WASINGTON STATE AND LOCAL TAX SYSTEM: DYSFUNCTION & REFORM Nine Comments Summary. In 1932, Washington citizens overwhelmingly passed an initiative to enact a graduated income tax, but it was ruled unconstitutional by the Washington State Supreme Court. Nearly ninety years later, Washington is one of only seven states without an income tax. Due to its excessive reliance on sales and excise taxes, Washington has arguably the most dysfunctional state and local tax system in the nation. The tax system is regressive, inadequate, unstable, and opaque. With regard to economic vitality, the lack of an income tax has created a tax haven for high-wage tech companies, whose employees are heavily subsidized by the state’s extremely regressive tax system. A superior state and local tax system for Washington would be a 10.4 percent single-rate personal income tax. Not only would a flat-rate personal income tax be constitutional, but the 10.4 percent rate would provide sufficient tax revenue to eliminate the need for a sales tax, a property tax, a business and occupation tax, and all other state and local taxes. 1. On most political maps, the state of Washington is colored blue. Yet, its state and local tax system is distinctly red. Few people like to pay taxes. Nevertheless, taxes are necessary to support vital government functions, such as educating our children, building roads and highways, and maintaining a military to protect our freedom. THE SOCIAL CONTRACT “The organizer of industry who thinks that he has ‘made’ himself and his business has found a whole social system ready to his hand in skilled workers, machinery, a market, peace and order—a vast apparatus and a pervasive atmosphere, the joint creation of millions of men and scores of generations.” L.T. Hobhouse, The Elements of Social Justice, 1922. The central tax issue is fairness: who should pay taxes? Fairness refers to the tax burden—taxes as a percent of income—placed on individuals and businesses. There are two guiding principles: the benefit principle, by which individuals and businesses are taxed based on the benefits they receive from government; and the ability-to-pay principle, by which individuals and businesses are taxed based on their income or wealth. Most economically advanced countries utilize progressive income taxes. The U.S. federal income tax system is also progressive. State and local governments in the United States adopt a mix of progressive and regressive taxes. Personal income taxes are typically progressive, while sales taxes, excise taxes, and property taxes are regressive. Sales taxes are highly regressive because low-income households spend a disproportionately large share of their income on goods and services subject to the sales tax. Washington is one of only seven states—the others being Alaska, Florida, Nevada, South Dakota, Texas, and Wyoming—without an income tax. It is therefore not surprising that 2 Washington has one of the most unfair state and local tax systems in the nation. A short history of Washington taxes describes how this came about: SHORT HISTORY OF WASHINGTON TAXES In 1932, attempting to reduce the burden of property taxes on farmers, seventy percent of the 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. Instead, the current state and local tax system consists of a retail sales tax, a property tax, a business and occupation tax, and various excise taxes. Since the adoption of the sales tax in 1935, the state government retail sales tax rate has risen from 2.0 percent to 6.5 percent. The Supreme Court decision, which was handed down during the Great Depression, saddled Washington with a state and local tax system that was not only unfair but also inefficient, unstable, and opaque. 2. With the most unfair state and local tax system in the nation, Washington has been dubbed “Number One of the Terrible Ten” by the Institute of Taxation & Economic Policy (ITEP). In 2002, the Washington State Tax Structure Study Committee reported its findings regarding the state and local tax burden on Washington households in 1999. The analysis concluded that on average 15.7 percent of the income earned by the lowest-income households (average income $11,689) went to state and local taxes. The state and local tax burden for the highest-income households (average income $206,840) was only 4.4 percent. Relative to their incomes, the poorest households paid 3.6 times more in state and local taxes than the wealthiest households. Nearly two decades later, using a similar methodology, ITEP estimated the state and local tax burden on families by level of income for each of the fifty states in 2018. ITEP ranked states in accordance to the regressivity of their tax systems and reported the findings in a publication entitled Who Pays? REGRESSIVE STATE AND LOCAL TAX SYSTEMS, 2018 Taxes as Percent of Family Income Rank 1 2 3 48 49 50 State Poorest 20 Percent Middle 60 Percent Top 1 Percent PoorestTop Ratio Washington Texas Florida 17.8 13.0 12.7 10.9 9.7 8.1 3.0 3.1 2.3 5.9 4.2 5.5 Delaware Vermont California 5.5 8.7 10.5 5.8 9.4 8.9 6.5 10.4 12.4 0.8 0.8 0.8 United States 11.4 9.9 7.4 1.5 Acknowledging that all state and local tax systems are to a degree regressive, ITEP called attention to the “Terrible Ten,” the ten most regressive states. These states rely heavily on sales 3 and excise taxes, making little or no use of a personal income tax. With no income tax and three-fifths of its tax revenue derived from sales and excise taxes, Washington held the distinction of having the most regressive state and local tax system in the nation. It is true that, measured in number of dollars, the highest-income households pay more in state and local taxes than the lowest-income households. Nonetheless, ITEP’s analysis revealed that the Washington state and local tax system was grossly unfair. Relative to their incomes, the poorest families ($24,000 or less) paid 5.9 times more in state and local taxes than the wealthiest families ($545,900 or more). Strapped with a 17.8 percent tax burden, the lowest-income families had to work 9.3 weeks out of the year to pay their annual state and local tax bill. With a 3.0 percent tax burden, the highest-income families had to work only 1.6 weeks. There is another perspective with which to view the unfairness of the Washington tax system. Suppose the citizens of Washington chose to finance state and local governments with only a personal income tax. Would they tax the poorest families at a 17.8 percent rate and the richest families at a 3.0 percent rate? Such a scenario is inconceivable because of the obvious injustice inflicted on the poorest families. But that extremely inequitable income tax structure is in effect no different than Washington’s current sales-based tax structure. So, why do the people of Washington tolerate such a shamefully unfair tax system? One reason is the opaqueness of the tax system (refer to the seventh comment). 