Ruling In Favor Of Washington State Capital Gains Tax, A Big Win For Progressives, Is An Outlier In The Overall Trend

As last week was coming to a close, the Washington State Supreme Court issued a landmark ruling on Friday, March 24, permitting the imposition of a state tax on capital gains. The Supreme Court of Washington State (SCOWA), by a 7-2 majority, ruled against the plaintiffs, who challenged the capital gains tax signed into law three years ago by Governor Jay Inslee (D-Wash.) on the grounds that it violates the state constitution, which only allows for a uniform income tax of up to 1.0%.

The SCOWA ruling upholds Washington’s capital gains tax on the grounds that taxing investment income, but calling the levy an excise tax, is a permissible way to circumvent the state constitutional restriction stipulating that any income or property tax must be uniform and cannot exceed 1.0%. The two dissenting justices, however, contend that calling an income tax another name does not change the nature of that tax.

“A tax is determined by its incidents, not by its legislative label,” noted the dissenting opinion. “The structure of the capital gains tax shows that it is a tax on income resulting from certain transactions—not a tax on a transaction per se. Therefore, the tax is an income tax, not an excise tax. Under our constitution and case law, an income tax is a property tax. As enacted, this income tax or ‘capital gains tax’ violates the one percent levy limitation of article VII, section 2.”

“Today’s ruling is unreal,” said Jason Mercier, government reform director at the Washington Policy Center (WPC), in response to the March 24 ruling. “The State supreme court agreed with lawmakers that Washington has discovered the first standalone excise tax on capital gains income on the planet.”

The Internal Revenue Service agrees with Mercier and the two dissenting Washington Supreme Court Justices. After Governor Inslee and the Democratic-led Washington Legislature enacted the capital gains tax in 2021, creating a 7.0% tax on capital gains income beyond $250,000 annually, Congressman Dan Newhouse (R-Wash.) submitted a formal inquiry with the Internal Revenue Service asking whether the IRS considers a tax on capital gains to be an income tax or an excise tax. In its official response to Congressman Newhouse, the IRS replied that a capital gains tax “is an income tax. More specifically, capital gains are treated as income under the tax code and taxed as such.”

“49 other states and the IRS already recognize that capital gains taxes are income taxes,” noted a WPC statement released after the SCOWA ruling. “Today’s decision will make Washington state the only state to define capital gains taxes as excise taxes and opens the door to the introduction of other income taxes as well.”

Progressives and many Democratic officeholders, meanwhile, celebrated the March 24 ruling.

“Washington’s capital gains tax helps right an upside-down tax structure where low-income Washingtonians ultimately expend a much larger share of their income in taxes than our wealthiest residents,” Governor Jay Inslee said in response to the ruling. “It is gratifying as governor to join so many Washingtonians in this historic victory today, one that has been elusive in the face of years of opposition from powerful interests. I want to thank the court for their timeliness in considering this case, and all the legislators and advocates who spent nearly a decade working tirelessly on this policy to make our state fairer and more equitable.”

“Our Supreme Court made it clear today that our elected representatives and senators correctly followed our plan of government two years ago when they took decisive action to balance our upside down tax code and provide sorely needed revenue for our underfunded schools,” said Andrew Villeneuve, president of the Northwest Progressive Institute, in reaction to the March 24 SCOWA ruling. “Thank you to Justices Debra L. Stephens, Steven C. González, Barbara A. Madsen, Susan Owens, Mary I. Yu, Raquel Montoya-Lewis, and G. Helen Whitener for thoughtfully considering all of the arguments and returning a sound ruling that empowers Washington to continue on its journey towards adopting a fairer, more just tax code that allows our essential public services to be equitably funded.”

The justices Villenueve thanked, in their ruling in favor of the capital gains tax enacted in 2021, wrote that the tax “is appropriately characterized as an excise because it is levied on the sale or exchange of capital assets, not on capital assets or gains themselves.” Ryan Ellis, an IRS-enrolled agent and president of the Center for a Free Economy, says the majority opinion is “absurd.”

“An excise tax is a government tax on the sale of a thing, usually a Pigouvian thing. Booze, beer, tobacco, etc.,” adds Ellis. “No serious tax expert would call the realization of a capital gain an occasion for an excise tax. It’s clearly in the income tax bucket.”

“In allowing the income tax on capital gains, the state high court has distorted the clear language of the state constitution which prohibits graduated taxes on anything subject to ownership, including income,” added the WPC statement released in response to the March 24 SCOWA ruling. Aside from the additional cost imposed by this new capital gains tax, which is estimated to collect $500 million annually, critics of the ruling say it will make Washington’s state tax climate less competitive and stable.

“With this ruling, the rules surrounding income taxes in Washington are now unclear,” added Mercier. “What will be the next type of income tax to be redefined by lawmakers? It is up to the voters now to respond.”

The March 24 SCOWA ruling is the state’s final say on the matter, Mercier concedes, while adding “that doesn’t change the irrefutable fact that literally every tax professional in the world, from the IRS, to every other state, to other countries will tell you the same thing – capital gains are income and taxes on them are income taxes.”

Many tax experts have joined Mercier and Ellis in lambasting the SCOWA ruling. “I try to be respectful of court rulings, and recognize that state supreme court justices know much more about the law than I do, but I don’t see any way to get around it on this one: the court wanted a capital gains tax so it ruled in favor even though the argument was ludicrous,” tweeted Jared Walczak, vice president of state projects at the Tax Foundation.

This matter is settled or now, “unless,” Mercier added, “there is a federal challenge for violating the commerce clause or the voters respond with a ballot measure.” One firm has already announced it’s leaving the state as a result of the court’s decision.

“In honor of the Washington State Supreme Court’s wisdom and knowledge of the law, and in recognition of whatever it may do next, Fisher Investments is immediately moving its headquarters from Washington State to Texas,” the firm, which has $197 billion in assets under management, announced the day of the ruling.

“The new tax will influence decisions going forward relative to where we choose to invest in building out the team as part of Tempo,” said Ted Hawksford, CEO of Seattle-based LiquidPlanner, a startup acquired last month by Tempo, a Boston-based software company. Hawksford added that his company recently went fully remote, noting that 40% of his workforce has already moved “to more agreeable destinations such as Texas, Florida, and North Carolina.”

The March 24 SCOWA ruling allowing the Washington State capital gains tax to take effect comes two weeks after President Joe Biden released a new budget proposing to raise the federal capital gains tax. Enactment of the capital gains tax hike pushed by the White House, in conjunction with Washington State’s new capital gains tax, would have the combined tax rate on the capital gains of Washington residents approaching 50%.

The number of no-income-tax states grew from seven to eight following Tennessee’s repeal of its investment income tax in 2021. The imposition of a capital gains tax in Washington State brings the number of no-income-tax states back down to seven. New Hampshire’s investment income tax, however, is scheduled to be fully repealed by 2027. When that happens, the number of no-income-tax states jumps back up to eight.

Legislation has already passed out of the Arizona Senate that would make Arizona a no-income-tax state, phasing out the state’s 2.5% flat tax over time based on revenue triggers. Legislators and governors in North Carolina, Kentucky, Arkansas, Wisconsin, Ohio, and other states are jockeying to become the next no-income-tax state. The imposition of a capital gains tax in Washington is a major victory for progressives, but it’s an outlier in the overall trend. What’s more, this decision underscores the consequential nature of state Supreme Court races and why $31 million is being spent on the race for one Wisconsin Supreme Court seat that will be determined on April 5.