Stalking the elusive state-tax dollar

They say that when God closes a door, he opens a window. Some people certainly hope that Washington'ꀙs current budget crisis, which seems to have slammed so many doors, has pried open the long-stuck window through which an income tax could slip into this state. At the very least, the budget crisis has forced key legislators to talk seriously about a tax increase.

On February 26, exactly one week after the state announced it was looking at $8.3 billion worth of red ink, Senate Majority Leader Lisa Brown told the Washington State Labor Council, "we'ꀙre going to look for ways that we can raise the necessary revenue to keep basic state services in education and higher education, and health care and critical human services."

This wasn'ꀙt the first hint that Democratic legislators were contemplating a break with Gov. Chris Gregoire'ꀙs no-new-taxes approach. Reporting the $8.3 billion deficit forecast, Gregory Roberts wrote in the Post-Intelligencer that the chairs of both the House and Senate ways and means committees, Kelli Linville and Margarita Prentice, 'ꀜsaid Democratic lawmakers are seriously considering drawing up a list of desirable programs that are on the chopping block and asking voters to approve new taxes to save them.'ꀝ

As revelations go, this is all very much dog-bites-man. Not only are these people Democrats, they'ꀙre responsible for a state that'ꀙs worse than broke. Even in Eastern Washington, $8.3 billion doesn'ꀙt grow on trees. On a per capita basis, that $8.3 billion pushes Washington farther into the red than the projected $41 billion gap that California legislators have evidently closed.

It will be virtually impossible to plug Washington'ꀙs budget gap without more revenue. Describing the California Legislature'ꀙs action, Jennifer Steinhauer reported in the New York Times that 40 of the 50 states faced deficits, and quoted Susan Urahn, managing director of the Pew Center on the States, who said "California is an example of what you will see" elsewhere. Steinhauer suggested that California'ꀙs approach — a combination of tax increases, borrowing, stimulus manna and deep program cuts — might provide a "template" for legislators in the 39 other red-ink states.

Of course, legislators in other states don'ꀙt have to send tax increases to the voters. Here, under Tim Eyman'ꀙs Initiative 960, passed in 2007, and Initiative 601, passed in 1993, any tax increase requires two-thirds votes in both houses of the Legislature or a vote of the people. Getting two-thirds for higher taxes is a non-starter. It will be up to the people. "In other places, [legislators] legislate," observes Remy Trupin, executive director of the Washington State Budget & Policy Center. "Other places have representative government."

In this state, any one who wants to raise more revenue must do it not only through a vote of the people, but also through a Rube Goldberg tax system that has been in place since the Great Depression. At the start of the Depression, Washington, like other states, relied almost exclusively on property taxes. By 1932, Washington'ꀙs farmers found themselves with lots of property and no cash to pay taxes on it. Charles Hodde, a Missouri-born farmer in his mid-20s living on rented acreage in Colville, recalled years later (after he had been Speaker of the House, director of the state departments of Revenue and General Administration, and chair of the state Tax Commission) that "in Chelan County where they had all the orchards and everything . . . less than fifty percent of the taxes were being paid. . . . You could let them go delinquent for five years before they could start foreclosing on your farm, so you just didn'ꀙt pay them, see."

"Well," Hodde said, "we had to do something about it." The Grange did something. Grange campaigns led partly by Hodde easily collected enough signatures to put tax reform initiatives on the ballot. The voters were asked to limit the property tax and replace the revenue with a graduated tax on net corporate and personal income. Income tax did not mean then what it does now. Even at the end of that bleak decade, only about 4 million Americans paid federal income tax. For most Washington citizens, replacing property tax with income tax represented a tax reduction pure and simple. For most citizens, in the early 1930s, a graduated net income tax represented a tax on someone else.

The people voted yes, basically shifting more of the tax burden to the rich. (Shifting the burden to someone else remains a popular tactic. That'ꀙs why visitors pay heavy taxes on hotels, motels and rental cars.) As a stop-gap until the income tax went into effect, the 1933 Legislature imposed a business and occupation tax — taxing the total amount a business took in, whether it was making a profit or not. Then the state Supreme Court ruled that a graduated income tax was unconstitutional. The court reasoned that income was a form of property and the state constitution required all property in a certain category to be taxed equally. Therefore, the state could not have a graduated tax that forced some people to pay higher rates than others.

Legislators could have come back with a flat-rate income tax, but they didn'ꀙt. Instead, they waited the constitutionally-mandated two years then exceeded the limit on property taxes. The people wouldn'ꀙt stand for it. Most voters didn'ꀙt seem to care how the Legislature paid the costs of government. That wasn'ꀙt their problem. In 1934, the people passed another limit on property taxes but turned down a constitutional amendment that would have authorized a graduated net income tax. That was evidently an idea whose time had already passed. "There is abundant evidence that [voters] knew what they were doing," J.W. Gilbert wrote in the Seattle Times. Nevertheless, "[t]he next session of the Legislature . . . must devise new sources of revenue."

The next session of the Legislature did exactly that: it imposed a two-percent tax on retail sales. And so the Legislature completed the trifecta: a limited (albeit widely resented) property tax; a B&O tax; a sales tax. Washington'ꀙs current tax system was complete.

Ever since, many people have assumed that the business and occupation tax is permanent, and that the state constitution forbids an income tax. The first of those assumptions has turned out to be true, at least so far. On the day the $8.3 billion deficit number surfaced, representatives of the Seattle Times and other troubled newspapers were in Olympia, arguing for a 40% drop in their own B&O tax rates. They wanted newspapers to pay only .294 percent of their gross earnings, just like aerospace or forest products companies — more than they'ꀙd pay as splitters of dried peas or breakers of perishable meat, but less than they'ꀙd pay as hospitals or chemical-dependency centers..

