• Washington: Gov. Inslee Proposes Controversial-And Perhaps Unconstitutional-Seven Percent Tax On Some Capital Gains
  • June 8, 2015 | Authors: David H. Godenswager; David M. Kall; Susan Millradt McGlone
  • Law Firm: McDonald Hopkins LLC - Cleveland Office
  • By law, the governor of Washington is required to propose a biennial budget in December, the month before the legislature convenes in regular session. With his state facing an “enormous budget challenge,” Gov. Jay Robert Inslee proposed a $39 billion budget plan hoping to spur the state’s slow but steady recovery from the worst recession since World War II.

    Gov. Inslee’s proposal incorporates tax and revenue changes that are projected to raise about $1.4 billion during the 2015-17 biennium. A controversial component, which is expected to raise $798 million in fiscal year 2017, is a new seven percent capital gains tax on the sale of stocks, bonds, and other assets. This tax would apply to earnings above $25,000 for individuals and $50,000 for joint filers, starting in the second year of the biennium. Because it taxes investment income, it would have the greatest impact on Washington’s wealthiest taxpayers by increasing their effective state tax rates. The proposal exempts capital gains earned on retirement accounts, homes, farms, and forestry.

    Other provisions of the governor’s plan would:
    • Increase the state cigarette tax by 50 cents per pack, and start taxing e-cigarettes and vapor products, which together will raise about $56 million;
    • Include $380 million in new revenue attributable to the governor’s market-based carbon pollution reduction plan; and
    • Repeal five tax breaks, resulting in approximately $282 million in additional revenue during the biennium. The applicable tax breaks are:
      • The sales tax exemption for trade-ins over $10,000;
      • The use tax exemption for extracted fuel, except hog fuel;
      • Sales tax exemption on bottled water;
      • The preferential business and occupational tax for royalties; and
      • Refunding the state portion of sales taxes to non-residents.
    The capital gains tax plan is controversial because it is an unreliable revenue generator, and may present questions of constitutionality. In its assessment, the Washington Policy Center (Center) notes that capital gains are considered income, even though Gov. Inslee presents the seven percent tax increase as an excise tax. The Center points to the fact that Washington’s Supreme Court has repeatedly concluded that “income” is property, and the state’s constitution provides that property cannot be taxed at a rate greater than one percent. This concern is evident in the fiscal note to the legislation which predicts that “up to five Superior Court actions will be filed challenging the constitutionality of the capital gains tax” after Jan. 1, 2016.

    Regarding the unreliability of such a tax, the Center cited the volatile history of capital gains taxes in other states that do not provide a very solid, fiscally sound, secure, and stable way of financing ongoing government services.

    What’s more, the Tax Foundation reveals that large swings in capital gains are not uncommon. For example, in 1987 and 2001, they dropped 55 percent and 46 percent, respectively. Further, in the two-year period encompassing 2007-2009, capital gains plummeted by 71 percent.

    Because these fluctuations are not uncommon, some experts, including those at the Rockefeller Institute and the Federal Reserve Bank of Boston, consider taxing capital gains to be particularly risky as a tax base. The Tax Foundation contends that it is the “lead culprit behind state revenue forecasting errors.”

    The Federal Reserve Bank of Boston identified another reliability related problem: “[t]he cyclicality of capital gains tends to have a disproportionate effect on state income tax revenues compared to other sources of taxable income because capital gains are more concentrated in the top tax brackets.”

    The Seattle Times reported that state democrats like the idea of a tax that impacts only wealthy taxpayers. In particular, Sen. Kevin Ranker (D-Orcas Island) told of a light bulb going off in his head because of the “eye-popping” cash that could be raised while only taxing a tiny fraction of the taxpayers. Sen. Ranker believes this to be a thoughtful way to raise revenue.