8 Facts You Should Know About I-1098

In a recent presentation to the Seattle Chamber of Commerce, local economist and forecaster Dick Conway presented his perspective on 8 key facts that underpin the debate over Initiative 1098. His comments are reprinted below:

Washington’s Tax Structure:

Washington may have the most dysfunctional state and local tax system in the United States. Lacking an income tax but having a business gross receipts tax, it is certainly the most different. The tax system has broken down twice in the last ten years due to recessions, but it has always had problems.

Fact 1: Tax base. Washington state and local governments have the narrowest tax base in the nation, collecting 62.0 percent of their tax revenue from sales taxes (retail sales taxes, business gross receipts taxes, and selective sales taxes), according to U.S. Bureau of the Census estimates for FY 2007.

Nationally, sales taxes amounted to only 34.4 percent of total state and local taxes. Sales taxes accounted for 78.3 percent of Washington state government tax revenue. Nevada ranked second behind Washington in terms of its reliance on state and local sales taxes (58.2 percent), but Nevada’s sales taxes include gaming taxes, which are paid largely by out-of-state visitors.

Fact 2: Equity. The Washington State Tax Structure Study Committee found that “the lowest income households pay 15.7 percent of income for total excise [sales] and property taxes, while the highest income households pay 4.4 percent of income for the same taxes.”

Washington’s sales-based tax structure is extremely regressive. The Institute of Taxation and Economic Policy has concluded that, without an income tax, “Washington has the most unfair tax system in the nation.”

Recessions exacerbate the regressivity of Washington’s tax structure. Rising unemployment increases the number of low-income households. Moreover, previously existing low-income households tend to bear the brunt of the layoffs. Of the nearly 200,000 jobs lost in Washington during the current recession, approximately 60 percent has been in residential construction, retail trade, accommodation and food services, and temporary employment services. In 2008, annual wages and salaries in these industries averaged $30,400, one-third below the $46,600 average for all workers in the state.

Fact 3: Volatility. Between 2007 and 2009, Washington personal income increased 2.7 percent, while taxable retail sales—the state’s biggest tax base—fell 15.0 percent.

Washington state and local tax collections tend to be more volatile than personal income because much of the tax revenue stems from the sales of goods (including new construction). The downturn in auto sales and the bust in residential and commercial construction accounted for 56.4 percent of the decline in taxable retail sales between 2007 and 2009.

Back-of-the-envelope calculations indicate that relative to personal income state and local tax revenue is currently running about 10 percent below normal (see Fact 6) While there is probably still room to cut public spending, the current fiscal crisis in state and local government is primarily attributable to the greatest shortfall in tax revenue in forty years.

Fact 4: Adequacy. All else being equal, a ten percent increase in personal income leads to a nine percent increase in taxable retail sales.

Adequacy refers to the ability of a tax base to keep up with the long-run growth of the economy, as measured by personal income (see Fact 6). Based on various econometric analyses, evidence strongly suggests that taxable retail sales are not an adequate tax base, since they grow more slowly than personal income in the long run.

The tax base was grossly inadequate during the last decade. Between 2000 and 2009, because of two severe recessions, growth in Washington taxable retail sales (1.9 percent per year) significantly trailed growth in state personal income (4.2 percent per year).

One consequence of an inadequate tax base is the need to periodically raise tax rates. Over time, the King County retail sales tax rate has crept up to nearly 10 percent, one of the highest rates in the nation. Until a few days ago, the county was considering an additional 0.2 percentage point hike in the rate.

Fact 5: Transparency. Input-output tables of the Washington economy show that about three-fifths of business sales are made to customers (businesses, consumers, and governments) located within the state.

A transparent tax system is one in which people can determine exactly how much they pay in taxes. To the extent that businesses can increase prices to cover some or all of their gross receipts taxes without their customers knowing it, the tax system is opaque.

Washington businesses that sell goods and services locally have an ability to pass on their business and occupations taxes to their customers. Since these businesses compete mostly with other local businesses that are obligated to pay the same taxes, they can raise their prices to at least partially cover their taxes without significantly affecting their relative competitive advantage.

In general, it is important to remember that ultimately people (consumers, workers, business proprietors, and stockholders) pay taxes, not businesses.

Fact 6: Tax lid. Between 1970 and 2009, U.S. state and local tax collections averaged 10.8 percent of personal income, according to the U.S. Bureau of Economic Analysis.

If the Washington tax structure is in fact dysfunctional, why do voters continue to resist the idea of tax change? Some people simply prefer the current system—it suits their economic situation—but many others have a fear that tax reform is just another way for government to pick their pockets.

This raises an important, though seldom discussed, question: how much should state and local government tax? If we can agree upon an answer to this question, we can then rationally discuss the best way to collect taxes.

Apart from minor variations due to economic cycles, the effective tax rate for state and local governments has been virtually constant. It was 10.9 percent in 1970 and 10.5 percent in 2009. In FY 2007, the latest year for which individual state data are available, Washington state and local tax revenue amounted to 10.5 percent of personal income, compared to 11.0 percent for the nation.

The fact that the ratio of state and local tax collections to personal income has remained stable for forty years confirms the notion that an adequate tax system is one that grows with personal income.

