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Reversing 85 Years of Bad State Retail Sales Tax Policy

Posted on Sep. 30, 2019
John L. Mikesell
John L. Mikesell

John L. Mikesell is the Chancellor’s Professor of Public and Environmental Affairs Emeritus at Indiana University, Bloomington, Indiana.

In the inaugural installment of Research From Flyover Country, Mikesell discusses problems with states’ policies for retail sales tax, addressing its history since the Great Depression and how its foundation has created bad tax policy today.

The retail sales tax yields important revenue for state and local governments and adds useful diversity to the income-tax-heavy American revenue system. However, the tax as it is characteristically structured fails to meet its potential as a robust, effective, equitable, sustainable, and efficient revenue source. The problem is that the retail sales tax, initially adopted during the Great Depression for desperately needed revenue, has not kept up with economic change or stood up to political pressure. In their quest for badly needed revenue, states got important sales tax policy elements wrong and have done little since to correct the mistakes. Indeed, several changes over the years have been in exactly the wrong direction. Given the significance of the tax in state tax systems and the fact that greater reliance on the retail sales tax often is part of a political strategy to lower property and income taxes, it would be reasonable for states to consider retail sales tax reform. The needed repairs are no secret, and they are particularly necessary if the tax is to continue its important role in the American revenue system.

American Retail Sales Taxes:
Fiscal Role and Great Depression Structures

The retail sales taxes emerged from the collapse of property tax revenues in the Great Depression. State property tax revenue fell by 11.4 percent from 1927 to 1932 and by 16.8 percent from 1932 to 1934. At that time, the property tax was the most important state tax, so this decrease created a fiscal crisis for most states. Property tax revenues could not support state services or provide expected transfers to local governments, which was a substantial problem because the local governments were themselves suffering a similar property tax crisis. When some states adopted retail sales taxes1 and the tax proved capable of producing quick cash, even in lower-income states, its utility in state revenue systems was proven. By 1938 states comprising 43 percent of the nation’s population (22 states plus Hawaii) had adopted the tax. By 1947 the tax was yielding more revenue than any other state tax, a ranking it retained until replaced by the individual income tax at the end of the 20th century.

The role of the property tax never recovered after the Great Depression. In 1927 that tax yielded 23 percent of state tax revenue, a share that fell through the subsequent years of economic collapse. By 1940 it had fallen to 7.8 percent and it has never been as high as that in the years since, currently accounting for around 2 percent. From nothing in 1932, the general sales tax share jumped to 14 percent ($364 million) by 1936 when it produced more revenue than the property tax ($228 million). The sales tax share rose consistently through World War II and the postwar period until it reached roughly one-third of total tax revenue by the late 1980s. This share continued until 2006 when it began a slight decline, rebounding to 31.4 percent in 2016.2 National aggregate yield from the state individual income taxes is now greater — not surprising given that the individual income base would be expected to be greater than the base of a retail sales tax and that the income elasticity of the income tax base is likely greater than the elasticity for the retail sales tax base. The general sales tax share was larger than the property or individual income tax share from 1936 through 1998, at which point the individual income tax share was greater (33.8 percent versus 32.8 percent). The significant role the tax has played in state finances is apparent.3

The national totals conceal and understate the full importance of the retail sales tax to state finances. State tax systems are developed state-by-state — not nationwide — and certainly not according to a national standard or template, so it is important to examine reliance at the individual state level. When sales tax reliance is considered at the state level, the conclusion is somewhat different from that based on national aggregates that are heavily shaped by a few large states. Figure 1 shows the mean reliance on retail sales and individual income taxes across the 45 sales tax states from 1950 through 2017.4 Sales tax reliance generally increased from 1950 through the remainder of the 20th century with no major disruptions to that trend. It has since declined from its peak of 36.4 percent in 2002-2003. The current level, 34.9 percent, is roughly the same as it was in the early years of the 1980s and higher than its level in 1950 (21 percent), 1960 (25.3 percent), or 1970 (32 percent). Until 1970 reliance was generally increasing, but since 1970, it has remained between 32 and 36 percent. Individual income tax reliance has been less than sales tax reliance through these years, although the difference between the taxes narrowed. The trend is toward increasing individual income tax reliance, from 1950 (7.1 percent) to 2017 (32 percent), with some declines in recession periods, particularly in 2001 and 2007-2009. The retail sales tax continues to play a vital role in individual state tax systems. Any restructuring to the tax will necessarily come on a state-by-state basis.

