Chafee plan for sales tax does not help Rhode Island

PBN Staff

03/26/2011

Gov. Lincoln D. Chafee’s proposal to broaden the sales tax base, while reducing its rate from 7 to 6 percent, is projected to result in a $165 million tax increase. When the details of the proposal are considered, it becomes clear that it is not in the best economic or fiscal interest of the people of Rhode Island.
Any tax program, particularly one of this magnitude, must meet the following tests (in no particular order) – equity, competitiveness, efficiency, transparency and administrative simplicity – for both the taxpayer and tax collector. The governor’s sales tax plan fails these tests and does not preserve the hallmarks of sound tax policy that the General Assembly has tried to meet.
As presented, for example, Gov. Chafee’s sales tax proposal lacks transparency. When considering any change to the state’s tax structure, the devil is always in the details. Taxpayers have a right to know who will be paying more and who less. Who are the winners and who are the losers in this plan?
Data should be clearly presented that includes incidence analysis, so decision-makers and the public will know how the tax increases will affect various income groups and businesses. Will sales tax base-broadening put more or less of a tax burden on the poor, middle class or upper-income taxpayers? How will it affect retailers, manufacturers, the construction industry, health care providers and other sectors of the economy? How much of the new tax burden will fall on business and how much on households?
In making the proposal to broaden the sales tax, the governor has not presented this type of incidence analysis to the public. Obviously, this information is critically needed if the public is to understand the potential economic, social and administrative consequences of a $165 million tax increase. Therefore, one must assume that either the administration does know the economic impact or does not think it is important enough to publish. In fact, the governor’s sales tax plan may cause serious harm to Rhode Island’s fragile economic recovery that is now under way.
Changes in consumption patterns since the sales tax was enacted in 1947 logically lead to discussion of ways to align the Rhode Island sales tax base with the 21st-century economy. In fact, such discussions have been taking place for several years, but a convincing case for change has not been made. In 2009, the Governor’s Tax Policy Strategy Workgroup examined alternatives that would have broadened the sales tax base while reducing the rate from 7 to 5 percent. While the work group did not recommend that Gov. Donald L. Carcieri or the General Assembly implement such a plan, its analysis included suggestions that should be considered if sales tax base-broadening were to be considered.
The work group found that the specific items added to the sales tax base matter, because they can have an impact on economic competitiveness and the cost of doing business. Expansion of the sales tax to business-investment purchases could deter businesses from modernizing and expanding their operations in the Ocean State.
In addition, a consequence of taxing business-to-business transactions is pyramiding and the impact it can have on consumers. Pyramiding occurs when a business pays a sales tax on a good or commodity it uses to produce a product for final sale. When the final sale happens, the sales tax is imposed again. To minimize this tax-cascading effect, sales tax-base expansion to business-to-business purchases should be avoided.
Instead, the governor’s proposal would apply the sales tax to just such economic activities. For example, the sales tax would be applied to manufacturing machinery and equipment used in production as well as equipment used for research and development. Thirty-three states, including Massachusetts and Rhode Island, currently provide a full tax exemption for manufacturing equipment. At a recent meeting of the National Governors Association, Michael Porter, a leading authority on competitiveness strategy at the Harvard Business School, stressed that the goal of a state’s economic strategy should be to enhance productivity and innovation and thus fundamental competitiveness. Taxing business investments aimed at enhancing productivity and innovation is neither a sound tax policy nor helpful to implementing a state’s competitiveness agenda. Measuring a state’s relative tax climate is a complex exercise. While economists may differ on what is the best measure of state tax competitiveness, there is agreement that a state does not want to be viewed as a “tax outlier.” Outlier states have tax rates that are much higher than their neighbors and/or tax items that are generally exempted elsewhere. Any plan to expand the sales tax base should not make Rhode Island an outlier, and special attention should be focused on Massachusetts. Therefore, the work group considered only base-broadening options if the goods or services to be taxed were done so in 20 other states. The governor’s plan would appear to make Rhode Island an outlier state.
Similarly, any plan to modify the state sales tax should not place brick-and-mortar businesses in a less competitive position with sellers who may not be located in Rhode Island. Yet, the governor’s plan does just that. As a result of the sales tax-base expansion and taxing certain items at a rate of 1 percent, the state will not be in compliance with the Streamlined Sales and Use Tax Agreement. Under this agreement, remote vendors collect taxes generated by Rhode Island residents and submit the proceeds to the state. If Rhode Island is determined to not be in compliance with the Streamlined Sales and Use Tax Agreement, those resellers will not be required to do so.
While it is difficult to understand how decisions were made to tax certain items and not others, what is clear is that the proposal in several instances ignores the principle of equity. The taxing of eyeglasses, home-heating oil, residential water and other necessities is regressive, and the tax will take a larger share of the resources of low- and moderate-income individuals and families. This approach to taxing consumption is in marked contrast to prior state policies aimed at minimizing the regressiveness of the state’s sales tax. A key characteristic of a quality state tax system is that it can be administered in a fair, efficient and effective manner, one that serves to encourage taxpayer compliance and is simple for the taxpayer to comply with. Taxing many personal-care services could prove difficult to collect and have the unintended consequence of driving parts of the economy underground.
Thus, the governor’s sales tax program raises concerns about fairness of the tax system, its impact on job creation, the cost of doing business in Rhode Island and the effective administration of the tax code. And at the same time, it does not appear to resolve the state’s structural budget deficit.
One of the objectives of a tax increase of this magnitude should be to close Rhode Island’s structural budget deficit. In fiscal years 2013 and 2014, the sales tax increase does appear to contribute to reducing, but not eliminating, the deficit.
However, by the end of the five-year forecast period, the deficit is projected to exceed $400 million even with the tax increase. Between fiscal years 2013 and 2016, the structural deficit is forecast by the administration to grow by 226 percent – increasing from $126 million to $411 million. If this historic sales tax increase does not eliminate the structural deficit, can we expect additional tax increases in the future or will the governor finally focus on limiting spending?
The answer to this question matters, because increasing taxes to address structural budget problems usually does not work unless there are at least two dollars in spending cuts for every one dollar increase in new taxes.
In the end, Gov. Chafee’s plan to include services in sales-taxable items does a disservice to Rhode Island and its citizens. There must be a better way to address the state’s structural deficit without putting an additional $165 million tax burden on the people with the economic uncertainties inherent in the governor’s sales tax plan. •

Gary S. Sasse is director of the Bryant Institute for Public Leadership. He is also a former director of administration and revenue for Rhode Island.

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