3. Amazon has given the Washington economy a big lift this past decade, but it has come at a cost: soaring home prices and apartment rents, regionwide traffic congestion, and an unconscionable subsidy to Amazon employees because of Washington’s regressive tax system. Many people take pride in the fact that Amazon, one of the richest companies in the world, calls Washington its home. In 2019, based on Washington Employment Security Department (ESD) data, the online retailer employed approximately 53,000 workers statewide who earned on average $200,000 in wages and salaries per year. By adding 50,000 jobs since the Great Recession, Amazon has given the Washington economy a much-needed boost, especially in the greater Seattle area. An analysis reported in the June 2015 issue of The Puget Sound Economic Forecaster indicated that the Amazon long-run employment multiplier for Washington is about 3.5. This implies that Amazon’s total impact on the state economy amounted to 175,000 jobs or 29 percent of the 600,000 wage and salary jobs created in Washington between 2009 and 2019. During that period, Washington employment grew at a 1.9 percent annual rate, considerably faster than the 1.3 percent U.S. rate. Without the Amazon expansion, Washington employment would have increased at a 1.4 percent rate. Some observers contend that the “Amazon boom” in Washington occurred without granting the company a subsidy. They point to New York City, where Amazon’s “asking price” to locate a satellite headquarters with up to 25,000 employees was $3 billion. When New Yorkers balked at the cost and raised concerns over the potential social disruption to the city (higher housing costs and greater problems for public transportation), Amazon pulled out of the deal. Settling for a $600 million subsidy, but recognizing the benefit of being on the door-step of Washington, D.C., Amazon decided to locate HQ2 in Arlington, Virginia. While it may not be obvious, the state of Washington does in fact provide a subsidy to Amazon. It is bestowed by the state’s regressive tax system and is not difficult to estimate. 4 The subsidy is the difference between the state and local taxes that Amazon employees should pay and the taxes that they actually pay. What should they pay? One reasonable answer is 10.4 percent of their annual personal income, since that has been the average state and local effective tax rate (state and local tax revenue as a percent of personal income) for all states over the past fifty years. In other words, 10.4 percent is the national norm for the state and local effective tax rate (refer to the next comment). In order to compare what Amazon employees should pay in state and local taxes with what they actually pay, it is first necessary to estimate their average personal income, which is greater than their average wages and salaries. One other component of personal income that can be reasonably determined from government data is the value of supplements to wages and salaries (i.e., employer contributions for employee pension and insurance funds and government social insurance). Based on data for Washington published by the U.S. Bureau of Economic Analysis, the estimate of the average wages and salaries of Amazon employees should be raised by 22 percent to $244,000 in order to take into account supplements to wages and salaries. Note that this estimate of personal income is still conservative, since it excludes other components of personal income, such as personal interest, dividend payments, and rent, which cannot be readily estimated for Amazon employees. In the 2018 edition of Who Pays?, ITEP’s estimates indicate that, lacking an income tax, the state and local tax burden on Washington families earning $244,000 per year—the average personal income of an Amazon employee—is only 6.4 percent. Thus, the average subsidy to Amazon employees because of their lighter tax burden is 4.0 (=10.4-6.4) percent of their personal income or $9,760 (=0.040x244,000) per year. The total annual subsidy to Amazon’s 53,000 employees amounts to an estimated $517 million (=9,760x53,000). The annual subsidy, which is in the form of foregone tax revenue to Washington state and local governments, is substantial. In only six years it would accumulate to more than $3 billion, the one-time subsidy that New York City refused to pay for a second Amazon headquarters. The subsidy is also unjust, since it is predicated on what ITEP calls the most unfair state and local tax system in the nation. While Amazon employees pay only 6.4 percent of their income on taxes, the poorest 20 percent of Washington families (those earning less than $24,000 per year) pay 17.8 percent. This means that the lowest income families have to work 9.3 weeks out of the year to pay their state and local tax bill, while Amazon employees have to work only 3.3 weeks. Amazon employees are not the only members of the Washington workforce benefitting from a regressive tax system. Preliminary data from ESD indicates that the software publishing industry engaged 68,000 employees who earned on average $260,000 in wages and salaries in 2019. Raising the personal income estimate to $317,000 per worker to account for supplements to wages and salaries and recognizing that the effective tax rate drops to 5.6 percent at that income level because of Washington’s regressive tax system, the estimated total subsidy to software publishing employees amounts to $1,035 million. Combined with the Amazon subsidy, the total subsidy to these high-wage tech workers approaches $1.6 billion per year. It should be noted that the above estimate of the Amazon subsidy is an approximation. If the calculation of employee personal income had included personal interest, dividend payments, and rent, the estimate would have been higher. On the other hand, if the calculation had taken into account the state and local taxes paid directly by the company—business and occupation tax, 5 property tax, sales tax, and other taxes—the estimate of the Amazon subsidy would have been lower. Whatever the subsidy, it raises an important question: how would Amazon react to the loss of the subsidy? For example, if Washington adopted a single-rate 10.4 percent personal income tax with no other taxes, eliminating the regressivity of the current tax system, would the financial consequences for Amazon cause it to alter its operations in the state? While the answer to this question is unknown, the answer to a related question provides a clue. In deciding where to locate HQ2, was Amazon attracted to New York and Virginia, the two finalists, because of their favorable tax climates? The answer is