By Erik Smith

Staff writer/ Washington State Wire

OLYMPIA, Aug. 27.—There are thrills in store for Washington state if Initiative 1098 passes in November, experts say – the giddy ride up the roller coaster when the economy booms, and the terrifying downward plunge when recession hits.

            And while a high-earner income tax might make for exciting times in the Evergreen State, they say one thing is clear. Anyone who thinks tax revenues are going to be more stable has another thing coming.

            Washington, one of America’s last holdouts where state income taxes are concerned, would become the 44^th state to tax personal income if I-1098 passes in November. But there’s something unique about the proposal that makes it like no other state income tax in the country. It would hit only those with the highest incomes – those who make $200,000 or more a year.

The very element that might make the idea appealing to the other 98.8 percent of the population is the part that may spell trouble the next time there’s a downturn. By soaking the rich, experts say, the tax would hit those whose incomes tumble the most when times are hard. That could mean big problems for everyone else – perhaps even higher taxes all around.

Washington State Wire talked to a variety of national experts on taxation, of every stripe – from the right, the left and the middle. And the consensus is that the income tax – particularly the type of income tax proposed by I-1098 – might rake in more money, but it will also make state tax revenues more volatile than they are today. Some say the state Legislature might be able to handle the problem. Others snort.

            Stability an Article of Faith

Initiative 1098’s supporters have touted stability as one of the advantages of their tax plan. Bill Gates, Sr., the leading spokesman for the measure, put it this way when he unveiled the proposal at a news conference last spring:

“Our tax code is unfair. It harms our economy and fails to provide the stable revenue we need for important state services, particularly priorities like education and health care.”

And when speaking with reporters last month as 1098 supporters dropped off 350,000 signatures at the state elections office, Gates said he believes the tax will help even out state revenues. “I think having a variety of sources does contribute to that, yes,” he said.

Behind the idea is an article of faith – the more ways government can raise money, the more stable its income will be, and the less vulnerable it will be to short-term fluctuations in the economy. It’s the conventional wisdom. The problem is that it doesn’t work that way in real life, the experts say.

The experience of the last dozen years has shown that income taxes are the least stable form of taxes around – less so than sales taxes or property taxes. High earner taxes are particularly volatile. Generally speaking, the more a state relied on an income tax, the more trouble it had when Wall Street tanked a year and a half ago and personal income plunged. Recession hit especially hard in states that had enacted high income rates for the wealthy – among them California, New York and New Jersey.

“Whatever side of the issue people are on,” said Don Boyd of the Nelson A. Rockefeller Institute of Government at the State University of New York at Albany, “on the factual question, volatility will be greater with an income tax. How much more volatile depends on the way the tax is configured.”

            Instability a Problem

            What’s the matter with volatility? It has to do with human nature. Just like everyone else, legislatures have trouble saving for rainy days – or when they do, they never save enough. Then problems hit and it's time for panic. When times were good a few years ago, Washington, like most other states, allowed spending to balloon. Spending increased 30 percent in just four years. Washington socked away a few hundred million dollars in a rainy-day fund, but it’s gone now, swallowed by the $12 billion hole that opened up when the economy tanked. Another $3 billion shortfall awaits the state next year.

            It isn’t easy for legislatures to exert discipline, said Scott Pattison, executive director of the National Association of State Budget Officers. “We are a democracy, and it’s hard to do that,” he said. “It’s hard to say no when a lot of money is coming in and you worry about the consequences later. You have people on the left saying ‘spend it on programs,’ and you have people on the right saying ‘give it back to the taxpayers.’”

            What it basically means is that legislatures spend every penny available to them. And if the current economic crisis has been hard on Washington, it’s been more pronounced in states with income taxes, and sharpest of all in states where tax brackets hit high earners hard. In recessions you just don’t see many executives cashing in their stock options. “When times are good, revenue goes way up, but when times are bad, they go way down,” said Joseph Henchman of the Tax Foundation in Washington, D.C.

