Stay the Course on Rhode Island Tax Reforms
Rhode Island has not yet phased out the capital gains tax as intended by the law enacted in 2001 and the alternative maximum flat tax enacted in 2006 is also not yet fully implemented. The impact of this important movement, praised by the Wall Street Journal as an important step in the direction of State tax policy, has yet to be tested. Time is needed to play out the true impact of these significant tax changes and to show that Rhode Island is a state where businesses can make decisions based on stability in taxation.
The economic importance of cutting the state’s capital-gains tax should not be underestimated. Capital-gains taxes are direct levies on investment, risk-taking and job creation. In this global market for capital, Rhode Island is finally in a position, by not taxing capital gains, to unleash entrepreneurial energy and become a magnet for capital.
State capital-gains taxes add another layer of impediments to investment and entrepreneurship, hampering economic growth and job creation. Even with a low state capital-gains tax rate of 4.5 percent, as in Connecticut, if one considers inflation on a venture-capital investment of $50,000 made in 2002 and sold for $70,000 in 2007, Connecticut's real capital-gains tax rate jumps to 12.5 percent.
States that do not tax capital gains, Alaska, Florida, Nevada, New Hampshire, South Dakota, Tennessee, Texas, Washington and Wyoming reap economic rewards accordingly. From 2001 to 2006, the rate of job creation in these nine states averaged 9.2 percent, more than three times the rate for the rest of the nation.
Our neighboring state of Massachusetts dropped its capital gains tax in 1994 while capital-gains taxes in Mississippi were eliminated for investments in Mississippi-based corporations. The Massachusetts economy was doing quite well with the elimination of the capital gains tax, but as a result of the fallout from the dot.com industry, the state ratcheted their rate back up to 5.3 percent in 2004. The results: a recently released assessment of the Massachusetts state budget declares that the State’s budget woes are “exacerbated by volatility in revenue growth.” Recent history reveals an over-reliance on the capital gains tax for more than half of the state’s new tax receipts...a revenue source that reacts in concert with Wall Street’s boom and bust cycles.”
Indeed capital gains are extremely volatile, dropping in one year in Rhode Island from over two billion in 1999 to $1 billion in 2001 and falling even further to less than $697 million in 2002. Not only is reliance on capital gains tax a deterrent to investment and job creation, it is not a reliable source of revenue as it is particularly subject to extreme swings just when revenues are most needed. States dependant on capital gains, such as Massachusetts, grew state budgets and programs during the “good years” only to be in a more precarious budget shortfall as the economy weakened.
The outright elimination of state capital-gains taxes remains the surest step to providing a real boost to a state's economy, usually with a relatively small loss in government revenues. Once it is understood that the driving forces behind economic growth are innovation, investment and entrepreneurship, it becomes quite clear that taxing capital gains is not the answer to Rhode Island’s budget woes.
The alternative maximum flat tax approved by the legislature in 2006 was intended to ease the competitive disparity between Rhode Island and Massachusetts in attracting and keeping high income residents who create companies and jobs.
At 9.9 percent Rhode Island had the highest tax rate on high income residents in the nation. So it is no surprise that less than 2.5 percent of Rhode Islanders had incomes of $200,000 or more in 2005 compared to 4 percent of Massachusetts residents and almost 5 percent of Connecticut’s residents. Not only does Rhode Island have far fewer residents with high incomes, but the average income of Rhode Island’s 2.46 percent top earners was $491,000 compared to almost $600,000 in Massachusetts and $700,000 in Connecticut.
The alternative tax was intended to give taxpayers the option of paying a set rate on their income that was on a par with neighboring Massachusetts. A move designed to boost the number of high income residents, bearing in mind that these residents contribute greatly to charity, invest in new enterprises and create jobs. A laudable tax policy that deserves the time needed to be played out.
Does the alternative maximum flat tax do away with the need for the elimination of the capital gains tax? No, because one nuance of the flat tax is that if a taxpayer chooses that option, the flat tax is applied to all income including capital gains.
Most of the debate over capital gains has focused on the relatively high incomes of a minority of taxpayers but most of the people with capital gains income are not in the highest tax brackets. The demographics of capital gains on tax returns tell another part of the story. Based on IRS data, between 40 and 50 percent of Rhode Island filers with capital gains had incomes of less than $50,000.
Tax Foundation economists found that the picture that emerges is largely a reflection of the “graying” of America: approximately 26 percent of taxpayers with capital gains are over age 65 while nearly 38 percent are over age 55. This should be no surprise as capital gains are increasingly more apt to be exercised in the retirement years.
Rhode Island tax policy has been moving in the right direction. The state’s new tax policy function is now in place to properly assess and evaluate what works and what does not work. It would be a shame to change the course before the state is able to assess the benefits of these two very important steps.