June 14, 2012

Trend #2: Income Tax Reform

Download Fiscal Fact No. 312: Income Tax Reform

Fiscal Fact No. 312
Note: This publication is part of our "Top 10 State Tax Trends in Recession and Recovery" series.

Most economists agree that tax systems should have broad bases and low rates: if targeted deductions, credits, and exclusions are avoided, substantial revenue can be raised with low tax rates. Such tax systems reduce political distortions of economic decision-making and promote overall economic growth.

Unfortunately, many state tax systems are precisely the opposite: high tax rates on a relatively narrow tax base. California, for instance, reported in 2008 that its various “tax expenditures”—credits, deductions, and exclusions—reduce individual income tax collections by approximately $36 billion, or 39 percent.[i] Put another way, only 61 percent of income earned in California is subject to the individual income tax. California’s high tax rates, it could be argued, are higher than they would need to be if the tax base was broader.

Although “tax reform” can mean different things to different people, the term generally refers to tax changes that broaden the base and lower the rate. Revenue impacts can vary by proposal, but tax reforms can be accomplished with revenue increases, revenue reductions, as well as by staying “revenue-neutral.” In 2006, for example, Utah under Gov. Jon Huntsman (R) enacted a tax reform replacing its complicated income tax system with a flat 5 percent rate and eliminating many deductions. (Huntsman’s efforts to similarly reform the sales tax, however, came to naught.)

The key income tax reform accomplishment during the recent recession occurred in Rhode Island, which for many years had a 5-bracket income tax with a top rate of 9.9 percent. Beginning in 2006, an optional flat tax was introduced to parallel the regular income tax, and continued bipartisan pressure to do something about Rhode Island’s poor economic performance and tax system complexity led to further reform in 2010, that took effect on January 1, 2011.[ii] Elements of the reform:

  • Eliminates the optional flat tax system and the alternative minimum tax.
  • Reduces the number of tax credits.
  • Increases the standard deduction for most taxpayers.
  • Eliminates the option to itemize deductions.
  • Reduces the number of brackets from 5 to 3, and reduces the top tax rate from 9.9% to 5.99%.

Overall, the reform was designed to be revenue-neutral and actually increase progressivity, while dramatically reducing compliance costs and barriers to economic growth. While Rhode Island still has problematic property and corporate income taxes, and although the income tax changes are still new, their tax reform will greatly boost the state’s competitive position. That an overwhelmingly Democratic legislature and the Republican governor came together to enact it shows that tax reform is a possibility in any state.

Rhode Island’s positive changes were unfortunately an outlier. Other states that made income tax changes either did so to adopt “millionaires’ taxes” on high-income earners, or adopted rate increases or decreases without base changes. Illinois, for instance, boosted its tax rate by 67 percent (from 3% to 5%) in 2011 and actually expanded the tax preferences in its tax code. (Revenue estimates have since fallen far short of expectations.)

Although Utah and Rhode Island are the only recent success stories, proposals are increasingly popping up across the country. A Maine tax reform proposal, which unfortunately incorporated a “millionaires’” tax and new tourism taxes, passed the Legislature but was repealed by the voters in 2010, interestingly on the same day that Rhode Island’s was signed into law.[iii] A Georgia income tax reform proposal in 2011 fell due to controversial components in its related sales tax reform.[iv] Also in 2011, an Arizona proposal died in the state Senate after passing the House.[v] This year, governors in Kansas and South Carolina have proposed reforms, with the Kansas effort resulting in a reduction in tax rates.[vi]

Table: State Income Tax Rate Changes, 2007-2012

States Increasing Income Tax Rates

States Reducing Income Tax Rates








New Jersey

New York

North Carolina



District of Columbia


New Mexico

New York

North Dakota



Rhode Island




(tax reform repealed at ballot)


(failed tax increase initiative)

Source: Tax Foundation.

Note: States may appear in multiple columns. Expiration of temporary tax increases are not counted as tax reductions.

[i] California Department of Finance, Tax Expenditure Report 2008-09, http://www.dof.ca.gov/research/documents/Tax_Expenditure_Rpt_08-09-w.pdf.

[ii] See Ryan Forster, Rhode Island Approves Tax Reform Package, Tax Foundation Tax Policy Blog (Jun. 9, 2010), http://www.taxfoundation.org/blog/rhode-island-approves-tax-reform-package.

[iii] See William Ahern, Income Tax Reform Repealed by Referendum in Maine, Tax Foundation Tax Policy Blog (Jun. 9, 2010), https://taxfoundation.org/blog/income-tax-reform-repealed-referendum-maine-last-paragraph-corrected.

[iv] See Joseph Henchman, Georgia Legislators Considering Changes to Income and Sales Taxes, Tax Foundation Tax Policy Blog (Mar. 29, 2011), http://www.taxfoundation.org/blog/georgia-legislators-considering-changes-income-and-sales-taxes.

[v] See Joseph Henchman, Arizona Weighs Income Tax Reform, Tax Foundation Tax Policy Blog (Mar. 21, 2011), http://www.taxfoundation.org/publications/show/27136.html.

[vi] See Joseph Henchman, Kansas Governor Proposes Significant Income Tax Reform, Reducing Rate From 6.45% to 4.9%, Tax Foundation Tax Policy Blog (Jan. 19, 2012), http://www.taxfoundation.org/blog/kansas-governor-proposes-significant-income-tax-reform-reducing-rate-645-49; Joseph Henchman, South Carolina Governor Calls for Reducing Individual and Corporate Taxes, Tax Foundation Tax Policy Blog (Jan. 26, 2012), http://www.taxfoundation.org/blog/show/27926.html.

A 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.

The tax base is the total amount of income, property, assets, consumption, transactions, or other economic activity subject to taxation by a tax authority. A narrow tax base is non-neutral and inefficient. A broad tax base reduces tax administration costs and allows more revenue to be raised at lower rates.

A 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.

A 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.