Washington Research Council releases analysis of proposed state capital gains tax

The Washington Research Council has analyzed the capital gains tax proposal heard last Friday in the House Finance Committee. In brief,

The questionable constitutionality of the tax makes it a risky source of revenue, whether for the schools as previously proposed or property tax relief now. Moreover, should the legislation somehow clear the high constitutional bar, the volatility of the tax would add a substantial degree of instability to property tax bills. It’s unlikely any property owner would welcome an unpredictable tax bill. Finally, the legislation is unlikely to make any substantial impact on the alleged and misdiagnosed regressivity of the state tax structure.

The brief takes a close look at errors in an often-cited analysis of the state’s tax structure.

The bill’s introduction describes the Washington’s tax system “as the most upside down and regressive in the nation.” This characterization is based on a flawed study by the Institute on Taxation and Economic Policy (ITEP). We have critiqued this study in previous reports (WRC 2010). The study has a number of serious problems: It’s a point-in-time measure relying on flawed data; it over- states the significance of state taxes by failing to recognize the progressivity of the federal income tax; and, its allocation of the tax burden across income groups overstates the degree to which sales taxes and business taxes are paid by low income households. Together, these errors substantially overstate the regressivity of the Washington tax structure.

We recommend you read the brief in its entirety. Here’s the WRC’s extended example of how the ITEP analysis leads to the false characterization of the tax burden.

We will highlight one problem here: The estimation of sales taxes paid by house- holds at the bottom of the income distri- bution.

ITEP uses the U.S. Bureau of Labor Statis- tics’ quarterly Consumer Expenditure Survey (CES) to determine how family expenditures vary with income. This sur- vey finds that on average low-income households spend much more than they take in income. For 1992 (the data vintage ITEP uses) the lowest 20 percent of households reported average expendi- tures equal to 216 percent of average after-tax income; the second quintile of households reported average annual expenditures equal to 136 percent of aver- age income; and the third quintile of households reported average expenditures equal to 114 percent of average after-tax incomes. Economists call spend- ing in excess of earnings “dissaving.”

Researchers at the Urban-Brookings Tax Policy Center have critiqued the CES methodology and find a reason for the apparent substantial discrepancy. They conclude

The most credible explanation for the high level of dissaving in the lowest and second-lowest income quintiles . . . is that the income reported in the [consumer expenditure survey] is substantially understated. (Toder, Nunns and Rosenberg 2011)

..Because income is understated in the CES for lower income households, ITEP over- estimates the purchases of these house-holds, and this leads ITEP to overestimate the amount of sales tax paid by these households.

Additionally, ITEP assumes that much of the taxes paid by businesses is pushed forward onto customers and distributes these taxes across households in proportion to consumption expenditures. The overestimation of consumption expenditures of low income households leads to an overestimation of the amount of business taxes they bear. The effect of this overestimate is not uniform across states. Because Washington state’s sales tax rate is higher than that of most other states and because Washington places a higher tax burden on businesses than do most other states, ITEP overestimates the tax burden of lower income households to a greater degree for Washington than for most other states. Consequently, ITEP’s state tax burden rankings are unreliable.

The intent section of the bill, of course, is simply a signal of the proponents’ intent. In this case, the intent is based on a misguided analysis. There are other good reasons, fully explored in the WRC brief, for rejecting the capital gains tax. This is compelling:

HB 2967 characterizes the capital gains tax as an excise tax. For all intents and purposes, though, it is an income tax, imposed on a narrow subset of income. In January, we analyzed Superior Court Judge John Ruhl’s decision rejecting the City of Seattle’s income tax (WRC 2018). Although the ruling did not hinge on his rejection of the city’s claim that its in- come tax is really an excise tax, Ruhl specifically struck down both arguments ad-vanced by the city in support of its unusual definition. As the Tax Foundation writes,

Courts frown on such semantic games and prioritize substance over form—and especially over nomenclature. Just last year, when Seattle tried to impose a high earners income tax by calling it an excise tax, a court dis- pensed with the idea in short order. A tax that falls on income is an income tax, whatever the name. (Walczak 2018)

If, then, the capital gains tax is an income tax, the 7 percent rate would conflict with the state constitution, which sets a 1 percent cap on the tax rate that can be applied to income.

Even in the unlikely event a court should hold that this capital gains tax is, in fact, an excise tax, HB 2967 might be challenged as violating Article 1, Section 12 of the state constitution, which states: “No law shall be passed granting to any citizen, class of citizens, or corporation other than municipal, privileges or immunities which upon the same terms shall not equally belong to all citizens, or corporations.” It seems problematic that the capital gains of S corporations would be subject to tax, while the capital gains of C corporations would be untaxed.

Every state that currently taxes capital gains does so through its state income tax rather than through a standalone excise tax.

 With $1.3 billion added to the revenue forecast last week, the pursuit of an unconstitutional capital gains tax seems particularly quixotic.