clearly no in the case of New York, which is notorious for its high taxes. In FY 2017, the New York state and local effective tax rate was 14.4 percent, well above the 10.4 percent national norm. At the same time, New York has one of the fairest tax systems in the nation. While Washington tops the list of the most regressive states, New York is ranked forty-fourth by ITEP. State and local tax burdens in New York for the poorest and richest families are virtually equal, 11.4 percent and 11.3 percent, respectively. Due to high taxes and a flat-rate tax structure, the state and local tax rate for a New York family earning $244,000 per year is 12.4 percent, according to ITEP data, nearly twice the 6.4 percent rate for a comparable family in Washington. This is likely one reason why Amazon wanted a $3 billion up-front subsidy to locate in New York City. From a tax standpoint, Virginia is a better deal. With an 8.9 percent effective tax rate, it is a lowtax state like Washington (refer to the next comment). Unlike Washington, however, Virginia has a relatively fair tax structure. Ranked thirty-third on ITEP’s list of most regressive states, the tax rates for the lowest and highest income families are 9.8 percent and 7.0 percent, respectively. For a family earning $244,000, the tax rate is 8.3 percent, appreciably higher than the corresponding Washington rate. The fact that Amazon was willing to locate HQ2 in states with employee tax burdens significantly greater than Washington’s suggests that Washington could impose a single-rate 10.4 percent personal income tax, negating the need for all other taxes, with little consequence. If Amazon chose to fully compensate its Washington workforce for a hike in the state and local tax rate from 6.4 percent to 10.4 percent, it would have to boost pay by 4.4 percent. If employee compensation accounted for one-half of the company’s operating costs—the actual share, though not known, is probably less—the total cost of operation would increase just 2.2 percent. Considering that the company itself would pay no state and local taxes under the new tax system, the impact on total operating costs would be even less. 4. The Washington sales-based tax system is inadequate, as it does not generate sufficient revenue to meet the public needs (e.g., education and infrastructure) of a growing economy without constantly increasing tax rates or expanding the tax base. Inadequacy is perhaps the most critical characteristic of the Washington state and local tax system. If tax revenue fails to keep up with the demand for public goods and services, it eventually becomes necessary to increase tax rates or expand the tax base. In a sales-based tax system like Washington’s, this makes the tax system even more unfair. Adequacy raises a question at the core of the debate over taxes: how much should government tax? Given that this is a value-laden issue, it is better to ask: how much does government tax? Or, how much are citizens willing to be taxed? 6 Since FY 1970 total tax revenue for all state and local governments in the United States has averaged 10.4 percent of personal income ($104 per $1,000 of personal income), according to data from the U.S. Bureau of the Census (Census) and the U.S. Bureau of Economic Analysis (BEA). Moreover, the state and local effective tax rate nationwide has been very stable over time, ranging from a low of 9.8 percent in FY 1982 to a high of 11.2 percent in FY 1973. During the Great Recession, the rate never fell below 10.1 percent. The existence of a stable long-term norm for the state and local effective tax rate has implications for Washington tax policy. (1) Washington’s state and local effective tax rate should average about 10.4 percent of personal income. (2) The state and local tax structure should be designed such that tax revenue grows with personal income, thereby maintaining the desired effective tax rate without raising tax rates or broadening the tax base. (3) Any tax change proposal should include an explicit estimate of its impact on the effective tax rate. WASHINGTON AND U.S. STATE AND LOCAL EFFECTIVE TAX RATES, FY 1987-FY 2017 Taxes Revenue as Percent of Personal Income FY 1987 FY 1992 FY 1995 FY 1997 FY 2002 FY 2007 FY 2009 FY 2012 FY 2015 FY 2017 Washington Effective Tax Rate U.S. Effective Rate Washington Rank 10.64 10.82 11.36 10.92 9.76 10.31 9.51 9.30 9.07 9.43 10.64 10.67 10.80 10.61 10.00 10.97 10.50 10.17 10.24 10.18 19 16 11 13 28 31 37 36 38 30 How has the Washington state and local effective tax rate behaved relative to the national norm over time? The answer is poorly, since Washington has had one of the most inadequate tax systems in the nation over the past twenty years. In FY 1995, due to a strong economy, the Washington state and local effective tax rate peaked at 11.4 percent. It was well above the 10.4 percent historical norm and the 10.8 percent average for all states in that year. The Washington effective tax rate was the eleventh highest in the nation. By FY 2002, however, the effective tax rate had fallen to 9.8 percent, below the 10.4 percent norm and the 10.0 percent nationwide average at that time. The effective tax rate ranked twentyeighth highest in the nation, a decline of seventeen places in just seven years (refer to the next comment for the reason). Since FY 2002 Washington’s effective tax rate has stayed well below the norm and the average for all states. After bottoming out at 9.1 percent in FY 2015, the effective tax rate rebounded to 9.4 percent in FY 2017, the latest year for which there is an estimate. If the effective tax rate had equaled the 10.4 percent national norm, Washington state and local governments would have collected an additional $4.1 billion in tax revenue in FY 2017. From FY 2002 to FY 2017, 7 Washington forfeited a total of $39.9 billion in state and local taxes due to its low effective tax rate. Inadequacy is a permanent fixture of the current Washington state and local tax system, as evident by the historical path of taxable retail sales, the state’s largest source of tax revenue. Taxable retail sales more than tripled between FY 1990 and FY 2017, increasing from $47.2 billion to $150.0 billion. As a percent of Washington personal income, however, taxable retail sales plummeted from 49.9 percent to 35.6 percent. If taxable retail sales had been an adequate tax base—had remained at 49.9 percent of personal income—it would have totaled $210.0 billion in FY 2017. Based on the 6.5 percent state sales tax rate, that in turn would have yielded an additional $3.9 billion in sales taxes for state government in FY 2017. 