Since emerging from the pandemic-fueled economic downturn, state budgets have been flush with cash, and lawmakers across the country have enacted a historic amount of income tax relief. 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.
Going into 2023, the push to cut income taxes does not appear to be over. Governors in several states—Nebraska, North Dakota and West Virginia, for example—have proposed reducing income taxes or even eliminating them.
Those with lower incomes typically spend about three-quarters of their earnings on items that are subject to sales tax, whereas top earners spend about a sixth of their income on taxed items.
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. Those with lower incomes typically spend about three-quarters of their earnings on items that are subject to sales tax, whereas top earners spend about a sixth of their income on taxed items.
To the extent that states continue to reduce income taxes, more reliance inevitably will fall on sales taxes, the second-largest state revenue source. Some economists who favor the sales tax say that taxing consumption is less economically distortive and more conducive to growth than taxing income.
However, states wishing to transition from income 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 economy and have gradually eroded over time. While 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, with many states forecasting slower revenue growth, sales tax revenues may become particularly sluggish. “Because of persistent high inflation, we are seeing substantial weakness in sales tax revenues as consumers are recognizing the toll of higher prices,” according to the Urban Institute’s analysis of monthly state revenues.
Background
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, and many provide exemptions and holidays for other specified purchases.
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 in a consistent downward trend over the past several decades; the mean sales tax breadth was 49% 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 to which they tax services. The group’s 2017 survey, its most recent, found that only five states—Delaware, Hawaii, New Mexico, South Dakota and Washington—taxed a significant majority of 176 specified services. A handful of services, such as cellphone or electric and gas utility services, are taxed by most states, but most are not. Professional and personal services, such as legal or accounting services, hair dressing and tax preparation, are rarely taxed. The digital era has also eroded the sales tax base. Many tangible objects, such as books, are being replaced by intangible digital versions, and about half the states still do not tax digital products or streaming services.
It is estimated that states could gain tens of billions of dollars in additional revenue if services were taxed broadly. States often estimate tens to hundreds of millions 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 portion of a given bundled transaction to a nontaxable service.
While some disagreement still exists about whether certain services should be taxed, most tax policy analysts agree that states would do well to include more of them in their tax base. But there is a long list of states that have tried, and 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 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 ’19.
Other Sales Tax Exemptions
In addition to excluding services and digital goods from the tax base, many states also exempt commonly purchased items, such as food or prescription medicines. 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 (Georgia and Iowa offer recent examples) estimate that tax exemptions for groceries annually cost hundreds of millions of dollars or more.
Besides permanent tax exemptions, many states also provide temporary sales tax holidays for certain purchases, commonly clothing, footwear, school supplies and computers. Tax policy experts from both ends of the political spectrum have cast doubt on tax holiday proponents’ arguments and lament there is no good policy justification for treating certain transactions made at certain times differently than others. The 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 they would, they do apply to transactions economists argue should be exempt. Specifically, business inputs—office computers, utensils used by restaurant customers, building materials, etc.—often are taxable. Because these are costs of production rather than consumption and often do not reflect 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 be built into a product’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 exemptions or tax credits for certain business purchases, but doing so would further erode the sales tax base. Dissatisfaction with taxing 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 product that is incorporated into a manufactured good.
Some question whether the exemptions states have adopted for business inputs are merited. For example, exemptions for rental car businesses, which generally don’t pay sales taxes on fleet vehicles, are estimated by some states to cost tens of millions of dollars in lost revenue annually (see examples from Illinois and Maryland). 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 adopting a separate excise tax on rental car transactions, usually imposed in addition to sales tax, was a means of offsetting revenue lost to the vehicle sales tax exemptions.
Massachusetts proposed legislation in 2022 to remove an exemption for vehicle purchases by rental car companies. If enacted, the state would join Georgia, North Dakota, Hawaii and Oregon in applying sales tax to such purchases.
Overcoming the Status Quo Is Easier Said Than Done
The sales tax has many long-standing weaknesses and limitations. As states push forward with plans to rely more heavily on consumption taxes, these issues will only become more pronounced. History, however, suggests states will have an uphill battle in effecting lasting reform. While 2023 seems ripe for sales tax modernization, it may be that the status quo will continue to reign supreme.
Jackson Brainerd is a program principal in NCSL’s Fiscal Affairs Program.