More importantly, the constant ratio implies that there exists a natural lid—roughly 11 percent of personal income—on state and local taxes. This lid is not one that voters have explicitly chosen. Rather, it is one that arises out of the collective actions of all state and local governments in the United States.

While it would be difficult to legislatively implement a lid on state and local taxes—a mechanism like a rainy day fund might work—the natural lid should at least be made known and taken into account whenever a change in the tax system is considered.

Initiative 1098:

I-1098 is an attempt at tax reform. It would impose a state income tax on high-income households, reduce property taxes, cut business and occupations taxes for small businesses, and provide financial support for education and healthcare.

Opponents to I-1098 have expressed two main objections: it will further burden tax-payers during these difficult economic times; and it will stifle job creation.

Fact 7: Tax burden. In 2009, federal, state, and local taxes in the United States amounted to 20.2 percent of personal income, the lowest effective tax rate in sixty years, according to the U.S. Bureau of Economic Analysis.

The popular perception is that households and businesses are overburdened by taxes. In fact, anyone born after World War II has never seen a lower effective tax rate.

As a result of falling federal tax rates—the Reagan and Bush tax cuts—there has been a long-term decline in the effective tax rate since 1970: 26.5 percent in the 1970s; 24.1 percent in the 1980s; 24.4 percent in the 1990s; and 23.3 percent between 2000 and 2009. Because of the various consequences of the recession—higher unemployment, lost wages, reduced consumption, legislated tax breaks—the effective tax rate dropped from 24.9 percent in 2007 to 20.2 percent in 2009.

I-1098 will shift the tax burden from low and middle-income households to high-income households. This will help rectify the longstanding problem of regressivity in the Washington tax system. It will also provide financial relief from those who can afford it to those who need it in the aftermath of the Great Recession.

Fact 8: Economic impact. Despite the Bush tax cuts for high-income households and increased defense spending to fight two wars, U.S. real Gross Domestic Product (GDP) expanded at a 1.6 percent rate between 2000 and 2009, resulting in a loss of 900,000 jobs.

This was the worst performance of the national economy since the Great Depression. In 2000, WEFA (now part of Global Insight, one of the nation’s leading forecasting outfits) predicted that between 2000 and 2009 U.S. real GDP would grow at a 3.3 percent average annual rate and that the economy would add 16,000,000 jobs. The underperformance of the economy combined with the tax cuts and increased defense spending led to a doubling of the federal debt, from $5.6 trillion in 2000 to $11.9 trillion in 2009.

It is difficult to argue that the Bush tax cuts and the “trickle-down effects” helped the national economy during that time. Rather, data on investment spending suggest that much of the tax savings flowed into the housing market and fueled the housing bubble.

If the Bush tax cuts for high-income households had no positive impact on the national economy, it is difficult to argue that imposing an income tax on high-income households in Washington would harm the state economy. Indeed, considering how the new tax revenue would be spent—to preserve jobs in education and healthcare, to increase disposable income for low and medium-income households, and to put money back into the hands of small businesses—the initiative would most likely foster job growth in the current economic environment.

Conclusion:

There are other quibbles with I-1098. While it attempts to make the Washington tax system less regressive, the reduction in property tax provides little direct financial assistance—an estimated $100-200 per household—to low and middle-income households. On the other hand, low and middle-income taxpayers will not have to pay an estimated $400 per household for the $1.1 billion in new revenue to support education and healthcare.

Another concern is the volatility of the new tax. As California has learned, taxes on the income and capital gains of high-income households can swing wildly, especially during economic bubbles like the dot-com boom and bust and the housing bubble. While it remains to be seen whether the proposed tax adds to the volatility of the Washington tax system, there are two reasons to think that it will not be a significant problem in the foreseeable future.

First, unless we have learned nothing from our recent economic suffering, it is doubtful that we will have to deal with another damaging economic bubble anytime soon. Second, to the extent that the new tax is volatile, it most likely will work in favor of increasing much needed state and local tax revenues as the Washington economy recovers from the Great Recession.

Perhaps the major underlying objection to I-1098 is that it would open the door to tax reform, which would include a broad-based income tax. Given how poorly the current system works, it is probably just a matter of time before we have to scrap it. If nothing else, I-1098 provides an opportunity to start the important debate on tax reform.

But this gets us back to the notion of a tax lid. The major sticking point for tax reform is the fear among voters that it means more taxes and the fear among public officials that an income tax is the “third rail of politics.” If we could agree to hold a reasonable line on state and local taxes—such as 11 percent of personal income—we could alleviate many of these fears. We would then have an opportunity to develop a tax system that is substantially more fair, stable, adequate, and transparent than the one we have now. I would even argue that a reformed tax system would make our economy more competitive, but I have run out of time.

Dick Conway is co-founder of The Puget Sound Economic Forecaster, and a member of the Washington State Governor’s Council of Economic Advisors, the Western Blue Chip Panel of Economic Forecasters, and the Washington State Economic Climate Study Advisory Board. He was also a member of the Washington State Tax Structure Committee.

The above material is copyright protected © 1993-2010 by Conway Pedersen Economics, Inc., and is used here by permission of the author. The views and opinions expressed are solely those of the author and do not necessarily reflect those of the Economic Opportunity Institute.

Looking for more information about Initiative 1098? Visit the Economic Opportunity Institute website.