House plans to test strength of WA's income tax ban

Mar 28, 2017

Earlier this session the Senate attempted to make the state's income tax ban court proof by sending voters a constitutional amendment making it crystal clear state and local income taxes are prohibited. Yesterday the House decided to move in a different direction by proposing a brand new capital gains income tax to test the strength of the state's income tax ban. In an attempt to justify the new tax, House leaders said they were merely closing a "tax break" on capital gains that only nine states have. Without getting into the phrasing of this as a "tax break" lets focus on what those nine states without capital gains taxes also don't have - income taxes. 

Knowing that voters don't support income taxes and case law prohibits graduated income taxes, the House tax bill (HB 2186) attempts to define a tax on capital gains income as an "excise tax." This is done knowing full well that if enacted the tax will be challenged in court for violating the state's ban on graduated income taxes. Lawmakers were warned in a fiscal note for a prior capital gains proposal that

"We assume that because the capital gains tax is a new tax actions challenging its constitutionality will be filed in Superior Court . . . We assume up to five Superior Court actions will be filed challenging the constitutionality of the capital gains tax and that such court challenges will be filed after the effective date of the capital gains tax . . ."

Perhaps this is the real goal though. Having repeatedly failed to get the voters to approve constitutional amendments to overturn 84 years of case law banning graduated income taxes, income tax proponents continue to seek ways to get back before the current Supreme Court to see if they'd overturn those prior rulings. This capital gains income tax proposal gives them that opportunity. 

Being less cynical about the ulterior motives, however, is a tax on capital gains income an "excise tax?"

In a series of tweets last night, a tax expert at the Tax Foundation provided this analysis

"Given constitutional income tax restriction, the WA capital gains tax proposal is being billed as an excise tax. Will this fly? States sometimes get creative with what they call their taxes, but courts typically care about a tax's characteristics, not its name. The idea is that it's an excise tax on the sale of capital asset, not an income tax on proceeds. But that's not how excise taxes work. If a capital gains tax was an excise tax, we would expect it to fall on the entire sales price (or flat per sale), not just net gain. We'd also expect it to fall on each transaction separately, not on the aggregate of capital gains and losses as reported on form 1040. 

Plus, although excise taxes are often paid by seller (tax stamps), economic incidence is borne by consumer. That's not the case here. The seller of a capital asset pays out of her income. Tax isn't embedded in transaction. It doesn't function like an excise tax at all. It's telling that taxpayers would have to submit their federal 1040 to report Washington capital gains. What excise tax works that way? 41 states tax capital gains -- all in their 'income taxes.' Federal gov't also taxes as income. Hard to argue WA cap gains different. If it looks and acts like a tax on a class of income (cap gains), it probably is."

Let's also look at how the House tax bill (HB 2186) itself defines capital gains (emphasis added): 

"'Adjusted capital gain' means federal net long-term capital gain . . . 'Federal net long-term capital gain' means the net long-term capital gain reportable for federal income tax purposes."

In fact, a different section of HB 2186 requires those subject to the new capital gains tax to send a copy of their federal income tax return to the state: 

". . . taxpayers owing tax under this chapter must file with the department on or before the date the federal return is required to be filed a copy of the federal income tax return along with all schedules and supporting documentation."

Does that sound like an "excise tax" to you? 

On the issue of the Legislature trying to call an income tax an “excise tax” to pass constitutional muster, former Supreme Court Justice Talmadge highlights the decision in Jensen v. Henneford:

"The Legislature attempted to describe the income tax as an excise tax on the ‘privilege of receiving income’ in the State of Washington. The Supreme Court was unmoved. The Jensen court stated that the 1935 Legislature’s effort to rename the tax did not make it an excise tax . . . Subsequently, in Power, Inc v. Huntley, the Legislature enacted what it described as a corporate excise tax, which was actually a graduated new income tax on corporations. Again, the Supreme Court indicated that legislative labels for a tax are not controlling."

Legal questions aside, does it make policy sense to rely on a highly volatile capital gains income tax to provide "dependable and regular" funding for the state paramount duty of basic education? 

Consider the warnings from those income tax states that tax capital gains. California’s Legislative Budget Office (LAO) says:

"Probably the single most direct way to limit the state’s exposure to the kind of extreme revenue volatility experienced in the past decade would be to reduce its dependence on the source of income that produced the greatest portion of this revenue volatility—namely, capital gains and perhaps stock options."

Heeding this warning, California lawmakers and voters in 2014 approved a constitutional amendment reducing the state's reliance on volatile capital gains. Explaining the impact of the constitutional amendment the LAO said:

"This constitutional amendment separates state spending from the rollercoaster of revenue volatility. This measure takes capital gains revenues that make up more than 8% of the General Fund - the average for the last 10 years - off the table rather than being used for unsustainable permanent tax cuts or ongoing programs."

The Washington state Department of Revenue (DOR) analysis of an earlier capital gains tax income bill (House Bill 2563 in 2012) agreed that capital gains are highly volatile saying:

“Capital gains are extremely volatile from year to year. Revenue from this proposal will depend entirely on fluctuations in the financial markets and can be expected to vary greatly from the amounts presented here.” 

As also noted by the Tax Foundation

"Relying on such a volatile revenue source to boost educational expenditures is risky. A revenue stream that can decline this rapidly is not one that can be relied upon to support meaningful long-term investments in public education . . .

Forty-one states tax capital gains income. In all cases, it is captured by the state’s individual income tax and not by a discrete tax on capital gains. Indeed, all states currently treat capital gains as income. Proposals to label a Washington tax as an excise on buying and selling stock, designed to elide constitutional restrictions, fall apart when one considers that the 'excise' is imposed on realized gains less losses (that is, income), and not on total share value or financial transactions . . . 

Foregoing an income tax is the Washington tax system’s competitive advantage, an inducement to individuals and entrepreneurs alike. And make no mistake, a capital gains tax is a form of income tax. Every tax system has its selling point, and this is Washington’s—one that could be seriously undermined by capital gains taxation. More importantly, such a tax could undermine the very programming it is designed to fund."

It is clear that litigation is certain if a capital gains income tax is adopted. Rather than tie the state budget up in the courts and break from the norm of the other states that don't tax income, Washington should continue to maintain its competitive advantage that the state Department of Commerce previously advertised by not taxing capital gains income.