Justices weigh legality of tax aimed at rebalancing state’s tax code

OLYMPIA — An effort to balance what is considered the nation’s most regressive state tax code came before the Washington Supreme Court on Thursday, with justices hearing arguments about whether they should overturn a prohibition on income taxes that dates back to the 1930s.

At issue was the legality of a 7% capital gains tax enacted in 2021 that would impact an estimated 7,000 people and raise close to half-a-billion dollars a year for education programs. The tax will be levied on the sale of stocks, bonds and other high-end assets, with exemptions for the first $250,000 each year and gains from sales of retirement accounts, real estate and certain small businesses.

Supporters have argued it is an excise tax, which is allowed under state law. Opponents, who filed suit, contend it is an income tax barred under the state constitution. In Washington, income is considered property and the state constitution requires uniform taxation on property, and this one is not, because it will not be applied to all individuals.

In Thursday’s hearing, an attorney noted that since the 1930s, Washington’s voters have rejected constitutional amendments or initiatives 10 times in favor of income taxes.

If Washington wants such a tax, “the way forward is to amend the Constitution,” former Republican Attorney General Rob McKenna argued on behalf of the challengers.

In defending the law, Solicitor General Noah Purcell argued “the fact that a transaction generates income does not make it an income tax.”

Washington is one of nine states without an income tax, and its heavy reliance on sales and fuel taxes to pay for schools, roads and other public expenses falls disproportionately on low-income residents.

They pay at least six times more in taxes as a percentage of household income than the wealthiest residents do, according to lawmakers, and middle-income residents pay two to four times as much.

Democrats in Olympia, led by Gov. Jay Inslee, sought to begin addressing that in 2021 when they enacted the capital gains tax.

It was expected to be paid by 7,000 people — fewer than 1 in every 1,000 residents — and to bring in close to a half-billion dollars a year to help pay for public education in Washington. But it faces a legal challenge from wealthy residents and business and agricultural organizations, who say it violates the state and federal constitutions and makes for bad policy to boot.

“Washington’s unique, unprecedented and unconstitutional tax on capital gains will discourage our state’s resident entrepreneurs and investors from investing in new and expanded businesses in our state,” the Building Industry Association of Washington and Washington Retail Association wrote in a friend-of-the-court brief. “It will also cause significant numbers of individual business owners to leave Washington to avoid the new tax.”

Among the key issues during Thursday’s hourlong arguments before the justices was whether the new tax is, as the state insists, an excise tax — broadly defined as a tax on certain goods, services or activities — or an income tax, which the court long ago held unconstitutional in Washington.

Voters overwhelmingly passed a graduated income tax in 1932. But in a 5-4 decision the following year, the state Supreme Court struck it down, ruling that a tax on income was a tax on property — and the state Constitution says property taxes must be uniform and limited to 1% per year.

Last year, Douglas County Superior Court Judge Brian Huber in central Washington sided with those challenging the capital gains tax as a forbidden income tax. Democratic Attorney General Bob Ferguson appealed, saying Huber got it wrong because the tax is not on property — it’s on what an owner does with that property by selling it.

The Edmonds School District and Washington Education Association, which intervened in the case on behalf of the state, said it agreed that the capital gains tax is an excise tax. But, they said, if the justices disagree and find that it is an income tax, then they should overturn their nearly century-old holding that an income tax is a tax on property.

Unlike property, income isn’t something that is owned and can be sold, their lawyers wrote: “This Court’s cases holding that an income tax is a property tax were wrong when decided and they are wrong now.”

The arguments came as progressives are making a push in several states to have the rich pay more in taxes. Bills announced this month in California, New York, Illinois, Hawaii, Maryland, Minnesota, Washington and Connecticut all revolve around the idea that the richest Americans need to pay more. But the proposals all face questionable prospects.

Those challenging Washington’s capital gains tax argue the state’s labeling of the capital gains tax as an excise tax is merely designed to conceal its true nature as an income tax.

The challengers also say it might apply even if the taxpayer takes no action to generate their gains — in other words, they are taxed simply because they own the asset. A Washington resident who owns shares in an out-of-state company might benefit if the board of directors decides to sell major assets, with revenue passed on to shareholders.

That’s no different from the state’s inheritance tax, which the court has upheld, Washington Solicitor General Noah Purcell argued. People can owe that excise tax simply by receiving money from someone who died out of state, he said.

Some 41 states that tax capital gains tax it as income. Seven other states have no income taxes at all: Alaska, Florida, Nevada, South Dakota, Tennessee, Texas and Wyoming. New Hampshire taxes only dividends and interest income earned by individual taxpayers.

It wasn’t clear how soon the justices might rule. The court is allowing the state to collect the tax beginning in April pending a decision, but Purcell urged them to issue a ruling quickly so the Legislature, which is in session, knows whether it can spend the money in the state’s next two-year budget.

Herald reporter Jerry Cornfield contributed to this report.