The competitive edge: 
rethinking Rhode Island tax policy 
for success in the new economy

REPORT OF THE RHODE ISLAND ECONOMIC POLICY COUNCIL
TAX COMPETITIVENESS COMMITTEE

February 2001

In January 2001, at the request of Governor Lincoln Almond, the Rhode Island Economic Policy Council convened a multidisciplinary Tax Competitiveness Committee to review the state’s tax policy and recommend mechanisms for enhancing Rhode Island’s tax competitiveness in the new economy. Chaired by Edward Mazze, PhD, Dean of the College of Business Administration at the University of Rhode Island, the Committee is composed of business leaders of emerging and established industries, as well as public sector economic and organized labor representatives.

After review and discussion of various aspects of the Rhode Island tax code in the context of new economy issues, the Tax Competitiveness Committee endorsed*, a series of incremental tax reform initiatives and advocates their passage by the Rhode Island General Assembly in 2001:

Context

Capital gains tax relief is the single most important tax reform initiative before the General Assembly during this session – critical to the development of clusters of new economy industries, many of which rely on stock options to create competitive compensation packages. Phase-out of the tax would help the state begin to build a critical mass of the entrepreneurs and investors who serve as magnets for new economy business development, and increase our competitiveness within the Boston Metro – while benefiting a wide spectrum of Rhode Islanders across industries and income levels as the demographics of investment continue to expand.

The Boston Metro
Rhode Island is not a self-contained economic unit. Along with eastern Massachusetts and southern New Hampshire, it is part of the Boston Metro – one of the nation’s most dynamic metropolitan regions, with an economy fed increasingly by high-tech ventures. The Boston Metro competes with other centers of commerce across the country and around the world, and Rhode Island competes with its neighboring states for a share of the Metro’s wealth. So far, the Ocean State has not achieved a winning record.

Based on labor force, approximately 12 percent of the Metro’s high-wage new economy jobs should be located in Rhode Island – but the state has attracted only about eight percent of those jobs to date. In fact, a significant number of the positions are filled by Rhode Islanders who commute to Massachusetts for work. In 1999, the most recent year for which complete data is available, 51,038 Ocean State residents received out-of-state credit for taxes on Massachusetts earnings. We have the talent to fill the new economy jobs, but we are exporting it to Massachusetts, filling our neighbor’s tax coffers instead of our own.

Rhode Island’s "job gap" within the region represents 6,000 software and communications positions (average 1999 salary: $73,000); 8,000 innovation services jobs (average 1999 salary: $69,000); 3,000 finance and insurance jobs (average 1999 salary: $72,000); 1,700 medical technology jobs (average 1999 salary: $68,000); and 11,000 electronics industry jobs (average 1999 salary: $67,000) – a collective 30,000 jobs, translating to $2.4 billion in direct payroll, an additional $2.2 billion in indirect payroll and approximately $144 million in net tax revenues lost to the state.

Included in that $144 million opportunity cost is tax revenue that has flowed to other states due to their greater success in attracting high-income residents, who in turn pay more taxes. Rhode Island trails its neighboring states in the share of total state adjusted gross income attributed to high-income residents. During the 1990s, many states reported a significant increase in the share of AGI earned by residents with incomes over $200,000 annually. Connecticut reported 17.7 percent growth between 1991 and 1998, the most recent year for which statistics are available. Massachusetts reported a growth rate of 14.8 percent during the same time frame. New Hampshire reported 10.5 percent growth.

During this period – the most prosperous in the nation’s history – Rhode Island reported only 7.6 percent growth in the share of AGI belonging to residents earning over $200,000, half the growth experienced by Massachusetts. In 1998, only 17.9 percent of Rhode Island income was from taxpayers in this income category, compared with 22 percent of American income. If the state had simply kept pace with the national average, Rhode Island would have collected approximately $72 million in additional tax revenues in 1998 alone.

Clearly, Rhode Island has not been rolling out the welcome mat for the region’s top wage earners – the entrepreneurs and business owners, the investors, and the dual-income families headed by high-tech workers. In 1999, the most recent year for which national data is available, Rhode Island ranked 4^th highest in state income tax for residents in the top income bracket – compared with Massachusetts at 31^st, Connecticut at 38^th, and New Hampshire at 46^th. Even Vermont – the only other New England state that, like Rhode Island, "piggybacks" on the federal tax system – ranked lower than Rhode Island, at 6^th.

