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Washington Supplemental Report

Tax Environment

Washington has chosen tax systems that are, relatively speaking, quite different from other states. It is one of only seven states with no income tax and no tax on dividends or interest. It is one of only nine states that have a significant property tax at the state level. (For most states, property taxes are collected and used locally.) In addition, Washington still has a personal property tax on business machinery and equipment. Its gross receipts tax on the state’s businesses, dubbed a business and occupation tax, is also unusual.

Washington has a very strong populist history going back to the 1800s and an active initiative and referendum process that has frequently targeted tax and spending issues.

In recent years, several significant changes were either caused or inspired by initiatives. These included:

• A 1999 initiative that did away with the 2.2 percent motor vehicle excise tax, restricted car tab fees to $30 and required a citizens vote for all future tax or fee increases. This initiative was declared unconstitutional by the courts, but shortly afterwards the legislature did away with the motor vehicle excise tax (though without the $30 lid on fees.)

• A 2001 initiative (I-747), which limits increases in property tax revenue collections to 1 percent a year, unless voters approve more. This replaced a 1997 referendum that was supposed to limit property tax increases to the rate of inflation. Increases based on new construction, improvements or increased state assessments of value are not included in the 1 percent limit. Cities and counties are also allowed a one-time chance to increase taxes more than that if they have unused taxing authority from the past.

At the same time as some initiatives have restricted tax dollars, others have mandated increased services. For example, in November 2000, Initiative 732 directed the legislature to hike teacher salaries to keep up with inflation. The cost of this action was estimated at $400 million.

Efforts at thoughtful top to bottom reviews of the state’s tax structure have taken place at least seven times since the 1920s, but with little major reform. The most recent one, a review set up by the legislature and led by Bill Gates Sr. — led to a call in December, 2002, for a state income tax or a value-added tax on business and a reduction in sales and property taxes. A full copy of the report can be found at http://dor.wa.gov/content/WAtaxstudy/wataxstudy.htm. Prior to this, there was a major tax study effort in the late 1980s, in which Governor Booth Gardner brought a package of commission recommendations to the legislature, which did not take action.

Recent Tax Developments

• A cigarette and tobacco tax increase, I-773, was approved by voters in November 2001

• The Legislature approved about 40 tax bills during 2001 — most of the bills provided new business and occupation (B&O), sales, and property tax exemptions, according to State Tax Notes.

• In November 2002, voters turned down Referendum 51, which was placed on the ballot by the legislature. It would have raised the gas tax by 9 cents a gallon, hike the vehicles sales tax by 1 percent and increase truck-weight fees. But during the winter session in early 2003, legislators agreed to raise the state gas tax by a nickel per gallon in order to pay for $4.1 billion worth of transportation-improvement projects over the next 10 years.

• Voters approved a November, 2002 initiative (I-776) which required the lowering of vehicle license-tab fees to $30, eliminating local vehicle registration surcharges, as well as requiring a public re-vote on Sound Transit’s light rail program. But a County Superior Court Judge ruled the initiative unconstitutional in February 2003 saying it violated the constitutional mandate that initiatives deal with only one subject.

Budget Information

Revenues in the 2001-2003 biennium showed a drop-off from the previous two-year budget cycle — an extremely unusual situation.

Tax cuts plus an anemic economy left legislators balancing the current two-year budget by using about $500 million in reserves. But that balance quickly disappeared as revenues continued to come in weaker than expected. By the fall of 2002, the Governor and legislators were struggling to deal with a $1.5 billion gap between revenues and spending, largely through cuts in spending, including the lay off of state workers and the cancellation of a planned raise for state employees.

By the end of calendar 2002, the state faced a $2 billion hole in the biennium that starts July 1, 2003. This had grown to $2.6 billion by the spring. In a House and Senate agreement that resulted in a $23 billion two-year budget, the gap between expenditures and revenues was whittled away through cuts, budget freezes, a hike in liquor prices and increased college tuition. ($400 million more from Congress over the biennium, Washington’s part of the $20 billion aid package for the states also helped to alleviate some of the pressure.)

