A Basic Reform to the

Business & Occupation Tax

Prepared by

Alan Harvey
and

Donald Hopps, Ph.D.

for

The Institute for Washington’s Future

March 2005

1
 Table of Contents
Executive Summary

Part 1: Shortcomings of the Current B&O Tax ................................................................................ 3

Part 2: The Reform ............................................................................................................................. 6

Proposed Structure: ....................................................................................................................... 6
Uniform 2% Rate ....................................................................................................................... 6
$100,000 Standard Deduction.................................................................................................... 7
Complete Deductibility of Capital Investment ......................................................................... 7
Deduction of Purchases from Other Taxpaying Entities.......................................................... 7
Treatment of Current Exemptions, Special Rules Defining Other “Taxpaying Entities” ...... 8
Economic Attributes of the Reform ............................................................................................... 9

Part 3: Effect on Specific Business Types ........................................................................................ 12

Nominal v. Effective Rate ............................................................................................................ 12
Specific Business Situations ......................................................................................................... 13
Example 1: A Small Manufacturer ......................................................................................... 13
Example 2: Startup Espresso-Pastry Store vs. Starbucks' Expanding by One Location ..... 13
Example 3: Service Businesses ................................................................................................ 14
Example 4: Grocery Stores ...................................................................................................... 14
Example 5: Wal-Mart .............................................................................................................. 15

Part 4: Compliance and Transition Issues ....................................................................................... 16

Compliance ................................................................................................................................... 16
Transition ..................................................................................................................................... 17
Capital Expenditures ............................................................................................................... 17

Part 5: Toward Systemic Reform: Adequacy & Balance ............................................................... 18

Adequacy ............................................................................................ Error! Bookmark not defined.
Historical Context ........................................................................................................................ 18
Nature and Magnitude of the Shortfall ....................................................................................... 19
The Relevance of the B&O Tax ................................................................................................... 20
Balance ......................................................................................................................................... 20

Endnotes ................................................................................................... Error! Bookmark not defined.

Appendix A: A Measure of Pyramiding of the B&O Tax

Appendix B: Calculation of the Rate and Yield
Appendix C: The Break-Even Point
Appendix D: B&O Taxpayers by Address

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 A Basic Reform to the Business and Occupation Tax*
Executive Summary

One of the most important issues facing Washington is the state of our current tax system. While taxes on
individuals and tax relief measures have dominated the debate in Washington for the past decade, the more
pressing issue is the need for genuine tax reform. Judged by credible observers for years to be grossly
inequitable, recent changes have made our system even more inequitable—and less adequate. The State Tax
Structure Study Committee’s report of 2002 makes the case for comprehensive reform to produce a more
adequate and equitable tax system. It recommended replacing the B&O tax with a subtraction-method,
value-added tax (VAT).

The need for business tax reform is just as important as reforming taxes on individuals. Creating a tax
system that treats businesses fairly and transparently, while producing adequate revenue, requires that we
address the structure of our Business & Occupation tax and the myriad business tax exemptions we have
created

We believe B&O reform can produce a more equitable tax for businesses, spur economic growth in
Washington, and lead more naturally to a more accountable and beneficial approach to granting business tax
exemptions.

Problem

Washington’s B&O tax has been a stable source of revenue through our economic cycles. Its strengths lie in
its stability, low tax rates and manageability. But its unique base of gross receipts produces a tax that violates
principles of equity and neutrality. The B&O tax:

 Places a relatively higher burden on new and expanding businesses,

 Places a relatively higher burden on small and non-vertically integrated businesses due to pyramiding of
the B&O tax,
 Favors out-of-state businesses, and
 Ignores a taxpayer’s fundamental economic status by ignoring the costs of doing business.

Reform Proposal

* This paper was prepared by independent economist Alan Harvey and Donald Hopps, Ph.D., Director of the Institute for
Washington’s Future, with the critical assistance of Kristin Pula, coordinator of the Institute’s Public Finance Reform
Project.

1
B&O reform can reverse these biases. Our proposed reform would reduce taxes on small and start-up
businesses, encourage capital investments, eliminate the problem of pyramiding, and rectify the current bias
favoring vertically integrated and out-of-state firms. The reform would achieve these goals through:

 A generous standard deduction for all firms (proposed at $100,000).

 Complete deductability of capital purchases and investments.
 Deductability of purchases—materials and services—from firms paying the B&O tax.
 Replacement of a half dozen nominal rates—and widely divergent effective rates—with a single rate that
is economically consistent from small to large firms and from sector to sector.

Advantages to Reform

This reform corrects the grave imbalances created by our gross-receipts base B&O tax, and creates instead a
more equitable and neutral B&O tax. The advantages of reform include:

 It is fairer to small, start-up, and low-profit margin firms, while removing the current B&O’s advantages
for large, vertically-integrated firms.
 It helps stimulate the economy by taking business costs into account and encouraging business
investments.
 It does not create a new tax, but reforms the existing tax to allow for deductions of some inputs.
 By creating a fairer tax, the reform eliminates the need for many of the special tax exemptions and
preferences currently in the tax code.
 While increasing reporting requirements, the reform decreases the total number of taxed—and thus,
reporting—businesses.

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Part 1:
Shortcomings of the Current B&O Tax

A 2002 study by the Washington business group Washington Policy Center found that small business
regards the B&O tax to be the most burdensome of all state taxes. ―In the written survey and in
roundtable discussions small business owners identified the Business and Operating [sic] (B&O) tax as
having the heaviest single impact among all taxes. The tax imposes a significant burden on businesses
struggling to reach profitability. The B&O tax is levied on all revenue above the minimum, even if the
business is operating at a net loss. Newly started businesses and those that are working through tough
economic times are the hardest hit.‖1 The reformed B&O tax proposed here brings rationality to the tax
base used in determining the tax, introduces fairness for all companies, and promotes and supports
Washington-based businesses.
The defects of a gross receipts tax such as the B&O tax begin with the base. Gross receipts is a quantity
not relating to income or another measure reflecting ability to pay. The defects are amplified by the
phenomenon of ―pyramiding.‖ Because the tax is collected on the full value of each transaction, it
multiplies as a product goes up through the production process and supply chain. This compounds the
inequities inherent in the base. The B&O tax becomes a tax with innumerable effective rates, one which
is applied more leniently on large, vertically integrated corporations and out-of-state suppliers. Both
vertical and horizontal equity are violated. Under appropriate taxation, all companies would be taxed at
the same rate, no matter how large and no matter what sector of the economy they lie in. The difference
in effective rates is sometimes a factor of two, three, four or more. This has led industries to seek and
legislators to grant, numerous special tax exemptions, further contributing to the complexity and
unevenness in the application of the tax.
Taxing gross receipts, pyramiding, and levying multiple rates leads to significant problems. They are:
The current B&O tax violates principles of horizontal equity. Appendix A to this report replicates a
table produced for the Tax Structure Study. 2 The first column displays the B&O tax’s effective rate on
value added by industry sector. Value added is the most fundamental measure of a company’s earned
income. The table reveals the wide variance of effective taxation between sectors. The range in this
table is produced solely by the inappropriate base of the current B&O tax. Since the tax falls on a
quantity that includes both income and costs, the effective tax on income, obviously, is greater or lesser
depending on the proportion of that income to the total.
The many nominal rates of the current B&O tax reflect in part an effort to provide a rough equity across
classifications. The divergent effective rates displayed in Appendix A demonstrate that this effort has
not proven out. For example, the 1.5% nominal rate for Services is more than three times that for
Manufacturing, yet the effective rate is in the middle to low end of all classes. This follows directly
from the gross receipts base. Since services do not, in general, involve significant intermediate goods,

1
Washington Policy Center, The Small Business Climate in Washington State, Eric Montague, March 2002, p.
6, http://www.washingtonpolicy.org/SmallBusiness/PBMontagueSmallBusinessClimate.html.
2
Washington State Tax Structure Study Final Report, 2002, Table 9-7.

3
the proportion of value added in the gross sales of the firm is much higher than for many manufacturing
activities.
This inequitable taxation can be further exacerbated by the pyramiding of the tax, since the intermediate
goods purchased by a manufacturing company may well carry B&O taxes with them. This additional
B&O tax burden is not reflected in Appendix A.
The current B&O tax violates principles of vertical equity. The weight of pyramiding depends on
the number of steps in the production process and whether these steps have been subject to B&O
taxation. For example, if a widget is constructed and sold in Washington state, it bears an increment of
B&O tax for each transaction in the production process and for wholesaling and retailing as well. A
widget produced in Oregon bears the B&O tax only at the final wholesaling and retailing steps. The
Washington widget carries a higher effective B&O tax than the Oregon version, even if the production
process is identical, because of pyramiding.

