Consumption Taxes

How important is the State's sales and use tax? What proportion of Rhode Island's FY 2000 State and local tax revenues will be derived from the sales and use tax?




How has this revenue source changed during the 1990s? What has been the year-to-year percentage increase (or decrease) in revenues received through the sales and use tax from FY 1990 through FY 2000 (estimated)?




How does Rhode Island compare? How has Rhode Island's overall general sales tax burden, as measured per $1,000 of personal income, compared to the average general sales tax burden across the United States from FY 1980 through FY 1996?

Key Facts

•The sales and use tax in Rhode Island is expected to generate $608.4 million in FY 2000, an increase of $145.1 million (31.3%) since FY 1996.

•Sales and use taxes will comprise approximately 34.8% of State general revenue tax receipts in FY 2000 and 19.7% of State and local tax revenues.

•While Rhode Island's 7.0% sales tax rate is the highest state rate in the country, 29 states have a combined (state and local) rate of 7.0% or greater.

•Rhode Island is one of only four states that completely exempts clothing and footwear from the general sales tax.

•Sales tax collections per $1,000 of personal income in Rhode Island were $19.71 in FY 1996 (ranked 40th in the nation), which was 28.9% below the U.S. average of $27.73.

Overview
As shown in Table VIII-1, Rhode Island’s general sales tax rate of 7.0% is, along with Mississippi, the highest state rate in the country. However, 34 states allow sub-state units of government to impose a general sales tax, and 29 states allow for a combined general sales tax rate of 7.0% or greater. In 1998 the combined state and local average sales tax rate among jurisdictions that imposed a general sales tax was 8.25%. No unit of local government in the six New England States levies a local sales tax.

As outlined in Table VIII-2, a general sales tax was first imposed in Rhode Island in 1947. At the present time, 0.6 cents of every 7.0 cents (8.57%) of sales tax revenues are dedicated to cover debt issued to pay depositors affected by the credit union failures (DEPCO). That debt is scheduled to be fully repaid during FY 2001, at which time all revenues raised from the sales tax is slated to go into the State’s general fund.

As Table VIII-3 shows, while exemptions vary across states, more than half of the states (26 of 45) with a general sales tax exempt, with certain exceptions, food prepared and consumed off premises. All states, with the exception of Illinois, exempt prescription drugs, and seven states fully exempt non-prescription drugs. Through December 1999, clothing was fully taxed in 31 states, partially taxed in ten states and exempt in four states.

Rhode Island is one of only four states with a general sales tax that completely exempts clothing and footwear. In addition, the State exempts non-prescription drugs (one of eight states), as well as over 50 other categories of goods. Rhode Island general sales tax exemptions include: food (not including prepared meals or food for immediate consumption), newspapers, gasoline (taxed separately), purchases for manufacturing purposes, residential gas and electricity, most purchases by charitable institutions, government purchases, boats and the trade in value of automobiles.

Table VIII-4 reveals that most services in Rhode Island are exempt from the general sales tax. Of the 164 service categories included in a 1996 survey by the Federation of Tax Administrators (FTA) , 28 were taxed in Rhode Island. Of this number, ten services categorized as "utilities" were taxed and six "business" services were taxed. Rhode Island ranked 33rd in the number of services taxed by the State. Half of the states taxed fewer than 25.0% of services included in the FTA survey. Only eight states taxed 50.0% or more of the 164 services.

In fiscal year 1996, 24.5% of all state and local government revenues in the United States were generated by the general sales tax compared to 17.2% in Rhode Island.

In Rhode Island, sales tax collections account for approximately one-third of State tax revenues. From FY 1990, when $394.8 million was generated from the sales and use tax, through FY 2000 ($608.4 million – excluding DEPCO-dedicated revenue), sales tax revenues have grown by $213.6 million or 54.1%. As a percentage of total State tax revenues, from FY 1990 through FY 2000 the sales and use tax has increased from 32.9% to 34.8% of total State tax revenues.

