Its Time for a State Income Tax

In 1932, attempting to reduce the property-tax burden on farmers, 70 percent of Washington voters passed an initiative to enact a graduated income tax. When the business community challenged its legality, the Washington State Supreme Court ruled in a 5-4 decision that the graduated income tax was an unconstitutionally nonuniform property tax.

If one more judge had ruled that an income tax was not a property tax or the initiative had proposed a flat-rate income tax, Washington would have an income tax today.

Eight decades later, Washington is one of only seven states without an income tax. (Two others tax only dividend and interest income.) The components of the current state and local tax system include a retail sales tax, a business and occupation tax, a property tax and various excise taxes.

Throughout their existence, the Washington state and local tax systems have been problematic. A heavy reliance on retail sales taxes, whose base does not keep up with the growth of the economy, has made it necessary to raise the state government sales tax rate from 2.0 percent to 6.5 percent. This, in turn, has greatly increased the regressivity of the tax system over time.

Today, Washingtons dysfunctional state and local tax systems badly need reform. In an updated study, Washington State and Local Tax System: Dysfunction & Reform (February 2017), I compared the Washington state and local tax systems with the tax systems of all other states, focusing on five characteristics: fairness, adequacy, stability, transparency and economic vitality. Based on the findings, I concluded that Washington has the worst state and local tax systems in the nation.

Its most egregious characteristics are unfairness and inadequacy, both of which are in play as the Legislature wrestles with satisfying the funding requirements for basic education as mandated by the Washington State Supreme Court.

The Institute on Taxation & Economic Policy (ITEP) has determined that lacking an income tax … Washington has the most unfair tax system in the nation. In 2015, the 20 percent of families with the lowest incomes paid 16.8 percent of their income on state and local taxes, while the 1 percent of families with the highest incomes paid only 2.4 percent.

This meant that the lowest-income families had to work 8.7 weeks of the year to satisfy their state and local tax obligations, while the highest-income families had to work only 1.2 weeks.

Adequacy is the ability of a tax system to generate sufficient revenue to meet the public needs of a growing economy and population. The state and local effective tax rate for all states (tax revenue as a percent of personal income) has averaged 10.5 percent and has been quite stable since 1970. In contrast, the Washington effective tax rate has fallen from 11.4 percent (11th highest in the nation) in FY 1995 to 9.4 percent (36th highest) in FY 2014.

Taxing below the 10.5 percent norm, Washington state and local governments forfeited $3.8 billion in taxes in FY 2014. The forgone tax revenue from FY 2005 to FY 2014 totaled $23 billion.

This extraordinary decline in the state and local effective tax rate has been due to the inadequacy of Washingtons sales-based tax system working in concert with Initiative 601, enacted in 1993. I-601 was the first of several voter-approved initiatives requiring a two-thirds vote of the Legislature to raise taxes. Declared unconstitutional in 2013, the supermajority rule thwarted tax increases for 20 years, even as the Washington state and local effective tax rate continued its downward drift from the national norm.

Washingtons public schools have been hard hit by the relative decline in tax revenue. In FY 1992, one year before I-601 became law, spending for elementary and secondary education amounted to $44.07 per $1,000 of personal income, slightly above the United States average of $43.68. By FY 2014, however, only eight states spent less on K-12 education than Washington. Compared to the national average of $38.46 per $1,000 of income, Washington allotted only $32.60. It would have taken an additional $2.2 billion to lift K-12 expenditures up to the national standard.

Contributing to the current fiscal problems in Washington is the volatility of its sales-based tax system. The impact of the Great Recession on state government tax revenue was severe and enduring. Tax revenue fell from $14.2 billion in FY 2007 to $12.9 billion in FY 2009 before bouncing back to $18.2 billion in FY 2016. This may look like a full recovery, but it does not take into account population growth and inflation.