Because a transaction (a sale) is necessary for the application of the B&O tax, companies which avoid
transactions avoid taxation. Large companies can do this by vertical integration, a type of monopoly
structure, which brings several steps of the production process in under a single roof. For example,
mining, smelting, fabricating, coating, engineering, forming, stamping, labeling , wholesaling,
transporting, and retailing could each be the province of a single competitive firm. If so, the B&O tax
would be applied eleven times. But if all of these are performed within the context of a single company,
the B&O tax is applied only once. Thus smaller and non vertically integrated companies bear a larger
load.

The current B&O tax ignores a firm’s ability to pay. The corollary to this violation of horizontal and
vertical equity is that the B&O tax is also blind with regard to a firm’s ability to pay. Businesses
struggling due to external factors, such as high energy costs, market weaknesses, or competition from
outside the state, still have to pay their B&O taxes based on sales. The current B&O tax ignores the
bottom line (net income) in favor of taxing the line at the top (gross sales). This is bad tax policy.

Worse is when this focus on the gross revenue ignores a firm’s business capital investment and attempts
to grow. These are precisely the firms Washington should be nurturing and protecting, but in the B&O
tax this valuable enterprise is ignored. The reform proposed here explicitly encourages business
expansion and development by including complete deductibility of all capital investment.

Complexity in the Tax System.

Of course, legislators are not insensitive to the need to help developing businesses. The most common
mechanism used, in fact, is the tax code, which is riddled with exemptions and credits focused on
specific businesses, sectors, or geographical areas. The Reform proposes targeting the valued activity –
investment – rather than picking individual actors. The exemptions and special preferences of the tax
code may be effective for a time, but lead to awkwardness and suspicion that it is not the activity of the
company, but its access to power in Olympia that leads to its being favored. 3

3
Washington’s tax code currently has 503 tax exemptions, and the number grows every biennium. Businesses
receive 210 of these preferences and exemptions, for activities including economic development, high
technology research and development, agricultural production, and small business support. Of these, 133 are
exemptions from the B&O tax. There is currently no public disclosure or reporting of these exemptions. An
4
Other General Shortcomings
The above are the major issues with the current B&O, and they are all connected to its base of gross
receipts. Additional problems may exist as companies attempt to avoid the tax via phony purchasing
agent arrangements, partnership agreements, or by moving centers of activity into essentially dummy
corporations out of state. Avoidance like this could arise under any system, and the reform would not be
immune. Compliance and enforcement are considered briefly in Part 4.
A final weakness of the current B&O is that its arcane construction and built-in inequities may
discourage legislators from looking to it as a revenue tool, since the imbalances of the gross receipts
B&O are amplified at higher rates. Ironically, it may be this weakness which has allowed the tax to
survive so long. (The acute problem of tax adequacy is considered in Part 5.)

additional improvement to tax administration would be stronger reporting requirements, so all tax breaks can be
evaluated on the criteria of public benefits.

5
Part 2:
The Reform

The reform put forward in this paper creates from the current B&O tax structure a tax which is sturdy
and stable, one from which the citizens of the state can expect a vigorous contribution, and a tax which
protects small businesses as it improves the competitive position of Washington-based businesses. The
proposed structure offers investment incentives to all, rather than limiting them to specific industries or
businesses.
Past adjustments to the B&O tax have attempted to calibrate its many rates for different types of
business activity (e.g., wholesaling, services, manufacturing, retailing) to arrive at a pretense of rough
equity across classes. This has never worked and never can work, because the flaw with regard to equity
lies in the B&O tax's base of gross receipts, not in the rate schedule. By simply allowing businesses to
deduct the costs of doing business, subject to some rules, the reform eliminates the mare’s nest of
problems in the current B&O tax. It replaces the several different rates with a single rate. The rules
ensure fairness and protect businesses at vulnerable stages in their development.

Proposed Structure:
 A uniform 2% rate
 A $100,000 standard deduction for all firms
 Complete deductibility of capital purchases and investment
 Deductibility of purchases from other taxpaying entities
 Retention of current exemptions for agriculture, some forestry and fishing activities, rental of
real estate, and activities which fall under one of the B&O tax’s sister taxes.
 Replacement of many special exemptions with deductions for all firms, targeting
economically desirable activities rather than individual actors.
Uniform 2% Rate
A 2% rate on net receipts replaces the several rates on gross receipts of the current B&O tax. Current
rates range from 0.471% for retailing to 3.3% for disposal of low level radioactive waste. Comparing
―nominal‖ or statutory rates is not helpful at all in judging the impact of the reform, as we have noted,
because the reform’s rate applies to a different base—to net receipts rather than gross receipts.
As an example, suppose a business buys stock for $90 which it sells for $100. The reformed tax is 2% of
the difference between the purchase price and sale price, or 20 cents. The current B&O tax is 47 cents,
even though the nominal rate is only 0.471% on retailing, less than a quarter of the reform’s rate. The
apparently low tax rate is applied to a far larger base, the entire $100 of sales. The reform tax rate of 2%
is applied only to a base of $10 in net receipts.

6
The rate of 2% has been chosen because it will generate $800 million to $1 billion per year in critically
needed revenue for state services, and at the same time will allow room for the $100,000 standard
deduction and the economically important deduction for all capital investment. The need for new
revenue is the subject of Part 5. Appendix B provides an overview and spreadsheet detailing the research
and analysis which informed the choice of the 2% rate. It should be noted that the tax rate could be
readily adjusted to achieve various policy goals. One value of a single rate is that it clarifies and
simplifies such adjustments.
$100,000 Standard Deduction
The reform proposes a generous standard deduction of $100,000 from the base of net receipts. This
deduction protects small and startup businesses. This standard deduction replaces the small business
credit in the current B&O tax, which applies a variable credit to taxes owed. The maximum value of the
current credit is $421, and it is available only to a small number of taxpayers. The value of the new
standard deduction is $2,000 (2% of $100,000). It is available to all taxpayers.
Complete Deductibility of Capital Investment
Under the reform all capital purchases will be deductible. The full value of capital investments may be
deducted immediately, which will front-load the tax benefits. This deductibility of capital purchases will
help all start-ups and expanding businesses, and provides a major new incentive for businesses to
expand and develop in Washington. The deduction of capital is focused on a desirable business activity,
not on specific businesses. As discussed below, the rationale for many of the special exemptions is
removed by the elimination of B&O taxation on capital purchases and investments.
Deduction of Purchases from Other Taxpaying Entities
It is by allowing the deduction of purchases of necessary intermediate goods that the tax base of the
B&O tax is changed from one of gross receipts to one of net receipts. Thus this component executes the
crux of the reform. Deductibility must be limited to purchases from other taxpaying entities in order to
ensure that each product or service is taxed at precisely the same rate, whether it is produced in
Washington, California, or China. A uniform rate of taxation is guaranteed because the deductibility is
offered only to those products and services that have already been taxed. This is the mechanism of a
subtraction method value added tax such as that which was highly recommended by the 2002
Washington State Tax Structure Study Committee.4 Items or services which have not been taxed are not
deductible. Understanding the rationale for this is understanding the strength and logic of the reform.
The allowable deductions of purchases are those which are made from other taxpaying entities. (Other
enterprises are defined as ―taxpaying‖ under the special rules below.) Again, this equalizes the tax rate
on every product and service sold or produced in Washington. Out-of-state products will be subject to
the same tax rate as in-state products, as they should be. The current B&O tax penalizes companies

4
Ibid., p. v.. This was the Committee’s first recommendation, even before the highly publicized call for a
personal income tax. The structure of a subtraction method VAT is discussed in the section beginning on the
Study’s p. 39. The vote of 9-2 in favor is reported in Appendix H. The subtraction method is more rare than
two other methods of a VAT. An ―addition method‖ adds the components of firm and employee income to
produce value added. An ―invoice method‖ involves credits for taxes paid which are passed up the supply chain.
The latter method is different only in a minor accounting sense from the subtraction method.

