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Washington: Gov. Inslee proposes controversial—and perhaps unconstitutional—seven percent tax on some capital gains

By law, the governor of Washington is required to propose a biennial budget in December, the month before the legislature convenes in regular session. With his state facing an “enormous budget challenge,” Gov. Jay Robert Inslee proposed a $39 billion budget plan hoping to spur the state’s slow but steady recovery from the worst recession since World War II.

Gov. Inslee’s proposal incorporates tax and revenue changes that are projected to raise about $1.4 billion during the 2015-17 biennium. A controversial component, which is expected to raise $798 million in fiscal year 2017, is a new seven percent capital gains tax on the sale of stocks, bonds, and other assets. This tax would apply to earnings above $25,000 for individuals and $50,000 for joint filers, starting in the second year of the biennium. Because it taxes investment income, it would have the greatest impact on Washington’s wealthiest taxpayers by increasing their effective state tax rates. The proposal exempts capital gains earned on retirement accounts, homes, farms, and forestry.

Other provisions of the governor’s plan would:

  • Increase the state cigarette tax by 50 cents per pack, and start taxing e-cigarettes and vapor products, which together will raise about $56 million;
  • Include $380 million in new revenue attributable to the governor’s market-based carbon pollution reduction plan; and
  • Repeal five tax breaks, resulting in approximately $282 million in additional revenue during the biennium. The applicable tax breaks are:
    • The sales tax exemption for trade-ins over $10,000;
    • The use tax exemption for extracted fuel, except hog fuel;
    • Sales tax exemption on bottled water;
    • The preferential business and occupational tax for royalties; and
    • Refunding the state portion of sales taxes to non-residents.

The capital gains tax plan is controversial because it is an unreliable revenue generator, and may present questions of constitutionality. In its assessment, the Washington Policy Center (Center) notes that capital gains are considered income, even though Gov. Inslee presents the seven percent tax increase as an excise tax. The Center points to the fact that Washington’s Supreme Court has repeatedly concluded that “income” is property, and the state’s constitution provides that property cannot be taxed at a rate greater than one percent. This concern is evident in the fiscal note to the legislation which predicts that “up to five Superior Court actions will be filed challenging the constitutionality of the capital gains tax” after Jan. 1, 2016.

Regarding the unreliability of such a tax, the Center cited the volatile history of capital gains taxes in other states that do not provide a very solid, fiscally sound, secure, and stable way of financing ongoing government services.

What’s more, the Tax Foundation reveals that large swings in capital gains are not uncommon. For example, in 1987 and 2001, they dropped 55 percent and 46 percent, respectively. Further, in the two-year period encompassing 2007-2009, capital gains plummeted by 71 percent.

Because these fluctuations are not uncommon, some experts, including those at the Rockefeller Institute and the Federal Reserve Bank of Boston, consider taxing capital gains to be particularly risky as a tax base. The Tax Foundation contends that it is the “lead culprit behind state revenue forecasting errors.”

The Federal Reserve Bank of Boston identified another reliability related problem: “[t]he cyclicality of capital gains tends to have a disproportionate effect on state income tax revenues compared to other sources of taxable income because capital gains are more concentrated in the top tax brackets.”

The Seattle Times reported that state democrats like the idea of a tax that impacts only wealthy taxpayers. In particular, Sen. Kevin Ranker (D-Orcas Island) told of a light bulb going off in his head because of the “eye-popping” cash that could be raised while only taxing a tiny fraction of the taxpayers. Sen. Ranker believes this to be a thoughtful way to raise revenue.

California: Gov. Brown creates the state’s first-ever earned income tax credit using the surge in general revenue funds

Last week, Gov. Jerry Brown released his 2015-16 May Revision (Revision), which revealed that increased capital gains and other income from high wage earners have strengthened California’s economy and driven increased revenues. Overall, the Revision reflects a $6.7 billion increase in general fund revenues as compared to what was budgeted.

Through the end of April, cash tax receipts are up a net amount of about $3.2 billion. This cash data suggests that personal income tax receipts are up approximately $2.7 billion, corporation tax receipts are up almost $250 million, and sales and use tax receipts are up $230 million.

The state constitution requires a portion of the $6.7 billion surge to be utilized as follows:

  • $5.5 billion for K 12 schools and community colleges as directed by Proposition 98;
  • $633 million for the Rainy Day Fund; plus
  • An additional $633 million to be used to pay down debts and liabilities, as directed in Proposition 2.

The majority of the remaining surge funds, about $380 million, will be used toward a first-ever earned income tax credit for California’s low-income workers, which is expected to benefit approximately two million people. In addition, some funds will go toward an unspecified increase in California State University funding and temporary assistance to the University of California to pay down its unfunded pension liability. These measures will allow undergraduate tuition at the state’s universities to remain flat. Finally, some of the surge funds will go toward providing healthcare and other services to undocumented immigrants who gain Permanent Residence Under Color of Law status.

