(The Center Square) – A capital gains tax passed by the Washington Legislature last weekend is facing its first lawsuit in its battle to undo generations of judicial precedent on tax law. One scholar believes the tax could win.
Profits on the sale of stocks, bonds and other assets over $250,000 would be taxed at a rate of 7% under a bill that cleared the Legislature on Sunday. Real estate, retirement accounts and timberland are exempt from the proposal. A legislative analysis found it would apply to some 16,000 households. Gov. Jay Inslee has pushed for a capital gains tax since 2014, two years after he pledged to veto new taxes in 2012.
Even without the governor's signature, the bill drew its first lawsuit less than 72 hours after its passage. The Freedom Foundation, a conservative free-market think tank, and Washington law firm Lane Powell PC filed the suit in Douglas County Superior Court on Wednesday. They allege the tax is unconstitutional on several grounds. The lawsuit contends the tax proposal violates the privileges and immunities, right to privacy and uniformity clauses under the state constitution by targeting a specific class of taxpayers and requiring personal financial disclosures. Plaintiffs also claim a capital gains tax violates the constitution's Commerce Clause by enforcing discriminatory interstate commerce.
The lawsuit names seven Washington residents as plaintiffs, all claiming they will be subject to the capital gains tax as written. It names as defendants the state, the state Department of Revenue and Vikki Smith in her official capacities as department director. Plaintiffs demand in the lawsuit that the courts deem the capital gains tax as unconstitutional, stripping the state of its ability to collect or enforce it in addition to paying their legal fees.
Another group, the Opportunity for All Coalition, also announced its intentions Wednesday to file a future lawsuit against the state's capital gains tax.
Maxford Nelsen, director of labor policy at the Freedom Foundation, told The Center Square he believes the lawsuit was not premature and gave no indication the case should have trouble holding up in court.
"Inslee has indicated his intent to sign it and his administration even formally submitted the legislation to state lawmakers," said Maxford Nelsen, director of labor policy at the Freedom Foundation. "Our lawsuit was ready to go and there was simply no reason to wait for Inslee's signature to challenge this unconstitutional tax."
Washington Democrats argue a capital gains tax would rebalance the tax system and raise cash for much-needed public programs. According to a legislative analysis, the tax should collect $455 million for public schools by 2023.
Republicans have argued that, because the IRS treats capital gains as an income tax, that's what they would be considered at the state level. New taxes, they say, are unnecessary when state coffers are flush with cash, and the state will expand it to more taxpayers. Inslee said this week he has no plans to propose such expansions.
Washington is one of nine states without an income tax. It treats income as property – a view setting it apart from every other state in the nation. Under Article VII of the state constitution, property taxes must be "uniform upon the same class of property." That provision has kept capital gains tax proposals on hold for the past century and a half. That section has been amended 16 times between 1900 and 2011 concerning school levies and other exemptions.
Washington voters last enacted a graduated income tax in 1932 during the Great Depression with 70% of the vote. The state supreme court nullified it the following year, deeming it unconstitutional.
Washington voters have turned away income taxes 11 times at the ballot box since the 1933 ruling. A capital gains tax proposal has never made it to the ballot after numerous failed attempts at passing the state legislature in recent years. Polling shows mixed support among Washingtonians, but state courts have yet to issue an opinion on capital gains.
In 1960, the high court ruled taxes on rental income were property taxes.
"Under those decisions, a tax on rental income is a tax on property, and not an excise tax," the court wrote. "Furthermore, a tax upon rents from real estate is a tax upon the real estate itself, and is, thus, a second tax upon real estate."
Professor Hugh Spitzer, who teaches constitutional law at the University of Washington, said the capital gains tax is an excise tax.
"The pending legislation is carefully written to impose the tax 'on the sale or exchange' of assets like stocks and bonds – not on the stocks and bonds themselves," Spitzer wrote in a Seattle Times editorial. "If you don't choose to sell a stock and benefit from the gain, then there's no tax on the asset itself."
Spitzer points to the state supreme court's 1933 ruling upholding the business gross receipts tax in which it reaffirmed the estate tax–or a transfer of assets–as an excise tax on a voluntary act rather than a property tax on what he calls "a stationary asset."
Washington voters will not get the chance to repeal the capital gains tax anytime soon. As written, the bill is protected from voter referendum and leaves voters with slim chances of repealing it through initiative before 2022.
"Democrats added insult to injury when they included language intended to block a citizen referendum," said Washington state GOP Chair Caleb Heimlich in a statement. "Washington taxpayers deserve to have a voice in how much taxes they pay."
Should a capital gains tax ever reach the state supreme court soon, Spitzer warns capital gains tax opponents to prepare for surprises.
"Washington's high court has recently shown a robust capacity to make big changes in long-held legal theories," Spitzer wrote. "So it just might be prudent for foes of the state capital-gains tax to hunker down and pay it rather than launching a legal challenge."
The Freedom Foundation's lawsuit now awaits its first hearing in superior court.