7
buying and selling within the state by pyramiding the tax, adding an increment on each sale. Activities
outside the state are ignored until they are imported.
Treatment of Current Exemptions, Special Rules Defining Other “Taxpaying Entities”
Many classifications of business are exempted from paying the current B&O tax. These fall into
basically two categories—those that the legislature wanted to spare from taxation for economic reasons
and those that are taxed under the tax code with a similar type of tax. The reform contemplates
continuing many of the exemptions as-is. However, in the first, or ―economic‖ category, one
troublesome area of exemptions is proposed for elimination. This ―economic‖ category is composed of
basically two groups: (1) special targets like research and development or investment by new businesses,
which want stimulus, and (2) activities such as agriculture and fisheries, which need protection or
special consideration.
Existing special purpose exemptions targeted to economic stimulus become largely obsolete under the
reform. Exemptions for economic stimulus purposes will be available to all, not just a few, with the new
investment deduction. The legislature will need to determine an equitable way of sunsetting the special
purpose exemptions, but again, this should be easier for the fact that many will become redundant to the
reform’s provisions.
On the other hand, Agriculture and some other resource-based activities in forestry and fisheries have
long enjoyed exemption from the B&O tax, and the reform proposed in this paper maintains these
exemptions. Resource-based operations are a primary source for creating value added, and in themselves
they comprise a very small proportion of total product. In contrast, the processing, packaging,
distribution and retail functions garner a far bigger piece of the pie, and will continue to be subject to
B&O taxation.
Agriculture operates in a very different context from other industries, which makes it difficult to treat
fairly under a set of rules designed for all business enterprises. For example, farming operates under a
continuous cycle of short-term debt. Farmers seek loans to plant their crops, and pay off their debt with
proceeds from the harvest. There is a long-term difference in the time between investment and payoff
for this industry as compared to others. The loan activity is invisible to both the B&O tax and the
proposed reform. The proposed reform continues the Agriculture exemption as a means of supporting
smaller operations and newer business models. (Note that unlike the exemptions discussed below,
―taxpayer‖ status will not be granted to agriculture and other resource-based activities. Thus the value of
their product sold or processed in-state will be subject to taxation at the next level.)
A second category of exemptions from the B&O tax is occasioned by the parallel, or sister, taxes to the
B&O tax. Public utilities, insurance, and pari-mutuel racing pay the public utilities tax, the insurance
premiums tax, and the pari-mutuel racing tax, taxes which are roughly parallel to the B&O tax, though
often with higher nominal rates. Another classification is also proposed to be included as ―taxpaying‖
under these special rules — rental of real estate. This is an partly an effort to continue forward the
current exemption for rental of real estate, partly to acknowledge the effect of property taxes, but mostly
to concede the problematic nature of taxing this function and the fact that rental and leasehold costs are a
primary burden on new and struggling businesses.

8
Economic Attributes of the Reform
The reform will generate substantial new revenue. Our estimate is that between $800 million and
$1.0 billion per year will be added to the revenue stream. This amount is necessarily imprecise because
the major part of allowable deductions derives from purchases from other taxpaying entities, and since
much of this amount is imported from out of state, it is not a part of the readily available data which is
based on state product and income. The reform generates new revenue by eliminating the current
advantages enjoyed by large, vertically integrated corporations, while reducing the share of taxes paid
by small and start-up businesses. Appendix B discusses the precision and reliability of the estimates.
The spreadsheet included is quite informative in terms of illustrating the magnitude of each of the
components in terms of revenue loss or gain.
Most Washington businesses will pay less, even in nominal terms, under the reform. The U.S.
Census Bureau counted approximately 140,000 firms in Washington with payroll. 5 Rough estimates
derived from these payroll numbers and the break-even calculation summarized in Appendix C suggest
that at least 75 percent of these Washington businesses would pay the same or less under the reform.
It is estimated that 60 percent of these Washington businesses would pay no tax at all. The Labor
Market and Economic Analysis branch of the State’s Employment Security Department counts 230,000
total firms, 180,000 with employees. 6 These figures do not include dollar values of payroll, but the same
sort of result is apparent. (Reconciling these numbers has been difficult. Both the Census and LMEA
have been responsive, but unable to fully explain the differences.) The Department of Revenue counts
roughly 260,000 active B&O taxpayers. 7 This number and other data generally corroborating our
estimates is displayed in Appendix D. Caution should be used with the data on in-state and out-of-state
addresses, as they may not fully represent the location of operations and employment.
It is impossible to know the proportion of total B&O taxpayers who will pay less under the reform, since
accurate data on these businesses do not exist. It may be safe to assume, however, that many or most of
the out-of-state firms would pay more under the reform, not because of any selective targeting or
discrimination against these firms, but because they benefit unfairly from the current B&O gross
receipts base.
The reform will increase the amount of Washington’s tax burden that is exported. ―Exporting‖ a
state’s tax burden means some of the load is paid by businesses or households outside the state. The
proposition that a portion of Washington’s tax load will be exported under the reform is not wishful
thinking, no matter which view of the incidence of the tax one may hold. The above discussion shares
the common approach within the state that the B&O (and hence the proposed reform) is a tax borne by
business. As such, and because the reform equalizes the effective rate, the advantage enjoyed by out-of-
state firms disappears, thus they pay more and in-state businesses pay less of the reformed B&O tax. A
second approach holds that a gross receipts tax such as the B&O tax becomes attached to the product or

5
U.S. Census Bureau, “Statistics of U.S. Businesses: 2000: All Industries: Washington: By detailed employment
size,” http://www.census.gov/epcd/susb/2000/wa/WA--.HTM.
6
Washington State Employment Security Department, Labor Market and Economic Analysis Branch, ―Size of
Firm by County Distribution for All Ownerships, Including Multiple Establishments, First Quarter, 2003,‖
October 3, 2003.
7
Correspondence from Stephen D. Smith, Department of Revenue Research Division, December 13, 2004.

9
service and is paid by the eventual purchaser as a sales tax, wherever that person may reside. In this
view, those products produced in Washington and shipped out of state carry the tax with them. The
burden is literally exported.
Our own view of tax incidence is less cut and dried. We see taxes as a cost faced by business like any
other cost, and thus, according to standard price theory, tax impacts depend on market factors, primarily
the strength of demand. In conditions of high demand, a tax will likely be borne by the purchaser. In
conditions of weak demand, the producer will likely bear the load. This may explain why complaints
from business over taxation become more vigorous during slumps in demand, either during a general
economic downturn, or for example, when a business is in the phase of building its customer base and is
experiencing specific demand weakness. (For this reason it is also important for the state to support
demand by every means reasonable, including stable government spending levels during downturns.
Cutting government spending only increases the stress on business.)
By whatever measure one chooses, a significant portion of the state’s tax burden will be exported under
this reform. This is a goal for all tax structures, as noted by the Washington State Tax Structure Study
Committee.8 Out-of-state producers who are favored currently will no longer be favored. By exporting a
portion of the tax load, resources are released in the private sector and public services are financed in a
more balanced way. The current B&O tax excessively focuses on activities within the state and fails
miserably in the goal of exporting the tax burden.
The reform is a business tax. While determining the incidence of taxation is not a precise science, the
B&O is considered Washington’s business tax, and the reform ought to be seen in this same light. As
such, it will be more likely to be appreciated as a measure which does not add to the share of taxes paid
by families and individuals, as would, for example, an increase in the sales tax or a new personal income
tax. The share of revenue expected by the federal government from corporations (particularly the large
corporations that would be most impacted by this reform) has fallen dramatically over the past decade.
Our reform may provide some balance to that trend. This is not to dismiss the contribution by businesses
to state programs. That contribution is by no means limited to the B&O tax, as it includes significant
employment taxes.
The proposed reform requires no new collection mechanisms or bureaucracy other than that
additional capacity inherent in the alteration of the tax base, which will be more difficult to calculate
than the current gross receipts base. Implementation of the reform should require no extended transition
period. Current exemptions will be retained, for agriculture, rental of real estate, certain forestry and
fishing activities, public utilities, and so on. The roll of taxpayers is identical under the reform. Part 4
examines further the issues around transition.
This proposal conforms to many of the principles developed by the Washington State Tax
Structure Study Committee, principles of neutrality, adequacy, fairness and stability, and moves
markedly in the direction espoused by the Committee in terms of exporting the state's tax burden. 9 By
exporting some of this load, the new tax will also improve the competitive position of in-state firms.

8
Washington State Tax Structure Study Committee, op. cit., p. 5. ―The state should minimize the burden on state
taxpayers by choosing a tax system that maximizes the extent to which taxes can be exported (paid by
nonresidents).‖
9
Ibid, pp. 3-5.

10
The reform eliminates the major liabilities of a gross receipts tax. The weaknesses and inequities
identified in Part 1 substantially disappear under the reform. Adjusting the base in the manner described
will eliminate the problem of pyramiding, because goods and services already subject to the B&O tax
are deductible and thus will be counted only once. The bias toward large, vertically integrated
businesses will disappear completely, because the same rate is applied to all value added. The invisible
but large effective tax rates that now eat at the bottom lines of small and independent companies will
crystallize into a single standard rate for all. The large company will not reduce its tax by reducing the
number of transactions. The small company will not be penalized for buying its inputs from independent
suppliers. The large standard deduction offered in the reform, in fact, will reverse the bias to favor small,
independent businesses. The inequity in effective taxation across business classes will also
completely disappear. A single effective rate will apply to all.
The reform is not blind to a company’s ability to pay. At least one eye will be opened. Deductions of
investment costs in equipment and facilities will be allowed, providing a great boon to start-ups and
companies that must retool or modernize. Purchases of intermediate goods will also be deductible.
Wages and salaries will not be deductible, however, so the cost of people can be avoided only by laying
them off. Significantly, however, the cost of training provided by outside vendors will be deductible
under the reform. Training and employee development are not now deductible.

