Article by Erik Smith. Published on Wednesday, May 26, 2010 EST.

Fatal Flaw in I-1098, McKenna Says — Would Drive Taxes Up

By Erik Smith

Staff writer/ Washington State Wire

OLYMPIA, May 25.—If Washington voters pass an income tax this fall, they’ll wind up paying a lot more than they think, says Attorney General Rob McKenna.

            Under Initiative 1098, they won’t be able to deduct state income taxes on their federal returns, McKenna said. That’s because the initiative is written to get around the peculiar features of Washington law that have blocked an income tax in this state for the last 77 years. The state’s top legal official says the wording will disqualify Washington taxpayers from getting a deduction that is granted to everyone else in the country.

            Advocates say McKenna is just plain wrong, and if the initiative survives the election and the inevitable court challenges, they are certain the Internal Revenue Service will see things their way. But the attorney general has certainly has put his finger on an enormous legal oddity – and a point that is likely to become a central campaign argument against the measure.

            The problem is this. Backers want the Internal Revenue Service to treat their income tax as an income tax. But they want the state courts to see it as something else. They want the state courts to see it as an excise tax.

That doesn’t make a lot of sense, McKenna said. You can’t have it both ways.

            Soak-the-Rich Measure

            Initiative 1098 is looking like the best chance the state has had since the Great Depression of winding up with an income tax. Washington is one of just seven states in the country that don’t impose their own income taxes – it gets money instead from a unique tax on business gross receipts called the business and occupations tax.

            The reason is a 1933 state Supreme Court ruling. The court threw out an income tax that had been approved by voters in 1932. It decided a graduated-rate income tax would require a constitutional amendment.

            That’s not an easy thing to pass in this state. It requires a vote of both the Legislature and the people, and whenever the issue has come up over the last 77 years, one or the other hasn’t been willing – sometimes neither.

            Now a coalition of social-service and labor groups say the time is right for another try. Heading up the movement is the influential Bill Gates, Sr., who has gotten most of the attention. But the unions and the poverty lobby are the key – they’ve been hit hard during the state’s two-year budget crisis, and they have the most to gain with a tax increase. They’re also the ones carrying the petitions. They need to gather 241,000 signatures by July 1.

To overcome the political problem, they’ve crafted a tax that slams the wealthy – those making more than $200,000 a year.

To overcome the legal problem, they’ve made it a kinda-sorta flat tax – albeit with two different rates that depend on income. Some people might call that a graduated tax. So that’s why the initiative calls it an excise tax – just to make everything clear.

Is the Tax Deductible?

If you think for one second that the tax would be limited to the wealthy, critics say they can get you a really good deal on a bridge in Brooklyn. The moment the Legislature gets in trouble again, they say the tax will be extended.

That becomes an important point where the state-income-tax tax deduction is concerned. It isn’t used much by those making more than $200,000, because the federal alternative minimum tax usually kicks in and wipes it out. It is used most heavily by those who make between $75,000 and $200,000 a year, and depending on income level, it can be worth thousands of dollars.

In a speech Saturday to the Mainstream Republicans of Washington, McKenna said the backers have been too clever for their own good. The way the proposal is written, the deduction just won’t work. The federal tax code allows the deduction for state income taxes, not for excise taxes.

McKenna said, “One of the few advantages we have in this state, given our unusual business & occupations tax, is that people who are choosing to start a company or a relocate a company or grow a company, the CEOs, know that they will not pay a state income tax here. This proposal takes us from not having an income tax to a tax they are calling an excise tax that will be the highest effective tax in America. Why? Because it will not be tax-deductible, the way they have structured it. It will not be deductible against your income taxes. So at nine percent at the high rate, that will be the highest effective rate in America.”

            And of course the tax will be extended, McKenna said. It’s a no-brainer. If the Legislature has an easy out, it’s more likely to get in trouble because it’s less likely to cut spending.

“Does anyone seriously think that the same forces behind trying to persuade our voters to adopt this tax are not going to come back again, and again, and again, demanding that it be increased? No, that’s going to happen.”

            Just Plain Wrong

Backers of the initiative say McKenna is wrong. There are other states that have declared their income taxes to be excise taxes, said spokesman Sandeep Kaushik. They get the deduction. So would Washington.

“We look forward to a full and honest debate on the merits of Initiative 1098 with opponents like Tim Eyman and Rob McKenna, but we would hope they would get their facts straight before making claims like that.”

But which other states? How have they worded their excise-tax laws to comply with the federal tax code? Has I-1098 done the same? For now, those are questions the campaign can’t answer.

            Kaushik said he’s checked with a few tax attorneys since McKenna made his charge. He said he is confident that the state would get the deduction – and that the tax would survive a state court challenge.

As for whether the tax would be extended, he points out that the initiative requires a public vote to change the threshold. The Legislature can get around the rule, but if it were to try, Kaushik said someone would be sure to file a referendum – so the voters would get a say, one way or another.

No Official Opinion

McKenna isn’t offering his opinion in an official way. And it doesn’t appear that there will be any official way to settle the question before the election. State and federal agencies don’t deal in hypotheticals. The state Office of Financial Management will write a fiscal impact statement for the initiative if it hits the ballot, but it won’t deal with matters of federal law. Federal tax authorities won’t make decisions until a law is in place.

And until then, all anyone can do is to hunt for experts on federal tax law to offer their opinion.

Curtis Dubay, a tax analyst with the Heritage Foundation, says the whole effort seems to be a farce designed to get around state law. Of course it’s an income tax, he said, and it’s bound to be challenged on that point. And the legal maneuvering is so questionable that there’s no telling how the I.R.S. would react. “It’s a ridiculous effort. The proper way to do it is by passing a constitutional amendment. If you can’t win by doing it properly, you’ve lost,” he said.

The federal rules regarding deductions are pretty clear, said Joseph Henchman of the Washington, D.C.-based Tax Foundation. They allow deductions for income taxes, sales taxes and a few other specific taxes. But not for excise taxes. So it doesn’t appear that they are deductible.

“If there are any states that define their income tax as an ‘excise tax,’ it’s a minority,” he said. And it’s not clear how they could do it and still qualify for the deduction, because the term really doesn’t apply to income taxes, as they are generally implemented.

“If the proponents define the tax one way for the voters and another way for the feds, it’ll either collapse under its contradictions or survive by being all things to all people.

“In other words, I don’t know. Labeling an income tax as an excise tax is very weird. Let us know, we’ll write a brief when it gets to court, if it passes.”

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