Washington Voters to Weigh in on New Capital Gains Income Tax

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On May 4th, Gov. Jay Inslee (D) signed legislation creating a 7 percent capital gains tax, to take effect next year. On November 2nd, Washington lawmakers will learn what voters think about it.

Although the ballot measure asking voters to recommend on retaining or repealing the new tax is purely advisory, this gauge of voter sentiment could be particularly illuminating as Washington barrels forward on the implementation of a highly volatile, constitutionally suspect tax that breaches the state’s historic barrier against income taxation.

Under the measure, Washington residents would be taxed on capital gains in excess of $250,000, raising an estimated $527 million in FY 2023, rising to $734 million by FY 2031, for a 10-year projection of $5.74 billion in additional tax revenue. Of course, all the state’s Office of Financial Management can do is assume that capital gains will increase every year, whereas in practice, capital gains are exceedingly volatile.

The realization of capital gains slid 71 percent between 2007 and 2009, 55 percent in 1987, and 46 percent in 2001. Under the unusual dynamics of the COVID-19 pandemic, stock markets saw substantial gains, but in a typical economic downturn, other tax revenue streams decline—but revenue from the taxation of capital gains falls off the chart. This makes a stand-alone capital gains tax a particularly undesirable source of revenue for recurring expenditures.

Washington’s state constitution functionally prohibits an income tax by providing that “all taxes shall be uniform upon the same classes of property” (called a uniformity clause, and present in many states) and that “the word ‘property’ as used herein shall mean and include everything, whether tangible or intangible, subject to ownership,” which state courts have appropriately interpreted as being a broad enough definition to include income. While we don’t usually think of income as property, it’s hard to deny that it meets the definition established under the state constitution. This doesn’t mean that income taxes are banned, per se, but it does mean that (1) they must be uniform and (2) per another constitutional provision, all taxes on property must not, in aggregate, exceed a rate of 1 percent.

Taken together, those two provisions have spelled the death knell for a state income tax, since the only way that one could meet constitutional muster is if it were a flat tax, with few or no deductions or exemptions, with a rate below 1 percent. Policymakers haven’t been particularly interested in a tax that fits these parameters.

Instead, lawmakers chose to poke the camel’s nose under the tent through a stand-alone tax on capital gains income, ostensibly justified by the claim that it is not an income tax on capital gains, but rather an excise tax on the privilege of earning capital gains, denominated in net income. It’s a facile argument, but some proponents would be fine with seeing that legal argument falter and using the capital gains tax as a means of once again putting the question of income taxation before the state supreme court, opening the door to a broad-based income tax in the near future.

As legal reasoning goes, the excise tax argument is weak, since the tax adopted by the legislature in no way functions like an excise tax. Not only are capital gains taxed as income in every state with an income tax, and by the federal government, but the proposal here is not to tax the transaction but rather the net—which is to say, the net income.

There’s a reason we often consider sales and excise taxes together: excise taxes are, at base, transaction taxes. Often, they are ad valorem, on the entire cost of a transaction—essentially a special sales tax. Other times they follow a specified rate schedule; for instance, a particular amount per pack of cigarettes, regardless of sales price. What they never do is fall on a calculation of net income.

If a capital gains tax were an excise tax, we would expect it to fall on the entire sales price (or a flat price per sale), not just the net gain. We would also expect it to be imposed on each transaction separately, not on the aggregate of capital gains and losses as reported on IRS Form 1040. And while excise taxes are often remitted by the seller, their economic incidence is borne by the consumer. That is not the case here.

The seller of a capital asset pays capital gains taxes out of her income. The tax is not embedded in the transaction or imposed on that transaction. Instead, it’s imposed on the net of gains over the course of a year. It is telling that taxpayers would have to submit their federal 1040 to report Washington State capital gains. What excise tax works that way?

This tax isn’t on capital gains transactions, or on the privilege of buying and selling investment instruments. It is on the net of gains and losses over the course of a defined period. That is decidedly an income tax—on a narrow class of income, but an income tax nonetheless. Across the country, courts have historically cared about substance over form when it comes to taxation, and certain substance over name. Simply styling a tax on a class of income as an excise tax doesn’t change its fundamental character.

Legal challenges to the tax are already pending and may ultimately do more to stop it in its tracks than can a nonbinding advisory vote. Nevertheless, the fate of Advisory Question 37 is an important one, not only because the capital gains tax itself would be economically harmful, or because it shows an irreverence for the state constitution, a concern in its own right. It’s also important because if voters signal their opposition to taxing this specific class of income, that sends a strong message that they are decidedly uninterested in efforts to scrap the state’s ban on a broader income tax.