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Washington Supreme Court Affirms Capital Gains Tax and Invites Challenge to Broader Income Tax Restrictions

By: Jared Walczak

Last week, the Washington Supreme Court not only gave its blessing to a capital gains tax that runs afoul of the state constitution, but it also set out a welcome mat for legislators eager to implement a broader income taxA tax is a mandatory payment or charge collected by local, state, and national governments from individuals or businesses to cover the costs of general government services, goods, and activities. . It did this despite nearly a century of jurisprudence in which state courts have repeatedly reaffirmed that the state’s constitution imposes strict limits that make an income tax virtually impossible.

The state’s 7 percent tax on high earners’ capital gains income is now firmly established—first payments are due April 18th—and it’s difficult not to think a wage income tax is coming.

Words matter—at least they’re supposed to, notwithstanding the court’s conclusion that a tax on income is not an income tax—so it is necessary to delve into the somewhat strange verbiage of Washington’s constitution, along with the linguistic gymnastics the court performed to endorse a tax on capital gains income.

Washington’s constitution never mentions income taxes in so many words, but it contains a uniformity clause that puts strict limits on property taxA property tax is primarily levied on immovable property like land and buildings, as well as on tangible personal property that is movable, like vehicles and equipment. Property taxes are the single largest source of state and local revenue in the U.S. and help fund schools, roads, police, and other services. es, while—under a voter-approved amendment adopted in 1930—defining property extremely broadly, to include “everything, whether tangible or intangible, subject to ownership.” Nearly a century of case law has held that this definition encompasses income, and thus functionally prohibits the state from adopting an income tax.

In 1933, after voters adopted an income tax by ballot measure, the state supreme court struck it down as a violation of this clause, with the majority considering the logic self-evident and unassailable:

It would certainly defy the ingenuity of the most profound lexicographer to formulate a more comprehensive definition of “property.” It is “everything, whether tangible or intangible, subject to ownership.” Income is either property under our fourteenth amendment, or no one owns it. […] There being no other classifications in our constitution but real and personal property and intangible property, incomes necessarily fall within the category of intangible property. […] It needs no technical construction to tell what those words mean. The overwhelming weight of judicial authority is that “income” is property and a tax upon income is a tax upon property.

That the ordinary definition of property does not include income is true enough, and that most other states define property differently is directly acknowledged by the court in that 1933 decision. But the Washington constitution does define property that way, and therefore, whatever an income tax might be elsewhere, “It has been definitely decided in this state that an income tax is a property tax, which should set the question at rest here.”

The state supreme court affirmed this 1933 interpretation in subsequent decisions in 1936 and 1951, then slightly expanded it in 1960. In 2019, the high court declined to review a lower court ruling reasserting this constitutional definition of property in a case involving local income taxes. Last week’s ruling also reaffirms these holdings as good law for now, though it’s obvious that the majority is eager for an opportunity to reconsider.

It must be emphasized that overturning this precedent would be legally dubious in the highest order. While an economist would distinguish between income (a flow) and property (a stock), and most individuals would implicitly grasp the difference as well, the state constitution is clear. Income is property in Washington, so, for constitutional purposes, an income tax is a property tax.

Technically, that doesn’t outright preclude the adoption of an income tax, but any tax adopted would have to be uniform (no graduated rates, and few or no deductions, exemptions, and exclusions) and, more importantly, at an extremely low rate. State and local property taxes in aggregate, including those currently imposed on what we traditionally view as real and personal property, cannot exceed one percent of the total value of taxed property. In practice, this makes an income tax all but impossible. Any income tax that would comply with the limitations is likely not worth imposing.

Lawmakers adopting a capital gains income tax had, it would seem, a two-pronged strategy. They offered a sympathetic court a way to uphold the tax without overturning 90 years of precedent, while clearly hoping that the court would reverse itself on income taxes altogether. Even though the justices did not go quite that far in the present case, they strongly indicated their willingness, even eagerness, to do so in a future case.

For now, the new tax on aggregate net capital gains income rests uneasily in a framework where the state supreme court still acknowledges that income is property, and that the tax would fail under that definition if it were, in fact, an income tax. Hence the ingenious (or perhaps disingenuous) solution: this tax, imposed on a class of net income, is actually an excise taxAn excise tax is a tax imposed on a specific good or activity. Excise taxes are commonly levied on cigarettes, alcoholic beverages, soda, gasoline, insurance premiums, amusement activities, and betting, and typically make up a relatively small and volatile portion of state and local and, to a lesser extent, federal tax collections. on the privilege of earning capital gains income, measured in income.

This doesn’t make sense. If the state’s capital gains income tax were a tax on a transaction or on the exercise of a privilege, it would apply to every sale of a capital asset. Instead, it is based on the aggregate net capital gains income from all transactions, with an income exclusion to ensure that the tax only applies to high earners. Reportable net capital gains income is pulled directly from taxpayers’ federal income tax returns. Clearly, the tax is on income, not transactions.

There is not only transformation (a tax on income becomes a tax on the privilege of earning that income) but negation (by becoming an excise tax, it ceases to tax income). The court’s credulous acceptance of the legislature’s framing is not, itself, enough: even if we dispensed with ordinary understandings of what constitutes an excise tax and accepted this as one, we have to go one step further, something the court confusingly fails to do. It asserts, based on a bad misreading of a 1916 federal case, that income taxes are, definitionally, a class of excise tax. But even if that were true, it’s unhelpful to their case, since this equivalence would not make them cease to be income taxes. And income taxes, according to the state constitution, are strictly limited. The argument only works if this is an excise tax rather than an income tax, not an excise tax by virtue of being an income tax. Even by the court’s strained logic, the argument fails.

All the way back in 1933, the state supreme court—in a ruling, remember, that is still good law—anticipated and rejected the excise tax argument: “It is asserted that a state income tax is an excise tax. That is not correct. The cases cited to sustain the assertions all involved corporate franchise tax laws and the like.”

But you can see where the court is going. Income taxes are excise taxes. Economic activities or events otherwise off limits for taxation under the state constitution are taxable if the legislature adds an incantation about how they’re really taxing a privilege and simply making the untaxable (or tax-restricted) thing the base of the tax. The court seems to want a new challenge to the income tax restriction, so it can rule that a wage income tax is constitutional—either because all income taxes are excise taxes and thus cease to be income or property taxes, or through some sleight-of-hand about how the tax is really on the privilege of working or earning income. It makes a nonsense of the constitution, but these are the casualties one must accept in service to a specific policy aim.

And don’t think the state supreme court wasn’t acting in service of a policy goal. They did not leave that option, with the majority opinion beginning with 12 pages lamenting—often with dubious citations and even more suspect economic analysis—how awful the justices think the current tax code is, and how important it is to change it. If the legal analysis that follows seems like a creative, if not quite convincing, effort to reach a preordained goal, well…

Unfortunately, however doubtful the jurisprudence may be, the court is the court, and the Washington capital gains taxA capital gains tax is levied on the profit made from selling an asset and is often in addition to corporate income taxes, frequently resulting in double taxation. Capital gains taxes create a bias against saving, leading to a lower level of national income by encouraging present consumption over investment. is now good law. In Washington, voters are asked to affirm or reject new revenue measures at the ballot box, though their votes are nonbinding, and 60 percent of Washington voters favored repeal of the capital gains tax even though very few of them will be paying it, with its $250,000 threshold. Perhaps they realized the inevitable: this is the test case. In the not-too-distant future, an income tax is coming for them, and it will wipe out the one major tax advantage Washington has over its competitors.