Capital gains tax alternative proposed

We’ve talked about how regressive Washington’s tax structure is and how people in higher income brackets contribute a smaller percentage of their money to funding public services.  One solution to this discrepancy was proposed by Representative Laurie Jenkins during the 2012 Legislative Session that would have helped to correct this imbalance. 

On February 29, 2012, Representative Jenkins, and 26 other Democrats, introduced House Bill 2563 - Establishing a state tax on capital gains – which would have applied a 5% tax on capital gains over $10,000 per year. For those of you who don’t know, capital gain is the profit from investing in capital assets (like stocks, bonds, or real estate), which exceeds the purchase price.  So if you buy a stock for $100, then sell it later for $150, you have a capital gain of $50.  It’s important to note that one of the exemptions for this tax removed any collection of capital gains from the sales of homes.  Also, the collection of this tax would mirror the federal model, which would make it easier for citizens during tax season.

It was projected that, if implemented, this bill would bring in over $1.4 billion during the 2013-15 fiscal biennium.  Also, 42 other states have a similar tax on capital gains, 31 of which are higher than the proposed 5% for Washington.  Representative Jenkins said,  “We should join 42 other states in making sure everyone pays their fair share for public schools and universities, prisons and parks. Capital gains is a big step toward tax reform and fairness.”  Lastly, according to the Washington State Budget and Policy Center, 96% of capital gains go to those with an annual income over $1 million.

This bill seems like a good way to even the tax burden in Washington. So, what happened? Two things killed the capital gains proposal. The first was time.  When this bill got it’s first hearing with the House Ways and Means Committee, it was day 52 of a 60-day legislative session and the cutoff for fiscal committee bills was two days earlier. This meant that Jenkins’ bill needed to be included in a proposed budget to survive, but this didn’t happen. The second thing that would have killed this proposal is Initiative 1053 and the supermajority requirement on the Legislature for any revenue increase.

It’s unfortunate that this bill fizzled in the legislature and with any luck it will progress further when lawmakers return to Olympia next year.  This was a good example of addressing our regressive structure without trying to implement an income tax.  It’s also a popular revenue source for a majority of states and the federal government.  If this concept is to survive the legislature or the initiative process, people will need to be more aware of the discrepancy in tax contributions for people with low and high levels of income. People who are better off enjoy capital gains without paying taxes at the state level. Others who are less fortunate shouldn’t have to give up a higher portion of their money to fund government.

Taxes and the Internet

Other posts about economic nexus and the use tax talked about how the Internet changed the way we interact and buy or sell goods and services. Electronic commerce is an emerging issue for states and local jurisdictions who deal with taxation of digital and out of state products. One of the main reasons governments haven’t had more dialogue on this issue is because of federal law.

The Internet Tax Freedom Act (IFTA) (Public Law105-277, Section 1100) was passed by Congress and signed by President Clinton in 1998. The purpose of the ITFA was to give the Internet some time to develop and to protect users from multiple and discriminatory taxation due to its decentralized architecture. The ITFA imposed a moratorium on state and local taxes for Internet access and banned multiple or discriminatory taxes on electronic commerce.  The law also created the Advisory Commission on Electronic Commerce, which analyzed Internet taxation and provided recommendations on dealing with this issue.

Two of these ideas included establishing “bright line” nexus standards for American businesses and placing the burden on states to simplify their own complicated telecommunications tax systems as well as sales and use tax systems to ease burdens on interstate commerce.  To address the issue of tax simplification, the National Governors’ Association and the National Conference of State Legislatures created the Streamlined Sales and Use Tax Agreement, which established a common set of definitions and tax laws regarding electronic commerce for government and businesses.  Currently, there are 24 states that have passed laws conforming to the agreement. Washington joined in July 2008 with the passage of Senate Bill 5089 - Conforming Washington's tax structure to the streamlined sales and use tax agreement.

Scott Peterson, Executive Director of the Streamlined Sales Tax Governing Board (Board), said that the consortium is recruiting mores states and seeking bill sponsors in Congress to create a national system for online sales tax collection and remittances. Remittance means sending the taxes collected to the jurisdiction of the buyer.  Businesses also like the agreement and 1,400 online retailers have volunteered to collect state sales tax. In return, Washington promises not to sue them for back taxes they might have owed.

While the Agreement is a step in the right direction, in order for there to be significant change the answer will need to come from the other Washington.  According to the Board, some studies estimate that states lose billions a year in uncollected sales tax and it could reach as much as $23 billion by this year.  Only Congress has the authority to let states require collection of this revenue.  The Agreement simplifies the complexity of this issue and as more states join, it applies pressure on Congress to act.

Unfortunately, in the current political climate in D.C. where lawmakers are willing to default on our nation’s debt for political purposes, change won’t come easy or quickly.  However, this change needs to happen. Even though the sales tax is regressive, it’s Washington’s primary source of revenue.  By fixing this issue it will help to modernize the state’s tax collection authority for a 21^st century economy.

What is a use tax? Is it effective?

According to the Department of Revenue (DOR), a use tax is a tax on the use of goods or certain services in Washington when sales tax has not been paid. Also, goods used in this state are subject to either sales or use tax, but not both. So the use tax compensates when sales tax has not been paid.

There are a few instances when you owe a use tax over a sales tax. If you buy something in another state that does not have a sales tax or a state with a sales tax lower than Washington’s, then you owe a use tax.  For example, if you buy something in Oregon that is used in Washington then you’re subject to the use tax.  The third option is if you buy something from someone who isn’t authorized to collect sales tax.  This happens if you buy something through a newspaper classified ad. Lastly, if goods are purchased by out of state by subscription, through the Internet, or from a mail order catalog company and they don’t collect Washington’s sales tax, you owe the use tax.

