Income Tax Rising

Feeling the Pinch: A large proportion of business owners would be affected by I-1098. Source: Defeat 1098/IRS (from 2008 tax returns). Click to enlarge.

They say the income tax is the third rail of Washington state politicsyou touch it and you die. Thats a bit of an exaggeration. Yes, the idea has come up a dozen or so times during the past 78 years, and its never gotten anywhere. But the people who pushed it always lived to fight another day.

Washington, one of just seven states that dont impose their own income taxes, never has been warm to the ideaunless you count that first vote, back in 1932, when nobody had much income to speak of, and the whole idea seemed safe. The state Supreme Court tossed that one out right quick. Every attempt since then has been squelched somewhere along the lineby the voters, by the governor or by the Legislature.

But its back again this year. And this time, business is scared.

State of Regression: The poorest taxpayers in Washington pay a much higher percentage of their income in state and local taxes than the richest do. Source: Institute for Taxation & Economic Policy, Who Pays?, 2009. Click to enlarge.

Initiative 1098, brought to the ballot by a coalition of labor unions, activist groups, social-service organizations and wealthy liberals, appears to be the most serious stab at an income tax in this state since the Great Depression. Unlike previous proposals, this one doesnt hit the public at largeit applies only to the states wealthiest citizens, those who make more than $200,000 a year, or $400,000 for couples. So 100 percent of the states voters get to decide whether to tax 3 percent of the population.

That approach explains some of its appeal. It also represents the first big test for the states progressive winga rising force in Washington Democratic politics, with a campaign organization and financial backing that makes it tough to beat. And behind it all are the states two largest public-employee unions, which see the income tax as their top issue of the year, more important to their long-term health than the election of any individual political candidate.

That gulp you hear? That response comes from Washington states business community. This time, it has a fight on its hands.

Somethings Got to Give

Its hard to guess how voters are going to view I-1098. Early polls, shortly after the initiative was filed, showed it anywhere from dead even to 39 percentage points ahead. But its clear that this run is more serious than previous attempts. Governors and politicians led those earlier charges, and the support usually ended at the edge of the Capitol campus in Olympia. But the push for I-1098 didnt come from Olympia.

Bill Gates Sr. Photo by Dan Lamont/Corbis

Its being promoted by Bill Gates Sr., father of that Bill Gates, the richest man in the United States. Gates Sr. has been a longtime advocate of tax reform, chairing a commission in 2002 that came up with a more traditional proposal for a graduated income tax. Gates kicked in $100,000 to support the initiative. But the real organizational and financial muscle comes from the Service Employees International Union and the Washington Federation of State Employees, the unions that provided most of the $800,000 or so needed to get the measure to the ballot.

In touchingembracing, actuallythe third rail, Gates has not just given the initiative momentum it wouldnt have without a famous name attached to it, but also called attention to the dynamics of wealth in the campaign: Gates is in the income bracket that would be most strongly affected by I-1098.

He doesnt, however, see his presence changing many minds in the upper income bracket already against I-1098.

Theres sort of an automatic negativism about it, he says. I dont think of myself as being an example thats going to make a lot of people with that state of mind change their mind.

Unions have taken a beating in the last few legislative sessions. Thanks in part to ambitious spending plans they advocatedpay hikes, program expansionsstate spending was out of whack with tax revenue even before the financial crisis. Then came the worst recession since the Great Depression. The result was a $12 billion shortfall over the past two years, which lawmakers covered in part by slashing state programs and laying off employees. Next year, another $3 billion shortfall is expected; in 2013-2015, the budget gap could be somewhere between $5 billion and $6 billion.

Somethings got to give, 1098s backers say, and its not state spending. We cant just cut costs in state government, says Marilyn Watkins of the Economic Opportunity Institute, the brain trust behind the measure. We need more money.

The real problem with the state budget, they say, is that the state is overly dependent on the sales tax. That was fine back in the 1930s, the last time the state tax structure was overhauled. But lately, sales tax revenue hasnt kept pace with the growth in personal income. Between 2000 and 2009, sales tax revenue grew 27 percent while personal income grew 45 percent. According to the state Office of Financial Management, the income tax would net about $2.2 billion the first year and rise to $3.2 billion in the fifth. I-1098 also would provide about $700 million a year in tax breaksa modest reduction in property taxes, and an exemption for the smallest businesses from Washingtons unique tax on gross receipts, the business and occupations tax.