How Rhode Island’s Sales Tax Compares

Sales and Use Taxes Per $1,000 of Personal Income and Per Capita

Since peaking at $24.99 per $1,000 of personal income in FY 1988, general sales tax collections per $1,000 of personal income have declined by over 20.0%. In FY 1996 the Census Bureau estimates that Rhode Island collected $19.71 in general sales taxes per $1,000 of personal income. This placed Rhode Island 40th in the nation, almost 30% below the U.S. average of $27.73 per $1,000 of personal income.

On a per capita basis, the Ocean State collected approximately $470 per person in FY 1996, ranking 39th in the nation, 26.2% below the U.S. average of $637 per capita. Table VIII-5 presents a comparison of sales tax collections per $1,000 of personal income and per capita for each state. This table also shows sales tax collections as a percentage of all state and local tax revenues.

According to the Rhode Island House Fiscal Advisory Staff, the relatively low sales tax collections in Rhode Island compared to other states is due to three factors:
1. Rhode Island, unlike 34 states, does not allow for a local option sales tax;
2. More items are exempt from the sales tax in Rhode Island than in most states, which narrows the tax base; and
3. Services are not taxed in the Ocean State to the extent that they are taxed in many other states.

Sales and Use Taxes as a Percentage of Family Income

As set forth in Table VIII-6, the Citizens for Tax Justice’s (CTJ) micro-simulation model estimated that the Rhode Island general sales tax in 1995 consumed approximately 2.6% of family income for families in the lowest 20.0% income bracket, 1.5% of income for families in the middle 20.0% bracket, and 0.5% of income for families in the top 1.0% bracket. These averages compare to the U.S. averages of 3.5% for the lowest 20.0%, 2.4% for the middle 20.0%, and 0.7% for the top 1.0%.

In October 1999 CTJ prepared an update of Rhode Island State and local taxes paid as a percentage of family income. As set forth in Table VIII-7, this analysis showed an increase in sales taxes paid as a percentage of personal income for families in the lowest 20% (3.3%) and middle 20.0% bracket (2.2%). However, the 1999 CTJ update included single individuals and the elderly, which were excluded from the 1995 calculations. This change in methodology affects the income ranges included within each quintile, significantly reduces the average income reported, especially for lower-income quintiles, and increases the tax liability for lower- and middle-income quintiles when compared to the 1995 data.

Neighboring States

Both Massachusetts (5.0%) and Connecticut (6.0%) have a lower sales tax rate than Rhode Island. Both states exempt food in the same manner as Rhode Island, however, clothing and footwear costing more than $50.00 in Connecticut and more than $175.00 in Massachusetts are fully taxed.

Massachusetts taxes services to a lesser extent than does Rhode Island, while Connecticut is one of only eight states that reportedly taxed over 50.0% of the service categories included in the 1996 FTA survey. It was noted in the FTA report, however, that Connecticut had enacted changes to take effect in 1997 to exempt several services (e.g., tax preparation, auctioneers, computer and data processing). Overall, Connecticut has been much more aggressive in taxing services that fit within the categories of admissions/amusements, personal, business, fabrication/repair/installation, and computer services. Professional services in Massachusetts, Connecticut and almost every other state are not subject to a sales tax.

Connecticut’s general sales tax receipts accounted for 19.5% (ranked 35th) of all State and local tax revenues in FY 1996. Massachusetts’s sales tax collections as a percentage of all State and local tax revenues were the second lowest (13.6% of total tax receipts) among the 45 states with a state sales tax.

In terms of State tax revenues, over 31.0% of Connecticut State tax revenues in 1998 were derived from the general sales tax, while 20.4% of State tax revenues in Massachusetts were received through the general sales tax, significantly less than the U.S. average of 32.9%.

