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State should trade in clunker of a tax loophole

Could another car tab fee levy emerge? Credit: Ben McLeod/Flickr

Washington’s legislature will soon convene for a special session that Gov. Chris Gregoire has already called “brutal” for its potential impact on education and other services. The governor has outlined cuts to cover the latest in a long string of recession-induced budget shortfalls. The cuts will land especially hard on middle class and low-income residents.

The special session will, in some ways, define who we are as a state and who our government really works for — the hard-working and struggling families in our communities, or powerful special interests. Lawmakers can enact another “all cuts” budget this year, or they can balance cuts with some revenue earned by closing tax loopholes. In fact, Washington’s tax code is riddled with 567 “tax exemptions,” collectively worth about $98 billion per biennium. In fact, state tax exemptions amount to almost twice the value of state tax revenues. So loopholes aren’t some sideshow to the Olympia budget circus, they are in the center ring.

Shutting just one of the more perverse loopholes — the “trade-ins exemption,” which mainly benefits auto dealerships — would fix one-fifth of the special session’s budget problem, providing $344 million per biennium in new revenue for state government, plus an additional $106 million to local governments. (It’s possible that the recession has reduced auto sales enough to have somewhat shrunk the value of the loophole, but the revenue department’s projection remains the most credible available.)

Those are big numbers, the kind of numbers that can make the eyes glaze. So let’s express trade-ins exemption by comparison: it’s enough money to protect a dozen or more of the bedrock family services that define the community values we hold dear in Washington, including the state’s Children’s Health Insurance Program, which provides health benefits to 134,000 lower-income children; preserve the Basic Health Plan, which provides coverage to 35,000 of the state’s poorest residents; cover maternity support services for the 55,000 women at risk of unhealthy birth outcomes; save full-day kindergarten for 16,900 children in high poverty schools; preserve state funding for domestic violence shelters that assist 16,700 state residents; protect child welfare programs that help 5,700 kids annually; and maintain the state’s work-study program for college students. All of these programs are slated for elimination in the governor’s suggested budget. Not only that, closing the loophole would also preserve about three-quarters of the state’s need-based grant awards to low-income students attending college.

The trade-ins exemption has a way of confusing voters. Like three-card Monte, it seems easy until you’ve lost your money — $334 million of it. Here’s how it works. (Later, I’ll correct some common confusions.) Let’s say I trade in a used car worth $5,000 and buy a $20,000 new car. Under the trade-ins exemption, I pay taxes only on the $15,000 balance. In contrast, if I first sell my used car to a private buyer, I’ll then have to pay sales tax on the full $20,000 purchase price. In this example, the exemption provides an incentive of roughly $450 to trade my used car in at the dealership, rather than selling it on my own. The result is to tilt used car transactions toward dealers and away from Craigslist.

Strictly speaking, the loophole applies to everything that gets traded in, including boats, bicycles, and musical instruments. But almost all of the benefit goes to auto dealerships, and to those relatively well-off buyers who regularly upgrade their old cars for new ones. The pricier your cars (and the more frequently you trade them in), the bigger the payoff.

In the days before the Internet, car dealerships helped buyers and sellers find one another. But today, online want ads such as Craigslist and Cars.com connect prospective buyers and sellers instantly across huge areas. Potential purchasers can easily research a vehicle’s legal history online, and web-based valuation databases such as Kelley Blue Book help buyers and sellers. Why subsidize middle men in what has become a thriving and efficient open marketplace?

Closing the loophole would restore a simpler, fairer tax code that also benefits Washington families. It’s something that fiscal conservatives and progressives alike should find appealing.

Closing the trade-ins exemption, or any other tax loophole, could run afoul of the politics swirling around Tim Eyman’s minority-rule provision put in place by Initiative 1053. This rule may not be an insurmountable obstacle. A fair-minded legislature — one not beholden to auto dealerships — could craft a bipartisan budget that would achieve the two-thirds majority stipulated by Eyman’s measure. Or the legislative majority can simply ignore the Eyman rule, which is patently unconstitutional but hard to challenge in court, for technical reasons. In fact, by ignoring it, the legislature would frame up exactly the kind of lawsuit that would give the state courts an unambiguous opportunity to apply the simple-majority voting requirement written into the state constitution. Given judicial review, the courts would almost certainly declare Eyman’s initiative unconstitutional.