11
Part 3:
Effect on Specific Business Types

The reform we propose may strike a chord with policy-makers interested in the goals of overall fairness,
neutrality, and economic stimulus, as well as increased revenue, but it will be the financial impact on
individual business owners that will determine the strength of support and ultimately whether a reform
can be enacted. When we move from the academic to the actual, the business owner will want to know
first how it affects his or her specific operation, not how it applies across broad classifications. This
short section cannot offer more than a taste of the range of impacts, but even these few examples should
give depth to the discussion, suggest likely winners and losers, and pick out potential points of confusion
which may arise in communicating the proposal to the public.
As noted in the last section, we estimate that 60 percent of Washington businesses will pay nothing
under the reform, and more than three-quarters will see their taxes stay the same or drop. These are
necessarily rough estimates, from the calculations detailed in Appendix C. This is possible while still
generating a marked increase in revenue. Under the reform, the tax burden will shift to out-of-state
enterprises and to larger companies that benefit most from the current inequities of a gross receipts tax.
The amount of the tax which will be exported under the reform is very difficult to ascertain. It is
conceivable that the proportion could rise from the neighborhood of 10 percent currently to as much as
one-third under the reform, or possibly higher. 10 And while the great majority of Washington firms will
pay less in B&O tax, some at the top will pay more, and this is where the great preponderance of value
added is produced.
In summary, very small businesses will benefit greatly. Companies that invest in capital will do well.
Service businesses may not be overly affected. On the other hand, companies that draw product and
services from outside Washington will have to absorb an increased burden. Larger, vertically integrated
companies will see their advantages disappear.
Nominal v. Effective Rate
The discussion above and the examples which follow concentrate on the tax bills of individual
companies, the size of the check they will write to the state. It is worth repeating at this point, however,
that the burden of the current B&O tax is far larger than the dollar figure on the check. As Appendix A
indicates, the effective tax paid by Washington businesses can be up to six times the nominal rate and
higher, a consequence of the pyramiding inherent in a gross receipts tax. This is a real and onerous
weight on those companies that cannot shield themselves from it. The tax rate in column 2 of Appendix
A is similar to a revenue neutral rate that might be expected under terms like those of the reform. This

10
The increase suggested (30%) assumes that a large part of the wholesale category involves imports, the rate on
which will be increased to the full 2%, an increase in the service sector will be at least partly attributable to
imports, and that at least some currently untaxed imports will no longer be able to avoid taxation.

12
column does not show the effect of the standard deduction, nor the full effect of the capital investment
deduction. It also fails to show the variability of taxation within classifications, where larger firms tend
to pay a lower rate and smaller firms a higher rate.
The removal of the pyramiding dynamic will be a competitive boost to smaller companies. Larger and
more established firms will lose this unfair leverage. Out-of-state competitors will also lose their
advantage, since their product will now be taxed at par with that of Washington businesses. Thus the
Reform is pro-competitive, a leveling of the competitive playing field. In this section, however, we will
be discussing the tax bills of typical hypothetical companies of specific business types, and thus will not
be dealing with the higher effective rate, but with the statutory, or nominal, rate. As the reform takes
hold and the pyramiding process of the current tax subsides, it will be interesting to see how prices
normalize over time.
And again, as we discussed in Part 2, the true incidence of taxation is a subject of considerable debate.
The burden may not be determined simply by who writes the checks to the state and may be more
related to market power, shifting in response to the market.

Specific Business Situations

Example 1: A Small Manufacturer
A small manufacturing business has a total of five employees. Their gross sales were $1.2 million 2002,
but dropped to $865,000 in 2003. Staff attribute the decline to the current economic downturn. In 2003,
the company rebuilt its principal machine tool at a cost of $200,000, and net sales were estimated at
$294,000, or 34 percent of gross sales. The company purchases pipe stock, almost exclusively (95%)
from in-state suppliers, and remanufactures it for commercial and residential use. Shipping is done
through UPS or by independent flatbed haulers.
Under the current B&O tax, this company’s 2003 tax bill would be $4,187 (0.484% on gross sales of
$865,000). The company cannot take any deductions for their inputs or for their capital expenditures.
Under the proposed B&O tax reform, this firm fares much better. First, it can deduct intermediate costs
from other taxpaying firms, so its tax base is now net receipts of $294,000. Second, it receives the
standard deduction of $100,000 and third, it can deduct $200,000 for its capital investment. So, under
this reform, the company has no taxable receipts and pays no tax.
Example 2: Startup Espresso Store vs. Expansion of Established, Vertically Integrated Coffee
Chain by One Location
Any small business that depends on independent suppliers is a victim of the B&O tax in its current form
because of the pyramiding of its gross receipts tax base. Large vertically integrated enterprises—those
which provide in-house the production and distribution of the products they retail—escape B&O
taxation in the main. Start-up costs for a new single-store business may be significant for the
entrepreneur. Under the current B&O tax, none of these costs are deductible, and the company is only
eligible for a meager credit with a maximum value of $421. Add to this the higher effective rate of
taxation occasioned by pyramiding, and it becomes clear why the current B&O tax is the bane of small
businesses.
An established coffee chain’s competitive position is enhanced by economies of scale, but in
Washington it also benefits from a lower effective tax rate, since many of the operations that go into its
13
product—distribution, roasting, baking and even professional services like marketing and legal
services—may be provided in-house. Obtaining goods and services from independent enterprises does
not occur, the transactions that the B&O taxes do not occur, and so pyramiding does not occur. Under
the reform, the established chain’s lower effective rate will disappear, and the company will pay exactly
the same rate on taxable net sales as the startup.
Example 3: Service Businesses
Service businesses (almost by definition) are high value added businesses. But this does not mean that
these enterprises will take a big hit under the proposed reform. Quite the contrary. The tax rate under the
current B&O tax is 1.5% on gross receipts. Under the reform it is 2.0% on net receipts. Since rent and
the first $100,000 of taxable receipts are deductible under the reformed B&O tax, thousands of small
service businesses may see the effective share of their taxes drop.
While this ought to encourage support from this sector, a question of balance needs to be raised here.
The reform is constructed to make the effective tax on value added uniform across business sectors, but
this is not true of the state’s tax system as a whole. The B&O tax and employment taxes are the only
direct contributions expected from service businesses. Some voices have called for the retail sales tax to
be extended to service businesses to rectify this imbalance. 11 These considerations are beyond the scope
of the present study. Suffice it to say that a sturdy, broad-based tax such as proposed in this reform could
supplant reliance on the retail sales tax in the future, bringing this calculus more into line. Mitigating
this imbalance is the fact that service businesses are (also almost by definition) jobs businesses.
Favoring them in the tax system is not without merit.
Example 4: Grocery Stores
Grocery stores are low profit margin businesses, meaning that the profit obtained from the sale of goods
is a low percentage of total sales. Grocery stores and supermarkets often operate with a margin of only
one to two percent. This contrasts with, for example, luxury merchandise businesses where the margin
may be 30 percent or more. Grocery stores are typically low-capital, high-volume businesses. This
profile will benefit or suffer under the proposed reform depending on the proportion of merchandise that
is deductible. The B&O tax reform allows deductions for goods purchased from other taxpaying entities,
while goods imported from out-of-state or purchased from other non-taxpayer sources are not
deductible. While we have not made a thorough investigation of the comparable effects on this type of
business, it seems likely that the smaller and more independent the enterprise, the lower will be its
exposure to tax increases under the reform.
It ought to be noted here that food and drugs have been exempted from the retail sales tax, so the B&O
tax is the only significant contribution to the State’s General Fund from commerce in these two
important consumer sectors. Hence the overall tax share expected from activity in these areas would still
be fairly low.

REWRITE BIG BOX RETAILERS

11
Economic Opportunity Institute, Extending the Retail Sales Tax to Services in Washington State, September
2002, Jason Smith, http://www.econop.org/Taxes/TaxPolicy-RetailSalesToServices.htm.

