When it comes to discussions about taxation, sales tax rates often dominate the conversation, leaving the underlying sales tax structure in the shadows. However, it's crucial to shine a light on this aspect, as there are three significant issues plaguing today's sales tax bases. Policymakers hold the key to rectifying these concerns and creating a more effective system.
Experts in public finance widely concur that a well-structured retail sales tax should encompass all final consumption, offering a broad base that enables a lower tax rate. Unfortunately, in practice, most states fall short of this ideal, encountering three primary challenges:
Exclusion of Services:
Most states do not comprehensively tax services, and this omission is primarily a historical artifact. The inaugural sales tax, enacted in Mississippi during the Great Depression in 1930, focused on transactions involving tangible personal property, essentially goods. In the decades that followed, 44 states and the District of Columbia introduced sales taxes and, for the most part, adopted a structure that exclusively taxed goods.
However, the American economy has transformed significantly since then, with services now constituting roughly two-thirds of consumption. Unfortunately, state sales taxes largely ignore this sector, leading to a narrowing tax base and diminishing revenue as a percentage of the economy. The solution lies in broadening the tax base to encompass services, with the resulting revenue used to reduce the sales tax rate or offset more economically detrimental taxes.
Exemption of Consumer Goods:
Often, there is a push to exempt certain "necessities" from sales taxes, such as groceries, clothing, and medication. While well-intentioned, these exemptions significantly reduce the tax base, as these items constitute a substantial portion of consumer spending. For instance, groceries and clothing alone accounted for 10 percent of personal consumption expenditures in 2016.
Although these exemptions are meant to assist low-income individuals, they apply to all consumers, including high-income earners. A more targeted approach would involve including these products in the sales tax while concurrently implementing relief measures for low-income individuals, either through income tax credits or targeted spending programs.
Taxation of Business Inputs:
The final issue pertains to the taxation of business inputs or business-to-business transactions that should ideally be exempt from sales tax. Businesses frequently purchase raw materials from each other to create products, and these transactions are not final consumption. Consequently, they should not be subject to sales tax.
When states do impose taxes on business inputs, these costs cascade down the production chain and inflate consumer prices, albeit in a less transparent manner. This practice disproportionately affects industries with lengthy production chains and can even encourage vertical integration for tax purposes, irrespective of whether it makes sound business sense.
By addressing these three challenges, states can establish a sales tax system that not only boasts a broad base but is also "right-sized. This means that each dollar of consumption is taxed once and only once. The outcome would be stable revenue generation and the capacity to maintain a lower sales tax rate while adequately funding essential government services.