The use tax was created by the Revenue Act of 1935 (read Justin's entry about it here) along with a majority of Washington’s tax structure.   As we’ve discussed in other posts, this system reflects an economy from 80 years ago that doesn’t adequately collect taxes in today’s Washington.  According to the Economic and Revenue Forecast Council and DOR, about half of all online sales to Washington residents go untaxed. Rather, the tax isn’t collected although its payment is legally required in the form of an equivalent use tax.

A use tax is required when sales tax isn’t collected for online sales but it’s up to citizens to know when and how to pay.  How is this enforced? As we move to buying more goods online this gap will only continue to grow when there isn’t a sales tax being collected.  There’s an incentive for businesses to be on top of this due to DOR’s ability to audit them, but it’s highly unlikely DOR would audit citizens for online purchases from sites such as Craigslist. This would be expensive, hard to implement, and hard to enforce.

As it’s currently configured, the use tax isn’t an effective method for ensuring compliance when the sales tax isn’t collected.  However, the online sale of goods and services has changed the economy in a way that states can’t adequately adapt to.  A key reason for this is federal legislation about Internet taxation; we’ll talk about that next time.

What else can be done about exemptions in Washington State

In a previous post I touched on the number of tax exemptions  and the impact they have on our state’s budget.  I also mentioned some of the complications that arise when trying to close exemptions.  With the increasing number of exemptions on the books and the limitations on the legislature’s ability to close those exemptions, the big question remains: what can be done to mitigate the impact of these exemptions in Washington State?

One interesting proposal, introduced during the 2012 Legislative Session, came in the form of HB 2530, introduced by Seattle Democrat Rep. Reuven Carlyle.  This bill, if passed, would have placed a mandatory sunset (expiration) date for all newly established exemptions.  Every 10 years an exemption would expire if not reviewed and extended by the legislature.  This would require the legislature to review an exemption and take deliberate action to extend that exemption if deemed necessary. 

This legislative proposal was a breath of fresh air in the exemptions debate.  So much of the debate has been characterized by extremes—one side calling for the closure of exemptions and the other refusing to consider any changes to the list of exemptions.  This proposal sits right in the middle by calling for a regular review that is based on sound economic principles, a review that is automatically triggered by a sunset.  This trigger would not be avoidable and would require careful consideration no matter how unpopular that discussion may be. 

Unfortunately, the legislation did not pass into law, but it did garner some media attention and added another facet to the tax reform debate in Washington.  Both Rep. Reuven Carlyle and Rep. Chris Reykdal spoke about this debate on an episode of TVW’s inside Olympia.  (click here for full video). This proposal addressed long term reform and, as written, would not provide immediate relief for Washington’s budget woes.  In this respect, this proposal is doubly refreshing in that it addresses larger long term systemic problems in our tax code.  In tough economic times, it is easy to become consumed with immediate action that provides instant relief.

The problems with Washington’s revenue system spans decades.  An undue obsession with short term solutions only compounds the problem by leaving the larger system failures in place.  If we do not take the lessons learned from the Great Recession to heart by addressing the larger systemic problems in our tax code, we are kicking the can of reform onto the coming generations which may be hit harder by future recessions.  Short term steps must be taken, but long term reform (like that introduced by HB 2530) is necessary.

What is Economic Nexus

I’ve done a few posts on the B&O tax, but none of them have touched upon how Washington taxes businesses that aren’t located in our state but that still carry out transactions here. Before June 2010, the law said that businesses could only be taxed if they had a physical presence in the state where the transaction occurred. This is referred to as the physical nexus, which is based on a U.S. Supreme Court case Quill Corp. v. North Dakota (1992).  However, in the 20 years since this decision was heard, the Internet completely changed how businesses and people interact around the world.  It was time to update the tax code to reflect this evolution.

This change came in the form of SB 6143 - Modifying excise tax laws to preserve funding for public schools, colleges, and universities, as well as other public systems essential for the safety, health, and security of all Washingtonians – which expanded nexus rules to include businesses that have an economic nexus in Washington. Economic nexus applies to certain business classifications such as professional services, interest from loans, or royalties. If these businesses have more than $250,000 of gross income attributed to Washington then they don’t have to be physically in Washington to be subject to B&O taxes.  Most other business classifications, like retail and wholesale, are only subject to physical nexus rules.  The Department of Revenue has a tutorial that explains these differences in more detail.

As the bill title above shows, this change was implemented to save money for programs and services that were being reduced due to the Great Recession.  The Washington State Budget and Policy Center said that “under the physical presence nexus standard some businesses that benefit from Washington’s public structures – i.e. courts, roads, and other services that improve access to markets -- are not required to help pay for their maintenance.” Also, this update helped to level the playing field. In a message to the Tax Foundation (which opposed the measure), Representative Ross Hunter responded with:

I fail to see why a business located outside the state and performing services inside the state should be able to avoid paying taxes on their activity. When the B&O tax was created, the only way a business could perform a service for a customer was over a handshake. This clearly hasn't been true since Al Gore invented the Internet. Imagine two businesses are set up 50 miles from each other, but one is across the border in Oregon. They both perform services for customers in Washington State. Why would they have different tax treatment?

Even though they agreed to disagree, the Foundation brought up an interesting point: What should matter more, that all products face the same tax, or that state powers are limited and prevented from harming interstate commerce?  I think Washington was right to include economic nexus when taxing businesses.  The Internet has changed the variables of interstate commerce and how we communicate. It’s time our tax code reflected this fact.