The Depression Hangover

The retail sales taxes embody bad tax policy largely because of continued fundamental structural features that emerged with the Depression-era adoptions of the early taxes. States were desperate for revenue, lawmakers were inclined to accept taxes that would produce cash, and that appears to have overwhelmed other possible tax policy concerns. States copied early adoptions and, once a tax is operating, changing it is politically difficult because any change would cause some to pay relatively more and others to pay relatively less. Three structural elements linger in sales tax policy today.

First, the tax usually applies generally to purchases of tangible personal property (TPP) but selectively at best to purchases of services. In the 1930s the service share of household consumption (and of the economy as a whole) was only around 60 percent of its current level, according to National Income and Product Accounts. The omission seemed not to have significant consequences when the first taxes were being adopted, particularly because states were unsure about their ability to administer the service portion of such a tax. Service transactions provided no audit trail to inventory purchases for administrators to track, making verification challenging. The administrative task was made even more difficult because many service businesses were small and often operated informally. It seemed not worth the effort to tax services.5

Property, General Sales, and Individual Income Tax Revenue as Share of Total State Tax Revenue, 1932-2016

Second, the taxes were framed on a philosophy of taxing finished goods. The taxes exempted inventory purchases but did not broadly exempt other business inputs. Much of what a business purchases — tools, machinery, fixtures, furniture, etc. — are finished goods in that their manufacturing or other processing is complete. Early sales tax framers did not accept that the test should be whether the purchase was a business input and part of the cost of the business, regardless of whether it was finished. Including these transactions, and thus embedding that tax on business inputs in the prices of products, prevents the final burden from being uniformly distributed across household consumption. The true effective sales tax rate — the total tax paid relative to net-of-tax price of the product — exceeds the advertised statutory tax rate because of pre-retail tax that is embedded in the final retail price of a product (even in products that the tax statute exempts from taxation) and the effective rate will not be the same for all products. Politicians like this result because it allows them to claim a lower tax rate than actually applies. However, concealment of the true costs of government is inconsistent with the transparency necessary for the functioning of a democracy.

Third, the taxes were added at purchase, rather than being embedded in the shelf price of products as is usually the case with European VATs. Lawmakers understood that retailer cooperation was critical for operation of the tax, and retailers wanted to avoid being seen as responsible for the price increase necessary to cover the tax. Alfred G. Buehler observed in 1940: “The most active opponent of the state general sales taxes . . . have been aggressive retailers who have led spirited campaigns against these taxes to prevent their adoption. In some instances this organized resistance has defeated a general sales tax, but in others it has not stopped its enactment.”6 Adding tax at time of purchase was one of the costs associated with overcoming retailers’ objection to the tax. That improved tax transparency (ignoring the opacity of tax embedded on the inputs used to produce the final product), but probably inhibited legislative action when new revenue was needed and encouraged obtaining revenue in even more hidden ways (like taxing intermediate goods).7

The taxes emerged in the Great Depression and were arguably appropriate for the desperate state revenue requirements of that time. But most of the time, the American economy is not in a depression, or even a recession, so a Depression-designed tax will almost always be out of sync with the economy. For robust, sustainable, and effective performance, the taxes need restructuring for the most probable economic conditions. Bad tax policy may be acceptable in desperate economic conditions when bringing in revenue matters far more than anything else, but the taxes need to escape their Great Depression roots if they are to be serviceable for the products, transactions, and technologies of the economy in the 21st century.

