Small businesses are thought to be job creators. Both leading candidates for governor would improve the vitality of small businesses by expanding tax breaks. But what are the costs and how will they be paid for? And are further tax incentives better than reforming the state’s one-of-a-kind approach to taxing businesses of all sizes?
The first gubernatorial debate identified several important differences between Rob McKenna and Jay Inslee, one being their approach to economic development and job creation. Inslee thinks that several sectors should be targeted, while McKenna would broadly address the state’s business climate.
Inslee’s focus is on seven industry clusters that he believes will “dictate our prosperity” — aerospace, life sciences, agriculture, military, information technology, clean technology, and maritime — and on the small businesses that support them. McKenna’s take is that the state should not be picking winners, and that there is a need for assistance across all business sectors.
Both see a need for ramping up tax credits for small businesses. For McKenna, this would be a significant increase in the current Business & Occupation tax credit that is based on the amount of taxes due.
Inslee, on the other hand, takes a more conditioned approach. He would give a B&O tax credit to small businesses that add workers, and increase the credit in proportion to the wages paid. The credit would top out at $4,000 for every job created, and the total would be capped at $8 million.
To encourage small start-up businesses in what he considers high-growth and often high-capital industries — biotechnology, biomedicine, clean energy technology, and information technology — Inslee would provide B&O tax relief for the first three years of a company’s existence. And to encourage small start-up businesses in high-capital industries, he would allow “pre-revenue” companies, within limits, to accrue R&D credits for resale.
Neither Inslee nor McKenna has placed a price tag on their proposals, and neither has indicated how they will be funded. A few of the costs can be estimated. All require more fiscal analysis, including costs versus benefits.
Some context is needed. The Legislature enacted the small business tax credit in 1994. For most types of businesses, a credit of up to $35 per month ($420 per year) can be taken for B & O taxes due. Above that amount, the credit is reduced until it reaches zero at $70. The credit is granted to all businesses. There are no criteria for receiving the credit such as number of jobs created.
The B & O tax, a tax on gross income, has several base rates. For retailing it’s 0.471 percent. Thus the credit for small retailers currently equates to a complete exemption from the tax for those with a maximum annual income of about $89,000.
The credit, then, is intended to assist the smallest businesses, including sole proprietorships. And they are numerous — the Department of Revenue estimates that 220,000 firms benefit at a cost to the state of about $100 million per biennium.
Frequent attempts have been made to expand the credit. Most recently Initiative 1098, the income tax measure that failed at the ballot in 2010, would have increased the allowable tax credit to $4,800 in all business categories. Although he opposed I-1098, McKenna thinks this was the one good idea it offered.
The fiscal analysis for I-1098 indicated that it would have exempted an additional 118,000 taxpayers from all state business and occupation (B&O) taxes, and reduced the tax liability for an additional 39,000. A manufacturer would be exempt on earnings up to $1 million. The added cost would have been about $510 million per biennium and would have been offset by taxes on individual and corporate income.
Bills have been introduced to expand and target the credit. In the 2011-2012 legislative session, one would have exempted all new businesses, and given the exemption to small businesses for a longer period. Another would have created a credit available to businesses with under 100 full-time employees for the cost of training interns, apprentices, or permanent employees in high demand manufacturing positions.
Washington is one of only two states that tax a business’ gross receipts. The other, Ohio, has a high tax liability threshold and much lower rates. Forty-four states (including our neighbors Oregon and Idaho) tax net business income while four states (Nevada, South Dakota, Texas, and Wyoming) have no business income tax.
After the state sales tax, the B&O is the second largest generator of state general fund revenue. It’s expected to bring in $2.6 billion in the current biennium, about 20 percent of total tax collections.
Undeniably, the B&O presents a hardship for start-ups that may sell products but who, because of heavy initial costs, show no profit. Thus it’s hardly a selling point to be used by proponents of economic development and job growth.
So business supporters have turned to numerous preferential exemptions, deductions, and special rates, in addition to credits, to soften the blow. Each involves a tax expenditure that reduces state revenues.
B & O tax breaks now number about 175 and have a total revenue impact of about $7.7 billion in the current biennium. Revenue actually realized from the B & O tax is less — $6.5 billion. Thus the tax breaks represent 54 percent of the potential tax base.
The small business B & O tax credit has achieved a special standing among all of these. The Legislature in 2006 passed a bill that prevents the Joint Legislative Audit and Review Committee from even considering its efficacy, a protection that only a few other tax exemptions have been given.
All of this begs a question: Would it not be better to reform the state’s business tax system rather than incrementally adopting new band-aides in the form of more credits?
Reform is unlikely to happen until the state’s business leadership decides it’s time to act, which doesn’t appear to be the case.
In its 2012 legislative agenda concerning jobs and the economy, the Association of Washington Business listed as a key objective: “maintain existing tax incentives used by employers and recognize them as a necessary part of the tax code due to high tax rates or competitive factors.”
The Washington Policy Center describes itself as an independent, non-profit, non-partisan think tank that promotes sound public policy based on free-market solutions. In the heat of the I-1098 debate the WPC advocated for a single rate business tax along with the elimination of tax loopholes. However, its 2011 state policy recommendations make no mention of it.
And there is the Washington Research Council, which provides fiscal analyses from a business perspective. Its recent commentary on the principles underlying the design of a good state tax system doesn’t talk much about the B & O tax. It does indicate that Washington taxes business too heavily.
So at this point the prospects for an overhaul of the state’s business taxes in the near-term look slim. And candidates for governor will be free to propose what seems to strike a popular chord.