Fiscal Fact No. 232
Rhode Island officials are taking steps that may result in a taxA tax is a mandatory payment or charge collected by local, state, and national governments from individuals or businesses to cover the costs of general government services, goods, and activities. reform effort with positive implications.
The Challenge
The Ocean State currently suffers from a 12.5% unemployment rate, higher than every state except California, Nevada, and Michigan. The state is the tenth-highest in state-local tax burden, has the seventh-highest state-local property tax collections, and has the fifth-highest state-local debt per capita. The 9.9% top individual income taxAn individual income tax (or personal income tax) is levied on the wages, salaries, investments, or other forms of income an individual or household earns. The U.S. imposes a progressive income tax where rates increase with income. The Federal Income Tax was established in 1913 with the ratification of the 16th Amendment. Though barely 100 years old, individual income taxes are the largest source of tax revenue in the U.S.
rate is among the highest in the country, as is the 9% corporate income taxA corporate income tax (CIT) is levied by federal and state governments on business profits. Many companies are not subject to the CIT because they are taxed as pass-through businesses, with income reportable under the individual income tax.
rate, and the 7% sales taxA sales tax is levied on retail sales of goods and services and, ideally, should apply to all final consumption with few exemptions. Many governments exempt goods like groceries; base broadening, such as including groceries, could keep rates lower. A sales tax should exempt business-to-business transactions which, when taxed, cause tax pyramiding.
is high as well. The cigarette tax is also the highest in the country. The state puts heavy reliance on the usual corporate giveaways through the tax code (job credits, research-and-development credits, investment credits, film credits, etc.). These programs are generally more about photo-ops and handouts to the politically connected than broad-based economic development.
Our 2010 State Business Tax Climate Index ranked Rhode Island 44th in the country in favorable business tax climate, comparing unfavorably with its immediate neighbors:
Table 1
Rhode Island and Its Neighbors’ Business Tax Climate Ranks
|
State |
2010 Index Overall Rank |
|
Rhode Island |
44 |
|
Connecticut |
38 |
|
Massachusetts |
36 |
Source: Tax Foundation 2010 State Business Tax Climate Index
As we put it last year, Rhode Island faces a tough tax situation because it has significantly lower per-capita income than its two neighbors, and therefore must impose higher taxes to raise revenues in line with its neighbors. Unfortunately, those high tax rates add further incentive for wealthy people and businesses to leave Rhode Island for its lower-tax neighbors, or for other parts of the country.
Consensus for Change: Optional Flat TaxAn income tax is referred to as a “flat tax” when all taxable income is subject to the same tax rate, regardless of income level or assets.
and Carcieri 2009 Proposal
Consequently, a consensus has developed among Rhode Island policymakers that the state’s tax system is a hindrance to long-term economic growth. In 2006, officials began phasing in an optional flat tax, whereby taxpayers could eschew the 9.9% rate coupled with myriad credits and deductions, and instead pay one rate on all their income. The rate began at 7% and has been stepping down each year. In 2009, the optional flat tax rate stood at 6.5%; in 2010, it is 6%; and in 2011 it will reach 5.5% where it will stay.
If the 5.5% optional flat tax was in place in 2010, Rhode Island would rank 43rd in the State Business Tax Climate Index instead of 44th.
The optional flat tax has been the key driver to the state’s modest improvement in the State Business Tax Climate Index, from dead last (50th) in 2006 to 44th in 2010. (Note: We give a state credit only for tax changes that are in effect as of our annual snapshot date, and not for legislated changes that have not yet taken effect. Sometimes legislated tax reductions are postponed or cancelled, as happened in Ohio this year.)
Last year, Rhode Island Gov. Don Carcieri (R) proposed a plan to phase out the state’s corporate income tax over four years, joining four other states without a major business tax. The plan also eliminated many deductions and credits and reduced the top individual income tax rate to 5.5%. Carcieri also proposed to raise the cigarette tax still further, by $1 to $3.46 per pack, the only part of the proposal that was enacted.
The 2009 Carcieri plan was ambitious but would have given Rhode Island a chance to step out from its neighbors’ shadows and specialize in attracting capital, business activity, and economic growth. Last year we estimated that had the Carcieri plan been enacted in 2009, the state would have moved from 46th to 16th in the nation in our State Business Tax Climate Index.
Current Proposal
In late May 2010, Rhode Island legislative leaders began outlining a tax reform proposal. As we understand it at press time, the plan would incorporate these elements:
- Replace the state’s current individual income tax structure with three brackets, with a top rate of 6%.
- Raise the amounts of the lump-sum standard deductionThe standard deduction reduces a taxpayer’s taxable income by a set amount determined by the government. It was nearly doubled for all classes of filers by the 2017 Tax Cuts and Jobs Act (TCJA) as an incentive for taxpayers not to itemize deductions when filing their federal income taxes. that most taxpayers claim, but eliminate the option to make a detailed list of deductions – a process known as itemizing.
- Allow only a handful of tax credits, including one for taxes paid to other states, the earned-income tax creditA tax credit is a provision that reduces a taxpayer’s final tax bill, dollar-for-dollar. A tax credit differs from deductions and exemptions, which reduce taxable income, rather than the taxpayer’s tax bill directly. , the statewide property-tax relief credit and a credit for residential lead-paint abatement. Tax credits for investment, research-and-development, and job creation would be repealed but the film tax credit would remain.
- The optional flat-tax method of calculating one’s Rhode Island income tax would be eliminated.
Minor differences between House and Senate versions remain to be worked out, but if the outline of the proposal were in place in 2010, Rhode Island would rank 41st in the State Business Tax Climate Index instead of 44th. This indicates the plan would be a modest but positive change for the state’s tax system.
Table 2
Rhode Island and Its Neighbors’ Business Tax Climate Ranks With Changes
|
State |
2010 Index Overall Rank |
2010 Index Overall Rank with Fully Phased-In Flat Tax |
2010 Index Overall Rank with May 2010 Tax Proposal |
|
Rhode Island |
44 |
43 |
41 |
|
Connecticut |
38 |
38 |
38 |
|
Massachusetts |
36 |
36 |
36 |
Source: Tax Foundation.
Conclusion
Rhode Island has shown its willingness to tackle its problematic tax system. Tax pundits were surprised when the state became a flat-tax pioneer, and the broad consensus for improvement means that this may be the Ocean State’s moment. Rhode Island can compete with its border states and beyond, and it has recently shown the political will to do so. As the economy improves, capital and investment will flow to those states best positioned for it. Rhode Island has a chance to welcome that opportunity, and frankly, the state has nowhere to go but up.
The state should not get rid of the optional flat tax lightly but the proposal under discussion is an improvement, albeit a modest one. Tackling the state’s high corporate income tax rate, particularly as they eliminate credits and deductions used by many businesses, may be politically essential. But the plan echoes the advice of tax experts everywhere: broad bases and low rates.
Note: After press time, we were informed that legislative leaders may only eliminate tax credits and deductions in the individual income tax code. Our report assumes the elimination of tax credits and deduction in both the individual and corporate tax codes.
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