The Capital Gains Tax is Back in Washington—and it’s Still an Income Tax

February 1, 2018

At a time when nothing feels certain, the reemergence of a capital gains tax proposal (House Bill 2697) in Washington State is almost comforting. Some things never change.

But no matter how many times policymakers introduce capital gains tax legislation, there’s something else that remains constant: capital gains income is still income. A rose by any other name is just as sweet, and an income tax by any other name is just as constitutionally suspect.

Washington does not impose an income tax, but it’s not for want of effort. Legislators have tried, only to see their proposals rejected by the courts. Constitutional amendments have been proposed, only to be rejected by the voters.

Surprisingly, if you look to the state’s constitution, you won’t find a provision banning income taxes as such. Instead you’ll find an amendment, ratified in 1930, which provides, among other things, that “all taxes shall be uniform upon the same classes of property.” On its own, that’s only mildly noteworthy. Plenty of states have uniformity clauses, particularly for property taxes, with various degrees of stringency. Those states tend to have income taxes—so what’s going on?

Here’s what: “[T]he word ‘property’ as used herein shall mean and include everything, whether tangible or intangible, subject to ownership.”

That’s an extremely broad definition, and the state supreme court has held that income is a thing subject to ownership, meaning that the uniformity clause applies. 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 one 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 one percent. Policymakers haven’t been particularly interested in a tax that fits these parameters.

Proponents of a capital gains tax have tried to argue that it’s not really an income (or, by extension, a property) tax, but rather an excise tax imposed on the privilege of selling capital assets or receiving capital gains. Opponents have responded with a mix of bewilderment and exasperation. By this logic, why couldn’t you evade the prohibition on a broader income tax simply by styling it an excise tax on the privilege of earning income?

(That’s not a hypothetical. Seattle actually tried something similar.)

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 dispensed with the idea in short order. A tax that falls on income is an income tax, whatever the name.

The capital gains argument is similar, and similarly flawed. The case is made that what is being taxed is, in fact, an event (the sale of the assets), making it an excise tax. It’s an unconvincing argument, particularly since the tax is based not on the entirety of the sale but rather on the net realization—in other words, on the income earned through the transaction.

If a capital gains tax was 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 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’s telling that taxpayers would have to submit their federal 1040 to report Washington State capital gains. What excise tax works that way?

It’s no coincidence that all states that tax capital gains income do so through their income tax, and that no states have a separate capital gains tax. Nor is it mere happenstance that, at the federal level, capital gains income is reported on the individual income tax form. Capital gains income is, fundamentally, income.

In Washington State, considering capital gains taxes is practically an annual tradition now. But no number of attempts can overcome the fundamental legal obstacle. The fundamental things (still) apply as time goes by.

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