With the Legislature, now in its second special session, still fighting about the budget, and with national studies ranking Washington last in a certain measure of tax fairness, it may be time to rethink how we tax ourselves to pay for the services we need.
Our system has been cited as the most regressive in the nation – that is, the tax burden falls most heavily on low- and middle-income people, while those with the most income pay a dramatically smaller share to the public good.
While it’s too late to make a fundamental change in the current budget negotiations, it’s not too early to begin considering a very different approach to taxation. I have a proposal for the public and our leaders to think about. The premise, based partly on outside studies, is that by making our tax system less regressive we can make it more stable and reliable at the same time. And without, as some fear when the subject is tax reform, bringing in more money.
First some background.
There was much handwringing about the fairness of our state’s tax system in January when a national tax watchdog organization again ranked Washington’s tax system as the nation’s most regressive. But little has been done to rectify the problem.
The state government itself acknowledges the fundamental unfairness of the tax burden. And tax inequality reaches into the economy. When low-income citizens are taxed heavily there is significantly less money that would otherwise be spent in the local economy.
A Standard & Poor’s study last year found that tax inequality hurts a state’s economy, its job growth and its ability to fund essential public services. S&P suggests that this can be countered by adopting a progressive tax structure. The benefits, it indicates, would be greatest in sales-tax dependent states such as Washington.
Two efforts in the 2015 legislative session sought to improve the progressivity of our tax structure, and at the same time generate new revenue. Democrats have promoted a tax on capital gains. The most recent version would apply a 5 percent excise tax to capital gains from stock sales and other investments and would generate an estimated $570 million in fiscal year 2017 and $1.3 billion in the next biennium.
A capital gains tax does improve regressivity but only at the high end of the scale. Households with incomes of $140,000 and more would pay a slightly greater share of their income to the state and local government. It has no appreciable effect on the lowest-income households.
A second and much broader tax restructuring was proposed by State Treasurer Jim McIntire. His proposal would introduce a 5 percent personal income tax, lower the state sales tax from 6.5 percent to 5.5 percent, eliminate the state property tax, and reduce some business taxes. McIntire’s tax package is, as he described it, an attempt to fully fund education. It would produce an estimated $4 billion in the 2017-2019 biennium. And it would reduce the relative tax burden on low- to middle-income households.
Both ideas met mixed reactions. Legislative Republicans rejected the capital gains tax as unnecessary and contend that it is really a tax on income, which would require constitutional change.
Gov. Jay Inslee was not supportive of McIntire’s package, which has not been introduced in bill form. The treasurer indicated that he would attempt to sell it to voters with the goal of passing a necessary constitutional amendment in 2016.
Then there is a proposal from outside government. Dick Conway, veteran Northwest economist, proposes a flat 10.6 percent personal income tax and the elimination of other taxes. The rate is equal to the effective rate of state and local taxes across all states over the past 45 years.
Conway makes his case succinctly: “If Washington were to adopt a single-rate personal income tax, it could have the best—not the worst—tax system in the nation. The single-rate tax system would be fair, adequate, stable, and transparent and would have no adverse effect on economic vitality.”
However, there doesn’t appear to have been a rush to embrace his idea, and Conway doesn’t say how revenue collected by the state would be distributed to local governments to replace their local sales taxes.
All of this seems to leave the door open for tax restructuring that reduces regressivity without offending the ideological sensibilities of either Democrats or Republicans and that is easy to understand. So here’s one idea for consideration.
This proposal suggests that two major contributors to the regressivity, the state retail sales tax and the state and local property tax, be reduced, and that a new graduated personal income tax be added. In addition, an earned income tax credit based on the federal credit would be available to low-income households (Working Family Tax Exemption Program).
Expanding the senior citizen exemption eligibility to include all low-income residential property owners would reduce the property tax.
To address Republican concerns, this package of tax changes would essentially be revenue neutral – that is it would not bring in any more money than the current system. The only difference from neutrality would be if any proposals for tax increases were made outside the regressivity proposal, such as a capital gains tax.
The tax reform package would consist of a constitutional amendment and implementing legislation. The amendment would establish the rates for the sales tax and the income tax and authorize the low-income property tax program. It would require two-thirds favorable votes in House and Senate and submission to voters for their initial approval and any future amendment. The implementing bills would require simple majority approval in each body, but would be subject to existing rules of procedure applicable to tax proposals. They would be effective subject to passage of the constitutional amendment. Voters would have the final say.
So here is one revenue-neutral alternative:
- Reduce the state sales tax from 6.5 percent to 2.8 percent
- Establish a personal income tax of 7 percent for incomes of $100,000 and up
- Fund the Working Family Tax Exemption Program (based on federal earned income tax credit)
- Extend the senior citizen property tax exemption to all low-income residential owners
The Department of Revenue has developed a tax model that allows the user to test this and other alternatives and that graphically displays changes in regressivity.
The sales tax cut for the proposed alternative produces an approximate $4.4 billion reduction in state revenue while the income tax produces an essentially equal amount of new revenue. The result is a downward shift in the regressivity curve as shown below (where the dark line is the current system and the red line is the alternative).
According to the DoR model, in 2014 an estimated 526,000 households across the state fell into the two lowest income deciles ($0 t0 $15,000, and $15,000 to $25,000). The lowest would realize a $400 gain in annual income, while the second would gain $570.
For those who are concerned about the impact of tax changes on the state’s business climate, the alternative reduces the overall business tax burden. Currently business pays 47 percent compared with 53 percent for households. With the alternative’s reduced sales tax, business’ share would be 39 percent., and 61 percent for households.
It’s important to recognize that tax regressivity is a moving target. Tax changes such as new property tax levies at the local level can offset improvements at the state level. Thus it would be helpful if every tax proposal were accompanied with a fiscal impact analysis indicating how it affects overall regressivity.
