Connecticut Mulls Large Corporate Tax Increase, Sales Tax Base Expansion

February 23, 2015

Connecticut lawmakers will take up a budget that includes $914 million in additional tax and fee revenue. Governor Dan Malloy’s FY 2016-2017 budget proposes changes—tinkering in some areas, offering sweeping changes in others—to a range of taxes and fees, including substantial adjustments to the sales tax, corporation tax, and health provider taxes.

The anticipated revenues support a 3.3 percent increase in state spending in 2016, and a further 3.1 percent increase in 2017, bringing the state’s annual budget to $19.7 billion by 2017.

As part of his plan, Malloy proposes broadening the sales tax base and lowering the rate in what will ultimately become a roughly revenue-neutral adjustment, albeit with a first-year windfall of $70 million.

Like most states, Connecticut’s sales tax base is narrow, and the share of the state’s economy it encompasses will continue to diminish as services continue to grow as a share of consumer expenditures. In addition to the services exemption, Connecticut also exempts a wide range of goods: groceries, medical supplies, vehicles, textbooks, bicycle helmets—and clothing, an exemption the Governor’s FY 2016-2017 budget proposes to eliminate, accompanied by an offsetting rate reduction.

Each of these exemptions forces the overall rate to be higher to achieve the same amount of revenue. In FY 2013, sales tax exemptions totaled an estimated $3.7 billion, while actual sales tax revenue ran $4.1 billion. That means that, if the sales tax were levied across all these categories, a 3.34 percent rate would have generated the same revenue as the 6.35 percent rate did.

Of course, not all sales tax exemptions are created equal. Some are designed to avoid tax pyramiding, which is good policy. Others are intended to address specific policy considerations, some of which are likely better than others. But carve out enough exemptions and you quickly have a tax that is both unnecessarily high and unreflective of the state’s economy.

The clothing exemption is new, just adopted last year for clothing and shoes under $50 and heavily touted by the Governor during his reelection campaign. It’s worth about $140 million a year, and by eliminating it, the Governor’s budget is able to reduce the sales tax rate to 5.95 percent by April 2017. The shift serves a revenue purpose: the reduction is phased in via a 6.2 percent rate beginning November 2015, and thus results in a one-year $70 million windfall in FY 2016.

The proposed changes to the corporation tax also include the elimination of certain exemptions, but here there is no effort to achieve revenue neutrality. Instead, the biennial budget proposes an astonishing 43.6 percent increase in business taxes in FY 2016, to decline somewhat thereafter, while still remaining well above the current baseline.

This tax hike is accomplished in three ways. First, the scheduled sunset of a 20 percent corporation tax surcharge is scrapped, keeping Connecticut’s corporate rate at 9 percent rather than allowing it to return to 7.5 percent. Second, the use of net operating losses is capped at 50 percent of liability, penalizing companies that experience greater volatility across the business cycle. Finally, the use of tax credits is capped at 35 percent of tax liability for calendar year 2015, 45 percent in 2016, and 60 percent in 2017 and thereafter.

As with the exemptions in the sales tax, many of these corporation tax exemptions—film tax credits, job creation tax credits, R&D credits, industrial site reinvestment credits—unnecessarily erode away at the base. A lower rate would do more to promote economic growth than these targeted abatements. This budget, however, keeps the rate at an extremely high 9 percent even as credits are capped, resulting in a 43.6 percent increase in corporate tax liability.

The increase over the current baseline is slightly smaller in subsequent years, due to higher credit caps and the elimination of the business entity tax, a $250 tax paid by every business in the state, including sole proprietorships.

An additional $165.2 million a year is raised through increases to the hospital net revenue tax, plus $18.7 million from extending current credit caps on insurance taxes for another two years. All told, general fund revenue would increase by $557.6 million in FY 2016 and $356.8 million in FY 2017, above the current baseline, if the Governor’s budget were to be adopted in its current form.

Eliminating credits and exemptions can be good policy, but by making Connecticut’s anomalously high business taxes even higher, this budget risks substantial harm to the state’s prospects for employment and economic growth.

More on Connecticut.

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