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.

Exactly how do you close tax exemptions in Washington State?

There has been increased discussion in the halls of our capitol about the impact tax exemptions have on our state.  Previously, I talked in detail about just how much exemptions are costing our state and how many we have on the books.  Many have argued that it’s time to close some of those exemptions, or at least bring them under review.  Unfortunately, closing an exemption is more complicated that you might think.

The authority to levy a tax is clearly given in Article VII of Washington’s Constitution, which is aptly named Revenue and Taxation.  The complexities of this article and the authority given have been the subject of numerous debates and countless courts cases.  The debates have played out in the legislature, the Supreme Court, and the ballot.  To say that it is complicated is, well, an understatement.  However, its relevance is paramount in trying to understand just how to address the issue of exemptions.

To put it plainly, the Federal Government and the Washington State Legislature have the authority to manage our tax system, including modifying any existing exemptions.

However, a recent ballot initiative has impacted the legislature’s ability to manage Washington’s revenue system.  Initiative 1053 (led by initiative activist Tim Eyman) passed in November 2010 with over 63% voter approval.  This initiative re-instated a 2/3rds vote requirement in both houses of the Washington State Legislature to make any changes to our tax code.  This requirement was first introduced by I-601 in 1993 and was later reinstated by I-695 in 1999 and again by I-960 in 2007.  The 2/3rds requirement INCLUDES the closure of tax exemptions because it would require legislative action that would amend our tax code resulting in a net increase in revenue. 

The super-majority requirement has plagued reform advocates since it was first introduced.  There have been a number of attempts to mitigate the impact of these initiatives, including the introduction of a temporary increase in sales tax on certain retail items to a full legal challenge of I-1053 which is currently being reviewed by King County Superior Court.  The outcome of the legal challenge will have a big impact on the legislature’s ability to address or modify existing exemptions.  Until then, it’s going to take a supermajority in the legislature to close any of the 452 revenue generating tax exemptions.

BUT, there is another way.  The ballot.  Both I-960 and its predecessor I-1053 reinforce the power of the ballot by reinforcing the people’s right to petition their government.  An existing exemption could be closed by a simple majority vote of the people.  However, it’s important to realize just how difficult it can be to pass an initiative in Washington State.  To date, nearly 1,200 initiatives have been introduced and only 69 have successfully passed into law.

Bearing in mind the complications associated with the closure of tax exemptions, reform advocates should remain diligent in their efforts to bolster fairness in our tax code through the elimination of some outmoded exemptions.  However, the road to closure for tax exemptions is wrought with pitfalls and speed bumps.  When trying to address the fiscal crisis other more short term measures should be explored as well.  Those might include the introduction of mandatory reviews and sunsets of existing exemptions or greater scrutiny of any newly proposed or existing exemptions.  These are two options that are being explored which I will discuss in another post.

What are the costs of tax exemptions in Washington State?

According to a recent Department of Revenue report, there are 640 tax exemptions on the books in Washington State.  Of those, 452 would likely generate revenue if eliminated.  However, the bigger question is how much revenue is being lost through these exemptions?

Revenue advocates make the case that closing some exemptions would help to address the budget shortfalls that have plagued Washington since the start of the Great Recession.  Before getting into the weeds of that debate, we need to know just how much the 452 revenue-generating exemptions cost our state.

Exemptions are spread across our entire tax code and can be found in every type of tax applied by the state.  176 apply to the B&O tax, 151 are in sales tax collections, 63 are found in other business taxes, 35 apply to taxes in lieu of an excise tax, 21 in miscellaneous taxes, and 6 in property taxes.  In total, these 452 revenue-generating exemptions resulted in $29.3 billion in lost revenue in the 2011 – 2013 biennium.

To fully understand the $29.3 billion in lost revenue, we need to relate this amount to the big picture—the state’s full operating cost. According to the Washington Citizen’s Guide to the Budget, total expenditures for the 2009- 2011 biennium added up to $74.8 billion.  Of that amount, $26.7 billion was spent on human services, $17 billion on public schools, $10.5 billion on higher education, and $8 billion on transportation.  If viewed as an expenditure, exemptions outweighed any other categorical expenditure in the state.  Currently, exemptions represent approximately 39% of our state’s operating cost.       

Since the beginning of the Great Recession, the legislature has had to rip $10.5 billion from the state’s operating cost as a result of continued budget shortfalls.  These reductions have had a tremendous impact on how the state conducts its business and funds its core values.  Across the board reductions have resulted in increased tuition at our 2-year and 4-year colleges, decreased funding for k12 education (resulting in a legal challenge that was recently upheld by our state’s supreme court), the elimination of vital social service programs, and the delay of critical infrastructure improvements.

