Washington’s Governor Seeks a Tax Trifecta

December 22, 2016

Over the past two years, Washington’s legislature and voters have rejected a capital gains tax, a carbon tax, and an increase on gross receipts taxes on services. In his new budget, Gov. Jay Inslee (D) chose to serve up all three with a proposed budget package that would increase revenue by $4.4 billion in the first biennium even though the two largest components—worth at least $2.7 billion—don’t even kick in until the second year.

We will consider all of these provisions at greater length as the budget process unfolds, but for now, it’s worth briefly noting the major provisions.

Capital Gains Tax

State budget documents emphasize that “Washington is one of just nine states that do not tax capital gains,” which, more generally, means that Washington is one of nine states without an individual income tax (capital gains being a subset of individual income). No state taxes capital gains separately from individual income.

Capital gains are the most volatile component of individual income, and are responsible for a large share of the error rate in state revenue forecasting, as we have documented previously. (See also this roundup of analysis compiled by the Washington Policy Center.) In 2015, when Governor Inslee included a 7 percent capital gains tax in his budget, he characterized it as part of a “very solid, fiscally sound, secure and stable way of financing” new spending programs. With the new proposal for a 7.9 percent capital gains tax, however, the administration does acknowledge the volatility issue:

To address concerns about the volatility of a capital gains tax, the governor proposes creating a school investment reserve fund. Any year in which the state collects more than $900 million in capital gains taxes, the excess amount would be directed to the reserve fund.

The proposed capital gains tax would not be levied until the second year of the biennium, when it is projected to raise $821 million. The state expects that the tax would raise $900 million or more—the threshold for diversion to the reserve fund—by fiscal year 2020. By setting the threshold for diversion so high, the state would be leaving very little room for error in preparing for the next economic downturn. Even setting aside the economic effects of a high-rate tax on capital gains, a tax on highly volatile capital gains (even with a modest reserve provision) remains an unreliable way to fund public education.

Carbon Tax

Washington is no stranger to carbon tax proposals. Governor Inslee’s previous carbon tax proposal was defeated, and in November, the voters rejected a carbon tax ballot initiative (Initiative 732) which split the traditional coalitions. A group called the Alliance for Jobs and Clean Energy is already gearing up for a new push for a carbon tax, and now the Governor is out with his own proposal, a tax of $25 per ton of carbon emissions. (In practice, this would mean, among other things, an additional 22 cents per gallon on gasoline.) The rate would increase by 3.5 percent plus inflation each year, and is estimated to raise $1.9 billion in the first year of its implementation.

We have written previously about some of the challenges of a state-specific carbon tax, from the potential to induce “leakage” of manufacturing to other states which do not impose such a tax to increases in the price of electricity to potential constitutional constraints on the use of carbon tax revenue. Future analysis will examine points of agreement with and divergence from the mechanisms employed in Initiative 732 and the proposal from the Alliance for Jobs and Clean Energy.

Increase in Gross Receipts Tax on Services

Washington’s Business & Occupation (B&O) tax is a gross receipts tax, meaning that it falls upon the entire revenue of a company rather than its net income (profit). As such, it is imposed without regard to ability to pay, falling more heavily on companies with slim profit margins and even hitting companies which post losses. Because it is imposed at every stage of production, moreover, it has a tendency to “pyramid,” with the tax embedded in the final price of a good or service several times over. (Here’s more on the economic theory and literature surrounding gross receipts taxes.)

The tax is levied at varying rates on different industries in implicit recognition of the degree to which distinct industry margins yield a range of effective rates. The highest rate (1.5 percent) is imposed on the service sector. The rate was temporarily hiked to 1.8 percent in 2010, but the increase was allowed to expire in 2013 and the legislature resisted a prior Inslee proposal to restore the 1.8 percent rate. In his new budget, however, the Governor proposes a much larger increase, to 2.5 percent. The increase is projected to raise $2.3 billion over the biennium.

While the legal incidence of these proposed taxes falls upon businesses and high net worth individuals, ultimately, many of the costs are reflected in employment levels and the cost of consumer goods, which is one reason why prior carbon tax proposals were resisted by otherwise likely allies. The overall effect of such a package of tax increases would be to discourage in-state investment and growth. With much of the new revenue delayed until the second year of the biennium, moreover, the total size of the tax increase is actually significantly larger than the $4.4 billion biennial price tag would suggest.

All three proposals face an uphill battle, if history is any guide. Clearly, though, there is an appetite in some quarters for Washington to chart its own course on tax policy, making the Evergreen State one to watch in the new year. 

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