Testimony: Volatility and Legality of the Capital Gains Tax Proposal in Washington

Prepared Testimony for the Washington
House Finance Committee

February 16, 2018

Madam Chairwoman and Members of the Committee:

My name is Jared Walczak, and I’m a senior policy analyst with the Tax Foundation, a nonpartisan tax policy research organization.

Capital gains taxation has been a subject of perennial consideration here in Washington, and by now you have heard most of the arguments on both sides many times over. In my brief time, I simply want to highlight two points which remain relevant each time these measures are considered.

The first is the extreme volatility of capital gains realizations. In every other state where capital gains are taxed, they are but one part of a broader income tax, so the radical swings are absorbed, somewhat, into the broader revenue trends. Here, the intention is to create a stand-alone capital gains tax to generate recurring revenue for key state priorities. But how do you handle the fluctuations?

During the Great Recession, the realization of capital gains slid 71 percent. They slipped 55 percent in 1987 and 46 percent in 2001. Now, very few revenue sources do well during a recession—but traditional tax bases don’t have three-quarters of their value evaporate in a single year. Even in more typical years, outside of recessions, capital gains realizations are highly volatile.

The second issue is, of course, the legal hurdle. To avoid challenges to the constitutionality of an income tax, the capital gains tax under consideration is termed an excise tax. I would call your attention, however, to the fact that it in no way behaves like an excise tax. Not only are capital gains taxed as income in every state with an income tax, and by the federal government, but the proposal here is not to tax the transaction but rather the net—which is to say, the net income.

There’s a reason we often consider sales and excise taxes together: excise taxes are, at base, transaction taxes. Often they are ad valorem, on the entire cost of a transaction—essentially a special sales tax. Other times they follow a specified rate schedule, for instance a particular amount per pack of cigarettes, regardless of sales price What they never do is fall on a calculation of net income.

This tax isn’t on capital gains transactions, or on the privilege of buying and selling investment instruments. It is on the net of gains and losses over the course of a defined period. That is decidedly an income tax—on a narrow class of income, yes, but an income tax nonetheless.

Across the country, courts have historically cared about substance over form when it comes to taxation, and certain substance over name. Simply styling a tax on a class of income as an excise tax doesn’t change its fundamental character. A proper reverence for the state constitution, and the avoidance of costly litigation, argues against adopting a proscribed tax by calling it something else.