Little known fact - income derived from sales to people outside WA is no subject to B&O tax. An Internet startup will likely have only 2% of their users in WA, and so only that much is subject to B&O tax.
This is not a tax advice, consult a competent accountant.
The issue is purchasing services within WA -- those services will be marked up due to B&O (tax pyramiding).
the 0.5-1% rate on final sales is inconsequential; it's the tax pyramiding on every purchase before that. Admittedly it matters a whole lot less for a startup than for a purely local business (say a coffee shop who buys bread locally which is made from facilities, staff, and multiple other inputs, each of which is also produced within the state and has gross receipts taxes added.
It's particularly bad because it essentially discourages outsourcing and encourages vertical integration, counter to efficiency and new business formation. The same product can cost a lot more if you use the best components and best assembly vs. more expensive and lower quality things produced entirely in-house.
When I am shopping for hosting services or hardware, I am shopping across entire country, I don't care if the vendors had to markup this or that, and I don't have to buy local, and vendors don't mark up their prices based on my location within US.
When selling, I am paying tax only on sales to WA residents, which is like 1% of my world-wide sales, and on those I am paying like 0.5% gross receipts tax. So it's 0.005% tax rate total.
How did you end up with "for a software/internet startup who buys hosting from a single provider only, it is probably more like a 3-4% income tax." ???
Most businesses buy a lot of products and services locally. It is infeasible for your garbage collection service or other utilities to be sourced from outside the local area, for a lot of goods there are licensing or transportation issues which make them local, etc.
Internet companies are a huge exception to normal businesses. (which is why they're so awesome and can turn into scalable startups so easily). Income tax is on profits, so if you have a low margin business, or an earlier startup business, you'd be paying low total income taxes even at the 3-4% rate., so a tiny B&O direct expense and higher costs for facilities, contractors, etc. translates to a much higher equivalent income tax rate.
B&O isn't a good argument against setting up your tech company in WA; it's just an unfair tax which penalizes some businesses (inherently local ones) while favoring others (prof services and internet). (the only good argument against tech startups in Seattle is the somewhat-smaller-than-Bay-Area pool of tech workers, largely better now than it was 10y ago when they were just Boeing and Microsoft, and the lack of great VCs (there are a few, but not the best in the world, and not many vs. SF, NYC, or Boston).
This is not a tax advice, consult a competent accountant.