In 2001, Rhode Island’s max-marginal income tax rate exceeds nine percent – at the same time that Massachusetts is reducing its rate to five percent. For capital gains, our max-marginal rate is 5.1 percent – compared with rates ranging from 0 to 5 percent in Massachusetts, depending on the duration that the asset is held.

Given this scenario, why would a successful entrepreneur choose to live in Rhode Island and build a business here? And even if he or she were lured by the Ocean State’s research and development tax credit, and sufficiently enamored of the state’s quality of life to overlook its generally uncompetitive tax structure, what would prevent that entrepreneur from moving the company across the border before selling – thereby depriving the state of the opportunity to tax any capital gains realized?

Rhode Island’s tax on long-term capital gains is consistently cited in surveys of business leaders as a barrier to growth. In fact, a 1999 study of 372 industry decisionmakers, conducted by the Rhode Island Economic Policy Council and the Rhode Island Public Expenditure Council, placed the tax in the top five obstacles to business expansion in the state. Phasing out taxes on long-term capital gains, in order to put Rhode Island on a competitive footing with neighboring states, is a critical missing piece of the economic development puzzle – as essential as reforming the unemployment insurance system or devising attractive corporate tax credits. In fact, without meaningful capital gains reform, other tax competitiveness initiatives are of limited impact in the end.

A capital gains phase-out is not a panacea. Its effectiveness will ultimately depend on the success of a larger strategy of attracting and nurturing high-wage new economy industries in Rhode Island – a multi-tiered strategy of industry cluster development, physical and digital infrastructure building, workforce development, and other initiatives already put in place by the Rhode Island Economic Policy Council and the Rhode Island Economic Development Corporation. But each of those elements is weakened by the absence of a competitive capital gains policy.

For a glimpse of the potential impact of capital gains relief, consider the Rhode Island software industry. Bolstered by an industry-specific capital gains exemption and a targeted cluster-building initiative, the industry (SIC 737) grew by forty percent in two years – encompassing 688 firms in 1999, up from 477 in 1997. Four startups – Context Media, Bluestreak.com, Defend.net, and Simpli.com – have raised more than $90 million in venture capital during the past 12 months, more than was raised over the entire previous five years by all Rhode Island firms. This growth was achieved in the context of an extremely limited capital gains incentive, which only exempts gains realized by employees on their own companies. The impact of a broader capital gains exemption would have been even more dramatic.

Serial entrepreneurs
Across all markets, the story of the new economy is the story of technology commercialization and the serial entrepreneur. Silicon Valley, Silicon Alley, Route 128 … all of the nation’s thriving high-tech centers are populated by entrepreneurs who constantly repeat a lucrative cycle of starting companies, selling them, and starting new ones.

From Apple to Microsoft, from SUN Microsystems to Netscape, from Genentech to Federal Express, business powerhouses often grow from small, venture-backed firms launched on the strength of a great idea. Rhode Island would do well to encourage innovative firms – and the innovators who launch them – to locate and grow in our state.

According to a 1995 study by Coopers & Lybrand, venture-backed companies create jobs at a faster clip than Fortune 500 companies. From 1989 to 1993, a period arguably at the dawn of the new economy, the venture-backed companies in the Coopers study grew jobs at 25 percent each year – offsetting a three percent annual job loss experienced by the Fortune 500 during the same time frame. From the time the average firm was one year old until it was five years old, investment in R & D accelerated nearly 70 percent annually – quadruple the R & D investment among Fortune 500 firms. During the same time frame, the companies grew their revenues by 40 percent each year, and spent 23 percent of their revenues on long-term capital investments.

In the information economy, entrepreneurs are free to base their operations in virtually any geographical location. And in selecting communities to host their ventures, these entrepreneurs look for places that offer a qualified workforce, quality of life amenities that will continue to attract talented workers, and a positive business environment – which includes a competitive tax structure.