14
Example 5: Big Box Retailers
―Big Box‖ retailing is a term applying to a spectrum of warehouse and large department stores
purveying a wide range of goods. On one end of this spectrum is a company like Wal-Mart, which
typically minimizes its capital investment and workforce costs and competes on the base of price, with
goods typically imported. On the other end of the spectrum are the mall department stores, which have a
substantial investment in their locations and compete both on quality and price.
Big Box retailers will likely pay a significantly larger share of B&O taxes under the reform proposed
here. The capital investment deduction will benefit some more than others, but the merchandise that is
produced out of state or out of the country and sold in these stores will be subject to the 2% rate,
whereas it currently is liable to less than 0.5%.

This is a very short list of examples. By no means does it display all of the ramifications of a change
from the current B&O tax to the reform proposal. In particular, restaurant businesses, with their
exposure to the retail sales tax and their relatively high labor input, will likely see an increase as they
grow out from under the umbrella of the $100,000 standard deduction.
The true effect on business of all types is ruled by the inequities of the current tax, the web of
pyramiding and its avoidance, and the unwise and unfair predicament in which it places start-ups and
small and struggling business. It will be welcome to see a tax regime in which all enterprises are treated
equally and where the tax share is visible in simple, unconfused terms, rather than being variable and
obscure. The considerable expertise of the Department of Revenue will be welcome in further exploring
the specific effects of this reform on specific businesses.

15
Part 4:
Compliance and Transition Issues

We have so far concentrated on theoretical and hypothetical issues. What will happen when the State
moves to apply the reform to real businesses? As a reform to an existing tax, our proposal does not
require an effort of the scale and detail necessary to institute a new tax, a personal income tax, for
example. But while they will be markedly fewer than with a new tax, difficulties and differences will
need to be anticipated.

Compliance
There is no doubt that whatever the economic simplicity and fairness the reform brings with it,
compliance and enforcement of the reform will be more complex. Eliminating the tax on companies
with less than $100,000 in taxable receipts will simplify auditing and enforcement tasks. It is in this
category that the great preponderance of noncompliance problems occur with the current B&O tax. 12 On
the other hand, the reformed tax will require more in terms of preparation than the simple calculation of
rate multiplied by the bottom (or top) line. For those businesses that do pay, the $2,000 represented by
the standard deduction may be a fair compensation for their increased accounting.
Restricting deductibility to other taxpaying firms creates a challenging tracking problem. But precisely
because deductibility depends on it, firms will likely be assiduous in reporting the sources of their
purchases, creating a self-policing dynamic that will be helpful for auditors. It is our great good fortune
to have one of the best agencies of its kind in the nation in the Washington State Department of
Revenue. Governing magazine gave the Department its highest rating, noting, "To their credit – or
sometimes to their embarrassment – Washington policy makers have plenty of good data to base their
decisions on. The state has better analytic capacity than most. In fact, overall, tax administration in
Washington is a model for other states...."13
The reform will not change the stipulation in the current B&O that the tax is a cost of doing business and
may not be invoiced to customers. A company’s tax bill ought to be 2% of its contribution to the value
of its products and services. In cases where there are not-taxpaying suppliers, the company will be liable
for 2% of this value as well. Agriculture is one category of non-taxpaying suppliers. Exportation
accounts for 80 percent of agricultural production, and this amount will not be taxed. The remaining
portion, which is sold or processed within the state, accumulates the B&O tax at the next step. There
may be other suppliers whose product is now processed under the radar. These avoided sums will also
be taxed at the next step. In this way, the reform mechanism may collect taxes that are currently illegally
avoided.

12
Washington State Tax Structure Study Committee, op. cit. Appendix C-8, Table 3, ―Total Noncompliance by
Size of Firm.‖
13
Governing.com, The Way We Tax, February 2003, http://www.governing.com/gpp/2003/gp3wasup.htm.

16
Transition
Transition problems ought to be minimal in comparison with other tax reform proposals, since the roll of
taxpayers role is identical to that for the current B&O tax (though as above, a majority will be liable for
no tax). The rules have changed fundamentally, but the mechanisms of collection and monitoring remain
the same.

Capital Expenditures
It will be necessary to adopt procedures to allow for appropriate treatment of recently purchased but not
fully depreciated capital. It would be unfair for businesses that invest one year prior to the enactment of
the reform to be deprived of the benefit of deductibility. And it would be quite unfortunate if businesses
delayed their investments while awaiting the outcome of the reform effort. Since accounting for
depreciation is an everyday part of business, particularly with respect to federal taxation, it ought to be
fairly simple to make an equitable arrangement by using extant depreciation schedules. Encouraging
capital investment should be one main attribute of a business tax. Investment in plant and equipment
brings with it good jobs and committed corporate citizens.

17
Part 5:
Toward Systemic Reform: Adequacy & Balance

The goal of tax reform is a fair, adequate, and balanced tax system. How does this proposed reform of
the Business & Occupation tax meet this goal? Throughout this discussion, we have focused on the issue
of the comparative equity of this proposed reform and the present tax. The foregoing analysis clearly
demonstrates that this reform would make the B&O tax itself eminently more fair by assessing it on a
rational basis, businesses’ net receipts—a base that factors in businesses’ ability to pay—and
eliminating the advantages to out-of-state firms. This would make the tax system as a whole
considerably more fair by reducing the taxes of small business owners—a significant portion of
Washington's middle-income people. In and of itself, this would be a significant reform for the State of
Washington. The purpose of Part 5 is to show how the reform brings improvement to the systemic health
of the total tax structure in terms of improving adequacy and balance.
Does the current tax system in Washington provide revenue adequate to the need? There is no reason to
argue the fine points of the budget to answer this question. A February 2003 study, The Government
Performance Project: The Way We Tax,14 identified the most important shortcoming of Washington's
tax system to be its inadequacy. The State earned the lowest rating due to its unwillingness to raise
sufficient revenue. We are currently facing a $2.2 billion deficit for the 2005-2007 biennium, after
shortfalls in the two previous budget cycles.

Historical Context
Previous levels of revenue have deteriorated over the past five years. Statutory reductions have been led
by citizen initiatives. The low unemployment and high personal income growth of the '90s created short-
term revenue surpluses for the state, which then became the rationale for long-term tax rollbacks. In
2000, ratifying an initiative ruled illegal by the courts, the governor and legislature eliminated the motor
vehicle excise tax (MVET). The MVET was responsible for 7 percent of State revenue, more than $800
million per year. Voters subsequently capped property tax revenue increases at 1 percent per year. Non-
statutory reductions in revenue accompanied the general economic decline which began in 2000. The
economic stagnation has eaten at retail sales, and hence the retail sales tax, the mainstay of the budget.
As its response to these events, the state has balanced its budget with a mixture of one-time fixes,
wishful thinking, and cuts in services. The State sold rights to some of its tobacco settlement, adopted
best case scenarios for federal funding, hiked sin taxes and, most importantly, cut spending. The
governor rejected any significant new revenues for 2003-05 and developed a budget that froze voter-
mandated cost-of-living increases for teachers, rejected voter-mandated class size reductions, froze
voter-mandated wage increases for home health care workers, cut higher education assistance, cut State
jobs, rolled back health coverage, and diminished support for other, mainly social support programs. 15

14
ibid.
15
A more complete examination of the budget balancing can be found in The Washington Budget 2003,
LeLoup, Lance T. and Grulke, Eric, Washington State University, July, 2003, presented in association with
18
The apparent rationale behind these financial contortions is that the state's economic problems would be
short-lived and the cash flow of the 1990s would return, along with a relief from fiscal stress and
renewed revenue flows through the existing taxes which would make replacement of the MVET
unnecessary. Unfortunately, the experience of state and local governments has not confirmed the
periodic announcements of an impending turnaround. Rather than a return to good times, Washington
has joined other states in a continual revenue squeeze.

