Resolution on local income tax coming on Monday

Monday, Council member Herbold will introduce a resolution affirming the city’s intention to pass an income tax ordinance by mid-July.

Here’s the text of the resolution.

Washington state has the most regressive tax system in the nation: in 2015, households with annual incomes below $21,000 paid on average 16.8% of their income in state and local taxes, while households with income in excess of $500,000 paid only 2.4 percent. That’s because Washington relies heavily on property and sales taxes, rather than income taxes. In fact, state law bans cities and counties from enacting a tax on “net income.” At the state level there have been several attempts to repeal the ban on income tax, including a voter initiative. All have failed.

There have been several calls lately for Seattle to enact an income tax anyway. If and when it does, it will be instantly challenged in court. But that would set up a key test of whether the state’s preemptive ban on incomes taxes is consistent with the state Constitution. Winning that is a long shot, but some are spoiling for that fight. But there’s a second path too: trying to concoct a version of an income tax that skirts around the state ban.

The letter of the law is important here: it says that a tax on “net income” may not be imposed. There are all sorts of loopholes in that definition that can be exploited: you could tax gross income, capital gains, or “unearned income” (capital gains, interest and dividends). The advocacy group Trump-proof Seattle Coalition has argued for a tax on adjusted gross income over $250,000 per year; at a rate of 1.5%, they claim that would raise over $125 million in new revenues. Herbold’s resolution quotes those figures but doesn’t commit to a particular form for the tax, preferring instead to committing to work collaboratively with the Mayor, the City Attorney, and Trump-Proof Seattle to have a first draft by May 31 with the goal of full passage by July 10.

The key questions they will need to answer:

• What types of income to tax;
• The threshold above which income is taxed;
• The percentage at which income is taxed;
• The use of the revenues raised;
• The administrative mechanisms to ensure collection.

The last two items are particularly interesting. As of earlier this week, the City Budget Office expects to raise $1.183 billion in general subfund revenues this year from existing sources; $125 million in income taxes would raise that by roughly 10.5%.

And there are certainly many important things that could be done with those extra funds: building affordable housing, addressing the homelessness crisis, opioid addiction treatment programs, transportation, etc. But there’s one other thing they could do with at least some of the money that would make the tax system even less regressive: reduce the sales tax. Apart from increasing the social-equity benefit, it would also at least partly inoculate the officials backing the plan from criticism that they are classic “tax and spend liberals” who want to tax everything they possibly can and then decide how taxpayers’ money should be spent.

As always, the incentives and disincentives created by this kind of change in the tax structure are complicated. A lower sales tax rate would also make Seattle a more attractive place to shop, an interesting incentive. Switching to an income tax has its disincentives too, the biggest one being that it might push some people to move outside the city limits. The resolution is silent on whether it applies to corporate income as well; if it does, then Seattle might likewise lose businesses to cities to the north, south and east. Particularly with property values so high in Seattle, it might be the final nudge that individuals and businesses need to look elsewhere (Amazon recently announced that they were expanding their workforce in Bellevue). On the other hand, it might not be such a bad thing if Seattle’s growth cooled off a bit; that might provide at least a tiny release valve on housing and commercial property costs.

The last question on the resolution’s list, regarding the administrative mechanisms for collecting the income tax, is a much bigger deal than it sounds. For property taxes, the city piggybacks on the King County tax collection system. For business taxes, it relies on the state’s collection infrastructure. Since no jurisdiction does income tax collection in Washington, the city would need to create its own bureaucracy — essentially a mini-IRS — for processing tax returns and payments for 700,000 residents. Technically it won’t be processing payments for all 700,000, but in order to properly enforce the tax it needs to look at information even for people who fall below the threshold and don’t owe anything. The city also needs to decide a myriad of issues on how taxes should be paid: is it one lump sum at the end of the year, or is it (like federal taxes) quarterly estimated payments that are reconciled at the end of the year? Simplifying it to a single annual payment reduces the workload and bureaucracy dramatically, but quarterly payments smooth out the cash flow for both the taxpayers and the city.

It’s worth pointing out that even among the states that levy an income tax, their methods vary widely. California has its own complicated income tax regulations that rival the federal government in their complexity, so taxpayers fill out a second tax return in addition to their federal ones. Alternatively, some other states simply ask taxpayers to take the adjusted gross income or net income from their federal form 1040 and multiply it by a flat rate to derive their tax rate.  But even in those states, there are complications, such as for non-residents who earn income in the state and must pay taxes on that portion of their entire income. If Seattle does create an income tax, it will also need to wrestle with how to handle income earned in the city by non-residents, as well as income earned outside the city by Seattle residents.

Depending upon the approach they take, the bureaucracy to run the income tax will be somewhere between large (by Seattle government standards) and enormous. They will need to duplicate all the functions of the IRS: payment processors, customer service reps, auditors, filing clerks, enforcement, etc. Just building the IT system to run it will take years (and tens of millions of dollars). The cost to run it will be a substantial fraction of the revenues an income tax would bring in. As a point of comparison, the State of Vermont has a slightly smaller population than the City of Seattle, but has a statewide income tax and a Department of Taxes that implements it (and other taxes such as property tax). Vermont’s tax department employs 161 people, has seven divisions, and spends $17 million a year. The City Council will need to figure out how to build, manage and fund a comparable department. They will also need to decide what the penalties (civil and/or criminal) are for not paying your local income tax and for cheating on your taxes.

The most immediate and obvious take-away is this: there’s no way they are getting this done by July 10. This is an order of magnitude more complicated than the secure scheduling legislation, and that took several months to work through. One can assume they really just want to get enough done so that they can start the legal challenge to the statewide ban on income tax, which itself will likely take a year or two to play out through the courts.  We won’t know what it will take to actually run the system, how much it will cost, or how much revenues the city will have to spend at the end of the day.

That means we’ll only be having part of the policy discussion: a referendum on the state’s regressive tax system. And we already know the answer to that: it’s terrible. I don’t know anyone who defends it. The problem is that we lack the political will to replace it at the state level with something better.

In the meantime, the conversation will be happening in the context of national tax and spending policy, with the Trump administration pushing for dramatic cuts to domestic programs with accompanying massive federal tax cuts (mostly for rich people and corporations). Trump’s budget proposal justifies many of those spending cuts by claiming that the programs should be owned at the state and local level, so in a sense it anticipates a shift from federal taxes to state and local ones to maintain the status quo (though of course maintaining the status quo is hardly the Republicans’ goal).  At the end of the day, that is perhaps the strongest argument for adding an income tax on top of existing taxes and levies. Though again, it will likely be months before Congress takes action on taxes and the budget, so we are left talking about a local income tax in a vacuum.

It’s hard to predict how a local income tax proposal will play out in the state courts; there will be sharp lawyers on both sides, and it will inevitably end up argued before the state Supreme Court. But assuming the income tax survives legal challenge, I think it’s very likely that implementing an income tax at the local level, without any infrastructure support from above, will turn out to be simply infeasible: too much overhead and bureaucracy, too little return for the investment. Our tax system won’t change until there is a statewide income tax as a foundation for local flavors. Which means that the real benefit of running a local income tax up the flagpole now is to advance the statewide conversation about tax reform — with the hope that it this time it leads to a change.