For new economy firms, a competitive posture on capital gains is especially critical. Many high-tech firms – startups and established ventures alike – base compensation packages for their top talent on stock options. Locating in a state where its workforce is not taxed for the capital gains produced by the company’s growth can significantly enhance a firm’s recruitment and retention of talent. Massachusetts has recognized this and has moved aggressively to make itself attractive to entrepreneurs and new economy companies, by eliminating the capital gains tax on assets held over 5 years and by reducing the tax rate on assets held one to five years. Our entrepreneurial companies will find it increasingly difficult to recruit and retain employees if Massachusetts presents a significantly more advantageous tax environment for capital gains.

Rhode Island should be extremely well-positioned to become a new economy mecca. While the state’s population hovers at one million, more than eight million people live within 75 miles of Providence. The state boasts one of the nation’s most robust university and research infrastructures, generating tremendous workforce potential and a ripe technology commercialization opportunity. A convenient, relatively uncongested airport, connections to high speed rail, and excellent highway access to the finance and innovation centers of New York and Boston – as well as recreation, arts, and other amenities second to none – combine to offer a stellar business climate. And the Ocean State is eminently affordable, compared with San Francisco, Cambridge, and many other high-tech hot spots that are feeling the effects of their success. It’s time that Rhode Island’s tax structure is enhanced to become another attraction, rather than a deterrent, to new economy firms.

Broad-based tax relief
While phasing out the tax on long-term capital gains is critical for attracting Rhode Island’s share of the Boston Metro’s high-wage new economy firms, the initiative also has the advantage of benefiting all Rhode Islanders who invest – no matter what their income level.

We are now a nation of investors. According to 2000 data from the Securities Industry Association (SIA), equity ownership among U.S. households increased from 33 percent in 1989 to 48 percent in 1999 – with nearly half of that increase occurring between 1995 and 1999. According to the Federal Reserve Bulletin (January ’00), stocks represented 22.7 percent of all savings in 1998 – compared with just 15 percent in 1989.

The demographics of investment have also flattened to embrace the middle class. Among the 69.3 million investors included in a 1998 study by the New York Stock Exchange, the median age was 43, the median family income was $50,000, and the median portfolio value was $15,500. Less than 40 percent described themselves as "professional/executive." Much of the increase in investing is attributable to growth in 401(k) plans – with more than 80 percent of plan participants holding equities in their portfolios. A growth in investment outside tax-deferred vehicles can also be expected in coming years, as baby boomers’ family responsibilities diminish and their discretionary income increases.

It should also be noted that stock options are not strictly phenomena of new economy, high-tech ventures. They have become increasingly common in compensation for rank-and-file employees, as well as high-level workers, and are offered by a wide range of companies, including Wal-Mart, Home Depot, Office Max, and other large chains. The National Center for Employee Ownership estimates that as many as ten million workers currently receive stock options as part of their pay, and these workers become stockholders when they exercise their options.

In Rhode Island, the capital gains phase-out has been portrayed in some quarters as a class issue – an initiative that would aid the wealthy while depriving the state of critical tax revenues that would otherwise support programs benefiting lower-income residents. This argument is flawed in that it assumes that the loss of tax revenues from capital gains will not be offset by economic gains resulting from a better competitive position within the Boston Metro. The Committee believes that the measure would benefit Rhode Islanders across all income levels through job growth, and that the tax reduction would directly benefit a broad spectrum of taxpayers.

According to the Rhode Island Department of Taxation, 96,084 Rhode Island taxpayers paid capital gains taxes in 1998, with 5,619 taxpayers in the $200,000 or more category and the remaining 90,465 spread across all other income brackets. As one would expect, the taxpayers in the top bracket had the most capital gains realizations and paid the most taxes – but it is significant that more than 90 percent of all capital gains taxpayers were in middle-income tax brackets, with some realizations noted even among those reporting income under $20,000. It is also important to note that capital gains taxes are not paid by the same 96,084 Rhode Islanders each year; hence, the phase-out would benefit hundreds of thousands of Rhode Islanders over time.

