Tax reform impasse has Legislature all tied up in knots

Washington lawmakers all agree the state’s tax system is broken. Why they still can’t fix it.

By John Stang, January 7, 2014, Crosscut

Talk to almost any elected state official in Olympia — including the governor and the Legislature’s budget writers — and you will hear that Washington’s tax code is among the worst in the nation.

 

“We have a stupid tax code, a bad tax code designed in the 1930s,” said Rep. Ross Hunter, D-Medina and chairman of the House Appropriations Committee.

 

Washington has one of the highest sales tax rates in the nation — a tax that hits people surviving paycheck to paycheck harder than it does those with significant savings. The Tax Foundation, a Washington D.C.-based tax research organization, puts Washington’s combined state and average local sales tax at 8.88 percent, fourth highest in the United States. Washington is one of six states with no income tax — a type of tax that tends to hit higher earners more in sheer dollars and in percentages of income. Washington is also one of nine states that don’t tax capital gains. This means people with significant investment portfolios dodge the taxman.

 

No one in Olympia likes Washington’s business-and-occupation tax, which hits the gross receipts — not the net incomes —of businesses. That means firms with narrow profit margins face an extra burden. Also, the majority of Washington’s businesses make less than $250,000 annually. This makes the gross receipts aspect a heavier burden.

 

Meanwhile, Washington has more than 650 different tax breaks. Their sheer number sparks anti-exemption rhetoric in the abstract, but politically they are extremely difficult to repeal — especially when tackled specifically one-by-one. Also, repealing a politically feasible number of tax breaks might raise a few hundred million dollars at most per budget biennium — a healthy gain, but far short of any multi-billion-dollar silver bullet for the Legislature’s budget woes.

 

All this translates to the working class carrying more of Washington’s tax burden than the state’s upper class. In late December, Gov. Jay Inslee said Washington’s economic top 1 percent pays an average of 2.8 percent of their incomes in state and local taxes, while the middle 40 percent pays averages of 8.7 percent to 10.4 percent. The bottom 20 percent pays an average of 16.9 percent.

 

“Washington’s tax system is the most unfair in the nation to working people,” Inslee said. Hunter added: “We’ re taxing a smaller and smaller fraction of the economy.”

 

This also means less-than-desirable revenue sources for the Legislature to use as it faces a $3.28 billion deficit for education fixes in 2015-2017. The state Supreme Court and the voters who passed initiative 1351 are both calling for dramatic improvements in student-teacher ratios in public schools.

 

Add to that burden the state’s financial demands in other categories, including normal inflation, court-ordered fixes in mental health and $583 million in negotiated pay increases for state employees.

 

The bottom line is that the Legislature will have to acquire more than $4 billion in extra revenue to meet the new requirements for this budget biennium. There is no politically painless way to raise that cash.

 

The only budget proposal so far revealed in Olympia to raise that extra money was put forward by Inslee in late December. Where some officials have made vague “trim-the-fat” statements, Inslee targeted $400 million in trimming as part of his $39 billion budget proposal. The House Democrats budget plan is expected in late March, followed a few days later by the Senate Republicans’ proposal.

 

David Schumacher, director of the state’s Office of Financial Management, addressed the issue at a Seattle Washington Budget & Policy Center forum in December. “The budget math for this (2015-2017) biennium is more difficult than last time,” he informed the room.

 

Rep. Reuven Carlyle, D-Seattle, is the chairman of the House Finance Committee and focused on tax reform. “Tax reform is obviously massive in scale. It is inherently on the table in a year like this. We all want to find ways to have Somalia-level taxes with Denmark-level services,” he said.

 

Rep. Bruce Chandler, R-Granger and ranking Republican on the House Appropriations Committee, said the state’s tax system should be simpler, though he said, “I’m guarded in respect on how far we can go.”

 

While Carlyle’s attention is on tax reform, the Legislature has a recent history of slow progress on the matter. The last major bipartisan tax reform bill, which ordered that new and renewed tax breaks include job creation and retention targets, was passed in 2013. Until then, the state had no way to measure the effectiveness of a tax break.

