Washington governor’s office
The “millionaires tax” bill Washington state lawmakers passed this month could generate more in-state demand for the state’s bonds, but just how much remains to be seen.
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The legislation, which Gov. Bob Ferguson is expected to sign by April 5, would institute a 9.9% income tax on annual household earnings exceeding $1 million, with the tax taking effect on Jan. 1, 2028, and collected during the 2029 tax season.
The key market ramification lies in the state-level tax exemption for municipal bonds. The bill stipulates that interest on Washington-issued state and local bonds will be exempt from the 9.9% levy.
It is a sea change for a state that has not taxed personal income.
Lawmakers estimated the tax would impact 20,000 to 30,000 households of the state’s roughly 8.1 million residents and apply only to the amount of income above $1 million. It is expected to generate $3.7 billion annually.
The policy generally mirrors how most other states handle in-state versus out-of-state muni investments. Most states offer tax exemption for their state and local government bonds, but tax out-of-state bonds. Illinois taxes both.
With the legislative session concluded, the State Treasurer’s Office has begun reviewing the potential benefit that Washington bonds could receive from the state tax exemption, said Jason Richter, deputy state treasurer of debt management.
“Looking to other states with state income taxes, there is generally a pricing benefit due to the additional exemption,” Richter said. “We expect that over time, Washington could experience a similar benefit.”
In the coming months, the treasurer’s office “will be researching the pricing benefit and how best to connect to Washington investors to further develop these relationships and make sure the state receives the best possible pricing for our bonds.”
Historically, Washington has traded as a “general market” state alongside others without a state income tax, like Texas and Florida, said Kim Olsan, senior fixed income portfolio manager at NewSquare Capital.
Washington residents had no in-state tax advantage and tended to buy municipal bonds from across the country based on yield or whatever fit their parameters, Olsan said. This would also apply to Alaska, Nevada, Texas, Florida, South Dakota — states that have no income tax, she said.
“Whereas, if people in a high tax bracket live in New York, New Jersey or California, they have in-state income to protect,” Olsan said. “I think California’s top (tax) rate hits at $3.3 million. If you are earning a 5% coupon, you are giving up 13% income to the state if you are not investing it in California munis.”
Olsan suggested “a slight advantage might develop for Washington names over the next couple years” and the potential exists for a “tighter spread scenario” for in-state names.
Washington sold $1.3 billion of general obligation bonds in February in a competitive deal.
Olsan said she checked the yields in the secondary market on that Washington paper after lawmakers approved the millionaires tax on March 19 and didn’t see any significant movement.
The high ratings of Washington GOs — Aaa from Moody’s Ratings and AA ratings from Fitch Ratings and S&P Global Ratings — helped it achieve solid demand, State Treasurer Mike Pellicciotti said at the time. All three rating agencies assign stable outlooks.
Cooper Howard, director of fixed income research and strategy at Schwab, believes in terms of demand “there might be movement on the margins, but it won’t cause a shift in all of the state portfolios,” because high-net residents subject to the millionaires tax are likely already muni bond buyers. Even without an income tax, retail investors tend to favor bonds in their state, he said.
Because achieving diversification is difficult by investing solely in a smaller state, Howard does not expect the tax to “drive significant demand that will move spreads.”
The legislation targets highly compensated employees at major Washington employers like Microsoft and Amazon, Olsan said.
She observed that Connecticut instituted an income tax in the early 1990s, but other than that she can’t think of a state without an income tax that has adopted one. Other states could follow Washington’s lead, she said.
Washington began moving in that direction in 2021 by adopting a its first capital gains tax.
The tax withstood challenges in the state court system and the U.S. Supreme Court declined to take the case.
Washington’s Republicans have said they will appeal the tax to the state Supreme Court if Ferguson signs it. If it survives the high court, it could start a wave of similar measures in other states, Olsan said.
For high-net-worth retail investors, the decision to buy out-of-state munis often involves weighing the benefits of diversification against the tax implications and logistical burden.
When an investor purchases a muni bond outside their home state, the interest is typically subject to their state’s income tax. This can significantly negate the state tax-exempt component, as noted above in the example involving California, where a high-bracket resident earning a 5% coupon could give up 13% of that income to the state if they do not invest in California munis, Olsan said.
With the exemption of the nation’s largest issuers by state – Florida, New York, Texas, California and Illinois — Howard says to get diversification in their bond portfolio, investors should invest in out-of-state bonds.
“If you aren’t in those states, I say you should add other states for diversification,” Howard said. “If you look at the percentage of the Bloomberg Muni Index, Washington is only 2.9% of the market’s outstanding municipal bonds. It’s a very small-sized issuer.”
Washington State Treasurer’s Office
Investors should aim to invest in at least 10 issuers with different credit risks, which is challenging in smaller municipal bond markets, Howard said.
“Investors may also achieve a higher after-tax yield even after paying state income tax with that approach,” Howard said. “This can occur if credit conditions in the state they are investing in are less favorable, or if other states have better credit ratings or lower market risk.”
Conversely, the downside of buying out-of-state munis is the logistical burden of being obligated to file a separate tax form for other states, Olsan said.
“Using California as an example, there are periods of time when there is so much demand for California munis that buying non-California munis would make sense, because the yields get so tight,” Olsan said. “The downside is I don’t know anyone who wants to be obligated to file another tax form.
“It becomes a logistics issue, when it comes to reporting where income is coming from and having to report it and pay for it,” Olsan said.
States are constantly seeking revenue generators, and the model of creating new income thresholds may be followed by other states with low or no income tax, like Arizona, Olsan said. The tax template “has been breached” by states like Massachusetts, which previously implemented a surcharge on income above 9%, she said.
If more states follow this path, creating new income thresholds would ultimately make munis in those states more valuable, she said.
The millionaires tax reached the governor’s desk despite conflict that briefly flared between Ferguson and his fellow Democrats in the legislature.
Ferguson championed the idea, and then balked at what was introduced initially by lawmakers, because he wanted guarantees in the legislation that revenue from the tax would alleviate the burden on small businesses and increase tax refunds to low income families.
He has indicated he will sign the final legislation.
