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June 16, 2017

Who Really Pays Washington State’s Taxes?

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It’s a compelling talking point in Washington state, and it’s a key argument behind Seattle’s proposed income tax ordinance: a progressive state has the most regressive tax code in the nation. The claim comes from the Institute on Taxation and Economic Policy (ITEP), which publishes an occasional study called “Who Pays?” But does the claim stand up to scrutiny?

All distributional analyses are estimates and require certain stylized assumptions to be made, assumptions which won’t perfectly correspond with the real world. It’s important, though, for those assumptions to be as realistic as possible, and here, ITEP’s approach has some serious shortcomings. Here are some points to bear in mind when considering ITEP’s result.

  1. It omits wide swaths of the tax code. The ITEP study only looks at sales and excise taxes (the B&O is included under this header), income taxes, and property taxes. That is not, of course, anything close to the full extent of Washington’s tax code, which also includes an estate tax, a leasehold tax, severance taxes, transit authority taxes, public utility taxes, insurance premium taxes, and more. How can one make claims about the overall distributional impact of state and local taxes when significant portions of the tax code are excluded from the analysis?
  2. It misclassifies a major tax it does include. Washington’s B&O tax, a high-rate gross receipts tax, is classified as a sales tax by ITEP and distributed accordingly. This is due to data limitations; ITEP relies on Census Bureau classifications, and Census classifies B&O revenue as general sales tax revenue. The “Who Pays?” methodology assumes that sales taxes are highly regressive, so the B&O contributes substantially to the state’s regressivity under their model. But there’s no reason to think that B&O distributional effects align with sales taxes, and this produces the curious result something like increasing the B&O rate on services—a cause championed by Governor Jay Inslee (D) and others on the left—would be considered an extremely regressive move under ITEP’s flawed methodology.
  3. It improperly includes one cherry-picked provision of the federal tax code. The ITEP report includes one major element of federal tax policy, the federal income tax deduction for state and local taxes paid, presumably because it’s regressive. Other, highly progressive, features of the federal income tax code are not incorporated. The result is that state tax systems—in Washington and elsewhere—look more regressive in this study than they actually are. Either ITEP should include all aspects of the federal tax code or none.
  4. It uses a controversial approach to calculating tax distributions. ITEP uses a “snapshot” rather than “lifetime” income approach in calculating tax distributions, which yields findings of substantially greater regressivity. For instance, a law school student can show up as extremely low-income, and have outlays well in excess of income, but it is not very meaningful to think of someone with a future of high income as being subject to regressive taxation. The same goes for a wealthy retiree with more assets than income. A better methodology would recognize the difference between stocks and flows.
  5. It considers state and local taxes in a vacuum, and defines all state tax codes as regressive. There may be value in examining the progressivity or regressivity of state and local tax structures on their own, but actual taxpayers also pay federal taxes, which tend to be quite progressive and yield a progressive overall tax structure. Notably, ITEP’s methodology always leads to the same conclusion, that state tax codes are too regressive. California has a highly progressive tax code with a ten-bracket individual income tax with a top rate of 13.3 percent, but ITEP concludes that low-income families are taxed more heavily than high-income earners. The same goes for Connecticut, where Democratic Governor Dannel Malloy is on record saying that the state cannot afford to tax the rich any more than they already do. ITEP reaches the same result for Massachusetts, Minnesota, New York, Oregon, and Vermont. If their methodology finds that no state is progressive enough, what does the word even mean? (For a lengthier, footnoted treatment of the methodological shortcomings of the “Who Pays?” report, see here.)

None of this means that policymakers shouldn’t care about the distribution of state and local taxes, but it does suggest caution in relying too heavily on ITEP’s claims about the Washington state tax code. It also raises an interesting question: while surely it doesn’t make sense to treat the B&O as a sales tax, as ITEP does, how does it perform distributionally? There’s good reason to think that, while it may not be as regressive as ITEP assumes, the economic incidence of the tax does fall disproportionately on lower- and middle-income earners. That ought to give policymakers pause about turning to ever-higher B&O rates as a revenue expedient.

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