While the state struggles to cut back on spending, some costs are spiking. In February, the state actuary announced that the state’s retirement-fund costs would balloon by more than 1000 percent. (Steep increases were also expected for payments from state employees).

Adequacy

Washington has an unbalanced structure caused by its abhorrence of an income tax. Because it shuns this tax, it is overly dependent on its sales tax and business and occupation tax, which is a gross receipts tax on business. (The current B&O tax rate is 1.5 percent for service industries, and slightly less than one-half of 1 percent for wholesalers, manufacturers and retailers, while the current sales tax rate is 6.50 percent with a local option sales tax maxing out at 2.40 percent.) With the exception of the property tax, most of Washington’s tax system is related to sales. The dependence on this leg of the tax stool for both state and local government has increased due to increasing limitations on property taxes (particularly restrictions put in place in 2001) and the elimination of the motor vehicles excise tax in 2000.

Meanwhile, the state’s economy has been more volatile than the national average. Historically, the timber and aerospace industries have had dramatic and traumatic ups and downs, and this can also be said, more recently, of the state’s substantial high-tech community. The growth of the state’s economy and the strength of its revenues led to significant surpluses from the mid to late 1990s. This, in turn, allowed legislators — and voters — to reduce taxes, with the impact masked by the booming economy. However, these cuts have proven painful as the state faces the current downturn and high levels of unemployment relative to other states. As one staffer says of the legislature: “When times were good, they took a short-term surplus and translated it into a long-term tax cut and that doesn’t work forever.”

Another source of worry for the state is that taxable sales have been shrinking as a percentage of the state’s economy — down from 61 percent thirty years ago, to 50 percent now. Many purchases — for example, groceries and medicine, legal services and airplane tickets — aren’t taxed by the state. The Department of Revenue estimates that the state could raise about $1.6 billion more for the state and $400 million for cities and counties by substantially increasing service taxation through the sales tax. The Washington State Tax Structure Study found in its December 2002 report that the current tax structure, created in 1935, “worked well for a mid-twentieth century manufacturing economy, (but) doesn’t work well in today’s economy with its greater dependence on the service sector.”

In addition, as with other states that are dependent on sales taxes, Washington also has major concerns due to the loss of revenue to Internet sales. And, since it’s next door neighbor, Oregon, charges no sales tax, it loses quite a bit of money in cross-border sales — $49 million in lost sales taxes, according to a 2000 study by the state House Finance Committee.

Washington has some pressing needs in terms of its infrastructure. Referendum 51, which sought to raise the gas tax 9 cents a gallon, was defeated in November. But during the winter session in early 2003, legislators agreed to raise the state gas tax by a nickel per gallon in order to pay for $4.1 billion worth of transportation-improvement projects over the next 10 years.

Fairness

Washington makes substantial use of tax credits and exemptions for businesses. Since 1994, the state has enacted 105 new tax breaks costing about $3.2 billion, according to David Brunori, contributing editor of State Tax Notes. Washington’s own reports indicate that it has 445 tax exemptions, which cost it about $8 billion over the course of a biennium.

The state taxes many services through its business and occupation tax. In fact, the Federation of Tax Administrators’ Sales Taxation of Services survey lists 152 services that are taxed out of a possible 164, putting it just behind Hawaii as the most service taxing state in the country. However, services in Washington are hit through the state’s business and occupation tax, which means that services are taxed at a low rate. There are some services that are taxed through the 6.5 percent sales tax — like landscaping or auto repair — but the vast majority are not.

The Institute on Taxation & Economic Policy has dubbed Washington “the nation’s most regressive tax system” due to its high reliance on sales taxes, it’s high cigarette tax and the lack of an income tax. Families with low income spend 16 percent of their income on taxes, while the highest income taxpayers only pay 4.4 percent, according to the report by the Washington Tax Structure Study Committee, which concluded in a December 2002 report that the current system is “fundamentally inequitable to low- and middle-income people, unfair to many businesses, and subject to sharp fluctuations in revenue.”