Bad Tax Policies in State Retail Sales Taxation

The unique position of the retail sales tax is that it allows government to use a quasi-market solution for the distribution of the cost of general government services across households. The tax, as applied to household consumption and the individual household’s assessment of what it can afford to purchase from the market economy, creates the same distribution of tax burden for support of government services. Those who believe they can afford more from the market will pay more sales tax, causing an equivalence in distribution between market and government. Thus, the retail sales tax ideal is to provide a tax on household consumption. John F. Due and I described the two structural principles needed to implement that ideal, when we wrote that:

a. It should apply to all consumption expenditures, and thus to all sales for consumption purposes, at a uniform rate. Failure to do so will distort relative outputs of various goods and services, discriminate among various families on the basis of consumer preferences, and, frequently, complicate compliance and administration because of the need to distinguish between taxable and nontaxable items and among sales at various rates.

b. It should apply only to consumption expenditures, and thus not to savings or to purchases for use in production. Taxation of savings or uses of savings would contradict the consumption intent of the tax. Taxation of production inputs has several undesirable consequences, including that of producing a haphazard and unknown final pattern of distribution of burden among various families.8

Tax policy is defined by what is included in and omitted from the tax base and what rate structure applies to the resulting base. For most retail sales taxes, a single statutory rate applies to all parts of the tax base, so the base identifies the tax policy. For the retail sales tax, policy emerges from the choices that cause the tax base to differ from household consumption. The statutory base may be narrowed either by an exclusion (when part of the otherwise taxed gross receipts is omitted from the law) or by an exemption (when a transaction that would be included in the tax base is removed from taxation by a statutory provision). Wisconsin retail sales tax law illustrates an exclusion: “For the privilege of selling, licensing, leasing or renting tangible personal property at retail a tax is imposed upon all retailers at the rate of 5 percent of the sales price from the sale, license, lease or rental of tangible personal property sold, licensed, leased or rented at retail in this state.”9 By omission, the retailer is not liable for the tax (and will not collect it from customers) on transactions that are not TPP, i.e., services, real property, or intangible personal property. West Virginia’s law illustrates exemption language: The tax applies to “purchases of tangible personal property and services except for those identified as exempt for reason.”10 The transactions would fit in the coverage of the sales tax, except for their specific exemption. Each exclusion and exemption narrows the sales tax base and reduces tax yield at any given statutory rate.

Sales tax exclusions provide a preference by omission from the base definition. The most important exclusion is for household service purchases. The problem is that for household consumption there is no difference between the purchase of a service and the purchase of a good. Most states excluded services from their tax base definitions when the earliest taxes were adopted, and other states continued that practice over the years. It is politically difficult to get transactions into the base once they are out, leading to the current pattern of minimal taxation of services at best.

In terms of coverage of service purchases, state sales taxes may be divided into three groups: taxes that are limited to purchases of TPP, taxes on purchases of TPP plus enumerated services, and taxes on purchases of TPP and services. The division of states into these groups has changed somewhat since 1970.

  1. Limit the base narrowly to purchases of TPP: In 1971, 26 states excluded purchases of services from the base. By 2018, only three almost entirely excluded services.

  2. Apply tax to enumerated services and TPP purchases generally: In 1971, 17 states taxed some selective service purchases. By 2018, that number was 38.

  3. Tax services on a basis roughly equivalent to that for coverage of TPP purchases: In 1971, two states included services on a general basis. By 2018, four states taxed services generally.11

The exclusion of services creates several problems. First, there is discrimination and an incentive for distortion between alternate approaches to the provision of equivalent products. For instance, in many jurisdictions, streaming a Netflix movie is an untaxed service while renting the same movie from Redbox is taxed. That is discriminatory and fundamental nonsense. Second, there is discrimination among households according to tastes and preferences. Otherwise equivalent households would bear different tax burdens according to their relative preferences between services and goods. Third, expansion of the base to include services would reduce the regressivity of the tax. And finally, expanding the base to services would improve the growth prospects for the tax because the service sector has been growing and is expected to grow more rapidly than the goods sector. Taxing services would reduce some of the narrowing of the tax base that has recently occurred. Of course, expanding the base to services translates to more revenue at any statutory rate and, in many state discussions, this revenue potential dominates the more complicated impacts.