5. Due to Initiative 601, the inadequacy of the state and local tax system, and the Great Recession, Washington spending for elementary and secondary education per $1,000 of personal income dropped from slightly above the national average in FY 1992 to well below in FY 2017. Education is the most important function of state and local governments. Nationally, about one third of state and local general expenditures is devoted to primary, secondary, and higher education. Washington has had great difficulty providing sufficient financial support for education. Because of the inadequacy of its tax system and a reluctance to increase taxes to compensate for it, tax revenue has often fallen below what is required “to make ample provision for the education of all children.” 1889 WASHINGTON CONSTITUTION Article IX, Section 1 It is the paramount duty of the state to make ample provision for the education of all children residing within its borders, without distinction or preference on account of race, color, caste, or sex. Washington’s struggle to amply fund K-12 education is a decades-old problem. In 1978, after two local tax levy attempts went down to defeat, Seattle School District v. State claimed that the state had failed in its “paramount duty…to make ample provision for the education of its resident children.” A superior court judgement affirmed by the Washington State Supreme Court declared: (1) Seattle School District children had a constitutional right to an adequately funded education; (2) the Legislature is required to fund a basic program of education; and (3) the state’s reliance on special levies is unconstitutional. While the Court asserted its right to define “ample education,” it deferred to the Legislature to find a solution. In 1977, the Legislature developed a working definition of “basic education” and gave a substantial boost to funding. In the ensuing years, along with continually adding to the budget for public schools, the legislators worked on a program of education to develop more precise academic objectives and actions to attain them. Throughout the 1980s, Washington current expenditures for elementary and secondary education per $1,000 of personal income stuck fairly close to the national average, according to Census and BEA data. In FY 1992, Washington’s rate of spending not only exceeded the national average ($44.07 versus $43.68) but also established a modern high for the state. [Note that the basis for comparing K-12 spending across the fifty states is “per $1,000 of personal income” rather than “per student,” since the latter does not reflect differences in the states’ cost of living.] 8 Unfortunately, FY 1992 also marked a major turning point for Washington K-12 spending because of 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 two decades, even as the Washington effective tax rate fell significantly below the 10.4 percent national norm. Despite the attempt by I-601 backers to constrain the growth of taxes, state and local tax revenue continued to surge in FY 1994 and FY 1995 because of the economy’s robust recovery from the 1991 recession. However, after peaking at 11.4 percent in FY 1995, the Washington effective tax rate began to slide. As legislators failed to muster enough votes to raise taxes to counteract the inadequacy of the sales-based tax system, the Washington effective tax rate plummeted for two decades before bottoming out at 9.1 percent in FY 2015. The tumbling effective tax rate in turn had a detrimental effect on Washington public schools. So-called current spending for 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 13.1 percent below the average ($32.57 versus $37.46) in FY 2017. Only eight states spent less than Washington on K-12 education in FY 2017, the latest year for reported data. In that year, Washington spent a total of $13.2 billion on basic education, implying that it would have taken another $2.0 billion to lift current spending per $1,000 of income up to the national average. WASHINGTON AND U.S. PUBLIC ELEMENTARY AND SECONDARY SCHOOL SPENDING, FY 1987-FY 2017 Dollars Per $1,000 of Personal Income FY 1987 FY 1992 FY 1995 FY 1997 FY 2002 FY 2007 FY 2009 FY 2012 FY 2015 FY 2017 Washington School Spending U.S. School Spending Washington Rank 41.14 44.07 42.79 39.36 36.30 34.98 34.46 33.22 32.37 32.57 42.92 43.68 42.90 41.32 42.10 43.02 41.29 39.30 37.97 37.46 36 32 33 34 46 48 46 46 44 42 In 2007, as Washington public school spending dropped to the third lowest in the nation, Mathew McCleary et. v. State of Washington attempted to speed up the process of increasing school funding. But the petition to implement meaningful reform could not have come at a worst time, as the Washington economy was about to fall victim to the Great Recession. Due to the volatility of the Washington tax system, state and local tax revenue, which had been growing at a rate of one billion dollars per year, fell from $28.6 billion in FY 2008 to $27.2 billion in FY 2009 and $27.1 billion in FY 2010 (refer to the next comment). Fearing a calamitous shortfall in revenue, Governor Gregoire proposed slashing $5 billion from the 201113 biennial state budget, which included cutting hundreds of million dollars from the allocation for public schools. She famously said, “I hate my budget because in some places I don’t even think it’s moral.” 9 In 2012, the Washington State Supreme Court upheld a trial court decision on McCleary, which demanded that the Legislature fully fund basic education as required by the state constitution. One year later, the Supreme Court declared I-601 unconstitutional, giving the Legislature a greater ability to raise taxes. Nevertheless, legislators delayed substantial improvement in public school funding until FY 2017. The foot-dragging was costly. By not spending at the national rate, Washington state and local governments short-changed public schools $20.0 billion over the ten years—almost a full generation of K-12 students—since the initial filing of McCleary. In FY 2017, as the fiscal impact of the Great Recession dissipated, the Legislature began a concerted effort to comply with the Supreme Court order. Legislators approved increases in property (state levy) taxes and retail sales taxes. Together, they were predicted to boost state tax revenue by an additional $2.1 billion in the 2017-19 biennium and another $3.3 billion in the 2019-21 biennium. As a consequence, state government spending for public schools rose from $20.2 billion in the 2015-17 biennium to $24.8 billion in the 2017-19 biennium. The current enacted operating budget calls for $29.3 billion in the 2019-21 biennium. On June 7, 2018, the Supreme Court declared the McCleary case against the Legislature done, announcing that the state had finally “complied with the court’s orders to fully implement its statutory program of basic education.” The Court acknowledged that the Legislature had more than doubled funding for public schools between 2012 and 2019. Despite the court settlement in 2018, the problem of financing public schools did not end there. Without an income tax, the Washington state and local tax system will remain inadequate, requiring endless tax hikes to support education and other public needs. If Washington continues to rely on property and retail sales taxes for new revenue, as it did in FY 2017, that will further aggravate its regressive tax system. 