Broader Sales Taxes Can Be a Good Thing

With lawmakers fighting to close budget gaps created by the Great Recession, some states are considering expanding their sales tax bases to include more services. (The Wall Street Journal had a good roundup of the trend yesterday.) Unlike another recent trend in state taxation - the enactment and increase of "Millionaire's Taxes" - this phenomenon may improve state tax systems over the long term.

When evaluating a proposal to expand a state's sales tax base, we should ask two key questions: what's being added to the base? And what will the state do with the new revenue?

The first question helps us determine if the reform will make the sales tax more economically sensible. Sales tax is intended to be a consumption tax, and an ideal consumption tax is applied to all consumption, exactly once, at the same rate. Such a tax is said to be neutral: not creating tax advantages for particular products, industries, or corporate structures.

Non-neutral taxes distort behavior, discouraging taxed activities and encouraging untaxed ones. This results in economic losses, because people make decisions based on avoiding taxes instead of creating the most economic value. So any reform of sales tax bases should be focused on making the tax more neutral.

States do not come close to the goal of taxing all consumption once. A 2003 study from Indiana University Professor John Mikesell estimated that the base of all sales taxes equals only 43% of personal income, meaning most consumption goes untaxed.

When you look at the bases of most states' sales taxes, it's easy to understand why. Services make up approximately two-thirds of our consumer economy, but most states apply sales tax to few or no services. They also often exclude "necessity" goods from sales tax bases, including grocery food, clothing, and medicine.

Meanwhile, states tax some intermediate sales between businesses.  The Council on State Taxation (a trade group for multistate businesses, including retailers), estimates that 44% of sales taxes are paid by businesses, not consumers. (The COST study includes gross receipts taxes that intentionally apply to intermediate sales, but even traditional sales taxes include significant intermediate taxation.)  These taxes become a component of consumer sale prices, a phenomenon known as "tax pyramiding." So, much consumption is double - or triple - taxed while most consumption goes untaxed entirely.   

The theoretical case for expanding the sales tax to consumer services is strong. But states can go wrong in implementing service taxes. If designed poorly, new taxes on services may not further the goal of producing a more neutral consumption tax base.

States can err by taxing business-to-business services, as Maryland tried with computer services in 2008. Meanwhile, Kentucky is considering a tax on "high-end" services like balloon rides and limo transportation. These are the sorts of services that should be taxed, but focusing on them exclusively (without run-of-the-mill services like haircutting and dry cleaning) is more a "soak-the-rich" gimmick than a true effort to improve the tax base.

However, if we are satisfied that a state's sales tax expansion proposal does bring the base more into line with total consumption, we still need to consider what the government will do with the money. The ideal case is that states use the proceeds to cut the sales tax rate or reduce other taxes. We saw this in Maine last year, where the legislature enacted a revenue-neutral plan that adds many services to the sales tax base while reducing income tax.

Revenue-neutral reforms decrease the economic distortion caused by the tax code without adding to taxpayers' aggregate burden or depriving the government of existing revenue. Shifts away from reliance on income tax toward sales tax also reduce the volatility of government revenues, because sales tax receipts tend to be more stable in recessions.

With 48 states facing budget deficits, many legislators simply want to broaden the sales tax base without offsetting tax cuts. Unlike Maine's initiative, this isn't pro-growth tax reform. However, it is preferable to many other options that legislatures consider to raise more revenue.

We should think about these proposals from an opportunity cost perspective. If the sales tax base is not expanded, will the foregone revenue be offset with spending cuts (and in what programs)? Or will legislators substitute other tax hikes that are more economically damaging? Recent evidence from two states shows that tax opponents should be careful what they wish for.

In 2008, Maryland legislators looked at expanding the sales tax to a raft of services while raising income taxes. Business lobbies fought hard against the base expansions, leaving just one that survived to enactment: the aforementioned tax on computer services. The outcry against this tax was so strong that the legislature came back the same year and repealed it - replacing it with a 0.75% increase in taxes on incomes over $1 million.

In 2009, New York Governor David Paterson proposed a budget with roughly $4 billion in tax increases, including extending the sales tax to clothing and various personal services. The governor's proposal left personal income tax rates unchanged, despite a national trend of higher income taxes. Faced with political resistance, the governor instead signed a budget that raised the top income tax rate from 6.85% to 8.97%.

Not only are income tax hikes more economically damaging than sales tax expansions, they also reinforce a negative trend in American taxation: an increasing reliance on taxes that few Americans pay. Legislators can sell a Millionaire's Tax increase as costing nothing for more than 95% of taxpayers. Because voters view those revenues as "free," they have less reason to impose spending discipline on legislators, now or once the recession ends.

It is easy to say that states should not raise taxes at all. But it's also important to be mindful of political realities - especially in states controlled by Democratic officeholders not inclined to make the sort of cuts necessary to balance budgets without new taxes. No amount of finger-wagging will talk every state out of raising taxes.

Some legislators view their choices as not whether to raise taxes, but what taxes to raise and how much. Where a tax increase is politically inevitable, it's better to choose one that imposes less economic damage, has at least some impact on all taxpayers, and reduces the economic distortions of taxation. Extending sales taxes to services can fit this bill.