Viewed as a whole, exemptions add up to a huge bite out of our state’s operating budget.  Still, a knee-jerk decision to close loopholes could have larger unforeseen ripple effects in our economy.  Currently, these exemptions are not subject to regular and rigorous review, with some exemptions remaining on the books for over 50 years.  When entering into the debate over the closure of exemptions, it is important to not only know the impact that these exemptions have on our budget but to also conduct a full and careful review of proposed exemption eliminations. 

It is hard to argue that the closure of exemptions should not be considered in trying to address the current fiscal crisis in our state.  Even if only 10% of the exemptions were closed, it would result in $2.9 billion of additional funds that could be used to mitigate some of the recent devastating cuts experienced by critical public programs.    

There is something happening here

We are in the midst of a crisis.  Changes are taking place in our state and our nation that look to undermine the dream of prosperity that our culture is built upon.  The gap between the haves and have-nots is growing at an alarming rate.  Poverty is turning into a national epidemic.  Washington State is no exception with 13.4%, or approximately 880,000 of our friends and neighbors caught in the grips of poverty.

Measuring poverty is complicated.  A 2007 Office of Financial Management (OFM) report details the problems associated with gauging poverty.  Two common indicators of poverty are income and social service caseloads.  Measuring poverty by income is difficult because the cost of living (healthcare, transportation, food, housing, child care etc.) changes depending on location and family size.  Depending on the method of measurement, there are conflicting reports of the rates of poverty in relation to income, ranging from 13% to 22% (with some counties reaching as high as 33%).  One common thread among income measurements is that poverty in Washington is following national trends and is rising considerably as a result of the lingering recession.  

In relation to social service caseloads, the OFM Data Book, a comprehensive collection of vital statistics about Washington State, indicates that caseloads for social service programs have steadily climbed since 2004.  Over the past seven years, there has been a 122% increase in demand for public assistance programs that help those struggling with economic hardship.  This increase has outpaced population growth which has grown only 14%in the past decade. 

Perhaps most alarming is the impact that poverty is having on children—one of the most vulnerable portions of our population.  The proportion of children living in poverty is not aligned with the state wide average.  18% of Washington’s children are living in poverty, almost a full 5% above the statewide average.  This population has grown steadily since 2007 and has reached a decade-long high, with trends most likely continuing to increase.

However, policy decisions can be made to ensure that individuals are given opportunities to break free from the cycle of poverty.  Social service programs and education help families and individuals move out of poverty.  Unfortunately, these public programs have been hit hard by the Great Recession.  Budget decisions, compounded by Washington’s volatile tax system, have taken a huge bite out of the very programs and services that act as a ladder for those continuing to struggle with economic hardship.  Downward economic trends cannot be completely avoided, but by rebuilding our tax system we can ensure greater stability and consistency in funding for public programs.

State Supreme Court overturns 70% of Washington Voters

In a pivotal 1933 case, Culliton v. Chase, the Washington State Supreme Court handed down a decision that overturned an income tax initiative that was supported by 70% of Washington voters.  This decision forever changed the fate of a graduated income tax in Washington State.

After the overwhelming passage of Initiative  69 in 1932, income tax proponents were celebrating their victory and state officials were taking steps to start collecting the recently passed graduated income tax.  As tax forms were being printed and prepared for delivery to the public, two Seattle businessmen brought forth a case that challenged the income tax on grounds of its lack of uniformity.  As written, Initiative 69 introduced an income tax that had higher rates for higher income earners.

 

William M. Culliton, an insurance broker, and Earl McHale, owner of a chain of gas stations, with the support of other Seattle business owners and prominent attorneys, filed their suit in Thurston County Superior Court. This challenge was based on the uniformity provisions of Article VII, Section 1 of the state’s constitution.  These provisions prohibit the state from levying different rates of taxation on the same property.

Washington had a long-standing precedent that sought to ensure that all forms of property were taxed uniformly.  This can be found in the territorial tax code and was later incorporated into the state’s constitution.  The drafters of Washington’s Constitution were vague in their definition of property.  This was intentional and came to be understood as any taxable property, both real and personal.

The vague nature of the constitutional definition of property was the grounds on which the graduated income tax portion of Initiative 69 was struck down.  The court found that income is property.  As such, a tax that introduced different tax rates on different incomes violated the uniformity requirements of the constitution. 

