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Thursday, May 20, 2010

Rhode Island - Possible Income Tax Reform

An article in The Providence Journal of May 20, 2010 ("R.I. legislators revamping personal income tax system" by Peoples and Downing) describes some possible income tax reforms that may be introduced by some legislators next week. The article notes that Governor Carcieri is also studying some reforms.

Apparently, the concern is the 9.9% income tax rate that per the article kicks in when one's income exceeds $373,000, while many pay at a rate of 3.75%. The concern is that the high rate (6th highest among the states according to the article) harms the state's business climate. The plan might also include elimination of itemized deductions in place of a larger standard deduction and elimination of most tax credits, although an earned income tax credit would remain.

A state income tax comparison chart from the Federation of Tax Administrators notes that Rhode Islands tax rates range from 3.8% to 9.9%. IRS data for 2007 indicates that only about 3% of returns filed report adjusted gross income (AGI) of $200,000 or more. So, it is a very small percentage of Rhode Islanders who possibly owe at the 9.9% rate that applies once income hits $372,950.

Generally, a tax with a low rate and broad base is more likely to meet principles of good tax policy. For example, replacing itemized deductions with a larger standard deduction makes the system simpler and puts a cap on large deductions of high income individuals, likely increasing the equity of the system. Yet, distributional neutrality of the new system should also be examined against what legislators think people in different income levels should be paying.

California also has a high top individual income tax rate and it also tends to be a focal point in rating a state's business climate even though it applies to a small number of high income individuals. I've written about this before (here) because an additional problem in California is that a very large portion of total personal income tax which represents about half of state tax collections comes from a few thousand individuals making the system volatile - if their income drops, so do state revenues. Alternatives include broadening the sales tax base (and lowering its rate) to tax more of the consumption of high income individuals. For example, individuals in CA get a sales tax break on their home utilities because it is a necessity of life. But, where is the necessity of heating and cooling an 8,000 square foot home?!

Let's see what happens in Rhode Island.

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