The byzantine B&O tax schedule reflects generations of special-interest lobbying. Carl Gipson of the free-market Washington Policy Center wrote last year that the state Department of Revenue recently listed 570 "exclusions, deductions, preferential tax rates, deferrals and credits," and that "over 70 percent of the value of the exemptions dates from the 1930s."

The system is nutty, not least because it'ꀙs hard on start-ups, which the state always says it wants to encourage, and on businesses that are just scraping by. John Burbank, executive director of the Economic Opportunity Institute, says that just as the sales tax weighs more heavily on lower- and middle-income residents than on the rich, so the B&O tax weighs more heavily on small businesses than on large.

Burbank doesn'ꀙt propose scrapping the whole system or even plugging all the loopholes. (That would be a tall order; he says there are so many loopholes that the whole system is "sort of like Swiss cheese.") He does propose plugging the specific loophole that shields money a company invests in intangible assets'ꀓstocks, bonds, sub-prime mortgages — rather than in plant and equipment. That is a "perverse incentive," Burbank argues. We should encourage businesses to invest in productive assets, not to speculate in financial markets. That particular loophole also costs the state a lot of money. Plug it, Burbank says, and the state could eliminate B&O taxes on all sales of services below $600,000 and all sales of goods below $1.2 million, thereby lifting the burden from 85 percent of its businesses — and still come out $100 million ahead.

If people are right to assume that the B&O tax, conceived as a short-term fix, has become permanent, popular assumptions about the income tax tend to be less accurate. The state Supreme Court never said that taxing income would be unconstitutional. It struck down a graduated income tax. There seems little doubt that Democrats could have had a flat-rate tax in the 1930s or 1940s if they had wanted one, but they weren'ꀙt willing to settle for half a loaf. They held out for a graduated tax or nothing. They got nothing. Be that as it may, by this time, the barrier to establishing even a graduated tax is probably not constitutional but political.

Many people assume that the 1933 decision "is still good law and that Washington courts would reach a similar decision today," state constitutional scholar Hugh Spitzer has written. He continues:

If that is true, a constitutional amendment would be necessary before the state could impose any income tax other than a flat tax on gross income at a rate no more than 1 percent. However, there is ample reason to believe that a modern income tax, established by the Legislature or by the voters, would now be upheld. The basic reason is that [the 1933 decision] was based on an earlier Washington case which the state Supreme Court clearly misread. More importantly, the earlier case was based on a line of Supreme Court cases that have subsequently been reversed.

A lot of people in politics realize this is the case. Lisa Brown, for one, seems to be signaling that it'ꀙs time to re-think the income tax. In her speech to the Labor Council, she didn'ꀙt just talk about raising taxes. She also said that new tax legislation shouldn'ꀙt "place that [additional financial] burden on people who are already paying too much in our unfair tax system." In tax reform circles, if you talk about the unfair burden on working people or the regressive nature of Washington'ꀙs tax system, you want an income tax. If you talk about making the tax system more predictable, leveling the state'ꀙs revenue stream through economic ups and downs, you don'ꀙt mean we should collect less money in good times. You mean we should collect more money in bad.

The Economic Opportunity Institute's Burbank is well aware of the public suspicion that tax reform simply means more taxes — and of its basis in fact. If we want to reform Washington'ꀙs tax structure, we'ꀙd better "make sure that this is not just an attempt to bring more revenue into the state,'ꀝ Burbank says. He'ꀙs not averse to raising more money, but "if you do have new net revenue, you have to prioritize where it'ꀙs going to go."

Would Brown and other Democratic legislators really put an income tax on the ballot this fall? It'ꀙs hard to believe that they would stick their necks out that far — or that they would stake the state'ꀙs short-term solvency on a major structural change in our tax system. Trupin, who wants an income tax — he says we lack "a tax structure that supports the values that Washingtonians say they support." — believes that changing the fundamental structure of the tax system "is very complicated . . . [and] would require tremendous fighting both in the legislature and on the ballot." He can'ꀙt imagine that happening by November. On the other hand, he figures we could'ꀜat least take a step toward 'ꀜ a better system. Burbank asks bluntly, "If not now, when?"

Burbank suggests an income tax limited to households that earn more than $200,000, which for most voters satisfies the criterion of shifting the burden to someone else. He also suggests linking an income tax to a reduction in sales or property tax, which could reduce the tax burden for 90 percent of the population. Burbank says that early last year, polling and focus groups found that about 70 percent of the people looked favorably on the idea.

How does that square with the public'ꀙs willingness to vote repeatedly for Eyman tax-cutting schemes? They'ꀙre caught in an unfair system, Trupin suggests, and the only way to keep their own unfair burdens from growing heavier is to keep the load down for everyone. "The reason people vote for [Eyman],'ꀝ he says, 'ꀜis that [Washington taxes] are regressive."

Burbank thinks the people may turn out to be a better bet than the Legislature. Legislators seem scared of the idea. 'ꀜMaybe, as in 1932, it will take an initiative of the people."

And Burbank is ready to roll the dice in the courts. "Let'ꀙs pass an income tax," he says, "and if someone wants to challenge, then that gives the state Supreme Court an opportunity to review their ruling from 1933."

Next: Olympia's red ink flows toward schools.