6. If a state draws significant tax revenue from consumer durable sales and new construction, as does Washington, its state and local tax system will be volatile. No state can escape economic cycles. Thus, no state has a perfectly stable state and local tax system. Even if its state and local effective tax rate remains constant, tax revenue will rise and fall with the cyclical movements of personal income. Some state and local tax systems, however, are more unstable than others due to the sensitivity of their effective tax rate to economic fluctuations. The variability of an effective tax rate depends upon the composition of the state and local tax base. If a state relies heavily on tax revenue from auto and other consumer durable sales as well as from residential and non-residential construction, the effective tax rate will be volatile. In contrast, a state with a personal income tax but no capital gains tax will have a fairly stable state and local tax system. The 2017 study of the Washington state and local tax system by this writer tested the stability of tax systems for each of the fifty states over a twenty-two-year period. The test covered three economic expansions (FY 1992-FY 2000, FY 2004-FY 2007, and FY 2010-FY 2014), two recessions (FY 2000-FY 2004 and FY 2007-FY 2010), and trend (FY 1992-FY 2014). Given that states have no control over economic cycles, the test of stability focuses on the variability of the effective tax rate. For purposes of comparison, a stability index is developed for each state in each time period. It is defined as the ratio of the absolute change in its state and local effective tax rate to the absolute change in the national rate (the average effective tax rate for all states). If the absolute change in the state’s effective tax rate equals the absolute change 10 in the national effective tax rate, the state’s stability index is 1.00. If the state experiences no change in its effective tax rate—that is, its tax rate is perfectly stable—the stability index is 0.00. One important finding of this test is that between FY 1992 and FY 2014 the Washington state and local effective tax rate declined from 10.87 percent to 9.38 percent, while the U.S. rate decreased from 10.69 percent to 10.36 percent. With a stability index of 4.52 (=1.49/0.33), Washington had the nation’s forty-second most stable—the eighth most unstable—state and local tax system over the twenty-two-year period because of its volatile and inadequate sales tax base. Perhaps more enlightening about the instability of the Washington tax system was its behavior during the Great Recession, which was caused by the collapse of the U.S. housing and financial markets. The impact of the downturn on state government tax revenue was not only severe but also enduring. Between FY 2007 and FY 2009, while current-dollar personal income increased 7.0 percent, rising from $267.2 billion to $285.8 billion, state government tax revenue decreased 9.2 percent, falling from $14.2 billion to $12.9 billion. This lowered the state government effective tax rate from 5.3 percent to 4.5 percent. By comparison, tax revenue for all state governments in the United States declined only 2.4 percent during that period. Because of a 7.7 percent rise in the cost of state and local government goods and services from inflation and a 3.1 percent increase in population, Washington real per capita state government tax revenue, measured in 2012 dollars, plummeted from $2,579 to $2,111 over the two-year period, an 18.1 percent plunge. WASHINGTON STATE GOVERNMENT GENERAL FUND TAX REVENUE, FY 2007-FY 2015 FY 2007 FY 2009 FY 2015 FY 2007-15 Percent Change 14.2 267.2 5.31 12.9 285.8 4.51 16.9 375.8 4.50 19.0 40.6 -15.3 Sales tax revenue (bils. $) State and local deflator (12=1.000) Population (thous.) Real per capita state tax revenue ($12) 14.2 0.858 6,416.2 2,579 12.9 0.924 6,614.8 2,111 16.9 1.058 7,109.3 2,247 19.0 23.3 10.8 -12.9 Personal income (bils. $) Personal consumption deflator (12=1.000) Population (thous.) Real per capita income ($12) 267.2 0.902 6,416.2 46,169 285.8 0.940 6,614.8 45,964 375.8 1.029 7,109.3 51,371 40.6 14.1 10.8 11.3 State tax revenue (bils. $) Personal income (bils. $) Effective tax rate (%) Washington state government tax revenue began to recover in FY 2010 and reached $16.9 billion in FY 2015. But the rebound did not impact the effective tax rate, which remained at 4.5 percent. Moreover, approximately one-third of the revenue gain during that time was due to non-economic enhancements, principally a consolidation of accounts, a tax amnesty program, and a temporary increase in the business and occupation tax for services. The non-economic changes added $1.7 billion to state government tax revenue in FY 2015. Thus, without the non- 11 economic enhancements, tax revenue in FY 2015 would have amounted to only $15.2 billion, implying an effective tax rate of 4.0 percent. Even with the enhancements, real per capita state government tax revenue hardly improved during the economic recovery, inching up from $2,111 in FY 2009 to $2,247 in FY 2015. As a consequence, the rally in tax revenue did little to recoup the earlier loss. On net, state government per capita tax revenue in 2012 dollars fell from $2,579 in FY 2007 to $2,247 in FY 2015, a 12.9 percent drop. In other words, on a per capita basis, the real purchasing power of state government tax revenue—the ability to provide public goods and services (education, safety, healthcare, and infrastructure) for Washington’s people and businesses—declined by oneeighth over the eight-year period. It is illuminating to consider how state government finances would have fared had tax revenue been tied to personal income. Accordingly, the state government effective tax rate would have remained at 5.3 percent throughout the period, which would have led to $15.2 billion in tax revenue in FY 2009 and $20.0 billion in FY 2015. As a consequence, rather than incurring a 12.9 percent loss over the eight-year period, real per capita state government tax revenue would have experienced a 2.9 percent gain, rising from $2,579 to $2,653. 