Since emerging from a pandemic-fueled economic downturn, state budgets have been flush with cash, and states across the country have enacted a historic amount of tax relief. Most of these efforts were focused on reducing income taxes and came in many different forms, including rebates, retirement income tax relief and increased earned income tax credits. At least 20 states have cut personal or corporate income tax rates, or both, since the start of 2021, reducing revenues by hundreds of millions or, in several cases, billions of dollars annually. The push to cut income taxes does not appear to be over. Several states are still discussing the possibility of reducing or even eliminating the income tax.
Eliminating the income tax is a highly contentious proposition. Replacing the average state’s most productive revenue stream could lead to budget instability and would increase the regressivity of the overall tax system. But to the extent states continue to cut income taxes, such efforts will inevitably place more reliance on the second-largest state revenue source, the sales tax.
Some economists favor the sales tax on the grounds that taxing consumption is less economically distortive and more conducive to growth than taxing income. However, states wishing to transition away from income taxation toward consumption taxation will eventually need to reckon with long-standing issues facing the sustainability of state sales taxes, which have not kept pace with changes in the modern economy and have gradually eroded over time. While state sales tax collections have been strong over the last two years because of increased spending on durable goods, sales revenue growth was slow or flat in many states in the years leading up to the pandemic. Going into 2023, many states are forecasting a return to slower revenue growth and sluggish sales tax revenues. According to the Urban Institute’s analysis of monthly state revenues, “because of persistent high inflation, we are seeing substantial weakness in sales tax revenues as consumers are recognizing the toll of higher prices.”
For tax policy purists, the ideal sales tax would fall on all final consumption, but state sales taxes are far from having such breadth. In fact, a growing number of consumer purchases are not subject to sales tax in most states. Many have excluded the purchase of services and digital goods from tax, many provide exemptions and holidays for other specified purchases, and changes to the economy have challenged administration and collection efforts.
According to the Tax Foundation, the average sales tax breadth, or share of a state economy included in the sales tax base, was 29.71% in fiscal year 2021. This represents the lowest point of a consistent downward trend over the past several decades; the mean sales tax breadth was 49.0% in 1970. As a result of the narrowing of state sales tax bases, statutory rates have gradually increased. The median state sales tax rate was 3.25% in 1970, 4.0% in 1980, 5% in 1990 through 2000, and is at 6% today. Rising tax rates are not the only consequence of a narrow tax base; weakened revenues, increased budget instability, and questions about tax fairness could become increasingly salient issues if sales tax base erosion is left unaddressed.
Services and Digital Goods
When the first state sales taxes emerged in response to dire state and local revenue needs during the Great Depression, tangible goods accounted for most of personal consumption. Most states chose not to apply sales tax to services because they would be more difficult to administer, and such exemptions weren’t nearly as expensive. Today, services account for about 70% of all personal consumption and most of those transactions are not subject to sales tax.
The Federation of Tax Administrators has periodically surveyed states on the extent they tax services. The most recent survey in 2017 found that, of 176 specified services, only five states— Delaware, Hawaii, New Mexico, South Dakota, and Washington—taxed a significant majority of them. A handful of services, such as cell phone or electric and gas utility services, are taxed by most states, but most are not. Professional and personal services in particular, e.g., legal or accounting services, barbers, tax return preparation, are rarely taxed. The digital era has also contributed to an eroding sales tax base. Many tangible objects are being replaced by intangible digital versions. Instead of buying a book at a bookstore, for example, consumers are downloading books onto their Kindles. This is hardly a new development, but roughly half the states still do not tax digital products or streaming services.
The revenue potential of extending taxes to more services and digital products is significant. It is estimated that states could stand to gain tens of billions in additional revenue if services were taxed broadly. States often estimate tens to hundreds of millions of dollars in new revenue from taxing digital goods as well. Furthermore, maintaining taxes on some purchases but not others can create clear competitive advantages for certain digital or service-based industries. In some cases, it could incentivize retailers that sell both taxable goods and nontaxable services to attribute a greater proportion of a given bundled transaction to a non-taxable service.
While some disagreement still exists about whether certain services should be taxed, most tax policy analysts agree states would do well to include more of them in their tax base. Yet, there is a long list of states that have tried, but failed, to do so in comprehensive fashion. The Council on State Taxation has noted that “over the last 30 years, about one-quarter of the sales tax states tried to enact sweeping sales tax reform that would extend the sales tax base to cover all or most services.” In several instances, opposition from affected industries and general public resistance to tax increases has resulted in states repealing new sales tax reform laws just days after enacting them.
Rather than try to tax services in one fell swoop, several states have been adding more services to the tax base in piecemeal fashion, often as part of legislation that provides relief in other areas. This year, Kentucky approved taxes on over 30 new services as part of a larger measure that reduced income tax rates. Connecticut and Iowa undertook similar, modest expansions in 2018 and 2019.
Other Sales Tax Exemptions
In addition to excluding services and digital goods from the tax base, many states also provide exemptions for commonly purchased items, such as food or prescription medicine. These exemptions are typically adopted to reduce the regressivity of sales taxes, as those with lower incomes will need to devote a larger share of their income to meet their food needs. Still, such exemptions can be quite costly. Most states estimate that tax exemptions for groceries cost hundreds of millions of dollars or more. Questions exist about whether the non-taxability of SNAP benefits might alleviate some of the concerns surrounding the regressive impact of taxing food purchases, but not all low-income families are eligible for SNAP and not all eligible families participate in the program and there is little political momentum for taxing food. Of the 13 states that still applied tax to groceries at the start of 2022, at least five—Kansas, Illinois, Idaho, Tennessee and Virginia--passed legislation to reduce or eliminate it.