Massachusetts ranked 43rd in sales tax revenues per $1,000 of personal income ($15.34) and 42nd in collections per capita ($428) in FY 1996. Connecticut, with relatively high personal income, ranked 36th in sales tax receipts per $1,000 of personal income ($23.50) but jumped to 10th in per capita sales tax revenues ($747).

Issues, Analysis and Recommendations

In FY 2000 Rhode Island will generate approximately 19.7% ($608.4 million) of all State and local tax revenues from the general sales and use tax. Given the advent of e-commerce and the New Economy, several salient policy issues pertaining to the general sales and use tax need to be considered in developing a long-term strategic tax policy for the Ocean State. These issues are important because potential erosion of sales tax revenues could place additional pressures on public officials to raise resources from either income or property taxes, or reduce spending for essential public investments. Strategic questions regarding the general sales and use tax include the following:

•Should Rhode Island’s general sales tax base be broadened, perhaps in conjunction with the rate being reduced, to include goods and/or services that are currently exempt from the State’s general sales tax?
•Will the continued expansion of Internet/e-commerce and catalog sales erode sales tax revenues, shifting the tax burden to other State and local taxes? Therefore, should the State develop a position and advocate for its consideration as Congress reviews the current moratorium on taxing of Internet-based transactions and considers the larger issue of the application of the sales tax to remote sales?
•To reduce interstate competition, limit tax avoidance and simplify cross-border administration, should Rhode Island enter into discussions with Connecticut and Massachusetts officials concerning the development of a tax compact that may result in a uniform general sales tax base and/or a uniform sales tax rate?
•Should the State allow communities the option of imposing a local general sales tax to reduce reliance on the local property tax?
•Are there opportunities to enhance revenue from selective sales and excise taxes?

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Sales Tax Base Broadening – Some Limited Opportunities

A strategic issue pertaining to Rhode Island’s sales tax is the composition of the sales tax base. As noted in the preceding section, Rhode Island more items from the sales tax than most states.

Factors that should be evaluated when considering the sales tax base include equity, economic neutrality, competitiveness and elasticity. For example, applying the sales tax to necessities such as food, clothing and utilities raises questions about tax incidence and fairness. Taxing business purchases of goods and services could encourage firms to produce services in-house. However, a broader sales tax base might ensure that sales tax proceeds keep pace with the relative growth of the service sector in Rhode Island.

In analyzing sales tax base issues, the Task Force organized its review into two categories – exemptions for goods and commodities and the tax treatment of services.

Goods and Commodities

There are 53 categories of sales tax exemptions included in the General Laws of Rhode Island. The State Division of Taxation estimates that sales tax expenditures resulting from 45 separate exemptions totaled approximately $269.5 million annually. However, $132.2 million (over 49.0%) of this amount was attributed to exemptions for food, clothing and footwear.

After examining the current sales tax exemptions for goods and commodities, RIPEC believes that significant sales tax base broadening cannot be justified on economic, social and/or fiscal grounds. For example, taxing food, drugs, residential utilities and clothing could result in a State tax structure that is more regressive. Taxing purchases for manufacturing used for business inputs "could place them (manufacturers) at a disadvantage relative to manufacturers located in states with lower rates, or with no sales tax, or countries which use the value added tax in place of a sales tax."

Therefore, RIPEC does not believe that broadening the sales tax base to include exempted goods and commodities would be a viable component of a long-term tax strategy.

Tax Treatment of Services

Most services in Rhode Island are exempt from the general sales tax. Based on the FTA survey, Rhode Island ranked 33rd in the number of services taxed by the State. However, half of the states, including Rhode Island, taxed fewer than 25% of services identified in the FTA survey.

In considering the application of the sales tax to services, RIPEC’s analysis disaggregated services into those primarily purchased and used by individuals and families, and those services purchased principally by businesses.

Business and Professional Services – Services purchased primarily by businesses include professional services (such as legal, engineering, accounting and advertising, detective/security services), computer services, services to buildings and tangible property, and services delivered with tangible property (e.g., printing, photocopying, fabrication).

