Research & Commentary: Capital Gains Taxes Are Still Unconstitutional in Washington State

Published April 9, 2019

Despite several rejections by voters and failed efforts in the legislature, two significant proposals have been introduced in the Washington House and Senate that would create a new tax on capital gains, a provision that would likely violate the state’s constitution.

Capital gains levies tax individuals and corporations on their profits that are realized when investors sell a capital asset for a net gain. Currently, 43 states tax capital gains. Because taxes on capital gains are paid by investors and businesses, they slow capital formation and reduce wages for workers.

Capital gains tax hikes remain popular because of the perception the taxes apply only to wealthier taxpayers while not affecting those with lower incomes. This is not the case. The Wall Street Journal noted capital gains taxes lower workers’ paychecks and cost many their jobs. “Even on class-warfare grounds, it is counterproductive to raise taxes on capital. Most of the returns on investment in a business benefit workers (not shareholders), because they become more productive with more modern factories, computers and equipment made possible with investment capital,” the writers noted.

The first tax proposal, introduced in the Washington State House, would create a new 9.9 percent “extraordinary profits” tax on capital gains of $100,000 or more for single-filers and $200,000 or more for married couples. Supporters estimate 14,000 Washingtonians would pay this tax, which clearly targets the wealthy.

The second proposal introduced in the Senate calls for a lower tax rate and higher taxing threshold. This version would create a new 8.9 percent tax on capital gains profits above $250,000. The Senate proposal attempts to reduce the economic burden of the tax by exempting retirement accounts, small businesses, and the sale of homes from the tax.

The revenue generated by the increased tax, estimated to be about $780 million starting in 2021, would be used to fund several tax cuts and credits. According to the NW News Network, these include: a working families tax credit, a business and occupation tax cut, an expansion of an existing property tax reduction program for senior citizens, and the elimination of the sales tax on items like diapers, feminine hygiene products, and over-the-counter medications.

Although the Senate version is superior to the House version, it would still place a large burden on investment, which drives much of the modern economy. Further, there remains an important question over its legality. The Washington State Constitution mandates property must be taxed at a uniform rate. The Washington Policy Center (WPC) points out the Washington State Supreme Court has ruled on several occasions that income is a form of property.

Additionally, Washington State voters have roundly rejected on four occasions efforts made by the legislature to redefine an income tax as an “excise tax.” Capital gains taxes have been widely accepted to be a form of income tax. The Internal Revenue Service includes capital gains in its list of income types on IRS Form 1040, and according to WPC, every state revenue department calls capital gains “income,” not monies that are subject to an excise tax.

“The only place an ‘excise tax’ on capital gains exists is in the minds of those trying to circumvent the state constitution and voters’ consistent opposition to imposing income taxes.

Washingtonians deserve an honest tax debate. It is time to call a capital-gains tax what it is — an income tax,” wrote Jason Mercier, government reform director for the Washington Policy Center, in a Seattle Times editorial. Mercier warns these taxes will result in an instant lawsuit against the tax that is likely to overturn any new capital gains tax.

States should focus on implementing tax policies that encourage capital formation and investment in their markets, not punish successful businesses, investors, and entrepreneurs.

The following documents examine capital gains taxes in greater detail.

House Democrats Propose State Income Tax on Capital Gains
Jason Mercier, government reform director for the Washington Policy Center, writes about the renewed effort in Washington State to impose a capital gains tax. Mercier argues the proposed tax would be illegal, due to language in the state’s constitution that appears to disallow such taxes.

Sorry, Washington State: Capital Gains Taxes Are Still Income Taxes—But There’s a Better Way
In this article, Jared Walczak of the Tax Foundation argues against the imposition of a capital gains tax in Washington and recommends that Washington legislators should instead look to broaden the state’s narrow sales tax base by taxing additional services.

The Capital Gains Tax Is Back in Washington—and It’s Still an Income Tax
In this article for the Tax Foundation, Jared Walczak examines the multiple attempts made by lawmakers in Washington State to create a capital gains tax. Walczak also describes how all these attempts have failed to address the core issue: Capital gains taxes are a kind of income tax, which the Washington State Constitution disallows.

Lawmakers Again Propose Capital Gains Income Tax
Jason Mercier of the Washington Policy Center argues that no capital gains tax should be allowed under the Washington State Constitution. He further argues efforts to redefine the tax are distorting what capital gains truly are. “Every state revenue department in the country calls capitals gains income. No state has an ‘excise tax’ on capital gains. Every state with a capital gains tax does so via an income tax. None of the states without an income tax has a tax on capital gains,” wrote Mercier.

The Effect of the Capital Gains Tax Rate on Economic Activity and Total Tax Revenue
This study by the Institute for Research on the Economics of Taxation identifies how taxpayers and investors react to capital gains tax rates: “The tax treatment of capital gains and dividends greatly affects the quantity of capital created and employed. The quantity of capital affects the productivity, wages, and employment of labor. Output and incomes are lower at higher levels of taxation of capital. Raising the tax rate on capital by increasing the tax rate on dividends and capital gains from current levels would shrink national income across the board.”

The Economic Costs of Capital Gains Taxes
This study from the Fraser Institute outlines the effects of capital gains taxes: “Unfortunately, the cost of capital gains taxes is not limited to the amount of tax collected. Capital gains taxes impose additional costs on the economy because they reduce returns on investment and, thereby, cause individuals and businesses to alter their behaviour.”

Corporate Dividend and Capital Gains Taxation: A Comparison of the United States to Other Developed Nations
Robert Carroll and Gerald Prante compare in this study the tax rates on dividends and capital gains in the United States to those imposed by other developed countries and discusses the policy concerns that have caused other countries to impose lower tax rates on capital gains and dividends.

A Capital Gains Primer
In this Review & Outlook piece from the Wall Street Journal, the authors argue that increasing capital gains tax rates is both counterproductive and could have damaging effects on financial markets. “Moving rates higher has damaging effects. Economist Allen Sinai estimates in a report for the American Council for Capital Formation that raising the capital gains rate to between 20% and 28% would reduce U.S. employment by between 231,000 and 602,000 jobs a year, and that with slower growth and a weaker stock market “the federal budget deficit actually ends up larger.”

Capital Gains Taxation: Federal and State
This Research piece from the Minnesota House of Representatives examines which states use a capital gains tax, how the capital gains tax is used, how they are charged and why.

Does Spending More on Education Improve Academic Achievement?
Dan Lips and Shanea Watkins of The Heritage Foundation discuss the rising cost of education and whether increasing education spending has improved education outcomes. “Taxpayers have invested considerable resources in the nation’s public schools. However, ever-increasing funding of Education has not led to similarly improved student performance. Instead of simply increasing funding for public Education, federal and state policymakers should implement Education reforms designed to improve resource allocation and boost student performance,” wrote Lips and Watkins.

School Spending and Student Achievement in Michigan: What’s the Relationship?
In this report, Ben DeGrow and Edward C. Hoang of the Mackinac Center for Public Policy examine the relationship between school spending and student achievement in Michigan. “The results suggest that there is only a very limited correlation between these two factors. Only one out of the 28 academic outputs analyzed showed a result that was positive and statistically significant, or different from zero,” the authors reported.


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