Whatever your opinion about a state capital- gains tax, it’s constitutional

March 30, 2021 at 2:45 pm Updated March 30, 2021 at 7:45 pm By Hugh Spitzer Special to The Seattle Times

Washington’s Legislature is poised to enact a capital-gains tax bill. The legislation narrowly passed the state Senate, and given the Democratic Party’s solid control of the House, the measure will likely become law.

The first $250,000 in gains would be exempt from taxation. Also, IRAs, 401(k)s, sales of real estate, timber, farm and ranch livestock, would be exempt. There would be a credit for business and occupations taxes paid on the capital gains, on similar taxes paid to other states, and a substantial reduction in the tax for the sale of small family-owned businesses.

According to an analysis by nonpartisan Senate staff, between 16,000 and 18,000 people would be required to pay the tax, which would collect about half a billion dollars in the 2021-23 biennium, ramping up to more than a billion dollars in 2025-27. The money would go into an education fund, the state general fund and an account used to compensate low-income people for the high percentage of their incomes they pay in sales taxes.

Proponents argue the capital-gains tax would bring more equity to Washington’s famously regressive tax system, shifting a higher burden to the wealthy. Because we don’t have a state income tax, governments rely solely on property taxes and excise taxes like the sales tax and a gross receipts tax on businesses. Low-income people spend virtually everything they earn, so a much higher portion of their incomes go to sales taxes. The lowest-income group of Washingtonians typically pay about 16% of their income in state and local taxes, compared to about 4% of the income of high earners.

Opponents assert that a new capital-gains tax is unnecessary because the state’s economy and revenues are already rising, that capital-gains revenues are volatile and unreliable, and they argue a capital-gains tax is an unconstitutional income tax in disguise.

Whatever the pros and cons of the proposed tax, state courts are likely to hold that this money-raising device is not an income tax and that it conforms to the state constitution.

The proposal would impose a 7% excise tax “on the sale or exchange of long-term capital assets” by individuals who live in Washington more than half of the year. That wording is important because the bill was carefully drafted to create a tax on a voluntary activity (choosing to sell an asset) rather than a tax on the asset itself.

In 1933, the Washington Supreme Court narrowly invalidated a graduated state net income tax passed by a statewide vote exceeding 70%. While most state high courts in the country had upheld income taxes as excise taxes, Washington’s court decided that because income, once received, became an asset, the income tax was a property tax rather than an excise tax. Under our state constitution, property tax rates must be uniform across any class of property, so a graduated income tax was seen as a nonuniform property tax.

Although the state Supreme Court tossed out the graduated net income tax almost 90 years ago, it has routinely upheld excise taxes on activities or events under the control of individuals and businesses. Examples are the sales tax on voluntary purchases, excise taxes on vehicles and boats that people choose to use on public roads and waterways, and a broad array of taxes on licensed businesses. In a 1933 opinion upholding the business gross receipts tax, the court also reaffirmed that the estate tax — a tax on the transfer of assets from one generation to another — was an excise tax on an event rather than a property tax on a stationary asset.

Back to the capital-gains tax. The pending legislation is carefully written to impose the tax “on the sale or exchange” of assets like stocks and bonds — not on the stocks and bonds themselves. If you don’t choose to sell a stock and benefit from the gain, then there’s no tax on the asset itself. The voluntary character of the action resulting in the tax is what makes it an excise tax rather than a property tax.

Opponents assert that because the federal government taxes capital gains as part of the income tax, a state capital gains tax must be some type of income tax. But this argument ignores the fact that the national income tax is not treated as a property tax. It is treated legally either as an excise tax or as a special tax category. In fact, Washington is the only state whose court-made law still treats income tax as property taxes.

Those opposing the capital-gains tax should be careful about what they wish for if they challenge it on the grounds that it is really an income tax. They might receive an unexpected and undesirable outcome, from their perspective.

The state Attorney General, defending the new tax measure, would likely argue that the capital gains tax is simply an excise tax. That’s the easy route. And the easy route for the state Supreme Court is to uphold it on that basis. But the Attorney General or other parties might argue that even if the capital gains were an income tax, it is high time for Washington’s judiciary to join the rest of the country and treat income taxes as excise taxes or as a special category.

In other words, a state constitutional challenge to the capital-gains tax could result in the state Supreme Court overturning its decades-old doctrine that a graduated income tax is a nonuniform property tax. That would open the door to a real state income tax. Washington’s high court has recently shown a robust capacity to make big changes in long-held legal theories. So it just might be prudent for foes of the state capital-gains tax to hunker down and pay it rather than launching a legal challenge.

Hugh Spitzer teaches at the University of Washington School of Law. The views expressed are solely his own and do not reflect a position of the University of Washington.