 

And other legislative budget writers don’t think the timing is right for major tax reform this session, citing other responsibilities like budget, education and transportation issues. One of those is Sen. Andy Hill, R-Redmond and chairman of the Senate Ways & Means Committee. Without Hill’s support, any House tax reform proposed by Carlyle will die in the Republican-controlled Senate.

 

While Hill believes tax reform should be addressed eventually, he says it will be difficult for the Legislature to wholeheartedly tackle tax reform without three conditions: a one party in control of one chamber and the other party in control of the other chamber to force the issue, a non-election year to keep legislators from getting skittish and a broadly expanding economy to cushion the jolts of switching tax systems.

 

Washington’s economy, Hill argued, is not ready. “It’s important not to upset economic engines, we’re not hitting on all cylinders. We’ve got to have the stars aligned right. We’re not there yet,” he said.

 

He’s not alone. “The economy may be booming five miles from here,” said Schumacher, the Office of Financial Management director, at the December Seattle forum, “but the rest of the state’s economy is not booming.”

 

Even Hunter, a proponent of tax reform, doesn’t see it happening during the 2015 legislative session. Because of its scale and complexity, he argues, tax reform should be studied and debated and a bipartisan plan mapped out between sessions so that proposed legislation is ready when the Senate and House formally meet. The Legislature routinely uses task forces between sessions to study and discuss topics like education and carbon emissions. However, Hunter said a tax reform task force would only work if all parties are serious about changing the system, and aren’t just going through the motions to look good.

 

“Even with the system being badly set up for them, people are afraid of change,” Hunter said.

 

Still, Carlyle noted some tax areas that could be reformed sooner: the B&O tax system, revamping business tax credits, exploring income or capital gains taxes, or looking at increasing property taxes. The state currently levies $1.98 of property taxes per $1,000 of assessed property value, but Carlyle said the Legislature could potentially raise that as high as $3.60, its legal maximum. Still, he noted it would be an unpopular move with significant effects on families and businesses.

 

Gov. Inslee’s plan, released in December, would create three new taxes, close five existing tax breaks and extend another eight existing tax breaks to raise $1.042 billion in new revenue between 2015-2017.

 

The new taxes proposed by Inslee include a 7 percent capital gains tax, a 50 cent increase in the tax on a pack of cigarettes, and a tax on electronic cigarettes. he says would raise another $18 million in the coming biennium. The capital gains tax Inslee proposed would start in 2016 and apply only to individuals making more than $25,000 a year in capital gains or joint tax return filers making more than $50,000 a year in capital gains. Capital gains from retirement accounts, plus the sale of homes and farms would be exempt. Inslee said that tax would affect only the richest 1 percent of Washington’s residents. He expects it to raise $798 million in the upcoming budget biennium.

 

The cigarette tax proposed by Inslee would increase the tax rate from $3.025 to $3.525 and raise $38 million in 2015-2017. Inslee also wants to tax electronic cigarettes, contending that would raise another $18 million in the upcoming biennium.

 

Inslee has said that his proposed tax break closures would raise another $282 million. They include closing an exemption on sales tax for vehicle trade-ins of more than $10,000, removing an exemption for recycled hog fuel (originally intended for sawmills, but not used predominately by oil refineries), and closing sales tax exemptions for non-Washington state residents worth $52 million.

 

The $1.042 billion in tax revenue Inslee has said his new plan would raise does not include predicted annual revenue from the cap-and-trade program he proposed earlier this winter, which is expected to raise $1 billion a year beginning in 2016. $380 million of that would go to education, increasing Inslee’s total proposed new revenues to the state’s general fund to $1.422 billion.

 

The other cap-and-trade revenue would go to transportation, tax rebates for poor families and some businesses handicapped with foreign competitors not facing pollution restrictions.

 

He has also proposed putting off roughly $1.9 billion in class size reductions imposed by I-1351 because he believes it is unrealistic to expect that money could be raised in this biennium. It is unknown whether or not the Legislature will decide to follow that suggestion. To formally suspend I-1351 this upcoming session, the Senate and House would each need the support of two-thirds of their members, which is an extremely difficult target.

 

Hunter and Hill noted that the last few swing votes to reach a two-third majority will likely come with difficult deals. “It’s hard to get two-thirds for anything. The last three to five votes are very expensive,” Hill said.

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