Nature and Magnitude of the Shortfall

Washington’s Office of Financial Management (OFM) prepares periodic predictions for the economy
and for fiscal factors affecting the State’s mandated functions. The January 2004 Six-Year Outlook16
identified three scenarios. The ―best case‖ scenario projected a $382 million shortfall at the end of the
2005-07 biennium. Its ―most likely case‖ projected the number at $1.1 billion. The ―worst case‖
projected a $1.8 billion gap at the end of 2007 (and an incredible $5.6 billion gap at the end of the 2009
fiscal biennium). The ’05-’07 deficit--has surpassed these projections, hitting $2.2 billion after the state
supreme court invalidated the estate tax in February 2005. The State is constitutionally prohibited from
running deficits. Since very nearly half of the budget—bond payments, pension contributions, basic K-
12 education—is immune to cuts, the other half, programs amounting to around $13 billion, must bear
the budget knife. Cuts of this magnitude mean more than a pound of flesh. The prospect is for sacrifice
of muscle and bone. 17
This adequacy problem stems largely, according to the authors of The Government Performance
Project, from imbalance in the tax system, meaning its reliance almost exclusively on sales and property
taxes. Inadequacy, again, was rated a more significant problem in Washington even than regressivity,
and as pointed out in Part 1, the state has the most regressive tax system in the nation, according to
ITEP. It is pertinent to at least reflect on the possibility that the two issues may be connected. That is, a
tax regime which taxes low- and middle-income households much more heavily than higher-income
households can never be adequate without being too oppressive to the most vulnerable.
Our admittedly preliminary work with regard to identifying the "structural" characteristics of the tax
system, those which remain after corrections for population, inflation and unemployment, indicates that

Western Political Science Association, sponsored by the Center for Public Policy and Administration,
http://www.cppa.utah.edu/westernstatesbudgets/WPSA02/wa_2002.pdf.
16
Washington State Office of Financial Management, Six Year Outlook,January 16, 2004,
http://www.ofm.wa.gov/fiscal/outlook/index.htm. Subsequent revisions to Six Year Outlook were published in
June and September 2004 and include revised projections for each scenario. These numbers are not reflected in
the current paper. These later versions project markedly lowered oil prices, while in fact, oil prices have spiked
upward.
17
Our view of the economic assumptions underlying OFM's projections suggest actual economic and fiscal
conditions will be very close to the worst case scenario. OFM has differentiated its cases based on assumptions
for population growth and health care ―inflation.‖ Inflation is a term more aptly used for general price rises,
rather than those of a single sector, but the significance of this factor is not debatable, particularly in an aging
society. Were the federal government to accept a more significant role in financing health care for the general
population, or even for the uninsured population, the great and growing weight on the states to deliver those
services could be relieved. In other words, health care reform at the national level is a potential boon for state
finances.

19
even in the best economic circumstances, tax revenue from the current structure could not pay the bills.
Real revenue per capita adjusted for employment is below the demands in real terms on that revenue. 18

The Relevance of the B&O Tax

The proposed reform to the B&O tax turns this unfair, regressive, and economically complex tax into
one which is sturdy, stimulative and equitable. It will produce an estimated increase of $800 million to
$1.0 billion per year. The tax base of the reformed B&O tax will rise in lock step with the economy as a
whole.
Funding basic and necessary services and facilities is the fundamental object of the tax system. If it fails
this function, it has failed fundamentally. Removing the inequities between businesses and the bias
against small and struggling businesses are valuable achievements for tax reform, but they are not
enough. Even the most balanced, fair and progressive tax scheme is a failed scheme if it results in
crumbling infrastructure, failing schools, and people forgotten in desperate conditions. If a water or
sewer system were renovated, it would not matter what high-tech efficiencies and equipment were
installed. A system not adequate to serve existing or easily foreseen demand would be seen as nothing
more than a mistake. For tax reform, this means that the two aims of balance and adequacy must arrive
in the same package.

Balance
Balance brings adequacy and fairness together by considering the composite effect of the various taxes
that form a tax system. It is a recognition that the whole is greater than the parts; that it is possible to
have a system whose individual taxes are fair and adequate, but when taken together as a whole can be
unfair or inadequate. It is also recognition that the system is relative, particularly to the economy. We
only have to look as far as Oregon to see the truth of this. Oregon is in the same fiscal trouble that
plagues Washington because Oregon relies far too much on its fair and, in a normal economy, adequate
income tax. The downside of an income tax is that it is notoriously sensitive to the economy. A
boom/bust cycle such as we have experienced in the Northwest during the last decade throws it
completely out of kilter. One year it brings in too much revenue and generates taxpayer resentment. The
next year its revenues could drop off significantly, failing to bring in enough to meet needs.
The Oregon and Washington examples demonstrate that balance requires adequacy and fairness in a
system over time and varying conditions. Its measure is not just productivity, but consistent
productivity.

18
Interestingly, we find that population, employment and revenue per capita in real terms all vary in the same
direction. (The budget restrictions of Initiative 601 passed in the early 1990s do not recognize this connection,
since they are keyed to population.) In other words, better times mean higher employment and higher
population growth and higher tax revenue per capita. In harder times, population increases are lower, as is the
revenue per capita, but the strain on services may not decrease as unemployment may fuel need. A further
exploration of this gap can be found in It’s Not Just the Recession: The Budget Crisis and Washington State’s
Structural Deficit, by Marilyn P. Watkins and Jason Smith, Economic Opportunity Institute (EOI), 2003,
http://www.econop.org/Taxes/ StructuralDeficit.pdf. It should be noted that the definition of ―structural‖ in the
EOI discussion relates to the structure of the tax system, demands on it, and its ability to respond. The more
traditional ―structural‖ definition has to do with the so-called ―full-employment‖ budget, that is, measuring
against a hypothetical ―good times‖ economy. The EOI analysis of the trends in state revenue capacity and
demands on that revenue are persuasive in their argument for a state personal income tax and/or extension of the
sales tax to services.

20
The reformed B&O tax would be the fairest tax in our system and thus the best to use to address
adequacy, but this may raise an issue of imbalance if businesses are seen to carry too large a share of the
state’s taxes. In an ideal tax system, the rate of our B&O tax might be lower than that proposed here.
The retail sales tax would also be considerably lower. These might be balanced by a personal income
tax. As it is, however, the regressive sales tax cannot in good conscience be raised enough to fill the
revenue gap. "Sin taxes" are even more regressive, and in any case, could never generate the level of
revenue needed. Property taxes are limited by law. And the B&O tax as currently constituted is so unfair
and counterproductive to economic growth that raising it is not a practical option
The reform proposed here creates fairness in the tax code and brings some balance and adequacy into
the system. Its enactment would create a sturdy, fair and fully functional business and make the weakest
leg of the State's tax structure into the strongest.

21
APPENDICES

Appendix A: A Measure of Pyramiding of the B&O Tax

Appendix B: Calculation of the Rate and Yield

Appendix C: The Break-Even Point

Appendix D: B&O Taxpayers by Address

22
 Appendix A

A Measure of Pyramiding of the B&O Tax

Tax Rate on Effective Pyramiding

Sectors & SIC Codes Value Added B&O Rate Index
4 MFG FOOD 20 2.0% 0.3 6.7
11 MFG PETROLEUM REFINING 29 3.1% 0.5 6.7
19 MFG AIRCRAFT & PARTS 372 2.6% 0.5 5.3
12 MFG RUBBER & PLASTICS 30 2.0% 0.5 4.3
15 MFG PRIMARY METAL 33 2.0% 0.5 4.1
5 MFG APPAREL & TEXTILES 22-23 2.0% 0.5 4.1
6 MFG LUMBER & WOOD PROD 24 1.9% 0.5 4.0
21 MFG PROF & SCIENTIFIC INSTR 38 1.8% 0.5 4.0
17 MFG IND/COMM/COMP M&E 35 1.9% 0.5 3.9
7 MFG FURN & FIXTURES 25 1.8% 0.5 3.7
20 MFG OTHER TRANS EQUIP 37 1.8% 0.5 3.7
8 MFG PAPER PROD 26 1.7% 0.5 3.7
14 MFG STONE/CLAY/GLASS 32 1.6% 0.5 3.4
10 MFG CHEMICAL PROD 28 1.5% 0.5 3.3
3 CONSTRUCTION 15-17 1.6% 0.5 3.3
18 MFG ELECT M&E (NOT COMP) 36 1.4% 0.5 2.8
13 MFG LEATHER ETC 31 1.4% 0.5 2.8
35 MOVIES/AMUSE/REC 78-79 2.2% 0.8 2.7
34 SVC MISC REPAIR 76 1.4% 0.5 2.7
22 MFG MISC MFG IND 39 1.2% 0.4 2.7
9 MFG PRINT & PUBLISHING 27 1.3% 0.5 2.6
23 TRANSPORTATION ETC 40-47 1.8% 0.7 2.5
2 MINING/QUARRY 10-14 1.2% 0.5 2.4
16 MFG FABRICATED METAL 34 1.1% 0.5 2.3
29 SVC LODGING 70 1.1% 0.5 2.2
30 SVC PERSONAL 72 2.0% 1.0 2.1
1 AG FOR FISHING 1-9 1.4% 0.7 2.0
33 SVC AUTO REPAIR, SERV&PARK 75 1.0% 0.5 2.0
24 COMMUNICATIONS 48 1.2% 0.6 1.9
26 WHOLESALE TRADE 50-51 0.9% 0.5 1.9
37 LEGAL/ENG/ACCT 81-89 2.1% 1.1 1.8
32 SVC BUSINESS 73 1.6% 0.9 1.7
27 RETAIL TRADE 52-59 0.8% 0.5 1.6
36 SVC MEDICAL & HEALTH 80 2.0% 1.2 1.6
28 FIRE 60-67 1.5% 1.0 1.6
25 ELECTRIC, GAS & OTHER UTIL 49 3.2% 2.1 1.5
31 SVC COMP/DATA/PROC SERVICES 737 1.3% 0.9 1.4
Statewide 1.5% 0.6 2.5

