Rhode Island Governor’s Tax Proposals Would Improve State’s Business Tax Climate

Even within the northeast, Rhode Island stands out as a high-tax state. The Ocean State ranks 46th out of 50 states (and worst in New England) on the Tax Foundation’s 2009 State Business Tax Climate Index, which rates state tax codes on their friendliness to business. Neighboring Connecticut is 37th; Massachusetts, defying the “Taxachusetts” moniker, is second-best in New England at 32nd.

With a simple glance at tax rates, it’s easy to see why Rhode Island compares so unfavorably to its neighbors. Its income tax tops out at 9.9%, higher than any state except California. Massachusetts levies a flat rate of 5.3%; Connecticut has a two-bracket system topping out at 5%. Rhode Island’s 7% sales tax is the highest in New England; Massachusetts charges 5%, and Connecticut 6%.

Rhode Island faces a tough tax situation. Its state and local expenditures are not out obviously of line: $9,084 per head in 2006, compared to $9,023 in Connecticut. Massachusetts is a bit higher at $9,626. However, because Rhode Island has significantly lower per-capita income than its two neighbors, it must impose higher tax rates 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. Meanwhile, Rhode Island is facing a confluence of crises: as covered on CNN last week, the state faces a significant budget gap and the country’s second-highest unemployment rate.

Earlier this month, Gov. Donald Carcieri (R) proposed a number of major reforms to the state’s tax code, in an effort to improve Rhode Island’s tax competitiveness. His proposal would:

• Phase out the state’s corporate income tax over four years, making Rhode Island one of just four states without a major business tax. The tax rate would fall to 7.5% in the first year and to zero by 2014.
• Simplify the individual income tax by cutting marginal rates, reducing the number of brackets, and eliminating many deductions. The new top marginal rate would be 5.5%, down from 9.9%. Rhode Island also currently offers an optional flat tax (at a 6.5% rate for 2009) and a reduced tax rate for capital gain income; those features would be eliminated.
• Increase the estate tax exemption from $675,000 to $1,000,000. Rhode Island currently ties New Jersey for the second-lowest exemption amount of any state levying an estate tax; only Ohio is lower. Thirty-four states levy no estate tax at all. (See Forbes.com’s “Where Not To Die” map.)
• Finally, Carcieri would raise the cigarette tax by $1 to $3.46 per pack. That would be, by a wide margin, the country’s highest state cigarette tax; the current leader is New York at $2.75 per pack.

I ran this proposal through the State Business Tax Climate Indexto see where Rhode Island would have stood if Carcieri’s proposals had been in effect for 2009. The effect is staggering: Rhode Island would have stood at 16th out of 50 states, 30 places higher than its actual performance. Instead of scoring 40th on the corporate income tax component of the Index, it would have tied for 1st. It would have jumped nine spots on the income tax portion and three on the property tax portion (because the Rhode Island corporate tax includes an assessment on corporate net worth), while dropping one position on the sales tax measure.

While small states can face competitive disadvantages with their larger neighbors (especially if those neighbors are wealthier) they also have an opportunity to specialize in attracting a certain kind of capital or business activity. Delaware made itself a desirable place to incorporate and collects approximately 30% of state government revenues from business license fees. Nevada built an economy around being the only state with generally legalized gambling.

Now, Gov. Carcieri has identified an opportunity for Rhode Island to step out from its neighbors’ shadows and become New England’s corporate tax haven. While the state’s legislature has a Democratic supermajority, Rhode Island’s Democratic legislators have previously shown interest in pro-growth tax reforms, including the state’s optional flat tax and its favorable treatment of capital gain income. We’ll be watching this spring to see whether Gov. Carcieri gets his way on remodeling the Ocean State’s tax code.