State's tax system: It's broke and needs fixing

No one likes paying taxes. The late Louisiana Sen. Russell Long often repeated the ditty: "Don't tax me, don't tax thee, tax the fellow behind the tree!"

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Taxes are recognized as one of the inevitable costs of living in a developed society in which we have to buy goods and services produced by others -- whether those goods and services come from the private or public sector. Either way, you have to pay.

But Washingtonians are grumpy about our tax system: Witness the repeated success of recent anti-property tax initiatives as well as those curtailing the Motor Vehicle Excise Tax. And although taxes are inevitable, there's nothing inevitable about the particular selection or level of taxes that we pay to the state.

In fact, Washington has a strange tax system, one that is radically different from the rest of the country's. We have the second-highest state retail sales tax rate in the nation -- 6.5 percent -- and the two states ahead of us don't allow local sales taxes as we do.

Washington is the only state with a gross receipts tax, the business-and-occupation tax, which collects from enterprises whether or not they are making money. Only three other states -- Nevada, South Dakota and Wyoming -- do not have some kind of income tax in their revenue mix.

The 2001 Legislature created a "Tax Structure Study Committee" to review the state's tax system, to report on its strengths and weaknesses and to recommend possible alternatives to the system based on the retail sales tax, the B&O tax and the property tax. The committee, whose report was issued last week, was chaired by Bill Gates Sr. and composed primarily of professors in economics, accounting and law from major universities across the state. Other members were four legislators, two of whom have doctorates in economics.

The Legislature asked the committee to evaluate the existing tax structure based, among other things, on fairness, stability, adequacy, neutrality among businesses, effect on the state's competitive position and transparency (taxpayer awareness of when and how much taxes are paid).

On balance, the committee gave Washington's tax system pretty low grades. Here's what the committee found:

Washington's tax system is highly regressive. Fairness is in the eye of the beholder but most committee members concluded that a highly regressive tax system such as Washington's is inequitable. The state relies on various sales taxes for 59 percent of its tax revenue, compared with 35.7 percent nationally. Because people with low incomes have to spend most of their money, the poorest households pay 15.7 percent of their income for excise taxes and property taxes while the highest income group pays only 4.4 percent. Although many think of sales taxes as fair because everyone pays the same rate, the effect is extraordinarily burdensome on the poor.

Washington's tax system is unstable. Economists tell us the most stable tax systems rely on a broad variety of taxes at relatively low rates. Thus, as the economy rises and falls, different taxes will respond differently and some revenue stability can be maintained. But Washington's sales tax-heavy system is volatile, collecting too much when the economy is hot and not nearly enough when business is down. This has recently led to parks being closed, social services curtailed and other public programs reduced.

Washington's tax system is inadequate. Economists define adequacy as a tax system's ability to gradually expand as the growth in population and personal income increases the demand for government services. One of the big surprises to committee members was that over the past decades our current system has almost kept up with Washington's expanding economy. Were it not for the recent voter initiatives repealing the motor vehicle excise tax and slowing the normal growth in property tax revenue, the state might have been able to make it through the current economic downturn without a massive reduction in public services.

Washington's tax system treats businesses differently from one another. Our system is not "neutral" among industries. Different businesses pay very different B&O tax and utility tax rates. More importantly, the B&O tax is paid over and over again as products move from one company to another on their way to a finished product. The B&O tax pyramids an average of 2.5 times. But on many services the rate is 1.5 times while in some industries the rate of pyramiding is over five or six times.

Washington's tax system puts us at a competitive disadvantage. Because Washington relies so heavily on sales taxes, we stand to be crippled by the explosion in Internet commerce, and border communities constantly lose sales to Oregon and Idaho. When people buy out of state, sales taxes are rarely paid. Without an income tax, Washington residents pay an additional $523 million annually in federal taxes because since 1986 we have been unable to deduct state sales taxes.

We are effectively subsidizing the rest of the country. By contrast, if we entirely replaced the 6.5 percent state sales tax with a 5.5 percent flat personal income tax, Washington itemizers would save $1.45 billion each year in federal income taxes.

Without raising total state tax revenue at all, the Tax Structure Study Committee concluded that we could rearrange our tax system to be fairer to people and businesses, more stable and in harmony with the rest of the country.

The committee suggested replacing with B&O tax with a non-pyramiding "value added tax." This would put all businesses and industries on an equal footing.

An idea supported by the overwhelming majority of committee members was to implement a flat rate personal income tax, which at a rate of 3.8 percent could reduce the sales tax to 3.5 percent and eliminate the state property tax. This could be done in a completely revenue neutral way -- tax receipts would not go up, but we would pay our taxes differently and more fairly.

The irony is that polls show that a state income tax would be least popular among those with the most to gain -- lower and lower-middle income residents. The greatest support for a new tax system comes from those whose tax bills would increase. That's because economically stressed people are so suspicious of government that they would rather keep the tax devil they know -- they equate change in the tax system with an increase in taxes, although one does not necessarily flow from the other.

Responding to the tax revolt sentiment among voters, the committee recommended that some of the state's unused property tax capacity be made available to local governments or school districts. Studies show that voters are more willing to pay property taxes when they know those taxes will be used within the community.

Finally, the committee suggested that if a personal income tax is implemented, a corporate income tax could be used to replace the B&O tax rather than applying the value-added tax alternative.

The committee also suggested a number of changes that could improve our tax system even if we don't undertake a massive overhaul. These include:

A constitutionally mandated "rainy day fund" that would automatically put money in a state savings account when times were good and automatically dispense funds when state revenue is in a slump.

An automatic review of each tax exemption every 10 years to evaluate whether it continues to make sense to extend that exemption.

A reduction in "dedicated" taxes because they reduce elected officials' decision-making flexibility.

Increasing the small business B&O tax credit, so the smallest businesses would not be subject to the tax.

Continuing the state's tax on large estates, even if the federal government continues to phase out that tax. The committee recommended that substantial wealth be taxed as it moves from generation to generation.

Exempting construction labor from the sales tax. Washington is one of only a few states that impose sales tax on the labor portion of construction. Eliminating this tax would help attract business and would reduce the cost of housing. The cost -- about $400 million -- would have to be made up by other tax sources.

Extend the sales tax to consumer services. Washington is moving from a heavy manufacturing economy to a service economy. But many services are not taxed, so the government revenue drops even as the economy expands and demand for governmental services rises. The tax base should include the whole economy, not just part of it.

Impose a personal property tax on motor homes, travel trailers and boats. Many of these are substitutes for vacation homes (or even principal residences), which are taxed. It seemed to the committee that equity demands that these major assets be taxed.

The Tax Structure Study Committee has provided the Legislature with a road map of potential changes to our tax system. Now it's the choice of the Legislature and the voters as to which roads to take.

In a democracy, it's our government, not somebody else's. The public is obviously unhappy with our tax system. But the tax system is ours, and we have the right and the ability to change it so that it is fair, stable, sufficient and enables Washington state to compete effectively with the rest of the nation and with the world.

Public finance lawyer Hugh Spitzer is an affiliate professor of law at the University of Washington. He is vice chairman of the Washington State Tax Structure Study Committee.

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