A Look at Washington's State and Local Tax System

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Tax Policy

The City of Seattle recently enacted its own local income tax, even though Washington State has none. In this article economist Dick Conway, principal of Dick Conway & Associates, discusses Washington's sales-based tax system and its impact on the state.

Dick Conway

By Dick Conway

Richard S. Conway, Jr. is principal of Dick Conway & Associates, a research and consulting firm specializing in regional economic forecasting and analysis. He has served on the Washington Governor's Council of Economic Advisors for thirty-two years and was a member of the Washington State Tax Structure Study Committee.

On most political maps, the state of Washington is colored blue. Yet, its state and local tax system is distinctly red. Lacking a personal income tax, Washington has the most regressive tax system in the nation. The inadequacy of the sales-based tax system has resulted in a low and falling effective tax rate, which in turn has critically short-changed public education.

In 1932, attempting to reduce the burden of property taxes on farmers, seventy 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 non-uniform 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. The major 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. In FY 2014, sales and gross receipts taxes accounted for 60 percent of Washington's total state and local tax revenue, well above the 35 percent national average.

Heavy Reliance on Sales Tax

Throughout its existence the Washington state and local tax system has been problematic. Its heavy reliance on retail sales taxes, whose tax base does not keep up with the growing economy, has made it necessary to raise the state government retail sales tax rate from 2.0 percent in the 1930s to 6.5 percent today (and as much as 10.3 percent including local sales taxes). The rising rate over time has increasingly aggravated the unfairness of the tax system.

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

Its most egregious characteristics are unfairness and inadequacy. The Institute on Taxation & Economic Policy in fact has determined that absent 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. In 2002, the Washington State Tax Structure Study Committee in a report to the Legislature came to a similar conclusion.

Adequacy is the ability of a tax system to generate sufficient revenue to meet the public needs of a growing economy and population. Adequacy raises a question at the core of the debate over taxes: how much should government tax? The state and local effective tax rate for all states (state and local tax revenue as a percent of personal income) has averaged 10.5 percent and been quite stable since FY 1970. It has varied from a low of 9.8 percent in FY 1982 to a high of 11.2 percent in FY 1973.

Forfeited $4.2 Billion in Taxes

In FY 2015, with personal income amounting to $365.0 billion, Washington state and local governments collected $34.1 billion in taxes. This implied that the effective tax rate was only 9.3 percent. Taxing below the 10.5 percent national norm, Washington state and local governments forfeited $4.2 billion in taxes in FY 2015 and a total of $27.2 billion since FY 2005.

Between FY 1995 and FY 2014, the Washington state and local effective tax rate dropped from 11.4 percent (eleventh highest in the nation) to 9.4 percent (thirty-sixth highest). The unprecedented decline was due to the inadequacy of Washington's sales-based tax system working in conjunction 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 nevertheless thwarted tax increases for twenty years, even as the Washington state and local effective tax rate continued its downward drift from the national norm.

Because of the tumbling effective tax rate, Washington spending for public elementary and secondary education per $1,000 of personal income fell from slightly above the national average ($44.07 versus $43.68) in FY 1992 to 15.2 percent below the average ($32.60 versus $38.46) in FY 2014. Only eight states spent less than Washington on K-12 education in FY 2014. It would have taken another $2.0 billion to lift Washington K-12 spending up to the national norm. Since 2012 the Legislature has been under a mandate by the Washington State Supreme Court to fully fund basic education as required by the state constitution.

Contributing to the current fiscal problems in Washington has been the volatility of its sales-based tax system. The impact of the Great Recession on state government tax revenue was both 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 fails to take into account population growth and inflation. Measured in 2009 dollars, per capita state government tax revenue plummeted from $2,376 in FY 2007 to $1,947 in FY 2009 (-18.1 percent) before rebounding to just $2,223 in FY 2016 (14.2 percent).

Volatility, Inadequacy of Sales Taxes

Due to the volatility and inadequacy of the Washington sales-based tax system, it is not uncommon for personal income and state government tax revenue to take different paths during cyclical downturns. Between FY 2007 and FY 2016, which encompasses both the recession and the recovery, real per capita personal income climbed 10.2 percent, while real per capita tax revenue fell 6.4 percent.

Identifying a state and local tax system that is superior to Washington's is not difficult, since almost any other tax system would do. Based on my analysis, I recommend a 10.5 percent flat-rate personal income tax with no other taxes. According to the 1933 Washington Supreme Court ruling, the proposed income tax would not be at odds with the state constitution. In addition, the flat-rate tax would be fair, as it would eliminate all regressivity. It would be adequate, as tax revenue would always be 10.5 percent of personal income, the national norm. Also, without a capital gains tax, it would be perfectly stable except for the variability caused by uncontrollable fluctuations in personal income.

In FY 2015, a 10.5 percent personal income tax would have raised $38.3 billion in state and local tax revenue, $4.2 billion more than collected under the current tax system. The difference would have covered the $2.0 billion shortfall in K-12 funding with $2.2 billion left over for other priorities.