The base narrowing from the services exclusion is the product of consumer behavior — states are not moving more services to the excluded list. The consumer behavior impact is shown in Figure 2. The figure reports the percent of total personal services consumption represented by that generally untaxed expenditures on personal services. The increase in percent has been persistent over time, from 35.1 percent in 1960 to 58 percent in 2017.12 As this percent increases, the percent of consumption and of personal income will decline without any legislation to change base coverage. By doing nothing, lawmakers have implicitly narrowed the sales tax base and — because trends are unlikely to change — have threatened the long-term sustainability of the retail sales tax.

Most sales tax reform packages include some proposed extension of the tax to services. When reforms translate into legislation, either proposed or enacted, they usually target a specific list of services for taxation, rather than taxing all household service purchases. That was the approach recently taken by the District of Columbia, Kentucky, Nebraska, and North Carolina, and it encourages service providers to act to get removed from the taxed list. Some categories on these lists are narrow and have minimal revenue potential. However, removing the exclusion of household consumption purchases of services (and thus correcting decades of bad tax policy) would be an important step for preserving the American retail sales tax.13

Untaxed Expenditures on Personal Services as Share of Total Personal Services Consumption, 1960-2017

A continuing struggle is to keep services purchased primarily as business inputs out of the list for expansion. A proposal in California embodies the ultimate in bad policy. The state’s current tax excludes most services, but S.B. 993 (2018) would tax all services purchased by businesses, with few exemptions, and would reduce the tax rate on goods. There is nothing consistent with sound tax policy in this proposal. Keeping services predominantly purchased as business inputs exempt to prevent tax pyramiding is a perennial challenge. It is difficult because taxing business purchases appears to burden businesses instead of people and it hides the tax burden.

Exemptions remove transactions that would otherwise be taxable because of type of purchase (food purchased for at-home consumption), type of purchaser (state universities), type of item (state flags), location where purchase will be used (enterprise zone exemption), nature of use (sales inventory), or type of seller (Girl Scout cookies). Lawmakers have reduced the application of tax to household purchases over the years for a wide array of reasons, thus reducing the tax’s productivity. While smaller exemption categories complicate administration and compliance, the fiscal impact is more important and worrisome for tax policy. There is always a clientele for exempting selected transactions from tax, derived from claims of public good, discrimination, or fairness, and there is seldom consideration of whether there might be more efficient, effective, and cheaper ways of dealing with the claimed issue — or even whether there is a sufficient public issue that needs action. Seldom is there consideration of the substantial amount of total tax reduction or the fact that exempting some transactions can cause the exemption to disproportionately go to more affluent households. The ideal retail sales tax applies to all household consumption expenditure, an approach that benefits the population by allowing lower statutory rates, reducing discrimination across taxpayers, and reducing consumption choice distortions. The tax is not a tax on luxuries or nonessential goods only — it is intended to apply to all consumption without distinction. Unfortunately, interest groups bend the concept of excluding necessities for targeted benefits to constituents, and these efforts are difficult to combat. Lawmakers are willing to respond to this demand because the concentrated benefit to the interest group overwhelms the more diffuse public cost, creating a political decision imbalance. Not all states have a tax expenditure budget or fiscal note process that quickly identifies the revenue impact of removing transactions from the base, and even fewer are able to include the non-revenue impacts in the discussion. Therefore, sales tax structures are perpetually vulnerable to narrowing the tax base by added exemptions, thereby placing more of the tax burden on the remaining transactions.

The record reveals significant narrowing by statute in several major types of household expenditure.

  • Food for at-home consumption: 28 states fully taxed in 1970 and seven fully taxed in 2018.14

  • Clothing: 40 states fully taxed in 1970 and 38 fully taxed in 2018.

  • Prescription medicine: 17 fully taxed in 1970 and none fully taxed in 2018.

  • Gasoline: Seven fully taxed in 1970 and three fully taxed in 2018.

