Nine ways to fix Washington's tax mess

How to eliminate unneeded tax breaks, improve the efficiency of those that boost our economy and save Washington state some serious money.
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How to eliminate unneeded tax breaks, improve the efficiency of those that boost our economy and save Washington state some serious money.

This is the third in a 3-part series on tax reform in Washington state. You may also want to read Part 1, "Olympia: So many bills, so little tax reform," and Part 2, "Olympia: Breaking up with a tax favor is so hard to do."

From Tax Incentives, Washington State Tax Structure Study, Alternatives Subcommittee Paper, April 18, 2002.

“The issue of whether tax incentives achieve their stated purpose remains an open question. There are limited means to determine who benefits from tax incentives and if they are effective in creating jobs. Washington law requires the Department of Revenue to prepare a periodic compilation of the reduction in revenues from all tax incentives and exemptions. A few other states have enacted programs that require firms to publicly disclose information on the amount of their tax savings and on the creation of jobs and goal attainment.

Studies that examine the effectiveness of tax incentives have conflicting and inclusive results. Academic studies show small, if any, impact on growth. There are studies involving interviews or surveys showing that for individual firms tax incentives are working to create jobs in the communities in which they locate.”

Let’s start with this premise: Once a tax break is enacted, it’s difficult to modify or eliminate. What's more, analyzing the effectiveness of a tax break – the benefits versus the costs – is a problematic exercise. At least this seems to be the conclusion of many economists and others who have closely studied the use of tax breaks by states to stimulate their economies.

Individual tax breaks on the books need to be carefully reviewed using an improved set of evaluation criteria, yes, but the whole idea that they are an effective way of fueling economic development and growth also requires a much closer look.

If this is true, we need to find new approaches. Here are a few suggestions in the category of personal opinion. Several will require legislative action.

1) Business incentives need to be grouped and given review priority.

Currently, the Citizen Commission puts together a 10-year plan for reviewing all tax exemptions. Health industry tax exemptions are slated to be reviewed next year under this plan.

While it’s certainly appropriate to submit health preferences to an early review — the cost of health care is a major policy issue — there are also numerous business incentives that may or may not contribute to the state’s economic condition that also should be reviewed without delay.

2) A new evaluation factor should be added for determining need among companies that receive tax credits.

House Bill 2532 tried to address this issue in the context of the high-tech R & D credit. But it got unduly complicated by involving contributions to the Opportunity Expansion Program for the purpose of increasing slots leading to degrees in high demand areas such as computer science.

The credit is clearly not needed by well-established firms with the means to invest in R & D. Several firms could be cited, but Microsoft serves as an example. At last count Microsoft had $53 billion available for investment. It should be possible to draw a line somewhere between zero and $50 billion, above which a firm is able to fund R & D without taxpayer assistance.

3) Statutory restrictions on what can be reviewed should be removed, especially the manufacturing machinery & equipment (M & E) exemption and the small business credit.

Currently, tax exemptions for small businesses and manufacturing firms that invest in machinery and equipment aren't subject to review at all. Both are used heavily, and both were the subject of bills in the last legislative session expanding the preferences.

The M & E sales tax exemption has a significant cost. And the cost of the small business B & O credit could increase even more since both candidates for governor support its expansion. Rob McKenna supports a plan that was embodied in Initiative 1098, which would increase the credit to $4,800 a year, at an estimated additional two-year (2013-14) cost of $520 million.

Allowing these preferences to be reviewed is not taking a position on their merits. It simply means that their cost-effectiveness should be understood. Does the M & E exemption help fund robotic equipment that, although increasing productivity, actually reduces manufacturing jobs? Would it be better to focus the small business credit on start-ups?

4) All newly proposed preferences should have a clearly stated objective and should be assigned an expiration (sunset) date.

This would ensure that benefits will be weighed against costs, and that inevitable changes in the business environment that affect the need for a tax break can be reviewed in a timely manner.

5) A new effort should be made to reform aspects of the state’s tax structure that invite enactment of ever more tax preferences.

A place to start is with the B & O tax, which is replete with preferences in the form of exemptions, deductions, credits and differential rates. The Department of Revenue 2012 Tax Exemption Study lists 176 preferences with a total cost to the state of $7.7 billion in the current biennium. Of these, 113 fall into the “business incentive” category with an impact of $1.7 billion. The state actually gives back more in breaks than it retains from B & O tax receipts. For every $1.00 than goes into the general fund, $1.19 is lost through the preferences. Shifting from a tax on gross revenues to net revenues would make most if not all of these unnecessary.