This table from Chapter 9 of the Washington State Tax Structure Study Committee’s report Tax Alternatives for
Washington State: A Report to the Legislature. http://dor.wa.gov/content/statistics/WAtaxstudy/Chapter_9.pdf

23
 Appendix B
A Fundamental Reform to the Business & Occupation Tax
Rate and Yield

This appendix is a technical discussion of the likely rate and yield under the proposed
reform to the B&O tax. We summarize the analysis which allowed us to estimate that a 2.0
percent rate applied to the reformed tax base will generate $800 million to $1.0 billion per year
in new revenue.
The rules of the proposed reform, to review briefly, are as follows:
• A $100,000 standard deduction for each enterprise subject to B&O taxation.
• Deduction of all capital expenditures.
• Deduction of all purchases from other B&O taxpaying enterprises.
• Retention of all current exemptions.
• Reduction of the several rates of the current tax to one rate of 2.0 percent.

Precision is wanting in this analysis because the available data are themselves not precise
and because there are several necessarily inexact, sometimes even crude, manipulations of the
data required to get to the desired end. At every step we have chosen the most conservative
treatment. While technical, the analysis is instructive as to the dynamics of the tax and is not
too difficult to follow.
A summary table of the last several steps is provided Below (Table B-1), and a spreadsheet
detailing all the steps and data is provided at the end (Table B-2). An addendum to the
spreadsheet provides an array of rates depending on the level of the standard deduction. We
hope that as this paper is reviewed by economists in the Department of Revenue and
elsewhere, they will comment and criticize, and the analysis will move forward in precision and
sophistication.

Developing the Rate and Yield

Data: State Gross Product by Industry
The object of the analysis is to find the applicable tax base for the reformed tax, then
increase the revenue to meet the adequacy objective of the reform. We have used the five
fiscal years 1997 through 2001 to provide an array of rates. We developed estimates of the
dollar impacts of the rules which define our reform and expanded or contracted the base as
appropriate. (The spreadsheet then divides by the actual B&O collections at each step to
provide an informative interim report on the rate.)
The seven steps from beginning to end are:
1. Obtain appropriate gross product data for the classifications of industry which will be
taxable under the B&O and the reform.
 2. Convert data from calendar year to fiscal year, so the revenue data will be parallel to the
tax base data.
3. Make certain ad hoc adjustments to keep the data consistent.
4. Convert from gross product data to net product to allow for the rule that capital purchases
are deductible.
5. Expand product data to reflect the limitation of deductibility to in-state firms to approach
the full tax base we are looking for.
6. Account for the cost of the universal $100,000 standard deduction.
7. Increase revenue requirements by 50 percent to address the chronic inadequacy of state
revenues.

Detailed Explanation of Steps

Data: The tax base we want is really one of net income to owners and workers. It is a
mirror image of value added to product. In a closed economy, product and income would be
identical. Washington state is very, very far from being a closed economy. The eventual tax
base under this reform will account for income from around the world, and in particular, from
other parts of the United States.
We began with state gross product data, because it is the most accessible, and in Step 6 we
expand this data to approximate the effect of an open economy. The data we have used comes
from a special report published in the September 2003 Washington Economic and Revenue
Forecast from the Office of Forecast Council. 19 The close relationship between product and
income becomes clearer with the comment in the report, ―In practice, GSP (gross state product)
estimates are measured as the sum of distributions by industry of the components of gross
domestic income. The difference between GDP (gross domestic product) and gross domestic
income is the statistical discrepancy.‖ 20
Step 1: Obtain appropriate gross product data for the classifications of industry which
will be taxable under the B&O and the reform. Not all industries are taxed under the B&O.
Some categories, like government and nonprofits, are obvious. Others which are not taxed under
the B&O are utilities, transportation and insurance, because they come under other parts of the
tax code. Agriculture, forestry, rental of real estate, and other special purposes are also exempt
from the tax.
In the Washington State Tax Structure Study Final Report, a table is provided for the
purpose of estimating the effective tax on value added for different business classifications. One
version of that table was referenced earlier and provided in Appendix A. Another appears in
Appendix C-12 of the Study.21 The table was used as a template to select the classifications for

19
“Washington State Gross Product by Industry,” pages 65-74 in the September 2003
Washington Economic and Revenue Forecast, Office of Forecast Council.
20
Ibid, p. 65.
21
Table 1, "Effective Tax rate on Value Added: Listed by Degree of Pyramiding," Washington
State Tax Structure Study Final Report, Appendices, p. 41.

25
our analysis. 22

The classifications obtained from these tables were first reduced by eliminating the class of
FIRE (finance, insurance and real estate), transportation and public utilities for the reason stated
above, they are taxed elsewhere. Rental of real estate for more than 30 days is exempt from the
B&O, though no corresponding tax is paid. Finance is a problematic category for several
reasons.
Again, our special rules allow these to be deducted by businesses, and for the purposes of
this tax the providers of these services are categorized as taxpaying entities. Eliminating these
entire categories from our calculations also injects a conservative bias to the tax base, as not all
activities will be exempt. Notice that the category of farming and some activities in forestry and
fishing have not been eliminated, since these will accumulate at the next level of the supply
chain.
Step 2: Convert data from calendar year to fiscal year, so the revenue data will be
parallel to the tax base data. Tax revenues are reported by the Department of Revenue in by
fiscal year,23 and in order to derive a legitimate rate, we need parallel data. To accomplish this
we simply (if crudely) add one-half of the first calendar year to one-half the second. This entails
data from 1996 which is not displayed.
Step 3: Make some ad hoc adjustments to keep the data consistent. The categories
displayed in the Tax Structure Study’s final report were used as a template for taxable
categories. That table lumps services together as "legal/engineering/accounting." We could not
desegregate the OFC data, so we simply added an amount comparable to the Study’s number.
Step 4: Convert from gross product data to net product to allow for the rule that
capital purchases are deductible. With the rule that capital investments are deductible, we
move from gross product to net product. Net product is a figure adjusted for the consumption of
capital. To obtain net product we simply reduced the gross product number by 10 percent.
Capital consumption has averaged 8 to 10 percent as a whole in the postwar period. We have
used the higher end of the range and applied it to total gross product in order to inject another
conservative bias to the analysis and to accommodate the proposal which allows outright
expensing of capital purchases. The deductibility of capital can come in two forms, depreciation
(which approximates the literal "consumption of capital") or in expensing outright. The latter
would be very helpful to start-ups and would strengthen the argument to eliminate other forms of

22
We need to note here that we could not replicate the numbers in this table of the Study. The
table was created in part using the 1998 Washington State Implan Model, a proprietary input-output
model from the Minnesota Implan Group, Inc. The model may have generated the "Value Added" column
as a function of income. As noted below, our analysis begins with product data. A second clarification is
also in order. It would be tempting to use the "Total State" effective rate on value added identified in the
table (1.53%) as a surrogate for the revenue-neutral rate for this reform. In fact, the deductibility of capital
expenditures is not clear from the table, and the reform’s stipulation that purchases must be from other
taxpaying enterprises broadens the base significantly beyond that considered by the Study. The
subtraction method VAT favored by the Study Commission in this context is very similar to the reform
proposed here in some of its mechanics and somewhat similar in tax base, however, and we would
expect the nine Commission members who endorsed the tax alternative of Chapter 6 to also support this
proposal.

