Public Record

Washington’s tax puzzle.

Last week the Institute on Taxation and Economic policy came out with its annual “Who Pays” study and found that Washington has the most regressive tax structure in the country. To anyone who has paid much attention it shouldn’t come as much of a surprise since we’ve been at or near the top of this list for at least a decade. You can thank our heavy reliance on sales tax and user fees.

What does it mean? Basically that most of us pay far more of a share of our income in state taxes but get less for it. It gets worse when you add in the fact that it’s difficult to deduct non-income taxes from your federal income taxes, so we also send extra to the other Washington.

I’ve written previously about how we got here and the problems it creates for our state budget.

Liberals reacted the way they usually do, with outrage and demands for an income or capital gains tax to balance things out. But it won’t take long for reality to set in and realize that the typical tools aren’t politically or legally viable. So we’ll give up and continue to pile on more and more tax burden on lower and middle income taxpayers.

But there’s another possibility that I’ve never seen considered in this state, or any other for that matter, and it involves throwing out our current system and replacing it with something substantially different, but far more effective.

I understand that many will view remaking our system with inherent suspicion. Most will worry that they’ll end up paying more than their fair share. Others will say that it’s a back door effort to grow government. A number of interests favored by the current system with special deals or loopholes will fight to protect their favor, and the institutional bias of large systems will push for incremental rather than dramatic change.

But without fundamentally reshaping our tax system, Washington will not only continue to unfairly hurt a large number of people, but also sustain divestment from important social and economic infrastructure like education, transportation, and care for our most vulnerable.

The Problem

If you thought the state was taxing us more and more each year, you’d have lots of company. But revenue per capita has also steadily declined over the last couple decades.

How is all that possible? The answer is in our overreliance on sales tax, a system based on a rapidly declining segment of our economy with loopholes large enough to drive a 747 through – literally in this case since jumbo jets aren’t subject to sales tax. At the same time, Washington is without an income tax and a property tax greatly limited by initiative to less than the rate of inflation. To compound the problem, sales over the internet have exploded and the federal government continues to deny states the right to tax them resulting in even more lost revenue.

While this system slowly eats away at important programs, the sales tax is also punitively regressive to those who depend upon them. ITEP estimates that:

low-income families typically spend three-quarters of their income on things subject to the sales tax, middle-income families spend about half of their income on items subject to sales tax, and the richest families spend only about a sixth of their income on sales-taxable items.

The result is a state tax system where the poor pay around 17% of their income in taxes while the rich pay less than 3%. If we started from scratch and came up with this tax code, even the most conservative members of the Legislature would call it needlessly cruel to the poor, yet here we are. Something clearly needs to be done to ease the burden on working families but ensure enough revenue to make critical government investments in infrastructure, education, and our safety net.

I think the answer might be found in a progressive consumption tax.

The Solution

At least as far back as the Truman administration, ideas have been floated for a progressive sales tax. Despite never receiving much serious consideration from politicians, it’s found favor across the political spectrum with free market economists like Milton Friedman, and progressive economists like Robert Frank. A tax policy adviser for three Republican administrations named David Bradford is responsible for a version of it he calls the “X Tax.”

Most recently, Bloomberg economics/politics blogger Josh Barro (son of renowned conservative economist Robert Barro) pitched the idea as a “consumed income tax.”

One of the most persistent concerns about taxation has been its effects on savings and investment. It’s most recently spurred Republicans to deify the wealthy as “Job Creators.” If you tax the Job Creators too much, they will smite us with unemployment.

Taxing something we want, like savings and investment, rather than something we don’t want like excessive consumption, does seem strange and produces unwelcome distortions in economic behavior. Cutting the income tax of  “Job Creators” does nothing to ensure they’ll invest it in their business, but taxing consumption completely removes that fear all together.

While it might sound like it is,  sales tax as currently structured isn’t a consumption tax. It just taxes certain kinds of consumption, particularly of the sort that makes up a large portion of poor people’s spending habits.

It’s also built for a time when a cash register was recording that consumption. If you buy something on line, or it’s structured as a service, you get to escape taxation. It’s a nice little subsidy for those businesses but unfair to their competitors.

The “X” tax makes no distinction on what you consume or why you consume it. It doesn’t try to influence behavior or play favorites between businesses.