Finally, we should bear in mind that capital gains realizations represent extraordinary income – a one-time infusion of cash, requiring a large lump-sum tax payment. As a large extraordinary event, there is more focus on and sensitivity to the tax, as compared to tax on ordinary wage income, which is paid much less visibly through the withholding system. One might liken it to getting a large bonus or winning the lottery. In some cases the capital gain realization is large enough to push the taxpayer into a higher income tax bracket temporarily. It is not unreasonable to conjecture that some of the 5,619 taxpayers reporting more than $200,000 income in 1998 may have been in that category because of their capital gains realizations that year. Many others in the $200,000 plus category were actually businesses structured as S corps or LLCs rather than wealthy individual wage earners.

Costs and benefits
According to analysis undertaken by the Tax Competitiveness Committee in collaboration with Rhode Island’s budget director and tax administrator, as well as other policymakers, the static revenue loss to the state as a result of phasing out the tax on long-term capital gains is expected to reach a maximum of $62 million in the final year of a five-year phase-out. Assuming that realizations hold steady at 1998 levels, the static cost to the state would follow this trajectory:

FY 2003 $20 million
FY 2004 $33 million
FY 2005 $45 million
FY 2006 $58 million
FY 2007 $62 million

Previous estimates had placed the final year cost of such a plan at $92 million. However, that projection was based on the assumption that realizations would continue to rise into the next decade. It is the Committee’s opinion, based on recent market behavior and an increasingly soft economy, that this assumption significantly overstates Rhode Island’s near-term potential to recover tax revenues from capital gains. The Committee believes that a revenue model based on realizations remaining at 1998 levels is actually somewhat liberal, and that the potential static revenue loss to the state as a result of the capital gains phase-out may ultimately prove to be significantly lower than $62 million.

The larger issue, however, is that the static revenue loss is only half the story. In weighing the wisdom of the capital gains phase-out, we must consider not only the costs but also the benefits. We must consider the additional tax revenues that could accrue if we are successful in closing the high-wage new economy "job gap" and attracting 30,000 well-compensated jobs to Rhode Island. If, for example, we can close the job gap over the five years of the Governor’s proposed phase-out of the capital gains tax, the total direct payroll impact of the 30,000 jobs in 2006 would be $2.4 billion.

Based on calculations using the state’s input-output model (REMI), we also know that the local purchases of these 30,000 new job-holders, and the companies who employ them, would create an additional 45,000 jobs with a total payroll of $2.2 billion in 2006. This $4.6 billion of total payroll would generate $154 million in income taxes ($92 million net of the $62 million capital gains loss), $93 in sales taxes, and $217 million in property taxes. This represents a total of $402 million per year in new tax revenues net of the $62 million capital gains loss.

REMI also calculates that these 30,000 jobs, plus the 45,000 indirect jobs, would generate $258 million per year in new state and local costs, for a net positive fiscal impact of $144 million per year. Most analysts believe that the REMI estimates of incremental state and local costs are on the high side – implying that the net fiscal impact of $144 million is actually conservative, assuming that we can close the 30,000 job gap. In fact, even if we only reduced the gap by half, the effect of the capital gain phase-out would still be revenue positive.

Beyond the Rhode Island experience, there is independent empirical evidence that taxes on capital gains actually have an adverse impact on revenues collected. Bogart and Gentry, reporting for the National Bureau of Economic Research in January 1993, showed that states with higher max-bracket marginal tax rates on capital gains actually have significantly less capital gains realizations than states with lower rates – that a capital gains tax rate increased by 10 percent actually decreases revenues by 6.7 percent. These findings are significant in that they result from rigorous, peer-reviewed research and not from advocacy groups such as the Cato Institute or the Coalition for Tax Fairness.

The reality is that, when it comes to taxes on long-term capital gains, Rhode Island is severely uncompetitive with its neighboring states. If we fail to act now, entrepreneurs, investors, and new economy professionals will vacation here, send their children to college here, and sell their products here – but they will elect to live and work in New Hampshire, Massachusetts, or Connecticut, where the tax structure is more hospitable to them. Our economy will stagnate, and Rhode Islanders at all income levels will feel the effects.

