What is Economic Nexus

I’ve done a few posts on the B&O tax, but none of them have touched upon how Washington taxes businesses that aren’t located in our state but that still carry out transactions here. Before June 2010, the law said that businesses could only be taxed if they had a physical presence in the state where the transaction occurred. This is referred to as the physical nexus, which is based on a U.S. Supreme Court case Quill Corp. v. North Dakota (1992).  However, in the 20 years since this decision was heard, the Internet completely changed how businesses and people interact around the world.  It was time to update the tax code to reflect this evolution.

This change came in the form of SB 6143 - Modifying excise tax laws to preserve funding for public schools, colleges, and universities, as well as other public systems essential for the safety, health, and security of all Washingtonians – which expanded nexus rules to include businesses that have an economic nexus in Washington. Economic nexus applies to certain business classifications such as professional services, interest from loans, or royalties. If these businesses have more than $250,000 of gross income attributed to Washington then they don’t have to be physically in Washington to be subject to B&O taxes.  Most other business classifications, like retail and wholesale, are only subject to physical nexus rules.  The Department of Revenue has a tutorial that explains these differences in more detail.

As the bill title above shows, this change was implemented to save money for programs and services that were being reduced due to the Great Recession.  The Washington State Budget and Policy Center said that “under the physical presence nexus standard some businesses that benefit from Washington’s public structures – i.e. courts, roads, and other services that improve access to markets -- are not required to help pay for their maintenance.” Also, this update helped to level the playing field. In a message to the Tax Foundation (which opposed the measure), Representative Ross Hunter responded with:

I fail to see why a business located outside the state and performing services inside the state should be able to avoid paying taxes on their activity. When the B&O tax was created, the only way a business could perform a service for a customer was over a handshake. This clearly hasn't been true since Al Gore invented the Internet. Imagine two businesses are set up 50 miles from each other, but one is across the border in Oregon. They both perform services for customers in Washington State. Why would they have different tax treatment?

Even though they agreed to disagree, the Foundation brought up an interesting point: What should matter more, that all products face the same tax, or that state powers are limited and prevented from harming interstate commerce?  I think Washington was right to include economic nexus when taxing businesses.  The Internet has changed the variables of interstate commerce and how we communicate. It’s time our tax code reflected this fact.

Property Tax 101: Exemptions, Credits, & Deductions

Part 1

Washington State’s Constitution allows for the legislature to declare certain exemptions for property taxes.  And declare they have!  Over the years, the number of exemptions, credits, and deductions has grown.   There are a number of classifications, too.  For example, there are various entities and types of property that are exempt from property taxes.  It’s probably no surprise that federal, state and local government owned properties are among those exempt.  But did you know that most non-profit organizations and many privately owned properties are exempt, as well?  For a complete list, read the Tax Reference Manual produced by the State Department of Revenue.  In the meantime, here are some examples:

Non-Profit Organizations:

·         Churches, parsonages, convents, and administrative offices of religious organizations

·         Humane societies

·         Assembly halls and meeting places

·         Thrift stores that sell only donated merchandise

Privately Owned Property:

·         Cemeteries

·         Widows/widowers of veterans

·         Property used to produce biodiesel, wood biomass, or alcohol fuel or as an anaerobic digester

·         Senior citizen and disabled homeowners (see below for a more detailed discussion)

As discussed in previous posts, some personal property is also exempt from taxation.  Certain intangible assets such as cash, stocks, and bonds are not included in property taxation.  Also, motor vehicles, farm equipment, commercial vessels, and recreational boats are exempt. 

In the 2012 legislative session multiple bills were introduced to expand exemptions or credits.  Here is a roundup:

·         SHB 1042/SB 5017 – Providing a property tax exemption for property held under lease, sublease, or lease-purchase by a nonprofit organization that provides job training, placement, or pre-employment services.  Did not pass.

·         HB 1385/SB 5628 - Concerning a limited property tax exemption from the emergency medical services levy.  Did not pass.

·         HB 1457 – Encouraging businesses to locate in vacant buidlings through a business and occupation tax credit for property taxes paid. Did not pass.

·         HB 2772/SB 6583 – Creating a property tax exemption for the value of new construction of industrial/manufacturing facilities in target urban areas.  Did not pass.

·         SB 6600 – Extending property tax exemptions to property used exclusively by certain nonprofit organizations that is leased from an entity that acquired the property from a previously exempt nonprofit organization.  Passed – effective 6/7/2012.

For more information on property tax exemptions, read part 2, coming soon.

What are the costs of tax exemptions in Washington State?