Who Pays? A Distributional Analysis of the Tax Systems in All 50 States shows an even greater disparity. The top 1 percent income individuals in the state pay 3.3 percent of their income in taxes, while the 20 percent of the population with the lowest income pay 17.6% of their income in taxes. http://www.itepnet.org/whopays.htm

Another issue: due to its B&O tax, which is a gross receipts tax, Washington has a significant problem with pyramiding, which means that the same items or services may be taxed multiple times as they move through the business chain. Since the extent of pyramiding varies in different industries, it causes major differences in the effective rate of taxation from one business to another. The Washington Tax Structure Study Committee also found that the nature of a gross receipts tax poses bigger burdens on new and low-profit margin businesses relative to others.

Management

The Department of Revenue (DOR) is well respected within the state. In terms of its internal management, it has had a secure and mature business planning process since 1986. The formal planning process, often pointed to as a model for other agencies within the state, takes place every two years. A contract with the Governor is used to target the department’s goals. Assistant directors then sign contracts with the director to outline their specific responsibilities for the next year. DOR follows the Malcolm Baldrige criteria in its self-evaluations. It uses both a taxpayer satisfaction survey and an employee attitude survey.

In the last several years, staff has been cut by about 10 percent, though, at the same time, the legislature beefed up the department’s audit programs.

Washington’s strengths include its drive toward better customer relations and a related ongoing effort to make the task of paying taxes simpler. Due to the state’s dependence on the sales tax, excise taxes and its business and occupation tax, all of the department’s direct “customers” are businesses, as opposed to private individuals. Its taxes are relatively simple to administer and Washington has a reputation among members of Tax Executives Institute as one of the top states in terms of customer relations with the business community, says Rich Prem, Director of Worldwide Indirect Taxes, Amazon.com and chair of the state tax committee of the Washington State Chapter of Tax Executives Institute. “There’s a relationship where business and the state can work together to look at points of irritation.”

Washington’s DOR is particularly strong in technology and is cited by a number of revenue officials in other states as a leader in this area. It has made business registration easier through a one-stop approach and is one of the states that has embarked on serious data-mining efforts.

Washington was the first state in the country to launch an Internet-based Electronic Filing and payment system for business taxpayers — the ELF system. Although the program has been marketed quite heavily, use of it has been somewhat slower than expected. As of June 2003, about 20 percent of monthly business filers choose electronic filing methods. The plan is to increase this by about 9 percent a month.

A Governing analysis of all 50 state tax websites put Washington in the top group. It stood out in terms of organization and the availability of taxpayer assistance information. In general, the state has done a particularly good job in providing information on its website, with reports and research about tax policy easy to find and active efforts to seek public comment about proposed changes and draft documents. One business executive notes: “Rulings and research are up there, much to the dismay of commercial providers who charge to aggregate that information.” The website is the first in the state to incorporate Content Management technology to quickly and accurately publish content. Managers are exploring ways the site can be improved through more options for customization.

The state estimates the value of all the exemptions and deductions and differential rates every four years. A new report is due in January 2004. It also has the ability to analyze the impact of tax changes on different income groups, according to the Corporation for Enterprise Development, “State Asset Development Report Card.” http://sadrc.cfed.org/states/wa.php

Washington has made very active efforts to analyze the roots of taxpayer non-compliance and use this information to better target individuals who may be shirking their tax obligations.

It is also one of the more active states in going after the money due it from cigarette sales through efforts to enforce the Jenkins Act. This act, which the GAO reported last year is just about never enforced, requires online cigarette retailers to provide sales receipts that indicate where goods have been shipped so states can collect excise taxes. In November, Washington’s attorney general filed a lawsuit against one Internet vendor from Missouri, asking the court to require it to deliver a list of Washington clients. The state estimates that $250 million in potential tax revenue is lost because of cigarettes smuggled into the state, purchased at Indian reservations or through the Internet. (Washington has also had some success convincing cigarette sellers on reservations to charge a tribal tax equal to the state’s cigarette tax. No money comes to the state directly from this tax, but it does rob purchasers of their incentive for buying on the reservation.)