Rhode Island is one of only 12 states that equally weigh sales, payroll, and property, plant, and equipment. Mounting evidence suggests that double-weighting sales will increase employment – particularly in the manufacturing sector – and actually increase tax receipts from firms that sell in Rhode Island but have facilities outside the state. The state should adjust the corporate apportionment formula to double-weight for sales and phase in 100 percent weighting of sales for manufacturing.

While the term new economy has come to conjure up visions of dotcoms, high-tech firms, and other recently evolved business forms, that image is actually incomplete. With visionary leadership, firms in "old economy" industries are adopting the business practices that will allow them to compete in the new economy. In Rhode Island, many companies in the manufacturing sector fit that description. For instance, eight percent of the state’s manufacturers doubled their employment in the past two years – a growth rate achieved by just four percent of all businesses. Rhode Island’s progressive manufacturers – those who invest in research and development, in their workforces, and in processes that will enhance their productivity – must be supported by the state’s tax policy.

Rhode Island’s current corporate apportionment formula puts our manufacturers at a competitive disadvantage with their counterparts in other states. Our tax system penalizes companies that make significant capital investments in Rhode Island and employ a high percentage of Rhode Island workers, while benefiting businesses that merely sell here - a fact that may help explain Rhode Island’s last place ranking in manufacturing capital investment (CFED 2000). Most states have changed their formulas to benefit their in-state companies at the expense of out-of-state companies. Rhode Island should follow suit.

Empirical data supports the change. Austan Goolsbee and Edward L. Maydew of the University of Chicago’s Graduate School of Business last year reported that state corporate tax apportionment formulas have a significant effect on a state’s economic growth prospects – with growth in manufacturing employment observed immediately, and increasing over time, after double-weighting sales. Goolsbee and Maydew also discovered evidence that firms choose to locate and grow in states with more favorable apportionment formulas. The case for adjusting corporate apportionment formulas was bolstered by an October 2000 Arizona State University study, in which economists Sanjay Gupta and Maryann Hoffman revealed that apportionment formulas clearly influence firms’ rates of employment and capital investment.

The Rhode Island Division of Taxation and the Rhode Island Public Expenditure Council, in separate surveys of a sample of current corporate taxpayers, estimate that the impact of a change in the corporate tax apportionment formula to double weight sales would result in a static revenue loss of approximately $5 million, net of the increase in taxes paid by out-of-state companies. The phase-in of a 100% weighting of sales for manufacturing would result in an additional static revenue loss of approximately $5 million. Based on the assumptions used above in the analysis of the impact of closing the new economy "job gap," the number of new manufacturing jobs required to offset the revenue loss would be approximately 2,000 jobs.

Corporate tax apportionment has been on the agenda in other states for several years, and some states are moving beyond reform in this area to put still more innovative incentives on the table. The apportionment reforms proposed by the Tax Competitiveness Committee would simply allow Rhode Island to catch up; the capital gains phase-out offers an opportunity to get ahead of the curve.

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While the capital gains phase-out and the adjustment of the corporate apportionment formula are the key competitive elements of this report, the Committee also believes that two biotech industry-specific proposals deserve consideration by the General Assembly.

Biotech companies – a healthy cluster of which are forming in and around Providence – can ultimately become economic engines for the state. But they are unique in that they must survive a lengthy, arduous FDA approval process before they can put a product on the market and post any profit. The state should extend the net operating loss (NOL) carry-forward from the current five-year limit to 20 years for startup biotech firms.

Twelve states with active and growing biotech industries have extended the carry-forward period to better accommodate the long product development cycles of biotech firms. With drug development cycles and FDA approval processes often taking decades, a short, five-year carry-forward is of virtually no benefit to this industry cluster.

This type of accommodation to a high-wage and high-growth industry is an inexpensive way for Rhode Island to leverage its many existing advantages for biotech and pharmaceutical companies, while remaining competitive with the twelve states that have already extended the carry-forward for this industry.

The Rhode Island Division of Taxation has indicated that only a handful of existing Rhode Island biotech firms would be eligible for the exemption – making this an ideal time to position ourselves as an attractive location for this high-growth, high-wage industry cluster.

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Fine-tuning Rhode Island’s sales and use tax exemptions to benefit biotech