According to a recent Department of Revenue report, there are 640 tax exemptions on the books in Washington State.  Of those, 452 would likely generate revenue if eliminated.  However, the bigger question is how much revenue is being lost through these exemptions?

Revenue advocates make the case that closing some exemptions would help to address the budget shortfalls that have plagued Washington since the start of the Great Recession.  Before getting into the weeds of that debate, we need to know just how much the 452 revenue-generating exemptions cost our state.

Exemptions are spread across our entire tax code and can be found in every type of tax applied by the state.  176 apply to the B&O tax, 151 are in sales tax collections, 63 are found in other business taxes, 35 apply to taxes in lieu of an excise tax, 21 in miscellaneous taxes, and 6 in property taxes.  In total, these 452 revenue-generating exemptions resulted in $29.3 billion in lost revenue in the 2011 – 2013 biennium.

To fully understand the $29.3 billion in lost revenue, we need to relate this amount to the big picture—the state’s full operating cost. According to the Washington Citizen’s Guide to the Budget, total expenditures for the 2009- 2011 biennium added up to $74.8 billion.  Of that amount, $26.7 billion was spent on human services, $17 billion on public schools, $10.5 billion on higher education, and $8 billion on transportation.  If viewed as an expenditure, exemptions outweighed any other categorical expenditure in the state.  Currently, exemptions represent approximately 39% of our state’s operating cost.       

Since the beginning of the Great Recession, the legislature has had to rip $10.5 billion from the state’s operating cost as a result of continued budget shortfalls.  These reductions have had a tremendous impact on how the state conducts its business and funds its core values.  Across the board reductions have resulted in increased tuition at our 2-year and 4-year colleges, decreased funding for k12 education (resulting in a legal challenge that was recently upheld by our state’s supreme court), the elimination of vital social service programs, and the delay of critical infrastructure improvements.

Viewed as a whole, exemptions add up to a huge bite out of our state’s operating budget.  Still, a knee-jerk decision to close loopholes could have larger unforeseen ripple effects in our economy.  Currently, these exemptions are not subject to regular and rigorous review, with some exemptions remaining on the books for over 50 years.  When entering into the debate over the closure of exemptions, it is important to not only know the impact that these exemptions have on our budget but to also conduct a full and careful review of proposed exemption eliminations. 

It is hard to argue that the closure of exemptions should not be considered in trying to address the current fiscal crisis in our state.  Even if only 10% of the exemptions were closed, it would result in $2.9 billion of additional funds that could be used to mitigate some of the recent devastating cuts experienced by critical public programs.    

Washington State’s First Tax Amnesty Program

When the economy’s in the tank and government needs cash without raising taxes, one thing lawmakers can do is create amnesty programs that forgive interest and fines on delinquent tax payments.  In 2009, State Auditor Brian Sonntag released his yearly audit report that showed Washington State was owed $1.6 billion in delinquent payments (at the time) and an amnesty program could be a one-time option for collecting revenue. He also discussed some of the possible cons of these programs such as implementation costs and lost revenue.

The Governor and Legislature agreed with his assessment and unanimously passed Senate Bill 6892 – Establishing a temporary penalty and interest waiver program for certain excise taxes administered by the department of revenue – which created an amnesty program to run from February 1^st to April 30^th of 2011.  At the time, state officials estimated that collections would bring in around $24 million that could be used to help bridge the gap in the budget deficit. 

The Department of Revenue (DOR) set up the application and payment process and ended up spending $381,000 on staff time and outreach efforts.  The result of this program was a huge success that dwarfed the initial collection estimate. In its final report, DOR says the program collected $345.8 million from 5,095 businesses (over 9,000 applied).   This resulted in $284 million for the state general fund, $5 million for other state accounts, and $61.3 million for cities and counties. This did come with a cost of $91 million in waived fees and penalties, but the quick infusion of cash helped to save programs and services that were on the chopping block.

According to DOR’s data, most of the money came from out-of-state businesses and 75% of businesses that were granted amnesty were small businesses that had a gross business income (GBI) of under $1 million. I’m not sure how much of an overlap there is between these two datasets, but it would be interesting to know why these two groups made up large pieces of the whole.  Regardless, this was a win-win for businesses and government.

DOR was also recognized nationally and received the 2012 Taxpayer Service and Education Award from the Federation of Tax Administrators. Citizen outreach is an important piece for any state program and process transparency builds trust between government and the public.  While this program can’t be implemented on a regular basis since it would be rewarding delinquent payments, it’s a good example of addressing a tax problem in the middle of a fiscal crisis.