How the “X” tax works

First, we use the numbers from our federal income tax system. I know that is going to throw a lot of people into a panic but hear me out because this is important – we’re not going to use it to tax your income. Washingtonians have shown a militant opposition to income tax that I’m not sure I understand, but it is clear and we’re not likely to change the Constitution any time soon.

We start with your gross income. Not taxable income, not net income. Gross. From that we subtract all savings and investment. The money could be in a savings account, CD, business, stocks, bonds, or whatever. The important part is only that it’s reported in your income tax return so that it’s verifiable.

What’s left has been consumed in some way. It might have gone to housing, food, or lotto tickets but the point is that you have spent it.

Now that we know how much a person consumed, the only thing left is to apply the rate. But here’s the beautiful part, the rate can be whatever we want. We could exempt the very poor. We could even have a gradually increasing rate — the higher one moves up in income, the more you’d pay as a percentage of your consumption. That might still trigger the legal questions that have made income tax cases difficult, but the point is that a flat rate is still a huge improvement over the regressive system we now have.

You might be wondering why we wouldn’t exempt things like housing or food as they are currently. I would ask why should we? We all need these things but ultimately they involved a choice to consume. By exempting certain sectors we increase both the volatility of the revenue stream and the tax rate. Preferential tax treatment also introduces market distortions that can have very negative effects. Is it really a good idea, for example, to encourage people to stretch how much home they can afford given what we know now about the damage a housing bubble can do?

It also creates a complication that requires auditors, regulation, and headaches for filers. If you think about what’s frustrating about filing income taxes, it’s the complexity of tax breaks. If you’re not an itemizer, chances are your taxes take less than a half hour to do.

Administrative headache

One of the biggest problems associated with our sales tax structure is that it puts a large burden on business owners to collect and administer it. Turning business into free labor for the government is unfair, particularly when your business must be prepared for numerous different tax rates.

In an effort to align Washington’s tax code with the rest of the nation’s sales tax states, the Legislature adopted the absurdly misnamed “Streamlined Sales Tax.” It was intended to create a uniform standard for taxing e-commerce, but years after doing so, Congress has shown no interest in lifting the ban. For Washington this meant changing where you are taxed from the point of sale, to the point of receipt.

Imagine you have a eCommerce website (or maybe you do and are aware of this problem). Previously, your business simply needed to know the tax code for the location of your business. Now, it must figure out and correctly apply the tax treatment for the location of delivery. For some businesses this can mean paying dozens of different rates.

All of this takes time, manpower, and lots of patience.

The downside

There is an inherent problem with this system that would need to be addressed and I haven’t worked out how to solve it. Local governments are heavily reliant on sales tax but this system doesn’t lend itself very easily to fair distribution among them. Gig Harbor happens to be a perfect example. Despite generating millions in sales tax revenue, our relatively small population would mean a small per capita distribution from such a tax structure. The County, despite having a small commercial base would receive a large one. Same with cities of small commercial base but comparatively large populations.

The result would be underfunding of infrastructure and urban services in areas with high economic activity and a disincentive for cities to provide adequate land use for economic growth.

Before implementing such a plan, we’d need to create a method of properly aligning incentives for local government and keeping their already strained budgets intact.

Conclusion

When I started looking at our tax system several months ago I set out three goals for any replacement ideas:

1. It should be predictable. Volatility is the enemy of long range budgeting and planning. The more we use narrow market sectors to fund government operations, the more likely we are to have a feast/famine type swings in available revenue. Taxpayers also should not have to worry about large swings in their tax burden.
2. It should be fair. Our state has one of, if not the most regressive tax systems in the nation due mostly to our lack of an income tax. Poor people pay a much higher percentage of their income in taxes than the wealthy as a result. One of the reasons Pierce Transit is asking for an even higher sales tax is that the state eliminated its matched funding that came from the somewhat progressive motor vehicle excise tax (license tabs). Only the Legislature has the power to correct this.
3. It should be simple. Every cent spent administering a tax by people, businesses, and government is a wasted resource. There will never be a completely frictionless system for funding government, but we can do much better than the crazy system we have today.

I think the Legislature has the power to meet all those goals, improve the lives of Washingtonians, encourage economic growth, and stabilize the budget. It would just take some hard work and political courage.