California offers a striking example of what can happen, he said. A little over a decade ago it was the first state to impose high tax rates on those making more than $1 million a year. It reaped huge rewards in 1999 and 2000, as a result of the tech boom, and the state built budgets as if those windfalls would last forever. Then came the post-9/11 recession, and California found itself in the worst straits in the country. It rode high a few years ago when the economy recovered; in the current recession it faced a shortfall estimated at $40 billion – and its legislature wound up passing a broad-based tax increase that hit the entire state. Even with spending cuts and the tax increase, it still faces a shortfall in the tens of billions.

            All of which shows that high-earner taxes aren’t the solution to an economic crisis, Henchman said – in fact, they can make the hit even worse.

            A Recent Trend

High-earner taxes are a relatively new idea. After California came New York and New Jersey. Maryland followed in 2008. Hawaii, Oregon, Wisconsin and Connecticut enacted their high-earner taxes within the last 18 months. The threshold keeps getting lower – Oregon’s, enacted at the ballot box this year, pegged the level at $125,000. If 1098 passes, Washington would be the ninth, but with a key difference – it would be the only state income tax that hits only high wage-earners. The narrower the base, the bigger the problem, Henchman said. “The problem is that there aren’t that many millionaires out there,” he said.

Because the movement is recent, most states with high-earner taxes haven’t had a chance to ride the roller coaster yet. But economists in Oregon, for instance, are starting to gulp. A few months ago the Oregon Office of Economic Analysis acknowledged its projections missed the mark by $500 million – a record for that state – and it blamed the problem on the volatility of its existing income tax. When revenue from the new high-earner income-tax brackets kicks in this year, the whiplash will be even harder, said senior economist Josh Harwood.

“Certainly there will be more volatility,” he said. “Revenue will be higher in good times and lower in bad times than it would be otherwise, because the focus is on those with the most volatile incomes.”

            Is it Manageable?

Yes, the swings in revenue might be more dramatic, but they can be managed, argues Matt Gardner of the Institute for Taxation and Economic Policy in Washington, D.C. ITEP leans left, and has provided much of the statistical information on which I-1098’s supporters are basing their arguments.

What it takes is a meaningful rainy-day fund, or some other means of leveling out spending and socking away money when tax revenue skyrockets, Gardner said. Forty-five states have them, he said – and the problem for Oregon and California is that they do not. In fact, he said much of Oregon’s trouble might be attributed to its “kicker” law, which rebates tax money to citizens when revenue jumps.

“The misleading thing is that people think volatility is what matters,” Gardner said. “What matters is the ability for state policymakers to fund programs over the long haul.”

The problem with Washington’s tax structure is that the existing taxes – particularly the sales tax – haven’t been keeping pace with the growth in personal income, he said. That’s why money runs short. Over the long term, an income tax solves that problem, he said. And a high rate for the rich – that’s a political decision, but Gardner argues it’s fairest for all.

But if 45 states have meaningful rainy-day funds – and 43 of them had to go back last fiscal year and cut their budgets because they ran out of money – do they really do the job? Gardner said the depth of the current recession is something no state legislature could have expected. “If there was ever a time to use your rainy day fund, this was it.”

            Volatility Will Force Extension of Tax

            You have to be realistic about things, said Curtis Dubay of the conservative Heritage Foundation in Washington, D.C. Do you really think the Washington state Legislature is going to discover discipline? Once Washington state becomes dependent on income taxes from the rich, he said, of course there’s going to be a downturn, and of course there’s going to be trouble. And that means eventually the soak-the-rich tax will soak everyone.

            “What will happen is that if Washington passes the income tax, and then the economy recovers, you’ll have big revenue gains,” he said. “People will pay lots of money in income taxes, and the Legislature will get together and say that’s great, let’s spend it. Who knows what they’ll spend it on? Education, maybe. That’s always popular.

            “But then, when the economy goes into recession, all that revenue will dry up. There is no way the teachers’ union will let them cut back when they’ve gotten what they want, and so the Legislature will extend the tax to a broader base.

            “It’s not too hard to figure out how these things will go.”