  • Residential electricity: 34 fully taxed in 1970 and 21 fully taxed in 2018.

  • Residential gas: 34 fully taxed in 1970 and 21 fully taxed in 2018.

  • Residential water: 23 fully taxed in 1970 and 12 fully taxed in 2018.

  • Cigarettes: 24 fully taxed in 1970 and 40 fully taxed in 2018.

  • Holidays from tax collection: No states offered sales tax holidays in 1970 and 17 offered at least one (sometimes several) in 2018.

For all the listed categories except for cigarettes, sales tax coverage diminished between 1970 and 2018. Taxability increased only for cigarettes, which represents a small and diminishing percentage of personal consumption expenditure (from 1.7 percent in 1970 to 0.7 percent in 2017). The tax has moved from its useful role as a general and uniform tax on household consumption to a more haphazard tax with complicated compliance and administration whose relative burdens are inconsistent across the population. And, of course, the base narrowing reduces the productivity of the tax at any statutory rate.

The Achilles’ heel of all household consumption exemptions is that they provide relief for each purchaser regardless of income level. As a result, a vast amount of tax relief goes to the affluent, thus creating considerable revenue loss without gaining any socially desirable effect. Household purchase exemptions do not target relief to those truly in need. Instead, they reduce considerable potential revenue by narrowing the base, complicate compliance and administration, discriminate according to household preferences, and distort consumer behavior.

Most troubling is that an option that reduces all these problems is readily available but is only in use in six states. This device is the credit/rebate system in which all or a portion of sales tax paid by families below a specified income level is returned by linking the sales tax system to the income tax system, usually via a credit that either reduces amount owed or refund returned. The systems have various names15 but all focus tax relief directly on the intended population and do not waste relief by failing to collect tax on those who would not ordinarily qualify for assistance. Including all household consumption in the tax base is the general policy objective.16

The record for exemption of business input purchases is somewhat different. Unfortunately, sales taxes have not managed to escape their Great Depression roots in terms of focus on finished goods, even when the purchase is for business use. Including business input purchases in the base has practical importance beyond just violating the basic idea of dividing the cost of government across household consumption. The tax paid on business purchases, as part of operating costs, gets included in prices paid by customers, hiding this piece of tax from those paying it and allowing legislators to inflate the base and hide the actual effective tax rate. Concealing the cost of government by taxing business inputs is inconsistent with democracy and good tax policy. Because it adds to business cost, it adds another impediment to capital investment and economic development, distorts patterns of economic activity when businesses account for tax in their decisions, and prevents the tax from being uniformly distributed across household consumption.

The states have not made great progress in removing business inputs from the tax. They generally exempt purchases for inventory and of component parts of a product, and frequently exempt utilities used in the production process, but their record in exempting equipment and machinery is comparatively poor. The Depression view is stubborn because those items are undoubtedly finished. They also are undoubtedly business inputs and should be exempt. Fortunately, there has been some progress regarding this exemption.17

  • Exemption of machinery and equipment purchases: In 1970, 13 states fully exempted such purchases, and the number of states had risen to 36 in 2018.

  • Full taxation of machinery and equipment purchases: In 1970, 22 states taxed such purchases, and the number fell to three states in 2018.

  • Taxation at reduced rate: In 1970, six states taxed machinery and equipment purchases at a reduced rate, and two states levied a reduced rate in 2018.

  • New and expanded industry: In 1970, four states limited the exemption to purchases for new or expanding capacity, the same number as in 2018.

There has been progress, but other business purchases continue to be taxed. Lawmakers have an affection for exempting popular or flashy activities like purchases for research and development, filmmaking, or hosting the Super Bowl or similar athletic events, regardless of the case for favoring such activities. Lawmakers like such narrow exemptions because they can connect their action to a particular event or activity regardless of whether the exemption was crucial to its development (and sometimes because these exemptions allow lawmakers to hang out with celebrities). Cynics would suggest that the narrow exemption provides an opportunity for extracting campaign contributions. A general exclusion of all business purchases — the preferred alternative — would not allow such opportunities. In terms of resource allocation, few would argue that lawmakers are better than the market at identifying promising businesses and industries, meaning that selective exemption programs are likely counterproductive in how they shift the tax burden.