Local issues

Washington’s cities and counties have been squeezed hard both by the action of the state’s citizens in several key initiatives and referendums, by increasing exemptions in the sales tax, and by the weak economy. The Washington Tax Structure Tax Study Committee noted that initiatives, tax reductions, exemptions and the loss of tax dollars through Internet sales have reduced local tax dollars by about $1.4 billion. Initiative 747 also was projected to cost local governments an additional $230 million in the next three years. Revenue problems are particularly profound for the state’s counties.

Like the state, local governments are dependent on the sales tax, which was first authorized for local use in 1970. While the state rate of 6.5 percent has remained steady for the last twenty years, local rates have continued to grow. Combined sales tax in the state ranges from 7 to 8.9 percent, according to the Washington Tax Structure Study Committee. There is very little capacity left in the current tax system for counties

A new bill signed into law by Gary Locke in April may increase the fairness of state taxation, but also deprives some cities of money they’ve been taking in through their own business & occupation tax. In the past, they have been permitted to levy their full gross receipts tax on businesses that operate in their borders. According to the new bill, after 2008, they will only be able to charge the tax proportionately to the percentage of the company’s business that is conducted in that city. The Association of Washington Cities estimates that losses to cities would be about $30 million annually.

Noteworthy Programs and Practices

• A Geographic information system is used to help citizens and businesses make sense out of the disparate tax rates in local communities. There are 350 taxing districts that can impose different tax rates, in terms of local option sales taxes. On the website, http://dor.wa.gov, there is a look-up table that will tell what the sales tax rate is for any address. It’s downloadable to companies and available on a look up basis to consumers. Managers believe that the GIS system has significantly improved the accuracy with which businesses are charging sales tax. In fact, a report about this technology in a private portion of the Federation of Tax Administrators website (http://taxadmin.org) indicated that the error rate in sales tax coding by businesses dropped from a high of 30 percent for some taxpayers to less than 5 percent among businesses that used the system.

• To better match experienced auditors with more complex tax collection cases, the Department of Revenue developed in the mid-1990s a system to identify and score accounts on the projected complexity level. The system, which replaced one in which cases were assigned by zip code, used the agency’s database of registered businesses and their history of tax reporting and delinquency. Delinquent accounts are now scored and referred to revenue agents based on an agent’s experience. This means agents are not overwhelmed by assignments above their experience level.

• Studies of non-compliance. Washington officials believe they were the first state and still one of the only ones to do a sophisticated Compliance Study, which is updated on a three-year basis. The Compliance Study is used to learn more about taxpayer non-compliance. It analyzes the percentage of money that comes in voluntarily, the percentage that comes in through enforcement efforts and the reasons behind common tax mistakes. The first Client Study showed Washington’s DOR that a very high percentage of taxpayers didn’t understand their tax obligations, particularly in relation to the use tax. To help remedy this situation, the Department used targeted mailings, spending thousands of dollars on postage and increasing tax collections by millions, officials say.

One example comes from the health care industry, as reported on the Federation of Tax Administrators private site for tax managers to share innovative programs. Washington officials found that of 15,000 registered accounts in the health care industry, only 2000 reported use tax. It sent out special notices to physicians outlining the kinds of purchases subject to a use tax and asked recipients to review their purchases and report any use tax that was due. This immediately resulted in half a million dollars in new use tax collections. A comparison of use tax collections from physicians in a selected quarter prior to the mailing and one year later showed an increase of 50 percent.

• A tax consultation service gives small businesses advice on gathering the necessary information to file tax returns and how to improve reporting. A company can arrange for a Department tax consultant to meet its executives, and help determine the taxes that apply to the business and at what rates. It helps taxpayers know they’re not overpaying or underpaying their tax obligations without risking tax assessments, past due interest and penalties.

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