This decision set a precedent that has haunted income tax efforts ever since. In the years following Cullion v. Chase, the state supreme court has struck down 3 additional attempts at introducing an income tax in Washington.  Income tax proponents have yet to build proposals able to pass constitutional muster because of the court’s original decision.

The social and political atmosphere of the 1930s was ripe for change and reform.  A climate of that magnitude has yet to come over Washington since.  While there have been many attempts to introduce an income tax in Washington, this supreme court decision almost 80 years ago unfortunately may have laid to rest any opportunities for a graduated income tax in Washington State.

---

 

Elasticity, more than just keeping your socks up

Elasticity - probably not something that you think of every day, but, it is a concept often used in economics and tax policy.  Unfortunately, the nuances of elasticity can be somewhat confusing.  To the best of my ability, I will try to make it a little more comprehendible.

Elasticity is a measure of how a tax system keeps up with changes in the economy.  It shows how tax revenues compare with the economy in good times, bad times, and over the long run.  An ideal tax system will keep pace with the economy and remain as steady as possible in both good times and bad.  If a tax system keeps pace with changes in the economy, then it is said to have good elasticity. Elasticity, or Short Run Elasticity (SRE) (as the 2002 Washington State Tax Structure Study calls it), measures the relationship between two economic factors.  More precisely, elasticity measures the percent change in one economic variable in relation to the changes in another economic variable.  Still with me? 

The goal of a well-designed tax structure is to have a 1 to 1 ratio in SRE. When one factor goes up, the other follows relatively closely, the same is true when one of the factors goes down.  Tax structures that are able to weather economic and business cycles without any drastic disproportionate changes in revenue are said to have good elasticity.   A tax system with a SRE ratio greater than one is volatile, subject to compounded fiscal crises.  In periods of economic expansion, tax revenues grow faster than the economy; in times of recession tax revenues shrink faster than the economy.

To try and put this in perspective, think of a roller coaster (I know, not the most comforting tax policy analogy, but it works).  A roller coaster has a number of cars to hold passengers.  Ideally, you want your economic activity (measured by personal or corporate income) and your revenue collections in the same car, so that when one goes up the other is right beside it.  If these two riders are generally instep, it is said that the system has good stability or elasticity.

Unfortunately, in Washington those two thrill seeking roller coaster riders are not in the same car, they are not even on the same ride.  In both the short and long term view, state revenue is not keeping pace with personal or corporate income.  This creates BIG problems when trying to plan and develop solid public programs like education, environmental protection, and infrastructure maintenance and development. 

http://www.eoionline.org/

One way to add elasticity to our tax code in Washington is to connect revenue collections to the major economic driver of the state—this has been done before in Washington.  The first time was before Washington’s statehood through the 1930s when Washington was a property tax state, and the economy was driven by agriculture.  The second time this was done was the shift to a consumption-driven sales tax that reflected Washington’s transition to a manufacturing economy.

As we transition further away from a consumption driven economy to an innovation driven economy we should make appropriate changes in our tax code to increase the elasticity and stability of funding streams used to fund core public programs and resources.  An introduction of an income tax would be one step towards greater stability and elasticity in Washington’s tax code.

What exactly is a tax loop hole anyway?

With so much heated rhetoric surrounding loopholes and the impact that they might be having on our tax code, it would be useful to spend some time getting at the heart of what a loophole, exemption, tax giveaway, or whatever you want to call it is.  For my purpose, I call it an exemption. However, a clear understanding in this department might make for more informed debate about the future of exemptions in Washington State. 

To date, there are 640 exemptions on the books in Washington.  Of those, 452 would likely increase revenue collections for core public programs if eliminated.  These exemptions can be found throughout the Revised Code of Washington (RCW).  The majority can be found in Title 82 and Title 84 of the RCW. 

Washington’s tax code has become riddled with exemptions.  So much so that in order to keep track of these exemptions and their complexity a full report must be written every 4 years by the state’s Department of Revenue detailing the presence of exemptions in our tax code.

These exemptions stand as a testament to our state’s changing culture and economy.  For example, RCW 84.39.010 provides for a property tax exemption for widows and widowers of U.S. Veterans. Another example is RCW 82.48.100, which provides an excise exemption for aircraft under specific circumstances. The list continues to a sum of 640 exemptions--452 of which would generate revenue if eliminated. 

After spending time with the list of exemptions, it becomes clear that this list is indicative of communal priorities.  Behind each of these exemptions, there was an influential voice that saw value in adding a specific exemption to our tax code.  A cynic would argue that these exemptions are the legacy of effective lobbying and special interest groups that cater to big business in the state.  An optimist would argue that these exemptions reflect the majority will of the tax paying public and were established through careful conversation and exploration.  Regardless of your perspective, it is hard to ignore the implicit values behind each of the 640 exemptions.