The share of the sales tax base that comes from business purchases in any state depends on the nature of the economy and the kinds of industries it hosts, the extent of exclusions and exemptions of household consumption, and what business purchases have been exempted in the law. A good indicator of how the business share has changed in recent years is provided from estimates done in studies by Raymond Ring Jr., and by the Council On State Taxation along with EY, for years from 1979 through 2015. The studies find the business share of the total base to be on average slightly above 40 percent across the states. Both sets of studies show some increase in the business share from the first to the last year of their studies (Ring, 42.5 in 1979 and 44.8 in 2013; EY and COST, 41.6 in 2004 and 42.6 in 2015).18 The message is clear: State sales tax policy toward business input purchases has not shifted in a way consistent with a uniform, transparent, efficient, and nondiscriminatory tax on household consumption. States need to become more general in their exemption for business input purchases.

Results of Bad Sales Tax Policy

Data reported earlier show that states on average collect about one-third of their tax revenue from their retail sales tax. That level has been normal for more than 40 years as states show little inclination to replace their use of the tax with heavier reliance on other taxes. The options that might allow serious reduction in sales tax reliance, i.e., higher individual or corporate income taxes, property taxes, or user fees, tend to be less politically attractive than the sales tax. Some state leaders have even increased their sales tax reliance to reduce or eliminate other taxes. In that political environment, it is no surprise that lawmakers have worked to keep sales taxes productive, one way or another.

The narrowing of the sales tax base because of the exclusion of service purchases, which have increased as a share of personal consumption, complicates the effort to maintain sales tax productivity and reliance. In contrast to the statutory actions that have narrowed the base as it applies to household purchases of goods, the narrowing regarding household purchases of services has been the product of legislative inaction combined with consumers’ economic behavior. In terms of impact, it makes little difference whether the result comes from action or inaction.19 And it is important to note that the narrowing began well before the internet age and the challenge of untaxed remote vendor transactions. States must look inward for the source of the problem.

Figure 3 reports the relationship between mean breadth of the tax base and the mean statutory tax rate applied to that base across the states from 1970 to 2017.20 The historical record for the base is one of almost constant decline, from 54.4 percent in 1970 to 37.7 percent in 2017. In relative terms, the 2017 base is 69.3 percent of its 1970 coverage — a major reduction in revenue potential. Over those years, during which the pattern is remarkably consistent, the mean statutory rate has increased from 3.53 percent in 1970 to 5.6 percent in 2017, making the rate 58.6 percent higher. That is a generally mechanical relationship, but it is important because little good can be said about a narrow base and high statutory rate revenue policy that states, possibly by accident but possibly on purpose, have been pursuing since 1970. The ratio of breadth each year to its 1970 level has persistently fallen while the ratio of statutory rate has persistently risen. The table shows the upward drift of statutory rates since 1970.21 In the early years, sales tax rates of 3 percent and below were levied in several states, but by 2018, rates of 6 percent and above were dominant. A narrowing base will require more rate increases if state revenue systems are to preserve the role of the sales tax. Rates are moving toward the danger zone of attractive noncompliance and, unless states can manage the narrowing base problem, that prosaic problem will become a significant challenge for state administrators in the first part of the 21st century.

Mean Statutory Rate and Breadth of Base Across States, 1970 to 2017 (Ratio of Year Relative to 1970 Level)

States have managed almost exactly the wrong set of changes by omission and commission over the years. They move the tax away from reform. Joel Slemrod concisely defines tax reform as measures that “seek to broaden the tax base and reduce marginal rates in a roughly revenue-neutral manner.”22 The state retail sales taxes produced badly needed revenue in the difficult period of the first adoptions. Unfortunately, those pathbreaking states did not embody important elements of good tax policy and the taxes have never been reformed according to a standard definition of tax reform.