Measured in 2009 dollars, per capita tax revenue plummeted from $2,376 in FY 2007 to $1,947 in FY 2009 (-18.1 percent) before recovering incompletely to $2,223 in FY 2016 (14.2 percent). Typical of Washington economic downturns is a disconnect between state government tax revenue and personal income. Between FY 2007 and FY 2016, while real per capita income increased 10.2 percent, real per capita tax revenue decreased 6.4 percent.

If Washington citizens were willing to tax at the national norm the 45-year average for all states there would be sufficient revenue to fund basic education adequately, improve mental health services and address other priorities. This could be accomplished by raising the state sales tax rate which has not been increased since 1983 from 6.5 percent to 9.5 percent.

But that would greatly aggravate the regressivity of Washingtons already notorious tax system. Indeed, since most of the states existing taxes (e.g., property taxes and gasoline taxes) are regressive, little can be done to raise revenue without increasing the unfairness of the tax system.

As evidenced by the record-long legislative session in 2015, which ultimately did little to resolve the school funding issue, the governor and the Legislature are trapped in an inadequacy-regressivity bind created by Washingtons unique tax system.

The solution to this bind is to replace all existing taxes with a flat-rate 10.5 percent personal income tax. The state and local tax system would be perfectly adequate without being regressive.

The 10.5 percent rate, which is neither too high nor too low, would eliminate the need for all other taxes. Legislators would never have to raise tax rates or broaden the tax base to ensure adequate revenue. At the same time, the 10.5 percent rate would mean that every household, no matter its income, would have to work 5.5 weeks of the year to pay its state and local tax bills.

Opponents to an income tax argue that it would put the Washington economy at a competitive disadvantage. But a statistical analysis shows no correlation between the Tax Foundation Business Tax Climate Ranking of a state, namely, whether or not it has an income tax, and the ability to generate jobs. Washington and Oregon have opposite tax systems Oregon has an income tax while Washington does not but their economies have performed equally well since 1970.

Instead, the lack of an income tax is harming the Washington economy. The unfairness of the current tax system is shameful. And its inability to fund education as well as other public necessities to make Washington a good place to live and locate a business is deplorable.

Among the several other advantages of a personal income tax system stability, transparency, simplicity there is one that would raise billions of dollars in new state and local tax revenue without costing Washington taxpayers a dime. Thanks to the generosity of the federal income tax system, state and local personal income, property and general sales taxes are deductible, resulting in savings on federal income taxes.

In FY 2015, Washington total state and local taxes amounted to an estimated $34.1 billion. Due to the federal offset, taxpayers saved $1.1 billion on their federal income taxes. This was a relatively small benefit, since Washington does not have a personal income tax.

With a 10.5 percent personal income tax, state and local taxes would have increased to $38.3 billion, while the federal offset would have jumped to $5.6 billion, since every dollar of state and local taxes would be deductible.

Importantly, the $4.5 billion increase in the federal offset would have paid for the $4.2 billion increase in state and local tax revenue. In other words, by not having a personal income tax, Washington squandered $4.2 billion in state and local tax revenue in FY 2015.

The personal income tax would increase state and local tax revenue and shift to households the tax burden borne by businesses. Nevertheless, by eliminating all regressive taxes and taking maximum advantage of the federal offset, three-fifths of Washington households would on net pay less in taxes than they do under the current tax system.

Households with the highest incomes, on the other hand, would pay more. The savings on federal income taxes for the one percent of households with the highest incomes $2.4 million per year on average would amount to one-third of their state and local taxes.

Even with the sizable federal offset, their net state and local tax rate would increase from 2.4 percent of income to 7.1 percent. But that would still be the lowest rate paid by Washington taxpayers. It would also be comparable to the tax rates for the highest-income households in Oregon (6.5 percent) and California (8.7 percent), according to ITEP.

DICK CONWAY is cofounder of Conway Pedersen Economics, an economic forecasting service for the Puget Sound region. He and Doug Pedersen have published the Puget Sound Economic Forecaster, a quarterly forecast and summary, since 1993.