After years of heavy lifting, Washington State sales tax is getting weaker

Washington’s state and local governments rely on the sales tax for much of the heavy fiscal lifting — more so than in nearly any other state. But almost 70 years after the sales tax was adopted, it is showing its age.

By Drew DeSilver
Seattle Times business reporter

A state committee last week reiterated that the tax overburdens the poor. It is also shot through with exemptions and finds itself on the wrong side of several economic trends — from the surge in e-commerce to the shift away from goods toward services.

"Our tax structure wasn’t designed for today’s economy," said state Sen. Lisa Brown, D-Spokane, an economist who will lead Senate Democrats when the Legislature convenes next month.

Many of the things people buy, from groceries and medicine to airplane tickets and legal services, aren’t taxed by the state. Through the years, those things have become a bigger share of people’s overall spending. Consumers also are buying more products online or through catalogs, which are almost impossible to collect tax on because such sales don’t have to be reported.

Three decades ago, according to the state Office of the Forecast Council, taxable sales accounted for 61 percent of Washington’s economy. This year, they’ll account for just over half. In 1985, after the current 6.5 percent state rate was fully implemented and groceries were exempted for good, the sales tax raised just under $2 billion for state government. In 2001, it raised $5.9 billion. But had taxable sales remained constant, the tax would have raised more than $6.2 billion, a Seattle Times analysis shows.

Between 1985 and 2001, state coffers missed out on nearly $1.3 billion — or consumers’ held onto it, depending on your point of view — because of the sales tax’s decreasing reach.

The Tax Structure Study Committee last week said the state should reduce its dependence on the sales tax by adopting an income tax or a value-added tax on business.

Failing that, the committee said Washington should extend the tax to consumer services. And it should work with other states to harmonize their various sales taxes, which in turn would make it easier to collect taxes on catalog and Internet sales.

Not keeping up

In the meantime, several forces are weakening the sales tax:

• The shift to a service-based economy. Services constituted 54.5 percent of gross domestic product last year, compared with 38.1 percent in 1959, according to the U.S. Bureau of Economic Analysis.

Although some services, such as telephone, auto repair and landscaping, have been added to Washington’s sales-tax base over the years, most remain tax-free. Taxing them, the state Revenue Department estimates, would bring in about $1.6 billion a year to the state; cities and counties would share more than $400 million a year.

• The rise of Internet shopping. The Census Bureau estimates that online retail sales nationally have grown from $5.5 billion in the fourth quarter of 1999 to $11.06 billion in the third quarter of 2002.

That was still only 1.3 percent of total retail sales for the quarter, but online sales are growing rapidly: Technology consultancy Forrester Research projects that by 2007, e-commerce will total $217.8 billion, representing 8 percent of all retail sales.

Internet merchants, like catalog merchants, have to charge Washingtonians sales tax only if their companies have a significant presence in the state. That’s why Amazon.com will charge state residents $1.52 tax on Alice Sebold’s novel "The Lovely Bones," but Barnes & Noble.com won’t.

Technically, consumers still owe that $1.52 as use tax. But even the state Revenue Department admits it has no realistic way to collect the tax, hence few consumers pay it. A 2000 study by the state House Finance Committee estimated that Washingtonians owed $87 million in unpaid tax on Internet sales, compared with $109 million in mail-order and other "remote" sales.

"The potential growth of tax-free electronic commerce represents a long-term threat to the existing state-local tax structure," concluded a 1998 report from the National League of Cities. But, the report added, "no one can predict with any real confidence how great the public-sector revenue (losses) will be, or how rapidly they will occur."

• Cross-border shopping. Since 1935, when Washington adopted its sales tax, revenue officials have had to deal with residents crossing the Columbia River to shop in tax-free Oregon.

As with catalog purchases, those people owe use tax, but it’s almost never paid. Cross-border shopping cost the state $49 million in lost sales taxes, according to the 2000 study.

• The disconnect between income and spending. While statewide personal income grew 80.5 percent during the 1990s in Washington, taxable sales rose only 60.1 percent.

Incomes rose fastest at the upper end, and as a rule, the more people make, the more they save or invest. A greater share of what they do spend goes to nontaxable services, such as legal and financial-planning services or airplane tickets, rather than taxable products, such as refrigerators and clothing.

On the other end of the scale, people who make less money end up spending a larger percentage of what they have.

Households with incomes between $20,000 and $30,000, for example, pay an average of 4.4 percent of their income in sales taxes, according to a study by the Office of Program Research, an arm of the state House of Representatives. Households with $60,000 to $70,000 in income pay 3.5 percent of it in sales tax. Above $130,000, and the bite falls to 2.2 percent.