7. Taxes should be transparent if Washington is to have a rational tax system. As a KUOW reporter discovered, Washington taxes are far from transparent. The reporter asked two baristas how much they paid in state and local taxes. The barista in Oregon had a good idea, since that state has an income tax but no sales tax. The barista in Washington had no clue. Transparency is a basic tenet of a market economy. When transactions are not transparent, we are susceptible to Ponzi schemes and the financial shenanigans associated with subprime lending and mortgage-backed securities. More importantly, we place our economy in jeopardy, as evident by the Great Recession. Taxes should also be transparent. In 2002, the Washington State Tax Structure Study Committee stated that “households should be able to determine their overall annual state tax burden, including any taxes embodied in the prices of goods and services that they buy…The finding (of the study) is that a significant part of the Washington state tax system is not transparent to households.” Indeed, it is difficult to find anyone who has a good idea of their “personal state and local effective tax rate.” A test of transparency was conducted for the 2017 study of the Washington tax system. Based on five types of taxes (personal income tax, business tax, sales tax, property tax, and excise tax), it indicated that Washington had the second least transparent state and local tax system in the nation. Comparing the transparency of tax systems across states is a somewhat subjective exercise, requiring a “quantitative estimate” of the transparency for each type of tax. A state’s rank is determined by a “total transparency index,” which is defined as the weighted average of the transparency of each type of tax. The weights are equal to each tax’s share of total state and local tax revenue. A totally transparent tax system would have an index equal to 1.000. The personal income tax is totally transparent, as there is always a record of payment. Its transparency index is therefore 1.000. The sales tax transparency index is assigned a value of 0.500, because “most households are unaware of their annual sales tax burden,” as noted by the Washington State Tax Structure Study Committee. The business tax transparency index is given 12 a value of 0.400, since an input-output analysis suggests that businesses can pass on up to 60 percent their business and occupation taxes and corporate income taxes to households, government, and other businesses by raising the prices of their goods and services. The property tax transparency index, which is 0.700, presumes that residential and nonresidential property owners are aware of the property taxes they pay but renters are not. Finally, the transparency index for the excise tax is assumed to equal the sales tax transparency index. With a total transparency index of 0.767, Oregon had the nation’s most transparent tax system in FY 2014. This meant that its tax system on balance was 77 percent transparent. Its top ranking owes to a significant reliance on a personal income tax coupled with the absence of a sales tax. At the other end of the scale, only Nevada edged out Washington for having the least transparent tax system among the fifty states. The opaqueness of the Washington state and local tax system is attributable to the absence of an income tax and its dependence on sales and excise taxes. STATE AND LOCAL GOVERNMENT TAX SYSTEM TRANSPARENCY INDEX, FY 2014 Total Transparency = 1.000 Rank 1 2 3 48 49 50 Income Tax as Percent of Total Taxes Transparency Index 40.8 37.5 32.6 0.767 0.738 0.730 Tennessee Washington Nevada 1.2 0.0 0.0 0.554 0.550 0.549 United States 22.8 0.673 State Oregon Maryland Massachusetts 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 are my taxes? Is everyone paying his or her fair share of taxes? Is the tax system good or bad for the economy? Opaqueness could well be the main reason why Washington has not adopted a personal income tax. It precludes us from realizing the utter dysfunctionality of the current tax system 8. Does the absence of an income tax give the Washington economy a competitive advantage? There is no simple answer to this question. Obviously, Washington has created a favorable tax environment for high-wage companies like Amazon. This in turn has led to a robust economy since the Great Recession. But it is also clear that Washington’s sales-based tax system has real costs. It unfairly burdens low-income families while subsidizing high-wage tech workers. It also consistently fails to generate sufficient funding for basic education and other public services without having to raise contentious taxes. The literature regarding the relationship between taxes and economic vitality is inconclusive. Some economists argue that low taxes are the best way to promote job and income growth, while others contend that high-quality education, good roads, and a safe environment are necessary for 13 a strong economy. Regarding tax policy, the issue boils down to two questions: how much should we pay in taxes; and what type of taxes should be utilized? A central question in this debate is whether an income tax promotes or hinders economic growth. In 2016, the Tax Foundation ranked states according to their business tax climate, which was based on the use of five different taxes: personal income tax, corporate tax, sales tax, property tax, and unemployment insurance tax. States judged to have the best business tax climate made little or no use of an income tax. The top five states—Wyoming, South Dakota, Alaska, Florida, and Nevada—do not have a personal income tax. After being ranked sixth in earlier Tax Foundation studies because it did not levy an income tax, Washington fell to twelfth in the 2016 study for no apparent reason. But it is important to point out that, unlike Washington, most of the high-ranking states without an income tax have little need for one. Four of the five states with the best business tax climates have major alternative sources of tax revenue: severance taxes from resource extraction (Wyoming and Alaska) and tourist-related taxes (Nevada and Florida). Despite having the best business tax climate, there is no evidence that it has done the Wyoming economy much good. In terms of employment, Wyoming grew faster than the nation between1970 and 2015 (1.9 percent per year versus 1.4 percent) but added only 172,900 wage and salary jobs, just 0.3 percent of the total national gain. Furthermore, approximately one-half of Wyoming’s new jobs were directly or indirectly related to increased mining activity. BEST BUSINESS TAX CLIMATE AND EMPLOYMENT CHANGE Rank State 1970-15 Employment Change (thous.) Percent of U.S. Employment Change 1 2 3 4 5 Wyoming South Dakota Alaska Florida Nevada 172.9 232.7 233.3 5,910.8 1,065.6 0.3 0.3 0.3 8.6 1.5 12 Washington 2,079.5 3.0 46 47 48 49 50 Vermont Minnesota California New York New Jersey 152.1 1,520.2 9,280.2 1,834.9 1,261.2 0.2 2.2 13.5 2.7 1.8 68,841.0 100.0 United States Setting aside the fact that Washington is a tax-friendly haven for high-tech companies, one could argue that the lack of a personal income tax has always been a spur to economic growth in the state. With roughly two percent of the U.S. economy, Washington accounted for three percent of national employment growth between 1970 and 2015. But there are other, more compelling, explanations for Washington’s strong economy. One obvious reason is the export trade opportunities arising from Washington’s proximity to California, the nation’s largest economy, as well as to Asia, the world’s fastest growing region. 