Day: November 28, 2012

In the previous installment, I discussed the large income tax cuts for the rich that hit Rhode Island in 2006, a major change to the economy that was followed by an early plunge into recession.  Unlike the federal government, states can’t offset income tax cuts with debt. So they have to offset them by either cutting spending or raising other taxes. Rhode Island took both approaches.

A critical mechanism for financing the income tax cuts for the rich was slashing the aid that the state government sends to the cities and towns. These severe cuts resulted in a wave of municipal budget crises that we are all too familiar with. Cities and towns closed part of the gap through severe cuts, but they also responded with drastic property tax hikes. Property taxes are notorious for being unusually bad for the economy. Even the Tax Foundation, a very conservative think tank, agrees that property taxes have a bigger effect on business location decisions than any of the other major taxes. Simply put, property tax hikes are very hard on business. The pain is not distributed evenly; property taxes hit small businesses especially hard. The problem is especially severe because the aid cuts were worst in Providence and Woonsocket, where businesses are disproportionately located, so the property tax hikes were worst in areas with the most businesses.

The other side of the economic devastation wrought by property taxes is the property tax on families, which squeezes budgets hard and reduces demand. Because the middle class is more likely to spend its money in ways that are good for the overall economy, shifting the tax budget to the middle class is a big blow to the economy. Redistributing wealth from the middle class to the rich is an especially bad idea when the vehicle is property taxes, because higher property taxes do extensive collateral damage. In the long term, property taxes create perverse incentives that lead to bad urban planning, extensive sprawl, and economic segregation of schools, but they also do serious damage to the housing market. The primary cause of the second Bush recession was the bursting of the housing bubble that inflated during most of Bush’s term in office. Like every state in the union, Rhode Island saw its housing market collapse. This was not the time to raise property tax rates sky high.

In much the same way as austerity begets more austerity by crashing the economy, property tax hikes can lock an economy into a vicious cycle, where higher property taxes depress the housing market, which in turn reduces revenue and requires higher property tax rates. States with large property tax burdens are particularly vulnerable to this feedback loop. Rhode Island, of course, is one of those states with large property tax burdens. Here’s how our tax revenue breaks down by the kind of tax:

Breakdown of Rhode Island tax revenue by type. Data from www.usgovernmentrevenue.com.

One of the consequences of our high property taxes is that our tax system is even worse than usual about taxing the 99% at a higher rate than the 1%. In Rhode Island, the bottom 20% pay a rate of 11.9%, and the top 1% pay a rate of only 5.6%. You can see how the burden breaks down in this (slightly out of date) graph from the Institute on Taxation and Economic Policy’s “Who Pays?” report. (For a fuller discussion of how this works, see Ted Nesi’s excellent piece in Providence Business News.)

Tax distribution in Rhode Island broken down by the Institute for Taxation and Economic Policy. This study was done on 2007 rates but updated for changes to the tax code up to 2009.