The property tax exemption for widowed spouses of veterans is a good reflection of a community that looks to honor and protect those that served.  The aircraft exemption is indicative of a set of priorities that includes the importance of business and ensuring that our state retains its competitive edge.  

Exemptions and their impact on our states revenue collections have battled with government efficiency for the center stage spot light during this recession in Washington State.  The exemptions debate has played out in the legislature, the courts, and the public through the initiative process.  Before entering into a tax reform discussion, background orientation will not only better inform debate, but may illuminate avenues for coping with future economic downturns.

Income tax initiative passes in Washington State!

Believe it or not, Washington voters once approved a people’s initiative to introduce a graduated income tax.  Not only did the initiative pass, but it won by a landslide, with over 70% approval.  However, it went on to be struck down by the courts and has been followed by 4 consecutive failed attempts to bring an income tax to Washington through the ballot. The People’s Initiative 69 was successful because of the blurring of the urban rural divide, dire economic realities, and a shifting domestic marketplace.  It was accompanied on the ballot by another tax reform initiative, People’s Initiative 64.  Initiative 69 was the first and only income tax initiative to pass in Washington State and set the stage for dramatic tax reform that culminated in the passage of the Revenue Act of 1935 (you can read more about the Revenue Act here), which remains as the blueprint for our current tax code.

Initiative 69 was placed on the ballot on November 8, 1932 and read as follows:

An Act relating to and requiring the payment of a graduated tax on the incomes of persons, firms, corporations, associations, joint stock companies and common law trusts, the proceeds there from to be placed in the state current school fund and other state funds, as a means of reducing or eliminating the annual tax on general property which now provides revenues for such funds; providing penalties for violation; and making an appropriation from the general fund of the state treasury for paying expenses of administration of the act.

There were a total of 5 initiatives on the ballot in 1932.   They represented a wide spread of populist interest addressing (in addition to tax reform) elections, campaigns, and alcohol consumption.

Initiative 69 sprang out of an anti-property tax sentiment that was spearheaded by advocates in the Washington Grange Association, including Charles Hodde, who worked diligently to gather the necessary signatures for placement on the ballot.  As its ballot description states, Initiative 69 was the direct result of an understanding that property tax alone was not going to fairly and adequately fund vital public programs - education being at the top of the list.  An overdependence on one revenue stream left rural Washingtonians feeling jilted as they saw their property tax bills continually raise. 

Supported by labor, agriculture, and education; initiative 69 earned 322,919 votes and won by a margin of almost 3:1! The success of this initiative is a key lesson in the importance of coalition building and working towards common interest.  Perhaps a glimpse backwards will give the bearing necessary to move forwards? 

Voter + I-64=40 Mills

The People’s Initiative 64 joined Initiative 69 on the 1932 ballot and was part of an initiative-driven-tax-reform effort that looked to diversify revenues and alleviate the burden of rising property taxes.  Initiative 64 introduced strict limits on property taxes in Washington and was the beginning of the eventual ballooning of the sales and B&O tax.

Derived from a palpable distaste for skyrocketing property tax bills, Initiative 64 placed limits on the amount of tax that could be levied by the state and local municipalities against an assessed property value.  Initiative 64 was a sister initiative to Initiative 69, serving as an important point of coalition between urban and rural income tax supporters.  By introducing a property tax limit, reform advocates were able to intercept concerns that the introduction of a new tax in Washington would not provide sure and certain relief in property tax burdens.
Initiative 64 introduced a 40-mill limit on property tax in Washington eliminating any non-market based growth in property tax collections.  As a result, the sales and use tax has increased 9 times since its introduction through The Revenue Act of 1935.  Having been on the ballot twice prior, Initiative 64 passed by a smaller margin then its counterpart, Initiative 69, getting 303,384 or 61% of the ballots cast.

By limiting the amount that could be levied in property taxes and the court’s ruling against the income tax portion of Initiative 69, Washington has come to rely heavily on its retail sales tax to fund critical services.  Of the three types of major taxation (property, excise, and income), only two are present in Washington, and one is subject to a cap, leaving the retail sales tax the only collection system that is open for growth.  As a result, we have seen a dramatic increase in sales tax in Washington since it was first introduced in 1935.  The state portion of the retail sales tax was introduced at 2% and has since increased to 6.5%. 