But why soak the rich? Why not tax everyone? Its an element of political pragmatism, Watkins says. The idea still has to get past the voters.

Tech Sector Leads Charge

Matt McIlwain. Photo by Hayley Young.

In the 25 years or so since the tech industry blossomed on the eastern shore of Lake Washington, theres never been a unifying issue like this one. The tech industry and the Washington Roundtable, a state association of large-business employers, first saw I-1098 as a serious threat. As meetings were held, PowerPoints projected, and implications recognized and discussed, venture capitalists, real estate developers and tech executives became unglued. These are people who arent normally involved in state politics, says Mark Funk, spokesman for the Defeat 1098 campaign. Some of them were saying, We supported Obama. How could they do this to us?

By the end of July, theyd raised $650,000, and the contributor list included some of the biggest names in the technology industryTom Alberg of Madrona Venture Group, Patrick Ennis of Intellectual Ventures, Sujal Patel of Isilon Systems, John Stanton of Trilogy Equity Partners, Concur Technologiesplus John Runstad of Wright Runstad, and Saltchuk Resources Inc. The point man for the opposition is Madronas Matt McIlwain.

Certainly other industries will have problems, too, McIlwain says, but the effect will be pronounced on the tech business. The soak-the-rich tax hits the very people who are responsible for the rise of the industry. Venture capitalists are wealthy by definitionthey need at least $200,000 to meet SEC investor qualifications. Executive salaries are big and so are the stakes. It took years to develop the critical mass of talent to build the industry, he says, and today it is one of the most vibrant economic forces in the greater Seattle area.

But Washington state still is off in the corner of the country; it doesnt have the infrastructure or the talent pool of a Silicon Valley. The income tax under I-1098 would give Washington the sixth highest individual tax rate in the country, according to the Washington Research Council. And so the golden goose flies elsewhere. Capital is mobile, just like people are mobile, McIlwain says.

A Double Tax

Washington State Data Total number of 2008 returns in Washington: 3,371,086 Number of tax returns $200,000 or more: 111,258 Percentage of Washington taxpayers affected by I-1098: 3.30% Source: IRS

So many arguments swirl around the issue that it sounds a little like a high-school debate. Theres the tax-justice argument, the volatility disadvantage and the deductibility question; also, the constitutionality problem that overturned the 1932 tax is certain to send the matter to court again should the measure pass. You also might wonder how long it would take the cash-strapped Legislature to lower the threshold and extend the tax to everyone.

But what sends business up the wall are specific problems with the tax plan. The first is that most small-business owners operate LLCs, partnerships or S corporations. These owners report that business income on their federal tax forms. Theyd be hit with the state tax, too.

That result may not be any different from other states with an income tax. But the problem is that Washington also imposes the B&O tax. No other state has anything like it. The B&O came about in the 30s as a substitute for the income tax that was tossed out by the court, Washingtons version of a corporate income tax more or less. With the income tax, the burden on those businesses nearly doubles.

The I-1098 campaign argues that few small businesses generate that much income, and many would be exempted by their B&O tax credit. But try telling this to the tech industry. Opponents say most tech businesses are too big to qualify for the credit, and theyd certainly be hit.

And then theres the matter of capital gains. The I-1098 tax would be based on adjusted gross income, unlike income taxes in other states that refer to a different line on the tax form. That means capital gains would be taxed to the full extent. Venture capitalists are always thinking about the exit strategy. The more theyre taxed, the less their investments are worth.

The thing of it is, McIlwain says, the one thing Washington has had going for it is the fact that it doesnt have an income tax, which has made it easy to recruit and retain talented employees. Under I-1098 that advantage goes away.

Sometimes even that little tech company started by the younger Gates concedes the pointas in a Twitter message Microsoft University Recruiting posted a month before the initiative was announced: Did you know … The state of Washington is one of only seven states that do not levy a personal income tax. Cha-ching!