States have generally avoided applying the sales tax to business-related services for the following reasons:

•Interstate competition for economic development;
•Tax cascading – sales taxed paid by businesses might be passed along to the consumer resulting in taxes on taxes;
•Vertical equity – taxing business services may discriminate against smaller firms who cannot afford to hire in-house legal, accounting, engineering and/or advertising personnel;
•Situs differences between the production and delivery of business services; and
•Complexities for e-commerce relationships.

Since 1986 a number of states have considered expanding their sales tax base to include services. The National Association of State Budget Officers (NASBO) found that these "attempts at comprehensive base expansion have all met with ultimate defeat…" NASBO reported:

The State of Florida undertook the most commonly cited foray into service taxation in 1986. The state enacted a broad expansion that would have increased state revenues by an estimated $761 million in its first year. Included in this expansion were services ranging from accounting to tree trimming. Most importantly, perhaps, was the inclusion of advertising. As the expansion took effect, advertisers by the dozens took to the airwaves to build public sentiment against the expansion. It worked. In the end, the expansion was repealed and, in its place, the state enacted a one-cent increase in the sales tax rate.

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…While several smaller expansions were made in the next few years, the next comprehensive attempt came in 1990 in Kentucky. When the state Supreme Court ruled that the formula used for funding education was inequitable, the state found itself in a situation where education funding would have to be increased dramatically. In response, the Governor proposed adding a wide range of services -- primarily business services -- to the sales tax base. Again, the proposal was defeated and, again, an increase in the sales tax rate was the option chosen.

Also, in 1990, Massachusetts enacted a sales tax base expansion that, like the Kentucky proposal, focused primarily on business services. Several extensions were enacted to delay the implementation of the bill and, in the end, it was in effect for just one day before the legislature repealed the expansion. Finally, in 1991, the Governor of Kansas proposed adding a host of services to the sales tax base for fiscal 1992. The proposal was defeated.

Where states have been able to broaden their sales tax base the approach has been incremental, not comprehensive. NASBO reports that Connecticut, New York and Texas have gradually added a limited number of services to their sales tax base.

The latest published analysis of Rhode Island’s sales and use tax base was included in KPMG’s 1993 Analysis of Rhode Island State Tax Structure. This report identified a number of business sales tax exemptions. Elimination of some of these exemptions may not necessarily have an adverse impact on interstate competitiveness, nor be effected by situs differences between the production and delivery of business services. For example, KPMG estimated that elimination of the sales tax exemption for detective and protective services would yield $2.3 million annually, and applying the sales tax to maintenance and repair services to business property would yield an estimated $6.3 million.

Services for Individuals and Families – Consumer services that are not subject to the State sales tax include services performed on tangible property (e.g., repairs and installations, services performed on real property, pest control, swimming pool cleaning, landscaping and lawn care), personal services (e.g., barber and beauty shops, shoe repair, tuxedo rental, and laundering and dry cleaning), and amusement and health club fees.

Issues that need to be considered when discussing broadening of the sales tax base to cover consumer purchases are tax incidence and administration.

The taxation of some services may exacerbate the regressive nature of the general sales tax while taxing other services may improve its progressivity. For example, lower-income families may use coin operated laundry services more than other income groups, while upper-income individuals may pay more country club fees. Applying the sales tax to these services would likely affect some income groups to a greater extent than others.

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While there is general agreement that upper-income individuals and families pay a smaller proportion of their total income in sales taxes than lower-income families, there is debate on whether expanding the sales tax to cover services would make the tax more or less regressive. According to NASBO, "Some argue that expanding the base makes a bad tax worse since it only enlarges the number of items taxed. Others argue that people with higher incomes consume relatively more services than lower income people and, therefore, bear a larger proportion of an expanded sales tax."

