for tax preferences enacted to offset problems inherent in Washington’s peculiar tax system. This is especially the case with respect to preferences related to sales taxes on business-input purchases and the business and occupation (B&O) tax, which together account for nearly one half of the business tax burden.

Indiana University economist John Mikesell says a good preference analysis begins by identifying the norm from which the preference deviates. Ideally, the benchmark normal tax base should be selected by the logic of good tax policy. Mikesell calls this the conceptual baseline approach and notes that it requires “a clear statement of what state tax policy actually is — not just an indication of how much money the state wishes to collect...”

In Washington, it is particularly important to get the baseline right for sales taxes. General sales taxes (i.e. the retail sales and use taxes and the B&O tax) provided 69 percent of general fund-state revenue in 2009. While many liken the B&O to a corporate income tax, public-finance experts see it as a sales tax. Revenue from the B&O is equal to one-third of the amount received from the retail sales and use taxes.

The sales tax problem to be solved stems from what analysts call “pyramiding,” multiple taxation of the same transaction. Consider a man’s shirt. The state collects sales tax (both retail sales tax and B&O) when a store sells a shirt. Should the state also collect sales tax when a shirt maker sells the shirt to the retailer? What about the shirt maker’s purchases of cloth, thread, and buttons? Although Washington provides a retail sales tax exemption for goods purchased for resale, these transactions are subject to the B&O.

Other purchases critical to the production and sale of shirts — for example, needles, thimbles, paper on which catalogs and invoices are printed, ink, and telephone service — are not physically incorporated into the shirt in the same way that cloth, thread, and buttons are. Because these things are not incorporated into the shirt, the resale exemption does not apply. The shirt maker is forced to pay retail sales tax on them all. All these are inputs to the shirt-making business, and all should be exempt from sales tax.

Applying the sales tax to business-input purchases creates distortions. Taxes as a share of the final product price will vary between firms producing the same product depending on how much production takes place internally and how much is purchased from outside vendors.

Even the Institute on Taxation and Economic Policy (ITEP), the research arm of the labor-backed Citizens for Tax Justice, agrees that the inputs exemptions make sense: “Taxing business inputs through the sales tax is generally akin to taxing the consumer more than once on the same retail sale. As a result, expanding the sales tax base to include business inputs will usually hurt low-income taxpayers.” They conclude, “The exemption from the sales tax of most purchases made by businesses is actually good policy.”

Another factor to bear in mind is that tax exemptions may also stimulate additional investment. In 1995 legislators repealed the sales tax on machinery and equipment (M&E) directly used in manufacturing. One study has estimated that the M&E exemption increases investment by 22.3 percent over a ten-year period, adding 54,000 jobs.

One also hears the loophole-closers advocate extending the retail sales tax to professional services (e.g. legal, accounting, architectural and engineering services). This would further compound the pyramiding problem and boost consumer costs. Business purchases account for 75 percent of in-state sales of professional services. The 2002 tax reform commission chaired by Bill Gates, Sr. concluded that professional services are “difficult to tax under a retail sales tax because they would pyramid” and recommended extending the sales tax to consumer services but not to professional services.

It's also important to understand that some preferences that benefit big business also aid consumers. For example, a B&O tax deduction for interest earned on first-mortgage loans for residential property is slammed a break for Wall Street banks. Eliminating this deduction, however, means the additional tax paid by mortgage holders will be passed on to borrowers in the form of higher mortgage interest rates.

The ITEP insight that taxing business inputs lands heavily on consumers is confirmed by a 50-state study presented at the 2009 annual meeting of the National Tax Association. Researchers found that when business taxes in Washington state are increased by $100 million, $52 million of this cost is shifted forward onto in-state consumers, $29 million is shifted back onto workers, $1 million is shifted back to in-state capital, and $18 million is exported.

Of course, the tax code should be regularly evaluated. Systematic, thoughtful, and objective review of tax preferences, such as that conducted by the Citizen Commission, may indicate that some preferences no longer make good fiscal policy sense. When they don’t, they should be repealed.

Clearly, however, this year’s focus on exemption review has been driven by a search for more money for the state budget. It has little to do with responsible tax policy. And it comes with considerable risk. We should be careful about increasing business costs. By raising taxes on business, we will make the recovery, as painfully slow as it has been up to now, even slower.

To read the version of this article by the Washington Research Council, go to this link. For a rebuttal from the liberal Budget and Policy Center, go here.

Kriss Sjoblom, vice president and economist of the Washington Research Council, co-authored this article.


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