In a press release, Gov. Brown acknowledged his ongoing efforts to combat poverty, noting that the earned income tax credit builds on his previous actions to expand Medi-Cal healthcare coverage, raise the minimum wage, extend paid sick leave to millions of Californians, expand California Work Opportunity and Responsibility to Kids (CalWORKs) program grants, and direct billions more in funding to students with the greatest needs.

Californians with incomes of less than $6,580 and no dependents, or $13,870 with three or more dependents, will benefit from the new earned income tax credit. The average household benefit will be about $460, with a maximum benefit of $2,653.

Despite Gov. Brown’s ongoing efforts, KPCC reported that the earned income tax credit is a response to those who accuse Gov. Brown of not doing enough for the state’s poor. Gov. Brown stated, “It's just a straight deliverance of funding to people who are working very hard and are earning very little money so in that sense I think it does a lot of good things."

Maryland: Tax credit for oyster shell recycling increases five-fold

Lawmakers in Maryland recently passed Senate Bill 694, which increases the tax credit that an individual or corporation may claim from $1 to $5 for each bushel of oyster shells—about 45-60 pounds, or 100-150 oysters—recycled during the taxable year, up to the lesser of $750 or the state income tax calculated. The increase is effective July 1, 2015, and applies to all taxable years beginning after Dec. 31, 2014.

Why oysters? According to the Oyster Recovery Partnership (Partnership) they are a “keystone species,” providing habitat for important marine life, and serving as the “kidneys of the 18 trillion gallon Chesapeake Bay by filtering silt, sediment, and nitrates from the water.” The Partnership brags that “the simple act of eating makes oysters Chesapeake Bay’s most effective water filtration system,” because they are capable of pumping and straining up to 2 gallons of water per hour. Unfortunately, the bay’s oyster population has been decimated.

The Chesapeake Bay Foundation (CBF) reveals that recycling oyster shells is important for the restoration of native oysters in Chesapeake Bay. The shells are becoming increasingly scarce, so recycling them by using them as homes for baby oysters, and then to build new oyster bars, helps replenish the population.

Chesapeake Bay itself is a critical resource, the largest of the 130 estuaries in the United States. It is home to 3,600 species of animals and plants, and two of the five major shipping ports in the North Atlantic region, Baltimore and Hampton Roads. But because the land used by nearly 17 million people drains into this one estuary, “the wildlife that depends on it is quite literally suffocating, causing economic resources to dwindle and recreational activities to be limited.”

All of this matters because there is an economic impact to letting the bay suffer. The CBF contends that the bay creates jobs and fosters economic growth in the several states that contain portions of the Chesapeake Bay. In particular:

  • Clean water can increase the value of a single-family home 4,000 feet or closer to the shoreline by up to 25 percent;
  • Improvements in water quality along Maryland's western shore to levels that meet state bacteria standards could raise property values by six percent;
  • Approximately 20,000 construction jobs are created by each $1 billion invested on water and wastewater projects;
  • The number of environmental industry jobs in Pennsylvania, Maryland, and Virginia has surged by 43 percent over the last two decades;
  • In Virginia, every $1 of state and federal funding invested in agricultural best management practices would generate $1.56 in economic activity;
  • 500 million pounds of seafood are harvested each year from Chesapeake Bay;   
  • The commercial seafood industry in Maryland and Virginia contributed $3.39 billion in sales, $890 million in income, and almost 34,000 jobs to local economies in 2009;
  • Nearly two million people go fishing in Pennsylvania each year, contributing more than $1.6 billion to the state’s economy;
  • Roughly $2.03 billion and 32,025 jobs are generated each year in Maryland due to its recreational boating industry;
  • Approximately eight million wildlife watchers spent $636 million, $960 million, and $1.4 billion in Maryland, Virginia, and Pennsylvania, respectively, on trip-related expenses and equipment in 2006; and
  • Americans take more than 900 million trips to coastal areas annually and spend approximately $44 billion during these trips.

With all these benefits, it is easy to justify preservation of the bay and the native oyster population through tax credit incentives.

For additional information regarding these subjects, or any other multistate tax issues, please contact:

David M. Kall
216.348.5812
dkall@mcdonaldhopkins.com

David H. Godenswager, II
216.348.5444
dgodenswager@mcdonaldhopkins.com

Susan Millradt McGlone
216.430.2022
smcglone@mcdonaldhopkins.com

Multistate Tax Services

Businesses must be vigilant and careful in managing their state and local tax liabilities and exposures. We understand this can be a daunting task. McDonald Hopkins Multistate Tax Services provides a broad range of state and local tax services including tax controversy, tax evaluation, tax planning, and tax policy. With professionals who have worked both inside and outside government agencies, our multistate tax team leverages its knowledge and experience to help clients control their complex multistate taxes.

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