Friend of
the Court Brief
Following
Order, Supreme
Court, No. 84362-7
King Co. No.
07-2-02323-2 SEA
The
Legislative session is drawing to a close, and action to comply with the
Court’s order pursuant to Matthew and Stephanie McCleary, et al, v. State of Washington,
will fall short of the “real and measurable progress” required in that order.
It is the
purpose of this brief to lay out the summary of a revenue measure that might be
implemented under the direction of the court, through the offices of the
special master or other instrument.
This brief
is appropriate for the court to consider, for while the litigation is not under
appeal, it is under ongoing review, further fact-finding and close scrutiny.
This brief
is timely, for although the initial report from the legislature is not required
until 60 days after the signing of the budget, it is apparent and evident that
real progress toward implementation is stalled by a political process and the
Court will need to act aggressively to enforce the Constitutional mandate and
its own place in the governmental system.
Proposal
The
Legislature’s constraint is revenue. It
is unwilling to raise the revenue needed to enforce the Court’s decision. A
fair and equitable means of raising this revenue, one that the Court could
impose without causing undue economic distortions or dislocations, and exists
within the power of the Legislature to implement, exists in the form of a few
basic changes to the Business & Occupation Tax.
A complete
examination of the proposal will show that:
- The reformed tax is fully adequate in terms of revenue generation. That is, it is completely capable of generating the scale of revenue needed without any additional tax changes, and can provide a source of funding going forward that can expand to the need.
- The design of the tax is economically sound, being broad-based and having a low rate.
- The changes to the B&O tax as it now exists substantially improve the tax system in terms of equity and negative impacts on Washington-based businesses and households.
- The core element of the reform is simple, and the Court need not micro-manage a complex change, but only initiate its fundamental beginnings.
- The tax has not been roundly rejected by voters, as has the income tax.
- The implementation lies within current law. Although subject to referendum, the tax amounts to the reform of an existing tax, not the imposition of a new form of tax.
- The reformed B&O can create enough revenue and in a manner that is equitable across all categories of business and consumers.
How Does It
Work?
In a matter
of this nature, the Court will need to come to conclusions that are not
strictly legal, but economic in nature.
It will be important for the Court and/or its special master to
understand the economics of taxation to a degree which provides confidence that
such a tax would be a sound and reasonable remedy. That said, there is ample evidence that the
approach recommended here is supported by a range of business and economic
leaders. The 2002 Washington State Tax
Structure Study Commission (the “Gates Commission”) examined in detail the
state’s tax structure, convened numerous public meetings and vetted proposals
from across the range. Its first
recommendation was an individual income tax, but a very close second was a
“subtraction-method value added tax.”
That is precisely the tax that would be created out of the current
B&O by this proposal.
Current
B&O
The Business
& Occupation tax in its current form is a tax on the gross receipts of
private business. The distortions and
inequity all follow from the choice of this tax “base,” because gross sales do
not represent capacity to pay a tax. That capacity to pay is directly related,
instead, to the net receipts, or net income, of a business. Consequently in the “gross receipts” form,
the B&O rate cannot be raised very much without harming one class of
business or another (the “low-margin” business, in economic parlance). Low margin businesses pay an effective tax
rate above, often far above, high margin businesses.
In order to
mitigate, however crudely, this problem, the B&O as it now exists imposes
several different rates which apply to different business categories,
presumably in an effort to match margins. But even within a category, no
individual business will have the same exact margin as another. At the same time, because larger businesses
tend to have larger margins, the effective tax rate on smaller businesses is
higher, often substantially higher.
In addition
to this, the fact that there are no deductions means the tax itself builds
(“pyramids”) as products and services go through the supply chain, which again
disadvantages smaller businesses and advantages larger and out-of-state
companies.
The
Change
The
proposed reform has as its primary element a simple change in the tax
base. Allowed under the reform is the deduction
of purchases from other tax-paying entities.
This deduction of purchased inputs creates a “net sales” or “net
receipts” tax. This base is completely
consistent with capacity to pay, as it is the incomes of the workers and owners
of the business. The different rates for
different classes of businesses can be immediately eliminated in favor of a
single rate applying to all classes. The
advantage to large and out-of-state businesses disappears. And most importantly for the Court’s
purposes, the resulting tax has such a broad base and low rate that it can be
applied in sufficient measure to create whatever revenue is needed while
causing the least possible amount of economic distortion and dislocation. That is, it is adequate to the task.
An additional
feature of the reform presented here is the proposal to extend the tax to the
government and nonprofit sectors, which would effectively broaden the base by
another 25 to 30 percent. While one
level of government cannot tax another, the “value added,” which is the base of
this tax is defined for the public sector as the wages and salaries of
employees, and these are routinely subject to taxation under federal and state
income taxes. Expanding the base in this
way increases the fairness and perceived equity of the reform to the population
as well.
The final
rate of the tax depends on its final design.
There are many technical issues to be addressed, none of which are
critical, but all of which might change the calculation. A “revenue neutral” level, one which would
generate revenue equivalent to today’s B&O, is likely to be around 2%. That
is, if the change were made, and businesses as a whole paid no more than they
do now, the rate would be about 2%. A
rate, then, that would be completely adequate to the State’s Constitutional
obligation would be no more than 4%.
To some
businesses this would be noticeable, particularly to those who benefit under
the current inequitable B&O. To
others, it would be trivial. To some
smaller businesses, the change would be negative. The details of impacts can be calculated and
displayed for the Court’s consideration in supplementary documentation.
Conclusion
The
Constitutional mandate to fully fund education, as described in detail in
McCleary v. Washington, is likely to be frustrated by inaction from the
Legislature in complying with the Court’s specific order. This inaction is founded in an unwillingness
to raise the necessary revenues. This
brief outlines a proposal that is fully capable of producing those revenues in
a fair and equitable manner and one that will not create economic distortions
or dislocations for the people and businesses of Washington State.
Such a
proposal might be enforced by the Court directly, or serve as an alternative to
the Legislature in the event of no full Constitutional compliance.