23
Tax Reference Manual, Washington State Department of Revenue.

26
business stimulus in the B&O structure. (The technical term for a tax, say a VAT, using
depreciation is "an income VAT." If expensing were allowed, it would be "a consumption
VAT.")
Step 5: Expand product data to reflect the limitation of deductibility to in-state firms,
thus expanding product data to the full tax base we are looking for. In the step that is
probably least precise of all the manipulations, we adjusted for the reform’s proposal which
limits deductions of purchases to those from other taxpaying entities. This in effect adds to the
tax base, as out-of-state firms’ products will not be deductible. The amount of this addition is
unknowable. Import and export figures are available for Washington with regard to international
trade, but these are superfluous to our purposes. (Even these, because they are based on point of
shipment, not point of production, are not relevant). We suggest a reasonable estimate of this
contribution to the tax base from out-of-state firms can be got by assuming that one-half of goods
and services taxable under Washington’s retail sales tax come from out-of-state suppliers. This
figure does not include food and drugs, which are exempt from the retail sales tax, nor many
services, and thus by no means does it represent one-half of the value of all goods and services.
Step 6: Account for the cost of covering the universal $100,000 standard deduction.
The tax base developed by these manipulations is further reduced by the impact of the standard
deduction of $100,000. The US Census Bureau in its "Statistics of US Businesses: 2000"
provides a table estimating the number of businesses in Washington by size of enterprise in
terms of employment.24 This table identifies 138,228 total firms. The 82,500 firms with fewer
than 5 employees have an average payroll of under $50,000. Payroll will not be a stable
proportion of taxable receipts across firms (see the next section), but it ought to be more or less
related. If we assume that an equivalent of 40,000 firms will be unable to take advantage of the
standard deduction of $100,000 by virtue of taxable receipts being below that figure, then we
produce a round number of 100,000 firms which take full advantage, resulting in an even $10
billion reduction in the tax base from the standard deduction provision. (The same 40,000
number would be obtained with the assumption that the equivalent of 80,000 firms could utilize
only half the standard deduction or that utilization for the 80,000 firms was distributed evenly
between $0 and $100,000.)
Both the Census table and that from the State’s Labor Market and Economic Analysis data
demonstrate a striking characteristic of the state’s employment — it is top-heavy. Firms
employing 500 or more comprise less than 2 percent of all enterprises in the Census data, yet
account for 45 percent of employment and well more than half of annual payroll. The largest
firms, those employing more than 2,500 account for barely 1 percent of firms, but more than a
third of employed workers and 45 percent of payroll.
Step 7: Increase revenue requirements by 50 percent to address the chronic
inadequacy of state revenues. The sequence of steps to this point results in the "revenue
neutral" rate. As discussed in Part 5, no reform will be successful or complete without
addressing the hole in the state’s fiscal foundation, the chronic and growing shortfall in revenues.
24
US Census Bureau, "Statistics of US Business: 2000: Washington: All Industries by Employment
Size of Enterprise," http;//www.census.gov/epcd/susb/2000/wa/WA--.HTM." The State of Washington,
Employment Security Department, Labor Market and Economic Analysis, also provides an estimate of
size of firm by number of employees, but the Census Bureau’s count is more relevant, as it excludes firms
without payroll and other categories which are not relevant to this issue — e.g., government
establishments. See "Washington State, Employment Security Department, Labor Market and Economic
Analysis, "Size of Firm by County Distribution," October 3, 2003,
http;//www.workforceexplorer.com/publication.asp?PUBLICATIONID=1610.)

27
 The final step in our calculation is to compute an increase that will measurably improve this
situation. An increase of 50 percent, or $800 million to $1 billion generates the range of rates
displayed in the tables. Our target is the 2006 fiscal year, so we believe that this is an
imminently practicable goal with the rate of 2.0 percent.

28
 TABLE B-1
STEPS 3 THROUGH 7
Fiscal Year

1997 1998 1999 2000 2001

Simple Product Divided by Actual Collections
Applicable Tax Base (millions) 96,938 106,477 118,361 126,820 129,326
Actual B&O Tax Collections (000s) 1,722,802 1,853,815 1,827,459 1,854,948 2,012,403
Implied B&O Reformed Tax Rate 1.78% 1.74% 1.54% 1.46% 1.56%

Step 3: Minor Adjustment for Continuity

Tax base Including $8 billion adjustment 104,938 114,477 126,361 134,820 137,326
for services discrepancy (millions)
Actual B&O Tax Collections (000s) 1,722,802 1,853,815 1,827,459 1,854,948 2,012,403
Implied B&O Reformed Tax Rate 1.64% 1.62% 1.45% 1.38% 1.47%

Step 4: Consumption of Fixed Capital at 10%

Consumption of Fixed Capital at 10% of Gross 16,851 18,364 20,025 21,328 22,052
Product (millions)
Revised Tax Base with Capital Consumption 88,086 96,113 106,335 113,492 115,274
(millions)
Implied B&O Reformed Tax Rate 1.96% 1.93% 1.72% 1.63% 1.75%

Step 5: Accting for taxpayer-only deductibility *

Sales Tax Collections by Fiscal Year ($millions) 4,373 4,663 4,948 5,406 5,519
Divided by State Rate of 6.5% ($millions)
Equals Approximate Taxed Retail Sales 67,278 71,745 76,127 83,163 84,909
Tax Base w/ "taxpayers-only" ded. at 50% of RST 121,725 131,985 144,399 155,073 157,728
Retail *
Implied B&O Reformed Tax Rate 1.42% 1.40% 1.27% 1.20% 1.28%

Step 6: The Influence of the Standard

Deduction at $100,000
Actual B&O Tax Collections (000s) 1,722,802 1,853,815 1,827,459 1,854,948 2,012,403
Tax Base reduction of $10 billion (millions) 111,725 121,985 134,399 145,073 147,728
Implied B&O Reformed Tax Rate 1.54% 1.52% 1.36% 1.28% 1.36%

Step 7: Calctg.the Rate for Enhanced Revenue

Actual B&O Tax Collections (000s) 1,722,802 1,853,815 1,827,459 1,854,948 2,012,403
Increasing Collections by 50 percent (000s) 861,401 926,908 913,730 927,474 1,006,202
Reformed Collections (000s) 2,584,203 2,780,723 2,741,189 2,782,422 3,018,605
Tax Base (millions) 111,725 121,985 134,399 145,073 147,728
Implied B&O Reformed Tax Rate 2.31% 2.28% 2.04% 1.92% 2.04%
* Assumes 50% of retail taxed under retail sales tax (RST) is not produced by Washington
taxpayers.

29
 Appendix C

The Break-Even Point

The current B&O undertaxes larger, established, and vertically integrated businesses. The
reform adjusts the burden in favor of nurturing small businesses, promoting investments in
capital equipment and facilities, and evening the load on users of in-state products. Can we find
a break-even point so that an individual business owner can know whether he or she will do
better on the tax return to the state under the current B&O or under the reform rules? 25

The short answer to this question is No. We would be comparing gross sales to net sales, and
as already discussed, the two may bear little resemblance to each other. We can get closer,
however, for some businesses. The tables below allow comparison for those who know what
the percentage of allowable deductions is against their gross receipts.

Table C-1

Break-Even Point Between Current B&O and Reformed Tax

at 2.0 Percent
Assuming Different Levels of Allowable Deductions 26

.00484 Rate: .00471 Rate: .015 Rate:

Wholesaling, Retailing Service and Other
Manufacturing Activities
70% 1,724,138 70% 1,550,388 70% negative
60% 632,911 60% 607,903 60% negative
50% 387,597 50% 378,072 50% negative
40% 279,330 40% 274,348 40% negative
30% 218,341 30% 215,285 30% negative
20% 179,211 20% 177,148 20% 2,000,000
10% 151,976 10% 150,489 10% 666,667
0% 131,926 0% 130,804 0% 400,000

25
Effective vs. Nominal Tax Rate. A potential area of confusion arises from the calculation of the
effective rate on value added, as displayed in Table 9-7, Appendix A. This effective rate does not
correspond to the nominal rate which we are discussing in this section, which is the amount which
a firm remits to the state at tax time. The effective rate earlier is no less burdensome and
appropriate for consideration, but it is the nominal rate we are discussing here. This rate can be
easily grasped and its weight communicated to business owners, and this is the amount on the
tax bill.
26
Calculated by solving for the equation .022-[(x - deduction%)(x) - 100,000)] = (b&o rate)(x).
This table indicates that a great many businesses in Washington state would pay less under the
reform proposal. Department of Labor data identify firms by size of work force. Of the nearly
140,000 total firms in Washington counted by the US Census Bureau in 2001, more than half
had fewer than five employees and an average payroll below $50,000. 27 The next cohort
reported, those businesses with five to nine employees, comprised another 20 percent of
Washington businesses, and their average payroll amounted to $167,000. Value added, as
discussed more fully in Part 5, is comprised basically of payroll and returns to ownership. The
reformed tax is based on a value added concept, but the tax exposure of an individual business
may or may not come close to economic value added because deductions allowed are
restricted to purchases from other taxpaying enterprises and to capital expenditures. In lieu of a
more complete discussion, we suggest simply that 70 percent of Washington businesses would
see a lower tax bill under the reform. Notice, however, that by far the greater number of workers
will be in those enterprises with a higher bill. Companies employing twenty or more workers
account for 80 percent of employment.

27
Statistics of US Businesses 2000: All Industries: Washington: By Employment Size of
Enterprise, http://www.census.gov/ eped/susb/2000/wa/WA- -.HTM.

31