Taxing Capital Gains: Will the Courts Save Washington State from Bad Economic Policy?

By SBE Council at 7 January, 2022, 1:09 pm

SMALL BUSINESS INSIDER

by Raymond J. Keating –

The state of Washington has enjoyed a huge competitive advantage over most other states. But part of that advantage is in danger of being lost.

Washington’s Competitive Advantage

What has the state’s advantage been? Washington has imposed no personal income, capital gains and corporate incomes taxes. Only five states in total have none of these levies – Nevada, South Dakota, Texas, Washington and Wyoming.

Not taxing the returns on working, and on starting up, operating and investing in businesses clearly enhances the incentives to undertake such critical economic activities.

And keep in mind that entrepreneurship and private investment serve as the engines or fuel of economic, income and employment growth. At the same time, starting up, operating and investing in businesses are endeavors rich in risk and uncertainty. Hence, reducing potential returns on such undertakings via capital gains taxes is particularly misguided.

Legislators Go “Tax Happy,” Pushing Constitutional Limits

Unfortunately, in 2021, state lawmakers in Washington ignored sound economics, ignored the benefits of having no capital gains taxes, and voted to inflict such a tax. Washington’s capital gains tax on individuals would go from 0 percent to 7 percent; be applied to Washington long-term capital gains in excess of $250,000 for individuals and couples; and go into effect of January 1, 2022.

The state’s Department of Revenue plans to go ahead with implementation of this tax, despite the fact that the measure is facing a legal challenge.

To say that this tax rests on shaky ground is to grossly understate matters.

In order to get around the Washington state constitutional requirement prohibiting graduated income taxes, legislators and the governor simply tried to rename a capital gains tax from an income tax to an excise tax.

But saying that a tax on income (i.e., on capital gains income) is not a tax on income, but instead, an excise tax, does not make it so. After all, an excise tax is a levy on the purchase of a specific good or service, such as gas, diesel, tobacco or alcohol taxes – quite different from an income levy.

As noted in an amicus brief on this case joined by the Washington Policy Center, among others:

“Roses are roses, ducks are ducks, and taxes on capital gains are taxes on income. Excise taxes or transaction taxes do not have exemption levels, nor are they imposed on annual totals, nor do they track the filing deadlines and requirements of the federal income tax. State income taxes do all those things. Washington taxpayers will fill out a return due the same day as the federal income tax, and the base of the tax will be derived from capital gains taxed under the federal income tax and state income taxes. The IRS, every other state, and every tax expert agree that capital gains are income.”

The Court Has Previously Held Firm…Will that Continue?

Washington’s Supreme Court has been sound on such tax measures in the past, and one should expect that to continue. Therefore, this capital gains tax ultimately should get tossed out. Of course, the U.S. has a long history of courts suddenly ignoring laws and constitutions in order to impose what they wish, so nothing is definite until a final ruling.

By the way, it’s well worth noting that there also was a nonbinding Advisory Vote (Washington Advisory Vote 37) on this tax on the November ballot, and 61 percent of voters advised repealing this capital gains tax, versus only 39 percent voting to maintain it.

Washington voters overwhelmingly rejected the arguments for the tax, namely, calls for fairness and more government spending trying to disguise tired, old class warfare politics, and apparently saw the real ills of taxing entrepreneurship and investment in the state, and that such a levy, if it were to survive, would lay the groundwork for a much broader state income tax.

Washington has exhibited great economic wisdom in not imposing any kind of income taxes. But wisdom can be lost, especially, as we see in this case, by politicians.

Let’s hope that the state’s Supreme Court has the wisdom to abide by the Washington state constitution and its previous decisions. In the end, imposing a capital gains tax will help no one in the state of Washington.

Raymond J. Keating is chief economist for the Small Business & Entrepreneurship Council.