Analysis of consumer services indicates that it might be possible to eliminate a few sales tax exemptions without making the sales tax structure more regressive or negatively impacting the State’s overall economic competitiveness. For example, if amusement fees (not including movie admissions) and health and athletic club dues were subject to the 7.0% State sales tax, approximately $11.0 million may be generated annually.

RIPEC finds that a comprehensive program to extend the sales and use tax to professional and business services is economically, administratively and politically problematic. However, RIPEC also believes that a limited number of sales tax base broadening options, like those discussed above as well as others, should be considered as potential resources to fund investments to either reduce other taxes or support government services.

In summary, the strategic questions are not whether to apply the sales tax to services, but can the sales tax base be broadened in such a way as to not make the tax more regressive and not adversely impact economic competitiveness? In addition, can a base broadening proposal be administered efficiently? RIPEC finds that while a strategic program to comprehensively expand sales tax coverage to both personal and business services is not feasible, there may be selective opportunities to broaden the sales tax base and produce over $20.0 million annually.

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Internet and Remote Sales

According to Rhode Island State law, items subject to the State's sales and use tax that are purchased over the Internet or through remote sales are subject to the 7.0% sales and use tax. In practice, most goods purchased through e-commerce or mail order sales escape the State sales and use tax.

However, with e-commerce transactions projected to grow by 25.0% a year, and with retail sales to consumers via e-commerce projected to increase from $20.0 billion in 1999 to $184.0 billion by 2003, growth in the sales and use tax could become severely restricted in the coming years. The current sales tax structure was enacted when consumers purchased goods on Main Street or at the Mall. A world of electronic commerce was never envisioned. The State’s leadership must recognize that the existing sales tax system may not make sense in the near future.

A study released in February by the Center for Business and Economic Research at the University of Tennessee contains findings that suggest that by 2003 state and local governments stand to lose an estimated $11.0 billion annually due to the emergence of e-commerce. The authors of the study, Donald Bruce and William Fox, estimate that Rhode Island could lose $56.0 million as a result of e-commerce transactions that escape the State's sales and use tax.

Balance in the State-local revenue system may be compromised further if the portion of resources generated by consumption taxes is reduced. Furthermore, a decline in the portion of State-local revenue generated by sales tax collections could exacerbate Rhode Island’s over-dependence on the local property tax, or cause further competitiveness problems associated with the Ocean State’s high marginal income tax rates.

To assure horizontal equity for all businesses and ensure relatively stable sales tax collections, RIPEC recommends that taxes that are being collected for purchases from stores located in Rhode Island should also be collected from on-line and remote purchases. Implementation of this objective will require that the 50 states work in unison to streamline the sales tax system.

While there is little that any one state can do unilaterally regarding the taxation of goods sold over the Internet or through remote locations, RIPEC urges the Governor, General Assembly and private sector to work together to support and promote the Trusted Third Party (TTP) approach being advocated by the National Governors' Association (NGA). The Appendix includes a section that outlines the key features of this proposal.

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The NGA proposal, "Streamlining Sales Tax Systems for the 21st Century," is based on the premise that: (1) substantial changes are necessary if the sales tax is to continue as an integral part of the state-local revenue system, (2) sales tax laws must be made more uniform among the states, and (3) the administration of the tax must be simplified.

The NGA proposal is voluntary, retains current law with regard to nexus and moves toward uniformity over an eight-year period. In the short term, the general approach of the streamlined sales tax system would be implemented through:

•Shifting sales tax administration to a technology-oriented business model in which primary responsibility for calculating, collecting, reporting and paying the tax is lodged with "Trusted Third Parties" (TTPs) instead of the seller;
•Simplifying sales and use tax laws and administrative practices in key areas necessary to enable the technology and new business model to operate properly; and
•States assuming responsibility for the costs of the system by sufficiently reimbursing TTPs for their costs and for the costs of integrating their systems with those of participating sellers to allow the seller to participate in the system. A participating seller should not be charged for participating in the streamlined system.

