THE REPRESENTATIVE TAX SYSTEM

Tax Capacity and Tax Effort in the Ocean State
How Rhode Island92s tax burden compares to other states is an ongoing point of discussion among policy makers, economic development officials and interested citizens. Central to this discussion is the manner by which a state92s "tax burden" is measured. Comparisons are often made on taxes paid per $1,000 of personal income or taxes paid per capita. Other models calculate and compare the percentage of state and local taxes paid for a range of family income levels.

This RIPEC Comments presents the findings of a report prepared by Dr. Robert Tannenwald, Assistant Vice President and Economist with the Federal Reserve Bank of Boston, that uses the representative tax system (RTS) to measure the FY 1994 and FY 1996 ability of a state to generate tax revenues (tax capacity) and the extent to which each state utilized its tax base (tax effort). RTS data for FY 1991 is also included.

Originally developed by the now defunct United States Advisory Commission on Intergovernmental Relations (ACIR), the RTS measures both tax capacity and tax effort.

The principal findings of this Comments are:

• Rhode Island92s capacity to raise tax revenues is 9% below the national average, ranking 38th among the 50 states; and
• Rhode Island92s tax effort, or tax burden, is 17% above the U.S. average and is the second highest in the nation.

Tax Capacity

The representative tax system defines the tax capacity of a state and its local governments as the amount of revenue they would raise if national average tax rates were applied to each state92s tax base for 26 individual taxes. Therefore, because the RTS rates are the same for each state, potential revenue yields vary directly with the size of the underlying tax base. Specifically, the RTS evaluates a state92s tax capacity by estimating the per capita yield that a hypothetical, uniform, representative tax system would produce in each state. For each of 26 individual taxes, a uniform tax rate is levied on a comprehensive tax base.

The hypothetical tax rate is determined by calculating the ratio of actual nationwide collections from the tax to the value of the nationwide standard base. For example, in FY 1996 the estimated nationwide standard retail sales tax base was $2.536 trillion. Nationwide collections from the retail sales tax were $169.0 billion, which results in an RTS standard sales tax rate of 6.67% (i.e., $169.1 billion/$2,536 trillion).

After the characteristics of each tax are determined, the RTS distributes each base among the states on a per capita means and applies the standard rate to each state92s base to estimate the state92s capacity to raise tax revenues. The U.S. average is set equal to 100. States with a tax capacity index above 100 are considered to have an ability to raise tax revenues that is greater than the national average, while states with an index below 100 are considered to have less ability to raise revenues.

As shown on Table 1.xls, Rhode Island92s tax capacity for fiscal years 1996, 1994 and 1991 has consistently fallen below the national average, and is less than the capacity of all New England and Mid-Atlantic states with the exception of Maine. In FY 1996 and FY 1994 Rhode Island had a tax capacity index of 91 (ranked 38th and 37th, respectively), compared to Connecticut92s second-ranked index score of 129 and Massachusetts92s 8th place tax capacity index score of 116.

In fiscal year 1996, as measured by the RTS, only 11 states had a lesser ability to raise revenue than Rhode Island. Seven of these states are located in the Southeast (Alabama, Arkansas, Kentucky, Louisiana, Mississippi, South Carolina and West Virginia).

Tax Effort

While the tax capacity index measures a state92s ability to raise revenues, the tax effort index compares the actual revenue raised by state and local governments against the hypothetical, uniform representative tax system discussed above. In short, tax effort measures the extent to which a state utilizes its available tax base.

As presented on Table 2.xls, Rhode Island92s State and local tax effort in FY 1996 was 17% greater than the national average. The Ocean State92s index of 117 was second highest in the country and the highest in New England. The index score for FY 1994 shows similar results for the Ocean State. Across New England, with the notable exception of New Hampshire, all states exhibited relatively high tax effort. Rhode Island92s FY 1991 tax effort index of 115 placed the State 4th in the U.S.

Property, Sales and Income Tax Capacity and Effort

In fiscal year 1996 the U.S. Census estimates that 81.0% of all state and local tax collections in the Ocean State were generated by the big three 96 property, sales and income taxes. Nationally these taxes produced 76.2% of all state and local government revenue.

Table 3.xls provides additional details for FY 1996 RTS calculations of tax capacity and tax effort among New England states for each of the three main state and local tax sources. Rhode Island ranks relatively low in terms of tax capacity for all three categories, while its 4th place property tax effort ranking (63.5% greater than the National average) reveals the Ocean State92s over-reliance on property taxes. The Ocean State92s personal income tax effort is 16.7% above the national average, which placed the State 19th overall. The State92s general sales tax effort is low compared to other states 96 19.5% below the U.S. average (ranked 35th) 96 likely due to the narrow base upon which Rhode Island92s sales tax rate is applied.

Comments

There is no shortage of data that can be used to measure the relative tax burden state and local governments place upon individuals and businesses. Commonly used measures include taxes collected per capita and per $1,000 of personal income, taxes as a percent of personal income (effective tax rates), an analysis of taxpayer profiles, and the representative tax system.

All of these aggregate measures are useful benchmarks, but all have their limitations. Critics of the RTS note the arbitrary choice of a standard tax rate, which may overestimate the taxing capacity of low-income states. In addition, the RTS assumes that a state92s ability to tax one set of economic transactions is independent of the intensity with which it taxes other bases. While RTS is far from a definitive measure of a state92s fiscal health, it is viewed as a reasonable indication of a state92s fiscal position and is a valuable tool in measuring aggregate tax capacity and the overall tax burden or effort imposed on a state92s taxpayers. Concerning the RTS, State Policy Reports said:

Those inclined to evaluate state policymakers are best served by comparisons that are sensitive to differing state workloads and tax bases85For aggregate versions of such comparisons, the most useful comparisons are afforded by calculation of the representative tax system and representative expenditure system85

So what does the RTS tell us about Rhode Island? All else being equal, the ideal situation is to have a high tax capacity and a low tax effort, or at least a positive differential between tax capacity and tax effort. For example, Delaware92s tax capacity index is 121 and its effort index is 90 or a +31 differential between tax capacity and tax effort. Other states with a relatively high tax capacity in relation to tax effort include Nevada (+68), Wyoming (+53), New Hampshire (+46) and Colorado (+32).

On the other hand, state and local governments like Rhode Island with relatively low tax capacity in relation to tax effort need to be mindful of the resource constraints they face and the need to expand their economic base. The Ocean State92s tax capacity index of 89 is 26 points below its tax effort index of 117. Those states with relatively low tax capacity in relation to tax effort include New York (-32), Mississippi (-30), RHODE ISLAND (-26), Maine (-24) and West Virginia (-21).

For further information, contact Bob Carey, Director of Research, at (401) 521-6320 or by e-mail, r_carey@ripec.com.