Changes have usually not moved toward consistency with the criteria for retail sales taxation, in that they have not moved toward uniform taxation of all household consumption and they have not moved toward removing tax from business input purchases. Also they have not been in the direction of general tax reform, that is, in the direction of a broader base/lower rate policy. Therefore, the conclusion: we have had 85 years of bad sales tax policy.

Conclusion

The retail sales tax emerged during the Great Depression as a means for state fiscal survival. It became a stalwart of state revenue systems through the second half of the 20th century. Despite significant increases in state reliance on individual income taxes, the retail sales tax remains the most important tax source for many states and a major contributor in all the 45 states levying such taxes. It serves as an important device for limiting overreliance on the individual income tax and would be difficult to replace with revenue from other available options.

Statutory State Sales Tax Rate Distribution Across States, 1970-2018 (January 1)

Rate

1970

1980

1990

2000

2010

2018

2% and fractions

5

1

 

 

1

1

3% and fractions

19

17

4

2

 

 

4% and fractions

15

18

15

13

11

11

5% and fractions

5

6

15

14

9

8

6% and fractions

1

2

10

14

18

21

7% and fractions

 

1

 

2

6

4

8% and fractions

 

 

1

 

 

 

The system creates many silly distinctions that complicate the process and that could be eradicated. Why should taxability of a forklift purchase depend on whether the manufacturer is going to use it in its warehouse or on the production line? Why should a movie’s taxation depend on whether it was rented from Redbox or streamed on Netflix? Why should taxation turn on whether tax preparation advice came from an accountant or from a guidebook purchased from a local bookstore? And why should it matter whether electricity used in the manufacturing process goes through a meter distinct from electricity going to illuminate the manufacturing floor? There are countless other available examples, and these distinctions interfere with the basic logic of the sales tax — that it be a uniform tax on household consumption. They also make tax administration and compliance more difficult. The clear distinction between household consumption and business inputs would make the tax much easier to implement. It is also good tax policy.

As structured, the tax embodies bad tax policy that appears to worsen over time, putting the sales tax on an unsustainable path. No remedial action is easy, but repairing the tax is surely simpler than starting over, and states need the revenue because the sales tax provides an important foundation for their tax systems. The solution is straightforward: Tax all household consumption expenditures and exempt all business purchases. States can begin by adding more household consumption services to the tax base and by restraining their inclination to offer exemptions that seem to be good ideas at the time. Social problems created by taxing all household consumption can be solved through the credit/rebate system, which ensures that relief goes only to the deserving. More flexibility for reform will emerge when the most fundamental elements of bad tax policy have been at least partially eliminated.

FOOTNOTES

1 Adopters in 1932 and 1933 included Arizona, California, Illinois, Michigan, Mississippi, New York, North Carolina, Oklahoma, Pennsylvania, South Dakota, Utah, and West Virginia.

2 Motor fuel tax revenue exceeded general sales tax revenue until the mid-1940s, but motor fuel collections were usually earmarked for roads and highways.

3 Data are from the U.S. Census Bureau, Governments Division, State Tax Collections (annual).

4 These are the 45 states levying a retail sales tax, including earlier years in which some of the states had not yet adopted their tax. Sales tax revenue from the last state to levy the tax appears in fiscal year 1970 and onward.

5 True gross receipts taxes adopted in the early 1930s, like the West Virginia business and occupation tax, included service receipts in their tax bases. Somehow the concerns for the retail sales taxes did not extend to these similar taxes. Recently adopted gross receipts taxes, like the Ohio commercial activity tax, also include services in the tax base.

6 Alfred G. Buehler, Public Finance (1940).

7 Some research suggests that adding the tax at purchase may have less impact on consumer decisions than embedding the tax in list price. Raj Chetty, Adam Looney, and Kory Kroft, “Salience and Taxation: Theory and Evidence,” 99 Am. Econ. Rev. 4 (September 2009). However, retailers and lawmakers are probably more concerned with the more blatant visibility of adding tax at purchase.