"The impact of the system as it’s currently structured falls on those with the lower incomes… Given everything else this state is going through right now, those impacts are even heavier," said Pat Higgins of the Institute for Washington’s Future, a Renton-based research and advocacy group.

Sales-tax breaks abound

Through the years, the Legislature has enacted hundreds of millions of dollars in sales-tax exemptions — walling off even more of the state’s economy from the tax.

In 1995, for example, lawmakers exempted purchases of manufacturing machinery and equipment from sales tax. The break saves companies an estimated $200 million annually. A year later, legislators exempted anodes and cathodes, electrical devices used to make aluminum, in an effort to aid that faltering industry. That was worth more than $12 million annually.

Tax fact

Washington relies on the sales tax (and its poor cousin, the use tax, which applies to goods bought by Washingtonians outside the state for use here) more than any state except Tennessee. Last year, the state sales tax raised $5.9 billion — nearly half of all taxes and 26.4 percent of total revenues. Sales taxes imposed by cities and counties raised an additional $1.8 billion.

Feed, seed and fertilizer used on commercial farms have long been exempt from the tax; most other agricultural supplies are as well, with a total worth of $133 million a year. A 1984 initiative exempted the value of trade-ins from sales tax, a break that will save car buyers an estimated $150 million this fiscal year.

Museums can buy art tax-free as long as they exhibit it; youth sports organizations, blood banks and the American Red Cross get their own breaks. Purchases of gun safes are tax-free, as are human body parts (an incentive for biomedical research).

"There’s always pressure to exempt more and more things, and they’re all good things," lawmaker Brown said. "Last year we had a bill to exempt gifts purchased by a nonprofit entity to grant wishes to dying people. And you look at something like that and say, ‘Well, why should that be taxed?’ "

While the tax base has narrowed, more cities, counties and other entities have imposed or raised local sales taxes. A 0.4 percent tax helps fund Sound Transit, for example, and a 0.5 percent surtax on bar and restaurant purchases in King County pays for the construction of Safeco Field.

The state sales-tax rate has remained constant for 18 years, but the average local rate has risen from 1.235 percent in 1985 to 1.889 percent last year.

All of these issues — overburdening the poor, shifts in the economy, border concerns — led the study committee to examine alternatives to the current sales tax. None is without problems.

Finding the fixes

Taxing more services would seem the simplest fix.

Most analysts conclude that taxing services — especially ones such as legal, accounting and engineering services that are used mostly by businesses and upper-income people — would make the sales tax somewhat less regressive, particularly if the tax rate were lowered as a result.

The idea has been kicking around for four decades, though the most recent proposal, in 1993, failed to clear the Legislature.

A few states, notably Hawaii, Iowa, New Mexico and South Dakota, have extended their sales tax to a broad range of services. But most states that have considered the change have found it difficult.

One big problem is cross-border services. Consider the Tacoma office of a Seattle-based accounting firm that does the books for an Oregon-based corporation with offices in three states. How much of the accounting services would be taxable in Washington? Whose rate would apply? And who would get the money?

Another possible fix is a value-added tax (VAT), of the sort Canada and most European countries impose. Depending on its structure, a VAT could replace the business-and-occupation tax and some or all of the sales tax.

A VAT is levied at each stage of the production and distribution process, from raw material to final consumer. A furniture maker that buys wood from a lumber mill, for example, pays tax only on the difference between the price of the milled lumber and what the mill paid for the raw timber — that is, on the value that was added by the mill.

However, critics say a VAT would be at least as regressive as the sales tax, perhaps more so. And the sheer complexity of figuring VAT would be an added burden on businesses.

Finally, there’s a state income tax, which the tax committee recommended as a way to reduce the sales tax. An income tax, either at a single flat rate or with graduated rates, also would make the system as a whole less regressive, backers like Higgins say.

But courts have said Washington’s constitution bars all but a 1 percent flat income tax. And aside from that, any such proposal would have to overcome popular and political hurdles — as well as the perception that sooner or later, the sales tax would start creeping back up.

Gary Strannigan, a former Republican state senator from Everett who sat on the tax-study committee, said many of his colleagues were skeptical when he briefed them on the various options.

"The idea of adding an income tax to supplement the sales tax got a very cool reception," Strannigan said, even if the sales-tax rate were lowered as a result. "The feeling was that both of them would end up going higher."

Drew DeSilver: [email protected].

Copyright © 2002 The Seattle Times Company

http://seattletimes.nwsource.com/html/businesstechnology/134593749_salestax11m.html