A Simplistic Reaction to the Flat Tax Will Hurt the State and Cities and Towns

Everybody wants to nix the flat tax in Rhode Island:

The dispute has drawn the interest of a host of powerful players — labor unions, mayors, and a coalition of elected officials — who hope to repeal the high-profile tax break that benefits 2,267 Rhode Island taxpayers. Supporters want to funnel the savings to the cash-strapped cities and towns, which are slated to lose more than $55 million in state aid for the budget year that begins in seven days.

Municipalities think it's an easy way to get a few million more dollars. Union members think it's a way to ensure that the local and state governments that employ them will be able to make payroll. Elected officials think they'll pick up a good talking point about looking after the majority against the narrow interests of a wealthy minority. I'd suggest that all of these groups would do well to be wary of short-term thinking.

As I've followed long-term trends from both Census and IRS data, the conclusion has emerged that one area in which Rhode Island has seen positive developments is among wealthier residents. Indeed, the state income that taxpayers with incomes over $200,000 per year are claiming on their federal tax returns was up more than 50% from 2002 to 2006 — the period during which our state's tax reforms began to kick into effect. That is why Steve Peoples and Cynthia Needham's characterization is woefully incomplete:

The state will forgo an estimated $34.7 million in tax revenue next year because of the flat-tax option, according to an analysis by the State Budget Office.

In tax year 2009, the rate is scheduled to drop from 7 to 6.5 percent. If frozen at the current rate, the state could recover $12.2 million in tax revenue for the coming fiscal year, according to the governor’s budget office.

One cannot calculate the "cost" of the flat tax by recalculating returns as if it did not exist, because some percentage of returns would not exist if it were not for the flat tax option. With residents with household incomes over $200,000 contributing about $400 million in income and alternative minimum taxes every year, we're talking a huge amount of money.

Unfortunately, the relevant data from the state ranges only from 2005 to 2007, and the presentation of resident and non-resident taxes is not uniform. Nonetheless, looking at the resident returns (which are parallel to federal data addressing Rhode Islanders), one can observe that, over that period, the total income and alternative minimum tax collected by the state was up more than $5.12 million from those earning over $200,000 and up a total of $40.33 million from those earning over $100,000. The actual number of state tax returns filed by those earning between $100,000 and $200,000 increased 20.8%, and those showing income over $200,000 increased 14.2%.

This is where advocates for repealing the flat tax will point out that, while actual taxes paid by the $100,000-199,999 group increased $13.5 million (5.5%) from 2006 to 2007, those earning over $200,000 — who benefit most from the flat tax option — contributed $37.4 million (8.6%) less. Given the close proximity of the dollar amounts, one might presume that the flat tax simply gave that money away (as Rep. Scott J. Guthrie, D-Coventry, would put it). That would be incorrect.

Of that year-to-year loss, the capital gains tax accounted for $30.1 million. In other words, non-capital gains income taxes among the wealthiest group decreased only $6.5 million (1.9%) in 2007 from 2006. More importantly, the average adjusted gross income per return fell 4.3%. (I'm not sure whether that includes capital gains.) Although there were more of them, the rich, that is, earned less money to tax.

All such aggregate analyses are tricky, of course, because so many factors and considerations come into play. Advocates making the journey from their municipalities to the State House to demand those dollars that the flat tax "gives away" should recall that these are residents. They are paying property taxes on homes and vehicles. They are paying fees for everything from dog registrations to construction permits. If they leave, they take not only the income tax dollars that the state may (or may not) filter down to the local level, but also all of the revenue that cities and towns currently procure directly. Moreover, they take the money that they pay to other residents as part of the private-sector economy.

For some general and rough perspective, consider this: The number of tax returns showing income over $200,000 increased 14% from 2005 to 2007. It will only have to decrease by about 7% for repeal of the flat tax to be a revenue wash for state income tax alone. If we broaden the group to those over $100,000, the increase from 2005 to 2007 was 19%, and only a 3% loss of the current number would cancel out the estimated tax revenue gain.

Rhode Island is already turning away from the path toward a vibrant economy in a vain attempt to ease short-term pain — which is to say that it is continuing on its path to collapse. Let's not expedite the process.