Sorry, Washington State: Capital Gains Taxes are Still Income Taxes—But There’s a Better Way

Sorry, Washington State: Capital Gains Taxes are Still Income Taxes—But There’s a Better Way

Tax Policy – Sorry, Washington State: Capital Gains Taxes are Still Income Taxes—But There’s a Better Way

Every state has its traditions, and in Washington, you can mark the dawn of a new year by the inevitable attempt to tax capital gains—and the insistence that, despite appearances, it’s not a tax on income.

On Thursday, Washington Senate Majority Leader Andy Billig (D) went on Inside Olympia to discuss the proposal and to explain why, in his opinion, it does not constitute a tax on income (functionally prohibited by the state constitution), even though in other states and at the federal level, capital gains are taxed under the individual income tax.

Senator Billig observed that “income gets taxed at one level [while] capital gains, at the federal level, gets taxed at another level”—which is true, at least where long-term capital gains are concerned. This, however, is a tax preference within the individual income tax: long-term capital gains receive a lower, preferential rate.

The tax code is full of preferences, old and new. Under the new federal tax law, pass-through business income receives preferential tax treatment, for instance, though this is accomplished through a deduction. For an alternative rate, one might look to the alternative minimum tax (AMT), which uses an entirely different rate schedule than the rest of the individual income tax, but is undeniably still taxing income. Which is why Sen. Billig is correct about this prediction: “Ultimately it’s going to be up to a court to decide.”

At the federal level, short-term capital gains are taxed as ordinary income, while long-term capital gains are taxed at a lower rate. Somewhat ironically, proposals in Washington would exempt short-term capital gains altogether and only tax long-term gains (which receive preferential federal treatment) because the state law would draw from that line of taxpayers’ federal income tax return—another hint, perhaps, that this is clearly an income tax.

But forget hints: consider the difference in how income and excise taxes function, since proponents of a Washington capital gains tax want to call this an excise tax on the privilege of earning capital gains. Excise taxes fall on specific transactions—for instance, the purchase of gasoline or cigarettes—and are typically levied per unit (on volume). For instance, Washington’s gas tax is 49.4 cents a gallon, regardless of the price of gasoline. Occasionally they look more like specific sales taxes, levied on an ad valorem basis, like Washington’s 37 percent excise tax on recreational marijuana.

But in either case, they fall on a specific good or service and—most importantly—they’re based on sales, either in price or volume. That’s not how capital gains taxes work. They’re not levied at a set rate on each financial transaction. Rather, they’re imposed on the net income from investments when that income is realized. There’s no getting around that this is an income tax—just a very narrow one.

 Interestingly, in his interview, Sen. Billig observed that “the best tax system is a tax that is wide but not deep, so tax a lot of things, but don’t tax them a lot.” Unfortunately, that’s pretty much the opposite of what can be achieved by a tax on long-term capital gains. It’s a volatile tax on a narrow definition of income, in an area where people often have significant control of when and how they realize that income.

If Washington did adopt a capital gains tax, moreover, one wonders whether state officials would maintain their insistence that it’s an excise tax for purposes of the state and local tax deduction.

When determining federal tax liability, taxpayers can deduct property taxes plus their choice of income or sales taxes, up to a (new) cap of $10,000. In a state like Washington, which forgoes an individual income tax, itemizers go with the sales tax—though, more accurately, most taxpayers use IRS tables that convert their income into a “standard” sales tax figure that can be substituted for actually tracking purchases.

If Washington adopted a capital gains tax, some taxpayers would benefit from deducting their state capital gains tax payments rather than their estimated sales tax payments, but that of course depends on their ability to characterize the tax as an income tax. It’s pretty clear the IRS would allow it—but what would state officials think, given their position that it’s decidedly not an income tax?

Incidentally, that new $10,000 cap also means that the cost of state taxes is now higher. The state and local tax deduction essentially subsidizes state taxes, allowing a portion of the burden to be exported to taxpayers across the country. The cap limits the ability to do that, particularly for high earners. States like New York, New Jersey, and Connecticut have all expressed concern that their high rates on higher-income residents could backfire on them, driving people out of state, now that this federal subsidy has been cut.