An over dependence on sales tax has resulted in Washington having one of the most regressive tax systems in the nation.  It places the largest tax burden, as a percentage of income, on those least able to pay.  Sales tax is driven by consumers, an over dependence on sales tax compounds economic downturns when consumer confidence is at its lowest.  Further, our economy has become more complex, it is growing increasingly difficult to effectively track and collect sales tax for online or digital purchases.  Washington is struggling with sales tax erosion that is the result of many factors.  If we are to thrive, we must address these factors to ensure that the quality of life remains high in Washington State. 

Dirt farmer and tax reform advocate

A self-proclaimed dirt farmer, Charles Hodde was an influential player in the development of Washington’s tax code.  He was dedicated to the public process and progressed from a grassroots organizer (working on tax reform and public power in initiatives), to state representative, to gubernatorial candidate, to agency director, and eventually, federal appointee.  A man of many hats, Hodde’s finger prints can be found all over the history of Washington’s tax code.


An examination of tax reform history in Washington without talking about Charles Hodde would be like putting together a puzzle with half the pieces missing.  Hodde was a part of the tax reform effort on nearly every front.  He started as an organizer for the Washington State Grange Association in which he contributed heavily to the filings of People’s Initiative 69 and People’s Initiative 64.  By walking and talking his way through Seattle, Hodde was able to promote the sister reform initiatives well enough to carry a victory throughout the whole area. 
Hodde’s influence on reform initiatives continued, and he went on to become a lobbyist for the Grange Association, which was one of the key backers in the income tax reform effort.  He was elected to the House of Representatives in 1937, and was elected to Speaker of the House in 1948.  This accomplishment earned him a hero’s welcome and parade in his home district.  Hodde speaks of the event:

[T]here’d never been a Speaker from a little cowtown. Well, that isn’t quite true, we had one from down in Garfield County way back in the twenties ... but when I took the bus from Spokane back to Colville, you never saw a more astonished little kid than I was when the bus was met by a band and a convertible. The citizens there loaded me on this convertible with my wife and my daughter, Dorothy was playing in the high school band and she marched along front. John [their son] rode with us, and I got a parade clear through Colville, a hometown hero (Hodde, 1986, p. 132).

Hodde held firmly to the need for reform to Washington’s tax code.  Many of the reasons that led him to champion reform still apply today.  Hodde understood that an adequate tax code must be applied fairly across income brackets, should not be too heavily dependent on any one form of revenue, and that each person should pay his/her share according to his/her means. Hodde built a near 60-year career in public service on these principles.  Contemporary reform advocates would do well to know their roots.

The Revenue act of 1935

The Revenue Act of 1935 is the origin of our contemporary tax code.  Passed by the legislature and signed into law by then Governor Clarence Daniel Martin, the act introduced dramatic tax reform.  With concerns about the stability of the previous revenue system, proponents of reform looked to develop a tax code that was in pace with the changing economy. The legislature at that time, had to wrestle with a dramatic economic downturn, a highly engaged citizenry, and a number of difficult state supreme court decisions. 

Governor Clarence Daniel Martin

Prior to the Revenue Act of 1935, Washington funded its core functions through property tax collections. Being that Washington was a predominately agricultural state, this provided the most reliable and consistent form of revenue.  However, this was proving inadequate, inequitable, and economically unsound as manufacturing increased and agriculture declined.

The notion of dysfunction in the state’s tax code carried far and wide and had largely populous support.  The reform discussion sprung from the successful passage of People’s Initiative 69 on November 8, 1932.  This initiative brought in sweeping revenue reform in Washington State, including a graduated income tax.  However, the initiative was challenged in court resulting in the removal of the income tax section.  As the economic situation continued to worsen, the legislature capitalized on the populous sentiment and put forth many of Initiative 69’s reforms in the legislative process.

The 1935 legislature introduced HB 237 with 17 titles and nearly 200 sections!  Within those titles were provisions for a B&O tax, a cigarette tax, a radio tax (that was vetoed at signing), a highly controversial sales tax, and much more.  In addition, the 1935 legislature introduced a second bill that instituted a graduated income tax with a 3% tax on all income over $4,000 and up to a 4% surtax on additional amounts. Reform proved to be difficult, creating more obvious divides between urban and rural communities. This divide played out in the legislature and discussions were difficult and controversial.

al. 

The income tax portion of the sweeping reform went on to be struck down by the Washington State Supreme Court because of its lack of uniformity (it wasn’t a flat tax), but other reform components still remain today. Only through intense and informed discussion was the Revenue Act of 1935 passed by the legislature.  Despite the difficulty of the discussion, the legislature and the people of Washington State pressed forward towards the changes that had to take place.

---