A System Out-of-Balance: Rhode Island’s Piggyback Personal Income Tax

Introduction
RIPEC’s award-winning report, A System Out of Balance – Rhode Island’s State and Local Tax System, urged the Governor and General Assembly to de-couple the State’s personal income tax from a percentage of Federal tax liability and establish a system based on Federal adjusted gross income (FAGI). By doing so, Rhode Island can:

• Gain critical policy control over a revenue source that generates over 40% of the State’ tax revenue;
• Craft an income tax system that reflects Rhode Island’s financial capabilities and its economic and social needs; and
• Minimize impact Federal tax reductions may have on Rhode Island personal income tax collections.

Of the 41 states with personal income taxes, 25 use Federal Adjusted Gross Income (FAGI) as a starting point for calculating their state personal income tax. Eight states base state personal income taxes on Federal taxable income (FTI), and only three states, including Rhode Island, use Federal income tax liability (FTL) as the starting point for calculating state personal income taxes. Five states’ income tax systems are not directly linked to the Federal tax code.

Since A System Out of Balance was published in May 2000, the President has proposed significant Federal income tax reductions. Given that Rhode Island’s personal income tax is directly linked to Federal income tax liability, enactment of major changes to the Federal tax code could have a direct impact on revenues and tax policy in the Ocean State.

This RIPEC Comments summarizes past recommendations to reform Rhode Island’s personal income tax system, presents estimates of the fiscal impact potential Federal income tax changes may have in Rhode Island, and calls for the adoption of a Rhode Island State income tax linked to Federal Adjusted Gross Income.

Review of Rhode Island’s Personal Income Tax System - The Piggyback

Rhode Island, Vermont and North Dakota are the only three states that use a piggyback system in which the state’s personal income tax is a percentage of a taxpayer’s Federal income tax liability. Therefore, the piggyback system mirrors the major structural features of the Federal income tax. As a result, the Rhode Island personal income tax generally has the same standard and itemized personal exemptions, deductions, tax brackets and credits as the Federal income tax. In 2001, Rhode Island taxpayers will pay a State personal income tax generally equivalent to 25.5% of their Federal tax liability, and in 2002, the State’s rate will equal 25.0% of Federal tax liability. In FY 2001, State personal income tax collections are projected to produce $863.7 million, or approximately 44.0 percent of total State tax collections.

The question of whether Rhode Island should continue to piggyback its State personal income tax on Federal income tax liability has been studied and debated over two decades. Indeed, the "proper method" of assessing and collecting a personal income tax is one of the most difficult and complicated tax policy issues that a General Assembly considers. Unfortunately, there are no easy answers to these complex issues.

When the piggyback system is compared to alternative income tax systems, advantages and disadvantages for either retaining or replacing it can be found. Proponents of retaining the current piggyback system note the ease of administration has a distinct advantage because of federal-state exchange agreements, the simplicity of forms, and ease of tax return preparation and compliance. However, since 1982, studies of the Rhode Island tax structure have concluded that these advantages may be offset by the singular disadvantage of the State having only indirect or secondary policy control over its major source of tax revenue.

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For example, in 1982 the Swearer Commission recommended:

"The Commission believes it would be appropriate tax policy to enact a new state personal income tax system that mirrors the current advantages of the piggyback system while at the same time limiting the disadvantage that results from being so susceptible to changes in the federal system."

In 1993, an analysis of Rhode Island’s State tax structure authored by KPMG for the Rhode Island Department of Administration, highlighted two structural issues relating to the Rhode Island personal income:

"limited state policy autonomy due to piggybacking; and the impact of high tax rates on competitiveness."

The KPMG study suggested four options to the current piggyback system and concluded:

"All of the…options would increase state policy autonomy with only a limited loss of simplicity."

In 1996 Governor Almond called for legislation to change the State’s personal income tax structure. The Governor said:

"The changes proposed in this piece of legislation are necessary to put the State of Rhode Island in a position of relying less on changes in the federal income tax rate, and would do well in altering the perception that Rhode Island has one of the higher tax rates in the nation."

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The Impact of Past Federal Income Tax Changes

Not only do Federal income tax decisions have a significant impact on Rhode Island tax collections and fiscal planning, but they may also influence a range of issues ranging from economic competitiveness to the distribution of the tax burden. For example, changes at the Federal level have simultaneously pushed Rhode Island’s top rate higher while reducing the average income tax burden for the majority of families. As the Federal government has increased the minimum tax threshold and expanded the 15.0% and 28.0% tax brackets, some Rhode Island families likely paid less in State personal income taxes in 1999 than they did in the mid-1990s. However, Federal actions, such as the addition of two tax brackets (from a 31% top bracket in 1992 to 36% and 39.6% brackets in 1993), and the reduction in deductions and exemptions for upper-income tax filers, increased their State income tax burden during the 1990s.



The Revenue Act of 1978, the Economic Recovery Act of 1981, the Tax Reform Act of 1986, and the Omnibus Budget Reconciliation Acts of 1990 and 1993 all have had an influence on Rhode Island’s income tax policies. Largely in response to Federal tax changes, Rhode Island’s tax rates have fluctuated considerably. During the past 30 years, the lowest marginal rates have ranged from 2.10% in 1983 to 4.13% in 1991, with top marginal rates ranging from a low of 6.4% in 1990 to a high of 13.5% of Federal taxable income in 1981.

However, the impact of past Federal tax changes on Rhode Island may pale in comparison to those tax plans currently proposed by President George W. Bush and some Congressional Democrats.