In addition to permanent tax exemptions, many states provide sales tax holidays for specified purchases for a temporary period of time, most commonly clothing, footwear, school supplies and computers. Some states have expanded or created new holidays for additional goods. Energy Star efficient products have been added in at least six states, and some coastal states created tax holidays for hurricane preparedness items. Sales tax holidays on firearms and hunting supplies have also gained popularity.
Tax policy experts from both sides of the political spectrum have cast doubt on many of the arguments put forward by sales tax holiday proponents and lament there is no good tax policy justification for treating certain transactions made at certain times differently than others. The existing evidence suggests such holidays merely shift the timing of consumer purchases and do not increase the amount people spend. Nevertheless, 20 states held at least one sales tax holiday in 2022 and such programs are generally anticipated to cost tens of millions in revenue.
To Tax or Not to Tax: Business Inputs
While sales taxes do not apply to many purchases one might expect of a consumption tax, they also include many purchases that economists argue should be exempt. Specifically, business inputs, or costs of production, are often taxable. Business inputs include things like office computers, utensils provided free of charge to restaurant customers, or building materials. Because these purchases represent production rather than consumption and often do not represent on the “final consumer,” economists generally discourage their taxation on the grounds that they create distortions and inefficiencies. Business purchases account for about 42% of total state sales tax revenues--the collections are about three times higher than state corporate income taxes. These sales taxes can get built into a good’s final selling price, which, unbeknownst to consumers, makes the effective tax rate higher than the advertised statutory retail tax rate.
This is a challenge for state tax modernization efforts. There are regular calls to provide increased sales exemptions or tax credits for certain business purchases, but doing so would further erode the sales tax base. Dissatisfaction with the taxation of business inputs has also hampered the policy goal of extending the sales tax to include services, as doing so would mean many additional business-to-business purchases of services could be included in the tax base.
While many business purchases are subject to sales tax, exemptions for business inputs are not uncommon. For example, many states exempt manufacturing equipment or machinery used in agriculture production. A typical case would be a manufacturer receiving a sales tax exemption for the purchase of a tangible good that is incorporated into a manufactured product.
In some cases, there are questions over whether the exemptions states have adopted for business inputs are merited. For example, rental car businesses are generally exempt from paying sales taxes on their purchases of motor vehicles for their fleets, estimated by some states to cost tens of millions of dollars in lost revenue each year. But whether these purchases are truly “business inputs” is not clear since rental car companies do not resell the cars or use them to produce other goods and services. Notably, legislative history in several states shows that the adoption of a separate excise tax on rental car transactions (usually imposed in addition to sales tax) was a means of offsetting lost revenue from sales tax exemptions for car rental companies’ vehicle purchases.
Massachusetts proposed legislation in 2022 to remove an exemption for purchases of motor vehicles by rental car companies. If enacted, the state would join Georgia, North Dakota, Hawaii and Oregon as states that apply sales tax to such purchases.
The difficulty of modernizing sales tax systems was exemplified by the states’ long struggle to collect sales tax on internet purchases from out-of-state sellers. There was widespread consensus when the internet first rose to prominence in the 1990s that e-commerce represented a serious challenge to the sustainability of state sales taxes as long as out-of-state sellers with no physical presence in a state had no legal duty to collect the taxes owed. It took over two decades until states gained the ability to collect these taxes via the Supreme Court’s Wayfair decision in 2018.
All sales tax states have adopted laws requiring online retailers to collect tax on sales made into their states, which has been estimated to increase sales tax revenues by 9.1%. However, to ease the new tax collection burden on smaller businesses, all of the states have provided safe harbor provisions and do not require taxes to be collected until a seller has made a specified number or volume of sales into a state. These thresholds vary by state but start at $100,000 in annual sales. These thresholds are necessary for the time being, but they nevertheless represent consumption that is not being taxed. Online sales are now almost 20% of total retail spending.
Additional Administrative Challenges
Myriad administrative challenges exist can also peel away at state sales tax revenues. The growth in the sharing economy has created a large number of new small businesses and gig workers, which historically have higher rates of non-compliance. As sales tax expert John Mikesell noted, “it is not clear that vendors will register as tax collectors, that taxes will be remitted appropriately, nor that pursuit of unpaid tax from particular vendors will merit the administrative cost involved.” In addition, revenue suppression software, known as “zappers,” allows retailers to erase transactions from their cash registers’ point-of-sale record and evade taxes. This technology has been outlawed in most states, but evidence suggests their use is still common and they are estimated to cost states billions of dollars in tax skimming.
Overcoming the Status Quo Is Easier Said Than Done
The sales tax has many longstanding weaknesses and limitations. As states push forward with plans to reduce income taxes and shift their reliance to consumption taxes, these issues will only become more pronounced. History, however, suggests states will have an uphill battle if they wish to make any lasting, substantial reforms. While 2023 seems ripe for sales tax modernization, it may be that the status quo will continue to reign supreme.