As states and their legislatures continue to deal with tight budgets, cuts to education, health care and the environment, lawmakers everywhere are looking for more tax revenue but are predictably hesitant to raise overall tax rates.

One of legislators’ favorite activities is now scrutinizing tax “loopholes” and “preferences” to try to close or eliminate preferential tax rates and various tax credits, deferrals and exemptions. This is a justifiable exercise as some tax preferences may have outlived their usefulness, were targeted too narrowly, or did not generate substantial economic activity or job growth.

Jobs are the main reason why states offer tax incentives or other financial enhancements. Usually a state will enact a sizable tax break because a large company has made a promise to bring a lot of jobs to a certain location, usually from a higher cost locale. The question then becomes did the tax break result in enough jobs and business activity to justify its enactment, at least in terms of tax revenue gained versus tax revenue lost.

States, including Washington, are getting better at analyzing the value of tax incentives and preferences. But they have a long way to go. A good example of a flawed analysis is the report the Washington Joint Legislative and Audit Review Committee or JLARC, produced examining the B&O credit for Research and Development that expires Jan. 1, 2015.

The first assumption that needs to be tossed is that tax incentives or preferences “create” jobs. This is a false assumption made by both proponents and policymakers. This is not to say that a particular tax incentive doesn’t result in job growth but rarely does a tax preference, in and of itself, “create” jobs. Jobs are created when a business cannot meet its needs with current staff and there is a budget to hire someone.

Click for the JLARC tax preference report.

Overall they did a very good job describing the various tax programs, their history, the fiscal effect, who benefits from them and other relevant information. The problem comes in their analysis of the B&O credit for R&D, a tax credit widely used by software and biotech companies, and many others. This tax preference allows certain R&D expenses to be credited against one’s B&O tax. The credit cannot exceed one’s B&O liability. The annual cap is $2 million taken by only 3 companies.

The other related R&D tax preference is the sales tax deferral for R&D facilities. This is a more “expensive” preference because it relates to large construction projects or major upgrades to R&D labs and facilities. As an example, in 2010, the state deferred/exempted $54 million in sales tax due to the R&D deferral while not collecting $23.5 million in B&O due to the R&D credit. The B&O credit is taken by over 500 entities, mostly for profit businesses. The sales tax deferral for R&D is taken by many fewer taxpayers, usually larger companies or research institutes building expensive labs or R&D facilities.

However, JLARC did not study the sales tax deferral for R&D and chose to focus only on the B&O credit. The problem comes when they try to measure job creation “as a result” of the B&O credit. This is an extremely narrow focus that does not look at other factors, such as jobs created through R&D spending, or tax revenue generated due to R&D spending. JLARC did not use this same standard for any of the dozens of other tax preferences they examined this year. They also found that Dept. of Revenue reporting was incomplete and that the amount of deferred sales taxes is overstated due to DOR rules. JLARC looked only at the jobs created “as a result” of the B&O credit. JLARC should have also looked at the sales tax deferral for R&D but claimed there were not enough participants to do an accurate analysis.

To JLARC‘s credit, their recommendation was to “review and clarify” the R&D tax incentives to ensure that the legislature’s goals are being met.

The Dept. of Revenue compiles detailed statistical reports from information submitted by business taxpayers that take one or both of the R&D incentives. That report shows that a large number of companies are doing over $7 billion worth of R&D, generating over $9 billion in taxable revenue. The number of “jobs covered” by the R&D incentives is over 100,000 workers statewide, of which 84,000 make over $60,000 per year. You can find that report here. Chapters 6 and 11 are the ones for the R&D tax incentives.

WTIA firmly believes that the legislature should make permanent both the B&O credit and the sales tax deferral/exemption for R&D, or at a minimum extend them for 15 years. While the legislature must definitely examine the efficacy of any tax preference, providing and incentive to perform R&D in Washington is smart public policy.