The Potential Cost of Future Federal Tax Cuts

The key issue that will be considered by the 107th Congress is not whether there will be a Federal tax reduction, but rather the size of the reduction and which taxpayers will benefit the most. As noted, the President has proposed $1.6 trillion tax cut, and, according to the Washington Post (February 18, 2001), "Democrats, after weeks of disarray appear to be coalescing around a smaller tax cut of $900 billion over 10 years."

Regardless of which tax reduction plan is enacted, Rhode Island’s state income tax proceeds will be affected. According to preliminary estimates of the Joint Committee on Taxation, President Bush’s tax reduction proposal announced last May would reduce Federal taxes by $1.3 trillion by 2010. As shown on Table 2, over two-thirds of the proposed Federal tax cut ($896.6 billion) represents a reduction in Federal income taxes. The proposal to increase the child tax credit (which is applied after Federal income tax liability) is estimated to reduce Federal taxes by $162.3 billion over the ten-year period. In addition, proposed estate tax law changes amount to approximately $236.2 billion and corporate tax changes represent the $25.5 billion balance.

If enacted, what would be the fiscal impact of the Bush tax reduction plan on Rhode Island? According to the Internal Revenue Service’s Statistics of Income (Spring, 2000), in calendar year 1998 the total Federal income tax liability for Rhode Island taxpayers totaled $2.8 billion. This represented .003395 percent of the $828.3 billion income tax liability for the entire United States. Therefore, Rhode Island taxpayers would theoretically see their Federal income tax liability decrease by approximately $3.0 billion ($896.6 billion x .003395) over the next decade. Assuming a State income tax rate of 25% of Federal income tax liability, a $3.0 billion reduction in Federal income taxes paid by Rhode Islanders over the next decade would equal a State personal income tax revenue loss of approximately $760 million during this ten-year period. Table 3 shows the annual estimated revenue effects on Rhode Island of the Federal income tax cut proposed by President Bush.

No one can predict with any certainty which tax reduction package will emerge from the Congress. However, with the Congress likely to enact Federal tax cuts in the $100s of billion ranges, now is the time to evaluate the viability of the State’s piggyback income tax and consider options.

RIPEC Recommendation – Establish a System Based on FAGI

What options do State lawmakers have to deal with a significant Federal income tax reduction that is phased-in over the next eight to ten years? One option might be to do nothing. This approach would require the State to tighten its belt and reduce the rate of growth in State spending. A second option could be to adjust the State’s income tax rate in order to limit all or a part of the State’s revenue loss. However, depending upon individual circumstances, Federal income tax law changes may not impact all Rhode Island taxpayers equally. Therefore, an adjustment to the State income tax rate could result in a tax increase for those who do not benefit to the same degree as others from Federal income tax law modifications. For example, not every taxpayer will benefit from a change in the marriage penalty. In addition, a reduction in Federal marginal income tax rates may not be proportional. It should be noted that increasing the State’s personal income tax rate could perpetuate the perception that Rhode Island continues to have one of the highest marginal income tax rates in the nation.

A third option would be to reform the current piggyback system. By way of example, a Rhode Island personal income tax system based on FAGI with three to four tax brackets could retain the simplicity of the current Rhode Island system, enhance the State’s economic competitiveness, and reduce the need for Rhode Island lawmakers and/or Tax Administrator to react when Congress amends the Federal tax code. While there will be some administrative costs for both taxpayers and the State in the short-run, RIPEC believes this change can be achieved with minimal inconvenience. More importantly, the benefits to the State from moving away from the piggyback on Federal tax liability will likely outweigh these initial costs.

The development of a FAGI-based system should consider, among other issues, the following:

• Tax rates and income brackets;
• How to treat different types of income (wages, dividends and interest, capital gains, etc.);
• Amount and type of standard deductions and personal exemptions;
• Itemized deductions (e.g., mortgage interest, charitable contributions, local taxes, etc.);
• Revenue reliability and taxpayer predictability;
• Taxpayer and tax collector efficiency and administrative ease;
• Horizontal and vertical tax equity and fairness;
• Impact on economic competitiveness; and
• Indexing.
  
  

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Once a tax sytem based on FAGI has been established the General Assembly will be in a better position to establish policy control over this crucial revenue source and respond to changing economic circumstances. For example, if Rhode Island currently had a personal income tax system based on FAGI rather than Federal income tax liability, more than 80.0 percent of the President’s Federal income tax reduction would not likely result in significant reductions in Rhode Island’s income tax collections.

By choosing to piggyback on Federal income tax liability, Rhode Island has effectively ceded policy control over its income tax system and allowed Congress to determine the various components of our State’s personal income tax system – including exemptions, deductions, credits, the treatment of types of income and income brackets. Changes at the Federal level can result in state revenue windfalls or losses, but more importantly can alter an individuals income tax liability and may place Rhode Island at a competitive disadvantage vis-à-vis its neighboring states. For example, in 1990 the highest effective marginal income rate in Rhode Island was 6.4%, which increased to 8.5% in 1991 largely as a result of an increase in the State’s tax rate. However, by 1994 the highest marginal rate had increased to 10.89% due to Federal tax policy changes, which were not ratified by the Rhode Island General Assembly.

With the Federal government projecting multi-billion dollar surpluses and members of Congress and the Bush Administration proposing changes to the Federal income tax system, Rhode Island may need to respond to an altered Federal tax system in the not-too-distant future. Rhode Islanders should seize this opportunity to remedy a fundamental weakness in its tax structure while maintaining its principles of fair tax policy. RIPEC urges the State’s leaders to seriously consider de-coupling from Federal tax liability and establishing a personal income tax system based on Federal adjusted gross income.

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