14 The Tax Foundation study in fact provides no evidence that a personal income tax either helps or hinders economic growth. As revealed by a simple statistical test, there is in fact no correlation (0.011) between a state’s business tax climate ranking and its ability to generate jobs. Illustrating the lack of correlation, with the third worst business tax climate because of its substantial reliance on an income tax, California created 9,280,200 payroll jobs—more than one out of every eight new jobs in the nation—between 1970 and 2015. Additional evidence related to how an income tax affects economic growth can be found “next door.” Washington and Oregon are a curiosity in the tax world, as there is no other pair of geographically adjacent states with more different tax systems. Washington has no income tax, while Oregon has an income tax but no sales tax. Despite fundamentally different tax structures, the Washington and Oregon economies have both performed well over the past fifty years, growing significantly faster than the nation since 1970. In terms of jobs, Washington has marginally outpaced Oregon, 2.2 percent versus 2.0 percent annually. By comparison, U.S. employment increased at only a 1.4 percent rate. Washington has also experienced somewhat faster per capita income growth than Oregon, 5.7 percent versus 5.4 percent per year. WASHINGTON AND OREGON ECONOMIC GROWTH, 1970-2018 Average Annual Percent Change 1970 1995 2018 1970-95 1995-18 1970-18 Wage and salary employment (thous.) 1,282.1 Personal income (bils. $) 15.0 Per capita income ($) 4,400 Population (thous.) 3,417.4 2,547.6 134.1 24,475 5,481.0 3,613.0 467.4 62,026 7,535.6 2.8 9.2 7.1 1.9 1.5 5.6 4.1 1.4 2.2 7.4 5.7 1.7 1,486.8 72.2 22,663 3,184.4 1,993.4 213.1 50,843 4,190.7 2.7 8.9 7.1 1.7 1.3 4.8 3.6 1.2 2.0 6.9 5.4 1.5 Washington Oregon Wage and salary employment (thous.) 767.7 Personal income (bils. $) 8.5 Per capita income ($) 4,065 Population (thous.) 2,100.4 The differences in the growth rates of the two states are largely due to the emergence of highpaying jobs at Microsoft and Amazon in Washington. Excluding the economic impact of these two companies, the Washington employment and per capita income growth rates for 1970-18 decrease to 2.0 percent and 5.5 percent, respectively, more or less in line with the Oregon rates. Also noteworthy are the respective growth rates of the Washington and Oregon populations. Specifically, between 1970 and 2018, the difference in their population growth rates (0.2=1.7-1.5 percent) equaled the difference in their employment growth rates (0.2=2.2-2.0 percent). In other words, faster employment growth in Washington led to faster population growth. This reflects the fact that, in a mobile economy like the United States, people follow jobs. One unfortunate consequence of this relationship is that the rapid job growth in the Washington economy does not permanently lower its unemployment rate, since it triggers a migration of people into the state in search of jobs. Historically, despite strong employment growth, the Washington unemployment rate has averaged one percentage point above the U.S. rate. A 15 comparatively large number of workers engaged in seasonal activities (e.g., agriculture and forestry) as well as the attractiveness of Washington as a place to live (the “Mt. Rainier” factor) have been conjectured as reasons for the above-average jobless rate. In October 2019, following a prolonged period of relatively rapid growth, the Washington seasonally-adjusted unemployment rate was 4.5 percent, while the U.S. rate was 3.6 percent. While most people welcome economic growth, it can create problems. The latest surge in the Washington economy has put excessive pressure on the greater Seattle area housing market. This has led to soaring home prices and apartment rents, the movement of low and middleincome households out to the less expensive perimeter of the region, and massive traffic jams during commuting hours. When coupled with an inefficient tax system, the cost of the solving transportation problems—not to mention the expense of providing teachers, school rooms, and other public services for the new arrivals—is straining state and local government budgets. A common shortcoming of tax policy studies, like the one authored by the Tax Foundation, is the presumption that states with the lowest taxes will generate the most jobs. They fail to acknowledge that reduced tax revenue can mean a diminished ability to provide the kind and level of public goods and services needed to make a state a good place to live and operate a business. As evident by the nearly zero correlation between the business tax climate ranking of a state and its job creation, there is much more to economic development than low taxes or, for that matter, whether or not a state has an income tax. 9. If one tax is superior to all other taxes, why would Washington not use it? In the 2017 study of the Washington tax system, tests of the fifty state and local tax systems indicated that Washington ranked at or near the bottom in terms of fairness (50), adequacy (36), stability (42), and transparency (49). Its low rankings were attributable to the fact that Washington was one of only seven states without an income tax. The tests also found no evidence that an income tax adversely affected economic vitality. Thus, in terms of fairness, adequacy, stability, transparency, and economic vitality, a single-rate personal income tax with no other taxes would be vastly superior to Washington’s current tax system, which is arguably the worst in the nation. Fairness. A single-rate personal income tax would be fair, as it would eliminate the regressivity of the current state and local tax system. If the tax rate were 10.4 percent of personal income, every Washington household, no matter what its income, would have to work 5.4 weeks out of the year to pay its annual state and local tax bill. Some policymakers would prefer a progressive income tax, which would be unconstitutional under current law. But that legal hurdle could be side-stepped with a standard deduction, which would be lawful if it were the same for all households. Consider the tax impact on low and