In our prior blog post we looked at the volatility of capital gains taxes and how California adopted a constitutional amendment to force more savings of its revenue from that source versus spending it to reduce the state's rollercoaster budgeting.

As we noted, rather than dedicate any of the revenue from his proposed capital gains tax to protected savings, however, Governor Inslee’s plan takes the opposite approach by preventing the funds from going into state’s constitutionally protected reserve account created by voters.

According to Section 113 of HB 1484, all revenue raised from the creation of a capital gains tax “must be deposited in the education legacy trust account created.” This serves two purposes. First, the Governor is dedicating the money to be used for his education spending and second, by putting the money into this account and not the general fund, the Governor avoids triggering the constitutional requirement passed by voters in 2011 “to ensure extraordinary and unsustainable [revenue] growth is saved, rather than spent.”

This second fact was illustrated by the conversation at the January 15 meeting of the state Budget Outlook Meeting. As noted by the handouts for that meeting:

Extraordinary Revenue. The Office of Financial Management submitted a correction to the budget the Governor submitted in December. Without correction, the calculation of extraordinary revenue growth under current law would result in additional revenues being transferred to the Budget Stabilization Account, which was not the intent of the Governor’s proposal. The correction dedicates new law revenues proposed in the budget to the Education Legacy Trust Account, rather than the general fund.

This means that the Governor has structured his capital gains tax proposal to avoid the money from this volatile tax from going to the constitutionally protected reserve account while also dedicating it to pay for education spending. Despite this maneuvering, the Office of Financial Management (OFM) acknowledges that capital gains taxes are volatile and that “careful budgeting” will be needed if enacted. According to OFM:

After exemptions to remove any capital gains tax on retirement accounts, homes, farms and forestry, the proposal will raise an estimated $798 million in fiscal year 2017. This estimate is an average based on 10 years of data; the actual amount collected from this tax would be expected to vary from year to year depending on fluctuations in the financial markets. The state can manage these fluctuations through careful budgeting. For example, Governor Inslee’s budget projects the state would have about $2 billion in total reserves by the end of the 2017–19 biennium.

According to the state’s most recent four-year budget outlook, that $2 billion would include $619 million in unrestricted reserves (or 1.5% of estimated spending) and $1.4 billion in the constitutionally protected reserves.

As reported by the Seattle Times, State Treasurer McIntire has concerns about the Governor's capital gains tax proposal:

State Treasurer Jim McIntire, a Democrat, said he agrees with Inslee the state needs new revenue, saying it will be 'mathematically impossible' in the long run to fund an adequate public-school system under the current tax code. Inslee's proposal would dedicate the revenue from the capital-gains tax to a special state fund that can only be spent on K-12 and higher education. But, McIntire said, 'capital gains is probably the most volatile revenue source for most state governments. That is a concern.'

Notwithstanding concerns about the volatility of a capital gains tax, is a rate of 7% constitutional in Washington? Although the Governor has framed his capital gains tax as an “excise tax” for the “privilege of selling or exchanging long-term capital assets” it is telling none of the states without an income tax have a capital gains tax. This is likely due to the fact capital gains are considered income.

Under Washington’s Constitution property cannot be taxed at a rate greater than 1% and the taxes must be uniform. Under several State Supreme Court rulings, income has been described as property meaning taxes on income must conform to the 1% limit. 

The fiscal note for House Bill 1484 assumes that litigation around the proposal will occur. According to the fiscal note:

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, which is January 1, 2016.

Although the Governor hopes to prevail against these legal challenges by calling the capital gains tax an “excise tax” it is arguably an income tax. As described by Former Supreme Court Justice Phil Talmadge in his legal analysis of Initiative 1098 (legal citations omitted):

Washington law is unambiguous. Income is property. Beginning in Aberdeen Savings and Loan Association v. Chase, and continuing through a series of cases, the Washington Supreme Court has held that income is property. As such, this tax is subject to the provisions of the so-called uniformity clause, article 7, section 1 of the Washington Constitution, which provides that all taxes ‘shall be uniform upon the same class of property within the territorial limits of the authority levying the tax . . .’ Moreover, article 7, section 2 of the Washington Constitution establishes the upper limit upon ad valorem property taxes. That constitutional restriction essentially limits any property tax to no more than one percent of the value of the property.

On the issue of the Legislature trying to call an income tax an “excise tax” to pass constitutional muster, Justice Talmadge highlighted 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.

While supporters of the Governor’s proposed “excise tax” for the “privilege of selling or exchanging long-term capital assets” will argue it is not an income tax, as noted by the fiscal note for House Bill 1484 litigation is certain if it is enacted. It is likely the fact that no other state without an income tax has a capital gains tax will be used to justify the position of those that believe a capital gains tax is in fact a tax on income.

Additional Information
Are capital gains taxes "secure and stable" or highly volatile?