This paper will be presented at the 2018 Municipal Finance Conference on July 16 & 17, 2018. The conference is a collaboration of the Brookings Institution’s Hutchins Center on Fiscal and Monetary Policy, the Brandeis International Business School’s Rosenberg Institute of Public Finance, Washington University in St. Louis’s Olin Business School, and the University of Chicago’s Harris Institute of Public Policy. It aims to bring together academics, practitioners, issuers, and regulators to discuss recent research on municipal capital markets and state and local fiscal issues.
Retail sales taxes are inefficient, inequitable, and hard to administer, according to “The Retail Sales Tax in a New Economy,” a paper to be presented at the 2018 Municipal Finance Conference at Brookings this week.
The retail sales tax was first enacted during the Great Depression, and became the largest single source of tax revenue for states in 1947. Across the 45 states with a current retail sales tax, sales tax revenue made up on average 34 percent of all state tax revenues in 2016 – slightly higher than 32 percent in 1970. But the tax base has been shrinking since the 1970s, and states have increased retail tax rates in order to maintain those revenues, say John Mikesell of Indiana University and Sharon Kioko of the University of Washington.
Tax revenues depend on the size of the tax base (the stuff that’s taxed), and the rate (how much that base is taxed). The sales tax base as a share of the economy has been shrinking over time, which decreases revenues as a share of a state’s personal income. The retail sales tax base includes purchases of tangible, personal property, but only selectively includes services. Because services are a growing share of economic activity, states are losing out on an increasing amount of potential revenue.
Using the Bureau of Economic Analysis’s calculations for tax bases from 1970 to 2016, the authors compare the typical retail sales tax base, as a share of personal income, under three scenarios: 1) the base at present, 2) what the base would be if it included all services excluding health and education, and 3) what the base would be if all services were taxed. They show that the tax base, relative to personal income, has decreased by 20 percent since 1970; if services other than health and education were included, the base would have decreased by only 8 percent. Taxing all services would have increased the base by 11 percent relative to the 1970 level, they find.
Further, many categories of goods—for instance, food for at-home consumption and prescription medicines—are exempt from the retail sales tax in many states. Such exclusions decrease the tax base, make the tax harder to administer, decrease compliance, discriminate according to household preferences, and reward narrow political interests, the authors argue. These exemptions are often seen as a way to lighten the burden on lower-income families for purchases of essential goods. A better approach, the authors say, would be to give lower-income families a rebate or a tax credit.
Mikesell and Kioko suggest that the retail sales tax may overreach in one dimension. The initial intent was to tax household purchases of finished products, making the retail sales tax a tax on consumption. This is not always the case in practice: on average, 40 percent of retail tax revenues come from intermediate goods that businesses purchase, the authors say. Thus, the taxes on these intermediate purchases are incorporated into the prices charged by businesses, so consumers doesn’t realize that are paying that tax. “While hidden taxes may be popular with legislatures,” the authors write, “they conflict with the idea that the population ought to have a clear idea of what they are paying for government.” Another unwelcome consequence is that tax adds a cost on capital investment and other purchases associated with economic expansion, potentially hindering economic growth. In this sense, the retail sales tax encompasses too broad a tax base. Exempting all business input purchases would be more efficient and less distortionary than the current policies, the authors say.
In the face of a declining tax base, states have increased tax rates in order to maintain tax revenues, the authors find.
In the face of a declining tax base, states have increased tax rates in order to maintain tax revenues, the authors find. The average tax rate among states that levy a retail sales tax was 5.7 percent in 2015 compared to 3.5 percent in 1970. Existing literature suggests that tax rates above 10 percent are almost impossible to administer due to low compliance. The authors note that tax rates have been drifting upwards since the 1970s, with many states already above 7 percent, and warn that retail sales tax compliance may become a challenge in the future.
The authors note that one change in the economy that creates difficulties for the retail sales tax is the rise of internet commerce. States have yet to devise an effective mechanism to enforce the sales tax on sales from remote vendors with no in-state physical presence. (In South Dakota v. Wayfair, decided June 2018, the Supreme Court ruled that states may charge sales tax on out-of-state purchases, even if the seller does not have a physical presence in the taxing state.) Another challenge is that the shared economy (where peer-to-peer transactions of goods or services are facilitated by online platforms like Airbnb and Uber) makes tax administration more complicated.
Mikesell and Kioko note that that a considerable share of the challenge to state retail sales taxes is within the control of state lawmakers, and some states have had modest success at restructuring. “The sales tax future much depends on the design of strategies to enact identified solutions to structural, behavioral, and administrative threats. None are impossible,” they conclude.
“The sales tax future much depends on the design of strategies to enact identified solutions to structural, behavioral, and administrative threats. None are impossible.”