Washington state’s sales-based tax system is badly out of balance

On most political maps, the state of Washington is colored blue. Yet, its state and local tax system is distinctly red.

In 2018, the Institute of Taxation & Economic Policy determined that Washington, lacking an income tax, had the most unfair state and local tax system in the nation. Strapped with a 17.8% average tax burden, the lowest-income families ($24,000 or less) had to work 9.3 weeks out of the year to pay their annual state and local taxes. With a 3.0% tax burden, the highest-income families ($545,900 or more) had to work only 1.6 weeks.

A second egregious characteristic of the Washington sales-based tax system is inadequacy, which is the failure of tax revenue to keep pace with the growth of personal income and the resultant demand for public goods and services. One consequence of inadequacy is the need to periodically increase tax rates or broaden the tax base. But this makes sales-based tax systems, like Washington’s, even more unfair.

Adequacy raises a question at the heart of the debate over taxes: How much should government tax? The effective tax rate (total tax revenue as a percent of personal income) for all state and local governments in the United States has averaged 10.4% and been quite stable since fiscal year 1970.

Due to the inadequacy of its sales-based tax system, Washington is a low-tax state. Enacted in 1993, Initiative 601 required a two-thirds vote of the Legislature to raise taxes. For 20 years, the supermajority rule thwarted tax increases that could have counteracted the inadequacy of the Washington tax system. Instead, the Washington state and local effective tax rate plummeted from 11.4% in FY 1995 (the eleventh highest in the nation) to 9.1% in FY 2015 (the thirty-eighth highest). By not taxing at the 10.4% national norm in FY 2015, Washington forfeited $4.9 billion in state and local tax revenue.

The tumbling effective tax rate had a detrimental effect on Washington public schools. Current spending for K-12 education per thousand dollars of personal income fell from slightly above the national average ($44.07 versus $43.68) in FY 1992 to 13.1% below ($32.57 versus $37.46) in FY 2017. In FY 2007, when Washington public school spending dropped to the third lowest in the nation, McCleary v. State of Washington petitioned to have the Legislature speed up full funding of basic education as required by the state constitution. In a costly delay for K-12 education, the issue was not resolved for another 10 years. By not spending at the national rate, Washington shortchanged its public schools $20  billion over the 10-year period.

The Washington tax system is now up against the COVID-19 recession, which is sorely testing its stability. At this point, there is no way of knowing how things will turn out, but revisiting the Great Recession provides a clue.

Officially, the Great Recession lasted from December 2007 to June 2009, but its adverse impact on Washington state and local tax revenue lingered well beyond that time. Because of the heavy reliance on cyclically sensitive sales taxes, the Washington effective tax rate steadily declined from 10.3% (close to the national norm) in FY 2007 to 9.1% (its lowest mark on record) in FY 2015. Meanwhile, real per capita state and local tax revenue — tax revenue adjusted for population and inflation — decreased 9.0% over the eight-year period. This meant that by FY 2015,  state and local governments had lost one-eleventh of their ability to provide public goods and services (e.g., education, health care and infrastructure) to the people of Washington.

Consider how Washington state and local governments would have fared during the Great Recession with a 10.4% single-rate personal income tax and no other taxes. In addition to being perfectly fair and adequate, the constant 10.4% effective tax rate would have generated about 9% more tax revenue ($24.6 billion) during the FY 2007-FY 2015 episode. Rather than incurring a 9.0% loss over the period, real per capita state and local tax revenue would have experienced a 2.9% gain.

The most disturbing finding about the Great Recession is the long-term decline of the Washington effective tax rate. If that were to occur during the COVID-19 recession, which threatens to be two or three times deeper, it would put state and local finances in an unprecedented bind.

Based on the historical record, a 10.4% flat-rate personal income tax with no other taxes would have outperformed the current Washington state and local tax system. Nevertheless, there is one often heard objection to a personal income tax system: It would not tax businesses. While there would be no direct tax levy, such as the Business & Occupation tax or a head tax, businesses would be subject to indirect taxation.

In 2019, there were 120,000 Washington tech workers earning on average $250,000 in personal income annually. Estimates from the Institute on Taxation & Economic Policy indicate that their average state and local tax burden was only 6.0% or $15,000 because of Washington’s regressive tax system. With a 10.4% personal income tax, the tax burden would increase to $26,000, resulting in an $11,000 income loss to tech workers. In order to hold on to its existing employees or to engage new workers, a high-tech company would likely have to pay an appreciable share of the $11,000 loss. If the Washington high-tech industry compensated its 120,000 employees for one-half of the lost income, the total cost to the industry — the indirect tax on the industry — would amount to $660 million.

Given its political leanings, why is Washington one of only seven states without an income tax? Some citizens believe that the issue was settled long ago. In 1932, 70% of Washington voters overwhelmingly 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.”

Others simply like the current tax system. One high-tech leader said that the lack of an income tax makes it easy for his company to recruit skilled workers to the state. He might have added that this is due to Washington’s extremely regressive tax system, which heavily subsidizes the take-home pay of his high-wage employees.

It seems that Washington is always on the hunt for a new tax, whether it is to raise revenue, correct the shortcomings of the current tax system, or influence personal behavior. But invariably, tax initiatives, even ones with good intentions, are turned down. In 2010, hoping to provide more money for education and health care while reducing the disparity in household tax burdens, Bill Gates Sr. proposed a 5% tax on individual earnings of more than $200,000. After businesses labeled Initiative 1098 a jobs killer, voters rejected it by a two-to-one margin. There was also the view that Initiative 1098 “picked on the rich,” a curious charge considering that the Washington tax system has always picked on the poor.

The city of Seattle is in the same boat with other state and local governments, desperately battling a fiscal crisis caused by the COVID-19 recession. Not surprisingly, shortly after repealing the $275 head tax, the Seattle City Council approved a new tax on big business. Companies with a total annual payroll in excess of $7 million are taxed based on the earnings of employees making more than $150,000 per year. Depending upon an employee’s pay, the tax rate ranges from 0.7% to 2.4%. The tax is expected to raise $200 million in the initial year.

Not for the first time, businesses are up in arms over a tax and threatening to leave town. But is this just a bluff? Consider these two calculations. First, as shown above, tech workers in the state effectively receive an $11,000 subsidy annually because of Washington’s regressive tax system. For the 120,000 tech workers statewide, many of whom are employed in Seattle, the total subsidy amounts to $1.3 billion per year. Second, if every employee in a company were subject to the 2.4% Seattle business tax rate, the highest rate, the total cost of labor to the company would increase 2.4%. If employee compensation constituted one-half of all costs to the company, its total operating costs would increase only 1.2% because of the new business tax.

It is doubtful that any company would pull up stakes under these circumstances. So why the uproar over the Seattle business tax? It is probably the fear that any new tax will open the door to a much-needed personal income tax.

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