RIPEC believes that this tax collection system could end discrimination based on the way an item is purchased. Under this system, goods are treated equally from a tax perspective regardless of whether they are bought in a store, from a catalog, or via the Internet, and the tax system will no longer build in a competitive advantage or disadvantage to one class of merchants at the expense of their competitors.

Explore Regional Sales Tax Compact

The economies of Rhode Island, Massachusetts and Connecticut are inextricably linked. Nevertheless, tax policies vary in the three states and it is not practical to believe any one state would give up any competitive advantage that their tax code may afford. Nor is it realistic to expect regional tax agreements that could have a negative impact on a state’s fiscal condition.

However, with regard to the sales tax, exploration of a regional tax compact may be feasible. In fact, Connecticut, Massachusetts and Rhode Island are parties to a Tri-State Agreement that provides for the exchange of sales and use tax audit and enforcement data. Furthermore, while there are some differences, a cursory analysis indicates that there are many similarities among the Rhode Island, Massachusetts and Connecticut sales tax bases.

Therefore, it may make sense for all three states to study the feasibility of adopting a uniform sales tax system based on a common tax base and common exemptions in order to minimize possible leakage/tax avoidance and mitigate competitiveness issues.

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RIPEC urges the Governor to take the initiative to explore the feasibility of establishing a uniform sales tax base and a regional system to administer and collect the sales tax.

Avoid Local Option Sales Tax

Granting cities and towns the option of levying a local sales tax, as is currently permitted in 34 states, is not a viable policy choice in a small state like Rhode Island. Local option sales taxes could have a disquieting effect on the State-local revenue system by increasing fiscal disparities among local governments. Communities with large retail bases would have an obvious advantage over those with less retail activity.

Selective Sales and Excise Taxes

In addition to the general sales tax, selective sales taxes are levied on commodities such as alcohol, motor fuel and tobacco products. Table VIII-8 shows how Rhode Island’s tax rate for gasoline, alcohol and cigarettes compares to tax rates in other states.

Rhode Island’s gasoline tax of $0.28 per gallon is the third highest state gasoline tax in the United States. This tax rate is exceeded only by Connecticut’s gas tax of $0.32 per gallon and Oregon's $0.29 per gallon tax. In FY 2000 it is estimated that Rhode Island's gas tax will generate approximately $130.0 million, with the majority of these funds dedicated to transportation-related expenses.

The taxes applied to beer and wine sales in Rhode Island are less than the median tax on such commodities for the nation as a whole. Rhode Island’s tax on liquor is $0.45 a gallon, or 13.6%, above the national median. In fiscal year 2001 Rhode Island's tax on alcoholic beverages is estimated to generate $9.0 million. Any increase in alcohol taxes would have only a very marginal impact on State tax revenues.

Rhode Island’s cigarette tax per pack is $0.71, which is the ninth highest among the 50 states. In New England, both Maine and Massachusetts have a higher cigarette tax. The House Fiscal Advisory Staff notes that, "The [cigarette] tax rate is not necessarily a good indicator for price of product comparisons however, due to other policies, including minimum markup provisions and differing sales tax rates."

As presented in Table VIII-9, the final estimated price for a pack of cigarettes is $0.45 higher in Massachusetts due to the Bay State’s minimum mark-up provisions. Also, while Rhode Island’s cigarette tax is $0.21 higher than the tax in Connecticut, when all factors are considered, the price differential is estimated to be $0.14 cents per pack.

Given this analysis, RIPEC suggests that consideration should be given to increasing Rhode Island’s cigarette tax by $0.29 to $1.00 per pack. Such an increase would generate approximately $20.9 million. In light of the demands being placed on the State to fund essential health and education programs while striving to maintain an economically competitive tax climate, the choice of increasing cigarette taxes appears to be a potentially appealing and viable choice.