Yet Washington policymakers want to impose a particularly high rate tax on capital gains income. That could be a risky move even if the tax didn’t face such an enormous constitutional challenge.

Sen. Billig is right to want a tax code with broad bases and low rates. This is the opposite of that. Instead, legislators might look to broaden the state’s narrow sales tax base, taxing additional services. This would make the tax more stable while also enhancing progressivity, since services are disproportionately consumed by higher-income individuals, and yet are currently exempt—a huge tax break for wealthier Washingtonians that carries very little economic benefit.

Source: Tax Policy – Sorry, Washington State: Capital Gains Taxes are Still Income Taxes—But There’s a Better Way

Ocasio-Cortez’s Proposed 70 Percent Top Marginal Income Tax Rate Would Deter Innovation

Ocasio-Cortez’s Proposed 70 Percent Top Marginal Income Tax Rate Would Deter Innovation

Tax Policy – Ocasio-Cortez’s Proposed 70 Percent Top Marginal Income Tax Rate Would Deter Innovation

As America’s advantage in innovation erodes and levels of entrepreneurial activity decline, it is becoming increasingly important that tax policy does not further hinder economic dynamism. Unfortunately, a recent proposal by freshman Rep. Alexandria Ocasio-Cortez (D-NY) to increase the top income tax rate to 70 percent would unmistakably do this. In addition to making dubious claims about tax history, advocates of this proposal ignore that a high top marginal income tax rate would deter innovative activity, including the work of inventors and entrepreneurs.

The congresswoman’s proposal is arguably based on the work of economists Emmanuel Saez and Peter Diamond, who claim that the optimal tax rate for maximizing revenue is 73 percent. This work does not account for the incentive to enter high-earning occupations.

Individual decisions to enter an occupation include weighing the expected return of one’s effort and educational investments and the cost of forgoing alternative opportunities. Saez and Diamond consider this but say there is limited economic data to determine how high top marginal income tax rates impact long-run decisions such as investing in education or becoming an entrepreneur.

High top marginal income tax rates could make some people reconsider their plans to upgrade their skills or try to implement a risky business idea. There are at least two forms of innovative activity deterred by a higher top marginal income tax rate: the generation of new ideas and formation of entrepreneurial ventures.

New ideas are often formed and implemented by individuals working in applied research, such as a medical doctor researching a cancer treatment or a materials scientist building a smaller lithium-ion battery. It requires a significant investment in time and energy to discover and refine an innovative idea, but the expected return is high. A higher top marginal income tax rate reduces this expected return, and makes alternative opportunities look more attractive for would-be innovators. Fewer of them would think the investment is worth the expected return.

A 70 percent top marginal rate would also deter potential entrepreneurs, who must invest high levels of time and effort into an innovative firm. These entrepreneurs often take new ideas and merge them with a sound business model in search of profit. As Stanford economist Charles Jones explains, “High incomes are the prize that motivates entrepreneurs to turn a basic research insight that results from formal [research and development] into a product or process that ultimately benefits consumers.”

The economic literature confirms that higher marginal income tax rates have a negative impact on innovation. Marginal tax rates weigh heavily on inventors when deciding where to locate, and empirical evidence suggests that “higher personal and corporate income taxes negatively affect the quantity and quality of inventive activity and shift its location at the macro and micro levels.”

These activities benefit more than just the inventors or entrepreneurs. Innovative activity increases incomes across all levels, as a productive idea is replicated and circulates throughout the economy in the form of higher worker productivity, output, and incomes.

Advocates of a 70 percent top marginal income tax rate take high-income earners as a given, forgoing the costs and risks these earners incurred to obtain that income. While any tax on high earners may deter some innovative activity, it is important that we consider what trade-offs we are making when we consider raising the top rate. A 70 percent top marginal income tax rate would make many potential inventors and entrepreneurs abandon their plans to invest in human capital, invent technologies, and form innovative businesses, to their detriment and to the detriment of society.

Source: Tax Policy – Ocasio-Cortez’s Proposed 70 Percent Top Marginal Income Tax Rate Would Deter Innovation