A seldom discussed benefit of a personal income tax is the savings on federal income taxes due to the deductibility of state and local personal income, property, and general sales taxes. In FY 2015, Washington citizens paid $34.1 billion in state and local taxes under the current tax system but saved an estimated $1.1 billion on their federal income taxes due to the federal offset. This was a small benefit—one-third of the average for all states—because Washington does not have a personal income tax.

Federal Offset

As noted, if Washington had a 10.5 percent personal income tax in FY 2015, state and local governments would have collected an additional $4.2 billion in taxes because of the higher effective tax rate. But the federal offset would have jumped an estimated $4.5 billion to $5.6 billion, since every dollar of state and local taxes would have been deductible. 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, thanks to the generosity of the federal tax system, a 10.5 percent personal income tax would have raised adequate tax revenue for schools and other public services without adding to the existing tax burden.

So, why does the blue state of Washington not have an income tax? There seem to be two major reasons. One is the contention by the business community that not having an income tax gives the Washington economy a competitive advantage, a claim that is often echoed in the press.

But there is no evidence that an income tax is a “job killer.” A statistical test shows that there is in fact virtually no correlation (0.011) between a state's business tax climate ranking (principally, the degree to which it uses an income tax) as measured by the Tax Foundation and its ability to generate jobs. For example, with the third worst business tax climate, California created 9,280,200 wage and salary jobs—about one out of every eight jobs in the nation—between 1970 and 2015.

Another bit of proof can be found closer to home. With opposite tax systems—Washington has a sales tax but no income tax, while Oregon has an income tax but no sales tax—the two economies have performed equally well over time. Since 1970 the Washington and Oregon employment growth rates have average 2.2 percent and 2.0 percent, respectively.

Ulterior Motives

Could there be an ulterior motive behind the business community's opposition to an income tax? “Washington Works Worldwide” was an economic development strategy for the state developed in response to the recession in 1981-1982. When the subject of an income tax came up for discussion among the members of the Economic Development Board, the representative of a company that had recently moved to Washington said that he did not want to talk about it. As a consultant to the project, I asked why he would not consider an income tax, when the business and occupation gross receipts tax could be a greater burden on a firm than a corporate income tax. He replied that his business had located in Seattle not because Washington did not have a corporate income tax but because it did not have a personal income tax.

While there is no evidence that an income tax hinders economic growth and welfare, it is increasingly apparent that the lack of an income tax is putting the Washington economy in jeopardy. The unfairness of the current tax system is shameful. And its inability to fully fund basic education—as well as other public necessities to make Washington a good place to live and locate a business—is deplorable.

The second and perhaps more important reason why Washington does not have an income tax is the opaqueness of the current tax system. Without a personal income tax, which is the only truly transparent tax, Washington ranked next to last among the fifty states in a test of transparency covering five types of taxes. Oregon, which relies heavily on an income tax, had the nation's most transparent tax system.

A reporter for KUOW, the NPR station in Seattle, succinctly illustrated this point. She asked two baristas how much they paid in state and local taxes. The one in Oregon had a good idea, since Oregon has an income tax. The one in Washington had no clue.

Tax System Not Transparent

If a tax system is not transparent, how can we make rational tax policy? Even fundamental questions are difficult, if not impossible, to answer. How much do I pay in taxes? Are my taxes too high or two low? Would I be better off with a personal income tax? It could well be that the main reason why Washington taxpayers have stuck with the current tax system for more than eighty years is their failure to realize how bad it is.

What is the prognosis for an income tax? In the near term, it does not look good. Neither the Governor nor the Legislature is likely to lead the band wagon. This year's legislative session lasted a record 193 days (even without passing a capital budget), as senate and house members wrestled to satisfy the Supreme Court's mandate to fully fund K-12 education. In the end, they decided to raise property taxes, which are also acutely regressive. Notably, there was hardly any discussion of an income tax during the prolonged debate.

The City of Seattle, a national leader in the $15 minimum wage movement, is now pushing for an income tax. In a unanimous vote, the city council passed a measure to tax individuals 2.25 percent on income over $250,000. Several suits, however, have been filed to block the measure. They question the constitutionality of the progressive income tax as well as the legality of the council to pass an income tax without a vote of the people. Proponents of the measure hope that this campaign will open the door for a state income tax.

Even if the Seattle income tax survives the legal battles, it is not clear that Washington residents elsewhere would welcome an income tax. In 2010, Bill Gates, Sr., the father of the Microsoft founder, proposed a statewide initiative to impose an income tax on high-income households. While two prominent businessmen donated $100,000 each to defeat Initiative 1098, it probably made little difference, as the income tax was thumped 2-1. One curiosity of the campaign was the argument that the proposed income tax picked on the rich. This is ironic since the current tax system has always picked on the poor.

Long Term Outlook

The long-term outlook for an income tax is more promising. Admittedly, the resistance to an income tax is still great. Many lawmakers believe that an income tax is the “third rail” of politics. Some taxpayers object to it because they would have to pay more taxes. Others fear that tax reform is just another way for government to pick their pockets.

But the overriding fact of the matter is that Washington's sales-based state and local tax system has become—and will continue to become—increasingly dysfunctional over time, especially with regard to fairness and adequacy. In light of this, tax reform, including instituting an income tax, is ultimately inevitable.

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