Legislation introduced in Washington State correctly diagnoses the problem with the state’s business taxA tax is a mandatory payment or charge collected by local, state, and national governments from individuals or businesses to cover the costs of general government services, goods, and activities. structure—but the proposed remedy could use some work.
Washington’s Business and Occupation (B&O) tax dates to 1933, and criticisms of this gross receipts taxA gross receipts tax, also known as a turnover tax, is applied to a company’s gross sales, without deductions for a firm’s business expenses, like costs of goods sold and compensation. Unlike a sales tax, a gross receipts tax is assessed on businesses and apply to business-to-business transactions in addition to final consumer purchases, leading to tax pyramiding. go back nearly as far. There is widespread recognition, acknowledged in state-commissioned studies, that the tax diverges sharply from the principle of neutrality, and that this harms businesses and households alike.
The pyramiding effects of a gross receipts tax, where the same final good or service is taxed multiple times along the production process, is widely recognized as yielding vastly different tax rates not only across different industries, but even within them. On average, the Washington B&O pyramids 2.5 times, but averages understate the effect.
For example, the effective B&O tax rate on value added in agriculture has been estimated at 4.4 percent, even though rates on agricultural activities range from 0.138 to 0.484 percent. Manufactured foods pyramid almost seven times; apparel pyramids more than four times, and furniture nearly that. Construction pyramids 3.3 times, while personal services pyramid about two times and utilities see pyramiding at 1.5 times. These differences are dramatic, and differential rates can only go so far in addressing them. A 2002 tax commission report called pyramiding “a fundamental problem that requires correction.”
Even this doesn’t tell the full story. The retail industry, for instance, includes everyone from low-margin grocers and discount stores to high-end boutique shops. One store might get by on 2 percent margins, while another might have margins ten times that. It doesn’t make one business better or more profitable (before tax); it’s simply different business models. But when the tax code cannot distinguish between the two, the result is extraordinarily high—or even infinite—effective tax rates on some businesses, without regard for margins or even profitability.
The latest effort to address some of these concerns, at least for small businesses, is Washington’s House Bill 2940, sponsored by House Finance Chair Rep. Kristine Lytton (D) and seven other legislators. In a press release touting the bill, House Democrats identified the crux of the issue with the B&O tax: “The underlying issue is requiring a business to pay taxes on all of the money the business takes in, with no consideration given for the costs of running a business. This leaves restaurants and other businesses with narrow margins very little ability to expand or hire new staff.”
As introduced, the bill would:
- Increase the threshold for B&O liability from $28,000 to $125,000;
- Offer a credit against all tax liability for businesses with marginal revenue of less than $250,000;
- Exempt from taxation new businesses with less than $250,000 in gross (not marginal) revenue
- Impose a surcharge of 6 percent on businesses with margins of $1 million or more; and
- Permit the Department of Revenue to change the surcharge rate by rule, subject to certain conditions, with the aim of making the bill revenue neutral overall.
Increasing the de minimis requirement makes a certain amount of sense, as the tax imposes substantial compliance burdens that are likely to be out of proportion to the liability of small businesses. However, by using a threshold rather than an exemption, the bill exacerbates the existing tax cliff. A business that grosses $125,000 has no B&O tax liability. A business that grosses one dollar more owes taxes on the full $125,001. This problem, although not new to HB 2940, is far more significant when the threshold is $125,000 than when it stands at $28,000.
A business’s margin is determined by subtracting (a) the cost of labor and (b) the cost of goods sold from its gross revenue, mirroring the way that net corporate income (for purposes of a corporate income taxA corporate income tax (CIT) is levied by federal and state governments on business profits. Many companies are not subject to the CIT because they are taxed as pass-through businesses, with income reportable under the individual income tax. ) is calculated in other states. If that margin is less than $250,000, a credit is offered wiping out the business’s B&O tax liability.
This approach, however, isn’t very well tailored to low-margin businesses. A business with $1 million in gross revenue could have an incredibly high 25 percent profit margin and qualify for the credit; a large grocery store, meanwhile, could have a margin of just over 1 percent and not make the cut. That’s at least partly by design, since the bill is intended to benefit small businesses, but the flip side is that to pay for new provisions which benefit some small businesses regardless of margin, other businesses—not all of them large by any stretch—will now see a tax increase.
The average profit margin for a supermarket is about 1 percent. A supermarket’s sales might range from $15 million – $30 million a year, but its margins may range from $100,000 to $600,000. A store with margins of $250,001 doesn’t qualify for the credit, even though the retail rate is 0.471 percent and its margins may be under 1 percent.
Other businesses, like those in the construction trade, often have significant gross incomeFor individuals, gross income is the total pre-tax earnings from wages, tips, investments, interest, and other forms of income and is also referred to as “gross pay.” For businesses, gross income is total revenue minus cost of goods sold and is also known as “gross profit” or “gross margin.” , but much lower margins once you take into account not only the cost of labor, but also the cost of all the material and equipment that goes into construction. It wouldn’t be hard for such a business to face the 6 percent surcharge even if its margins were quite low.
Making this an even worse deal for many businesses, the bill reserves to the Department of Revenue the discretion, in defining what constitutes the cost of goods sold, to “exclude items of direct and indirect costs it deems useful in simplifying the margin calculation for taxpayers, reducing the likelihood of disputes between the department and taxpayers, and preventing inflated cost deductions.” This is broad authority, and a goal of reducing disputes is at odds with a goal of making an accurate accounting of costs—to the detriment of the taxpayer.
Since the bill aims for revenue neutrality, moreover, the Department is granted the authority to change the surcharge rate by rule (before it goes into effect) if it determines that projections will be missed by at least 1 percent in either direction. Then, during the first year in which the surcharge is in effect, the Department is authorized to adjust the surcharge again by emergency rule to keep revenue on track.
Not only do many businesses get a tax increase, but they won’t even know how big of a tax increase they’re facing until well after the bill is adopted.
Chairwoman Lytton is right to note the inequities imposed by the B&O’s non-neutrality and to want to address the burden it places on low-margin businesses. Unfortunately, the relief offered by HB 2940 is poorly targeted, and for many taxpayers—including low-margin businesses—it makes the B&O even more burdensome. If the goal is to provide small business tax relief, a better approach might be to raise the threshold and turn it into an exemption.
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