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Why Washington State Can’t Claim Its Capital Gains Tax Is an Excise Tax

6 min readBy: Jared Walczak

When is an 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. 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. ? And for that matter, what exactly is an excise tax? The fate of Washington’s 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. These taxes create a bias against saving, leading to a lower level of national income by encouraging present consumption over investment. , currently in litigation, rests at least in part on the answer to these questions.

By way of background, Washington’s supreme court has repeatedly held that the state’s constitution functionally prohibits graduated income taxation. (It’s a little more complicated than that, but suffice it to say, if the new capital gains tax is determined to be an income tax, then the courts can’t uphold it without overturning almost a century of precedent regarding a clear constitutional constraint.) To get around this restriction, lawmakers passed a tax on high earners’ capital gains income that is called an excise tax on the privilege of earning capital gains, hoping that the verbiage makes a difference.

In a motion for summary judgment, plaintiffs challenging the new law argue that (1) it’s clearly an income tax and (2) even if it were an excise tax, it would be an unconstitutionally imposed one—which, if anything, further points us in the direction of calling it an income tax. The arguments are sound, but sometimes a legal brief can be short on explanations that help get lay readers from Point A to Point B. So let’s flesh those out a bit, because it’s an interesting question with implications beyond just Washington and its standalone capital gains tax.

What is an excise tax? We could just look to the dictionary, with Webster’s defining an excise tax as “a tax on certain things that are made, sold, or used within a country.” This seems roughly correct, especially when we consider the most prominent excise taxes, on things like fuel, alcohol, tobacco, and airline tickets. The definition has to stretch a little, with “used” taking an expansive enough meaning to cover real estate transfer, inspection fees, the provision of health insurance, and even mineral extraction, if you want to classify severance taxes as a class of excise tax.

And in common parlance it would also narrow in another way, putting special emphasis on “certain things” by focusing on taxes on very particular things, rather than broader-based consumption taxes like the sales taxA sales tax is levied on retail sales of goods and services and, ideally, should apply to all final consumption with few exemptions. Many governments exempt goods like groceries; base broadening, such as including groceries, could keep rates lower. A sales tax should exempt business-to-business transactions which, when taxed, cause tax pyramiding. . From a legal standpoint, however, it would be easy enough to characterize the sales tax as a “general excise tax” even if this terminology is not very useful in most circumstances, where excise taxes are more likely to be referred to as “special sales taxes” than sales taxes are to be considered “general excise taxes.” (See here for more on what constitutes an excise tax, and their traditional rationales.)

So the dictionary is basically right but perhaps not sufficient to inform our understanding of the legal distinction between an excise tax and an income tax. What prevents us from referring to an excise tax on income?

Fundamentally, excise taxes are indirect taxes while income taxes are direct taxes. That distinction is why the U.S. Supreme Court struck down early attempts to impose a federal income tax before ratification of the 16th Amendment, since, prior to that constitutional change, all direct taxA direct tax is levied on individuals and organizations and cannot be shifted to another payer. Often with a direct tax, such as the personal income tax, tax rates increase as the taxpayer’s ability to pay increases, resulting in what’s called a progressive tax. es had to be apportioned among the states, which was an insuperable barrier to income taxation.

The income tax is a direct tax because it falls directly on people. The legal incidence is on particular people, and tax liability is assessed per person, not per sale or activity. While the economic incidence of excise taxes is also borne by people (what alternative is there?), the legal incidence is based on the particulars of a transaction or activity, and it is ultimately not calculated on a personal basis. In practice, this means that excise taxes will be imposed as specific taxes (based on volume, e.g., gallons of gasoline or packs of cigarettes) or as ad valorem taxes (based on price, e.g., a tax on the retail price of marijuana).

Consider the gas taxA gas tax is commonly used to describe the variety of taxes levied on gasoline at both the federal and state levels, to provide funds for highway repair and maintenance, as well as for other government infrastructure projects. These taxes are levied in a few ways, including per-gallon excise taxes, excise taxes imposed on wholesalers, and general sales taxes that apply to the purchase of gasoline. , for instance. There is no question that you “pay” the gas tax when you fuel up, even though the service station remits the tax on your behalf. But the government is not imposing a tax on you specifically, and the tax is owed based on where the fuel is purchased or used, not based on the fuel’s ultimate “owner.” You don’t file a tax return at the end of the year detailing how much fuel you purchased and paying accordingly—and even if you did (a vehicle miles traveled tax, VMT, would be somewhat more aggregated, because it’s on an activity rather than a transaction), the taxable event would be the activity, not the person. If a Washingtonian flew to California, picked up a rental car, and drove around San Diego, there’s no way that Washington could say that the driver owes the state VMT taxes simply because they’re a Washington resident, since the taxable activity has no nexus with Washington even though the person does.

This is key to one of the plaintiffs’ arguments, one I might have distinguished a bit more than they do. For states to tax someone or something, they must have nexus: sufficient connections to be allowed to impose a tax. With direct taxes, the nexus is with the person. At least as far as nexus is concerned, a state can impose an income tax on a resident’s out-of-state income, because with a direct tax, the nexus question begins with the person. (There are additional constraints related to fair apportionmentApportionment is the determination of the percentage of a business’ profits subject to a given jurisdiction’s corporate income or other business taxes. U.S. states apportion business profits based on some combination of the percentage of company property, payroll, and sales located within their borders. and relatedness to state services; nexus is just the threshold question.) With an indirect taxAn indirect tax is imposed on one person or group, like manufacturers, then shifted to a different payer, usually the consumer. Unlike direct taxes, indirect taxes are levied on goods and services, not individual payers, and collected by the retailer or manufacturer. Sales and Value-Added Taxes (VATs) are two examples of indirect taxes. , however, nexus attaches to the transaction or activity. If you buy gas in Oregon, Washington has no claim on that transaction even if you’re a Washington resident.

Washington’s capital gains tax is designed as a direct tax, not an indirect one. It taxes out-of-state earnings and out-of-state activity. If we accept the state’s argument that it’s an excise tax, then it’s probably an unconstitutional one, because it fails to meet the nexus requirements established in cases like Complete Auto Transit v. Brady. If, on the other hand, it’s a direct tax, then we have nexus—but we’ve also acknowledged that it’s an income tax, which is what Washington can’t afford to acknowledge.

Of course, it is an income tax. Let’s go back to that distinction between an indirect tax on things made, sold, or used—or, put another way, on activities and transactions—and a direct tax, which would be on an individual’s earnings or possessions. It’s possible to impose an excise tax on the activities surrounding capital gains—bad policy, but possible. If Washington had chosen to levy a tax on sales of stocks or bonds, such a stock transfer tax would be an excise tax, because it’s based on the transaction or activity. Washington’s tax, however, is not based on the number of transactions, or on any activity, but on the net capital gains income earned over the course of the year. The object of the tax is clearly the person, with a focus on their aggregate income. It is a direct tax. It is literally denominated in income. It is, in short, an income tax.

And in Washington, that should be an end to it.