The benefits of closing the loophole are clear, but discussions about the trade-ins exemption often get confused by misunderstandings. Let’s address those now.

  •  “It’s not fair to tax trade-ins because they don’t constitute a sale.” This common objection misunderstands the problem. To be clear, trade-in vehicles are not taxed now nor would they be if the loophole were closed. What’s at issue is whether the state should tax A) the full sales price of a vehicle, or B) the sales price minus the value of a trade-in. By choosing option B, the trade-ins exemption violates the logic of Washington law. The state collects sales taxes on bartering, for example, so why give special treatment to trade-ins? The answer is not to be found in logic but in politics. The state got along just fine without the loophole until a 1984 ballot measure created the loophole for auto dealerships.
  •  “Doesn’t the loophole benefit Washington’s economy, by stimulating new car sales?” The trade-ins exemption modestly boosts car dealerships profits, in part by boosting new car sales. But in a state with virtually no car manufacturing, is boosting car sales a good thing for the state to be doing? Most of the value of car purchases flows to car-building regions like Michigan, Japan, Europe, or the American South. Just so, although the state is home to several refineries, Washington produces no petroleum, so the money spent to power our vehicles mostly flows out of the state. In 2011, Washington residents are projected to spend roughly $15 billion to import oil from other states and countries. In fact, closing the loophole may yield environmental benefits by ending what is, in effect, a subsidy for automobile purchases.
  • “Wouldn’t closing this loophole mostly help rich cities like Seattle, where people can afford to buy new cars?” No. It would help to stave off some of the more severe cuts to Washington’s social services and education, which benefit families statewide. It would also be a boon to local governments, many of which are struggling to provide basic community services and maintain public structures. Furthermore, the benefit would be proportionately smaller in urban places like Seattle, which has few auto dealerships relative to its population, and larger in the suburban and small town jurisdictions that sell the bulk of the state’s cars. Still, by providing more than $100 million to counties and cities, it would benefit almost every place in the state.
  • “Doesn’t the trade-ins exemption benefit the moderate-income families who buy used cars?” Quite the opposite. Used car buyers who don’t have any wheels to trade in pay the full sales tax either way. But even used car buyers pay a hidden price for the trade-ins loophole. By steering the used car market toward dealerships, which have higher overhead and generally charge more, the loophole reduces the quantity of second-hand cars available through lower-cost private transactions. In effect, the loophole serves as a hidden tax on used car buyers; dealerships pocket the benefit.
  • “Wouldn’t closing the loophole be regressive?” No. In fact, the existing trade-ins exemption is grossly unfair. Its greatest beneficiaries are the BMW set: well-off people who frequently trade in their high-priced, slightly used cars for the latest models. Lower-income families — who own fewer and lower-priced cars, and purchase autos less frequently — see little benefit from the loophole. (And needless to say, few low-income families benefit from the trade-in exemption for boats!) What’s more, the proposed state budget cuts would have severe consequences for middle class and low-income residents of Washington.

Last session, the Washington legislature closed its budget gap with an “all cuts” strategy — slashing spending without any attempt to boost revenue. Yet a Washington Poll, conducted by University of Washington professor Matt Barreto in October, found that state voters do not want another “all cuts” budget: 71 percent of respondents supported covering at least a portion of the budget shortfall with revenue increases.

Trying to close a tax loophole is politically hard. It’s practically an invitation for special interests to rush to defend their special treatment. One can already imagine the legions of auto salesmen hightailing it to Olympia to protect their tax giveaway. There is almost no chance that closing this loophole will be politically easy, yet ending the exemption is a matter of restoring good sense and basic fairness to the state’s convoluted tax code which, more often than not, stacks the decks against families and communities in favor of insiders and powerbrokers. If we don’t rise to the challenge, though, Washington will sacrifice its low-income kids, poor seniors, and aspiring but disadvantaged college students in order to keeping showering hundreds of millions of dollars each on auto dealers and those who are lucky enough to be new-car buyers.

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