6) The usefulness of the 'fiscal impact' measure should be reconsidered, and similar newly proposed metrics should be carefully thought through before they are adopted.

Currently, the state benefits of tax preferences are assessed using a number of factors, including "fiscal impact" which tries to measure the total impact of the preference on the state economy. This has, however, proven difficult to assess, and the results have not been encouraging. Newly proposed metrics such as rate of return and net benefit analysis may be equally hard to compute. This is implied by the Joint Legislative Audit and Review Committee's (JLARC) review of both the R & D sales tax exemption and the B & O credit, and by a separate study of the credit by the Upjohn Institute.

JLARC found the results of the R & D incentives to be “mixed.” It concluded: “The B&O tax credit resulted in an estimated one-time employment growth of 454 jobs with an average cost per new job of $45,000 and an estimated increase of new earnings per job of $25,000. In addition, while beneficiaries made R&D expenditures in Washington, it is not clear how much of this spending occurred as a result of the tax credit.”

Although Upjohn’s report is technically complex, its conclusion is summarized by this statement:

“(E)ach new job created by a state tax credit program in Michigan produced about $3,100 (in 2009 dollars) in fiscal benefits to partially offset the costs of the program. If a similar number applied in the state of Washington, the 484 jobs that are estimated to be created in 2009 due to the tax credit would provide about $1.5 million in fiscal benefits. This would offset less than 10 percent of the $24.34 million cost of the credit.”

7) The Citizen Commission should collaborate with other entities involved with tax preference issues.

One such entity is the state’s Economic Development Commission. The EDC has produced an inventory of economic development programs managed by state agencies between 2008 and 2011. It details 128 economic development programs provided by 32 state agencies and organizations. And it also lists 57 economic incentives – tax preferences – to encourage economic expansion. But it doesn’t correlate the programs with the incentives.

A cursory review of the inventory indicates that there may be a nexus between a number of programs that are funded through both direct state budget expenditures and certain business tax preferences. These programs address issues such as innovation zones, commercial area revitalization, export assistance, economic development in rural counties, business loans, training for high-demand jobs, and educational centers of excellence at community colleges.

A side-by-side analysis of preferences and programs may uncover opportunities for increased efficiency. One or the other might be more cost-effective alone, allowing savings compared to the total expenditure for both. Or cost-effectiveness could be greater when programs and preferences are appropriately aligned.

8 ) We need to examine federal tax incentives that encourage economic growth and how they might either substitute for or complement state tax incentives

Questions that need to be answered include: what federal incentives are currently available and what has been proposed? The latter would take into account President Obama’s American Jobs Act, which is pending before congress and which currently includes an allowance for 100 percent expensing of investments – a tax deduction on investments in new plants and equipment.

9) We should mine national economic studies for a better understanding of state tax preferences.

Several national studies have reached pessimistic conclusions regarding the effectiveness of state tax preferences to stimulate state economies. They should be consulted to answer important questions. Is tax break competition between the states more or less a zero-sum game?

The Brookings-Rockefeller Project on State and Metropolitan Innovation, last year concluded that: “job gains and losses are overwhelmingly driven by intra-state business dynamics rather than the between-state movement of firms. Furthermore, the tax incentives that smokestack-chasing relies on have steep present and future costs but offer only varying and uncertain benefits. State resources would then be better spent supporting the many factors that drive entrepreneurship and help firms to grow…”

Recently the Pew Center on the States issued a report that evaluates how all 50 states analyze the effectiveness of tax incentives for job growth. Washington was found to be one of thirteen states “leading the way.” However Pew concluded that no state, including Washington, “ensures that policy makers rely on good evidence about whether these investments deliver a strong return.”

The state would benefit greatly from a wide-ranging discussion regarding the costs and benefits of business tax breaks, with a view toward enhancing economic development through the efficient use of scarce resources. This is something that the Citizen Commission is best positioned to organize. It has representation from business and an economic policy center, and the Chair of JLARC and the State Auditor are non-voting members. And it has a mandate to provide “effective citizen input”.

In this observer’s opinion there is a brief window of opportunity to address these important tax reform issues. The last legislature showed commendable restraint when it did not act in haste on several new or expanded tax breaks. But that may not be easy for the next legislature if recovery from the Great Recession continues to drag out.


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About the Authors & Contributors

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Dick Nelson

Dick Nelson is a former Washington State legislator. He currently contributes to the public debate on state and local fiscal issues through research and commentary. As when he was in the legislature, he prefers the Democratic Party.