8 John F. Due and John L. Mikesell, Sales Taxation: State and Local Structure and Administration 16 (1994).

9 Wis. Stat. chapter 77, 52 (1)(a).

10 W. Va. Code section 11-15.

11 Data for 1971 from Due, State and Local Sales Taxation: Structure and Administration (1971). Data for 2018 from IntelliConnect (online).

12 Bureau of Economic Analysis’s National Income and Accounts. Some personal service purchases — like meals, drinks, and utilities — are generally taxed. These transactions are subtracted to produce a measure of services that are typically excluded from the base. BEA classifications do not match the language of retail sales taxes, so the analysis here can only provide a general idea of the effects.

13 Interest group efforts can interfere with sound tax policy. Realtor organizations in Kansas (2016) and Arizona (2018) managed to pass constitutional amendments that prohibit new or increased taxes on services. Modernizing the retail sales tax in these states is essentially impossible.

14 All Supplemental Nutrition Assistance Program purchases became exempt in 1987 when exemption became a requirement for state participation in the program. Program benefits are efficiently delivered and well-targeted to low-income households, so the benefits of the rest of the exemption fall to households more affluent than this low-income line.

15 These credits are the Maine Sales Tax Fairness Credit, the Kansas Food Sales Tax Credit, the Oklahoma Sales Tax Relief Credit, the Idaho Grocery Credit Refund, the Wisconsin Child Sales Tax Rebate, and the Hawaii Refundable Food/Excise Tax Credit.

16 Michigan and Ohio have crippled their capacity to make this move to efficiency by forbidding taxation of food purchased for human consumption (excluding prepared food intended for immediate consumption in Michigan or for human on-premises consumption in Ohio) in their state constitutions. Both provisions were enacted in the 1970s, when the states should have known better.

17 Due and Mikesell, supra note 8.

18 Raymond Ring Jr., “The Proportion of Consumers’ and Producers’ Goods in the General Sales Tax,” 42 Nat’l Tax J. 2 (June 1989); Ring, “Consumers’ Share and Producers’ Share of the General Sales Tax,” 52 Nat’l Tax J. 1 (March 1999); and Kathryn Birkeland and Ring, “Consumers’ Share and Producers’ Share of the General Sales Tax,” Proceedings of the 107th Conference on Taxation of the National Tax Association (2014). Computed from State Tax Research Institute; Council On State Taxation; EY, “Total State and Local Business Taxes, State-by-State Estimates” (annual); and U.S. Bureau of Census, Governments Division, State and Local Government Finances (annual).

19 Some argue that the narrowed base produces the higher rates and others argue that higher rates have produced a narrow base as interest groups have lobbied for exemptions to avoid the rates. In terms of tax policy, the direction of causation is irrelevant: Narrow base and high rates is bad tax policy, regardless of how it emerges.

20 Sales tax data for this analysis are standardized across states to adjust for peculiarities in how the Census Bureau reports general sales tax data and for how some states structure the relationship between retail sales and selective excise taxes. These standardization adjustments are explained in Mikesell, “State Retail Sales Taxes: Revenue Performance for Fiscal 2015,” State Tax Notes, Feb. 20, 2017, p. 675. The adjustments are not the same for all years. For instance, the Indiana gross income and West Virginia business and occupation tax need to be subtracted from the Census reports for some years (both taxes have been repealed). Adjustment data come from unpublished data graciously provided by the Census Bureau, department of revenue annual reports, state comprehensive annual financial reports, state budget documents, and direct inquiries to state officials. In fiscal year 2017, adjusted retail sales tax data ranged from 73.4 percent to 134.1 percent of Census-reported data, so failure to adjust to a standard retail sales tax concept would give a misleading idea of tax structure and performance across states.

21 Due and Mikesell, supra note 8; and Tax Policy Center, “State Sales Tax Rates” (annual).

22 Joel Slemrod, “Is This Tax Reform, or Just Confusion?” 32 J. of Econ. Persp. 4 (Fall 2018).

END FOOTNOTES

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