middle-income households of a $15,000 standard deduction. In 2018, Washington personal income, which amounted to $467.4 billion, would have yielded $48.6 billion in state and local taxes with a 10.4 personal income tax. However, by offering a $15,000 standard deduction to each of the 3.0 million Washington households, the tax base would have been trimmed by $45.0 billion to $422.4 billion, causing tax collections to decline by $4.7 billion to $43.9 billion. In order to maintain an effective tax rate of 10.4 percent, the national norm, it would have been necessary to elevate the personal income tax rate to 11.4 16 percent. With the smaller tax base, the 11.4 percent tax rate would have yielded the desired $48.6 billion in taxes. ITEP estimated that the average annual personal income of the 20 percent of Washington families with the lowest incomes was $13,500 in 2018. With a 17.8 percent tax rate under the current tax system, these families paid on average $2,403 in state and local taxes. With a 10.4 percent tax rate and no standard deduction, the average tax bill would have fallen to $1,404. With a $15,000 standard deduction, the lowest-income families would have paid nothing. The effective tax rate in the last case would have been zero. With a 12.4 percent tax rate under the current tax system and a $33,300 average income, the average tax bill for the next 20 percent of households was $4,129. With a 10.4 percent tax rate, it would have been $3,463. But with an 11.4 percent tax rate and a $15,000 standard deduction, it would have been $2,086. The effective tax rate in the last case would have been 6.3 percent. Adequacy. A 10.4 percent single-rate personal income tax would be perfectly adequate. With a 10.4 percent rate, there would be no need for a sales tax, a business and occupation tax, a property tax, or any other state and local tax. Being the average rate for state and local tax systems in the United States since 1970, the 10.4 percent rate would be neither too high nor too low. In the future, legislators would never have to raise tax rates or enhance the tax base in order to generate adequate revenue for the public sector. Stability. Apart from the ups and downs in tax revenue caused by the uncontrollable but relatively moderate fluctuations in personal income, a single-rate personal income tax system would be perfectly stable. Thus, tax revenue would be relatively easy to forecast, thereby facilitating the public planning process. Transparency. A single-rate personal income tax system would be completely transparent. Every household would know exactly how much it is paying in state and local taxes. As noted previously, a major impediment to tax reform in Washington is the opaqueness of the current tax system, precluding citizens from realizing how dysfunctional it is. Economic vitality. An income tax per se would not ensure economic vitality. At the same time, there is no evidence that an income tax would hinder economic growth and welfare. What is increasingly apparent in Washington is the mounting threat to the economy posed by its inadequate sales-based tax system, which short-changed public schools by a low effective tax rate for two decades. Unless the people of Washington are willing to tolerate a decline in the quantity and quality of public goods and services—education, transportation, safety—which would hardly be conducive to the long-run health of the state economy, there are two options: (1) continue to increase the tax rates or broaden the tax base of the current tax system, thereby exacerbating its unfairness; or (2) adopt a 10.4 personal income tax, which would guarantee adequate funding for the public sector with a fair tax system. Other benefits. There would be other benefits of a single-rate personal income tax: Simplicity. A single-rate personal income tax is the simplest tax structure possible, making it easy to understand and comply. Universality. Everyone earning personal income, whether it is wages and salaries or transfer payments, would pay taxes. Thus, every income earner would have “skin in the game.” 17 Government efficiency. A single-rate income tax system would be inexpensive to administer. It would greatly simplify the budgeting process by eliminating the need to argue over taxes, since tax revenue would always be adequate. Neutrality. A flat-rate personal income tax would eliminate the non-neutralities—taxes that cause individuals and firms to alter their economic decisions—in the current tax system. Examples of non-neutralities include the pyramiding of business and occupation taxes in the chain of industrial production and the non-uniform taxation of consumer goods and services. Tax harmony with bordering states. Without a Washington sales tax, there would be less incentive to shop out of state. Home ownership. Eliminating the property tax and the sales tax on new construction would increase the affordability of home ownership by hundreds of dollars per month. Income disparity. Eliminating the regressivity of the current state and local tax system would significantly reduce household income inequality, which has been a mounting problem nationally for decades. Geographical income disparity. The current tax system is regressive with respect to counties. A flat-rate income tax would shift some of the tax burden from low-income counties to highincome counties. Federal income tax deduction. If the $10,000 cap on the federal income tax deduction for state and local taxes (SALT) expires in 2025, Washington taxpayers would be able to take maximum advantage of the deduction, significantly reducing their federal income taxes. Selected References Conway, D “It’s Time for a State Income Tax,” Seattle Business Magazine, April 2017. Conway, RS Jr “Washington State and Local Tax System: Dysfunction & Reform,” 2017. Institute on Taxation & Economic Policy Who Pays?, 2018. Tax Foundation 2016 State Business Tax Climate Index, 2016. Thompson III, W “Demise of the Pygmy: Seattle School District No. 1 v. State,” University of Puget Sound Law Review, 1979. U.S. Bureau of Economic Analysis “National Income and Product Tables,” www.bea.gov. U.S. Bureau of Economic Analysis “Regional Economic Accounts,” www.bea.gov. U.S. Bureau of the Census “Government Finance Statistics,” www.census.gov. Washington State Economic and Revenue Forecast Council Washington State Economic and Revenue Forecast,” various issues. Washington State Tax Structure Study Committee Tax Alternatives for Washington State, 2002. Dick Conway Regional Economist Principal, Dick Conway & Associates, 1977-2018 Co-Publisher, The Puget Sound Economic Forecaster, 1993-2017 Member, Washington Governor’s Council of Economic Advisors, 1985-2018 Member, Washington State Tax Structure Study Committee, 2001-2002 February 5, 2020