Capital gains tax: A look at how Washington got here and what’s still to come

OLYMPIA – The road to pass a capital gains tax in Washington is a long one. Democrats have pushed for it for years. Even before talks of a capital gains tax, the state grappled with implementing an income tax. In the last century, the state Supreme Court ruled an income tax unconstitutional, and voters have continued to strike down proposals to implement one.

Opponents of the capital gains tax say it is a type of income tax, and therefore unconstitutional. Supporters, on the other hand, say the final capital gains proposal will hold up in court, as the bill implements an excise tax, not an income tax, on capital gains.

Gov. Jay Inslee signed the bill into law last week. It implements a 7% tax on the sale of stocks, bonds, businesses and other investments if the profits exceed $250,000 annually. Exceptions include the sale of all real estate, livestock and small family-owned businesses.

It’s expected to bring in about $415 million for the state to pay for child care and early learning. Revenue would start coming in 2023.

But the debate on the tax is far from over with two possible lawsuits already on the horizon.

Long history of tax debates

The debate around an income tax – and likely what the state Supreme Court will have to use to determine if a capital gains tax is constitutional – comes down to the 14th Amendment of the state constitution.

The amendment, which voters approved in 1930, says all taxes in the state must be “uniform upon the same class of property.” Property is defined as “everything, whether tangible or intangible, subject to ownership.”

Just two years after the amendment passed, voters approved a graduated income tax, only for it to be shot down by the state Supreme Court. In 1932, the court in a 5-4 decision said the tax was unconstitutional because it considered income as property, which the constitution says cannot be taxed gradually.

Since then, the Legislature has tried to pass various forms of an income tax in an effort to make the state’s tax system less regressive, meaning lower-income taxpayers pay a greater share of their income on taxes than high-earners.

The state’s regressive taxation system has always been brought up in the Legislature, former Spokane Democratic Rep. Dennis Dellwo said. But no income tax proposal has ever been enacted.

The Legislature has asked voters 10 times about a personal income tax or corporate income tax. Each time, it failed.

A tax on capital gains was first brought up in 2012. The proposal would put an excise tax on the sale of investments, stocks and bonds. Supporters argue that because it is an excise tax, it is allowed under the state constitution. An excise tax is a tax on the sale of specific goods or services. Washington already has a real estate excise tax.

Opponents point out every other state that taxes capital gains treats them as income.

Dellwo, who served in the Legislature in the 1980s and early 1990s, said he wasn’t sure how Democrats got the votes this year.

Jason Mercier, director of the Center for Government Reform at the right-leaning Washington Policy Center, attributed the passage this year on the Legislature’s more progressive politics. Although the partisan breakdown in the Legislature didn’t change this year, the newest lawmakers’ beliefs did.

“The Democrats that came in were more liberal than the Democrats they replaced,” he said.

Dellwo said he thought the Legislature has gotten more partisan in recent years, not necessarily more progressive. Instead of creating legislation that works for both sides, Dellwo said Democrats are “going ahead on their own.”

Republican leaders say the passage of the capital gains tax this year is due to a change in leadership in the Democratic party. House Republican Leader Rep. J.T. Wilcox, of Yelm, said the current leaders of the Democratic caucuses were much more motivated this year to pass a progressive agenda.

Senate Minority Leader John Braun, R-Centralia, said leadership has always been committed to progressive policies but never had this much motivation to pass the capital gains tax. This year, the Democrats “simply had the votes to do it,” he said.

Democrats, on the other hand, attribute their success to a more diverse Legislature that saw the effects of the COVID-19 pandemic on the state.

In a post-session news conference, Senate Majority Leader Andy Billig, D-Spokane, said the pandemic exposed many institutional problems across the state, and that built public and legislative momentum to push a lot of bills through.

Capital gains debate isn’t over

Opponents have long said if the tax passed the Legislature, it would either get wrapped up in a referendum, similar to the ones that have failed to pass, or it would make it to the state Supreme Court, which may use the opportunity to rule differently on an income tax.

The final version of the capital gains tax cuts out the ability for a referendum. The final bill makes the tax “necessary for the support of the state government and its existing public institutions.” This phrase could prevent voters from bringing a referendum on the tax to the ballot in an attempt to repeal it.

Instead of the referendum, the way opponents will fight the bill will be through a lawsuit. The question before the court will likely be: Are capital gains income, and therefore, what is the constitutionality of the tax in the state of Washington?

At least two groups have either expressed interest in suing or filed a lawsuit.

The conservative group Freedom Foundation, along with the Seattle-based law firm Lane Powell, filed a lawsuit on April 28 seeking to overturn the capital gains tax.

The lawsuit, filed in Douglas County Superior Court, alleges a tax on capital gains is a tax on income and unconstitutional in Washington. It asks the court to declare the bill unconstitutional and stop the state from collecting the tax.

“How many times do we have to go down this road?” Freedom Foundation CEO Aaron Withe said in a statement. “Capital gains are clearly income. And when you tax them, it’s an income tax – no matter what you choose to call it.”

Another group, the Opportunity for All Coalition, also announced its plan to sue last week. In a statement, President Collin Hathaway said the capital gains tax “looks a lot like a state income tax.”

“The state’s constitution clearly prohibits this type of tax, something that its supporters know,” he said.

Mercier said he doesn’t know for sure how the court will rule, but looking at past court rulings, he feels “pretty confident” the court will rule it as unconstitutional.

Supporters of the tax, on the other hand, are confident it will make it through a court challenge. House Appropriations Chair Rep. Timm Ormsby, D-Spokane, told reporters he never had a concern about the tax going to the courts. It was never a reason to not pass it, he said.

Opponents say Democrats are using the capital gains tax to see how the current court feels about an income tax. If the court rules a capital gains tax is constitutional, opponents say it is one step closer to having an income tax in Washington.

Dellwo said he doesn’t necessarily think that’s the case. Instead, he said, the state Supreme Court will have the opportunity to make a further decision on what taxation is legal and illegal in the state, and it won’t necessarily give lawmakers the opportunity to pass an income tax.