The previous installment of this series presented information on the amount of revenue that could be generated by expanding the state’s sales tax base to include various goods and services that are currently untaxed. However, an expansion of the sales tax base should not be undertaken without consideration of the advantages and disadvantages.
Two items are most frequently mentioned when discussing of expansion of the sales tax base: clothing and services. Based on calculations using data from the Minnesota Departments of Revenue and Finance, eliminating the exemption for clothing would expand the Minnesota’s sales tax base by approximately nine percent, while eliminating the exemption for services would more than double the size of the sales tax base.
Linking Revenue to a More Rapidly Growing Tax Base
The Institute on Taxation and Economic Policy (ITEP) notes that the practice in most states of applying the sales tax to goods but not services is a “historical accident.” When states began to impose sales taxes during the 1930s, services were a relatively small share of consumer spending and were overlooked.
Spending on services is growing more rapidly than spending on goods. Including services in the sales tax base should provide more robust revenue growth over time. This is an especially important consideration, given the long-term structural gap between revenue and spending currently projected for the state’s general fund.
A Broader, Fairer Tax Base
In the absence of pressing policy considerations, economists generally frown upon tax exemptions that favor one form of economic activity over another. For example, it is difficult to see why the purchase of shampoo should be taxable, while the purchase of a haircut should not.
In a presentation to the Governor’s 21st Century Tax Reform Commission, Art Rolnick, Senior Vice President at the Federal Reserve Bank of Minneapolis and associate economist with the Federal Open Market Committee, argued that as a general rule the government should not skew economic decisions through tax exemptions that favor some taxpayers at the expense of others. According to Rolnick, “The broader the tax base, the better.”
According to ITEP, “sales taxes generally include a wide variety of special exemptions, which often discriminate between similar taxpayers in ways that are not defensible from a tax fairness standpoint.” This would seem to be the case in Minnesota. The way to rectify this situation would be to broaden the sales tax base to include services and possibly clothing.
A More Regressive Tax System
A principal criticism of the sales tax is that it is regressive, which means that it takes a larger bite out of the incomes of low and moderate income households than of high income households. Based on information from the 2007 Tax Incidence Study prepared by the Minnesota Department of Revenue, the state’s general sales tax is even more regressive than homestead property taxes.
However, unpublished data from the Department of Revenue indicates that a sales tax on clothing is significantly less regressive than the current state sales tax. In addition, ITEP argues that expanding the sales tax base to include services will also make the sales tax less regressive.
If the expansion of the sales tax base is accompanied by a reduction in the sales tax rate that results in no net gain in state revenue, the sales tax and the overall tax system would become less regressive. However, expanding the sales tax base in a revenue neutral manner will do nothing to address the state’s projected revenue shortfall.
If the sales tax base expansion generates a significant amount of new state revenue, the overall tax system will become more regressive. While the sales tax will become less regressive, it will still remain a significantly regressive tax. Increasing the state’s dependence on a very regressive tax-albeit one less regressive than it was before-will contribute to an overall increase in tax regressivity.
Recent tax incidence reports from the Department of Revenue indicate that Minnesota’s tax system has become steadily more regressive during the current decade and that this trend is projected to continue through 2009. This being the case, policymakers should be reluctant to expand state revenues in a way that further accelerates the trend toward regressivity.
In order to offset the increased regressivity that will result from a significant increase in sales tax revenue, ITEP proposes increased use of targeted tax credits, such as the Earned Income Tax Credit or a sales tax credit. Both tax credits would reduce the tax burden on those households with the least ability to pay. Properly designed, credits such as these could offset the increased regressivity resulting from increased dependence on the sales tax.
Problems With Taxing Internet Sales
A 1992 U.S. Supreme Court decision, Quill Corporation v. North Dakota, exempted out-of-state retailers from collecting tax on remote sales in states where they do not have a physical presence. Most have interpreted “remote sales” to include internet sales. Even in instances where internet retailers or customers are required by law to remit the sales tax, enforcement can be problematic.
The problem with sales tax avoidance primarily applies to sales of goods, as opposed to services. The growth in sale of goods over the internet poses problems for state sales tax administrators and could undermine the collection sales tax dollars.
In order to address the challenges of collecting taxes on remote sales, nineteen states, including Minnesota, have enacted the Streamlined Sales and Use Tax Agreement (SSUTA), which simplifies the administration of the sales tax on sales between states in compliance with the SSUTA. The ultimate goal of states participating in the SSUTA is to convince Congress to enact legislation which will enable states that have enacted the SSUTA to collect sales taxes from retailers in other states that have enacted the SSUTA. In this way, participating states hope to curtail the erosion in sales tax collections resulting from the growth of internet sales.
However, there is no guarantee that Congress will ultimately enact the legislation sought by states that have adopted the SSUTA. Furthermore, even if Congress does enact such legislation, a large number of states may nonetheless decline to adopt the SSUTA; retailers in these states would still not have to pay sales taxes to states where they do not have a physical presence. Thus, the continued erosion of sales tax collections resulting from internet sales is likely to remain a real possibility. States that choose to address their revenue problems through increased dependence on the sales tax should be cognizant of challenges posed by internet sales.
Expansion of the sales tax base to include goods and services currently exempted could generate a lot of new money for Minnesota at a time when it is sorely needed. However, the increase in revenue is only one of several factors-both positive and negative-that should be examined when considering sales tax base expansion. Tomorrow this series on sales tax base expansion will conclude with a summary and an examination of the last time Minnesota attempted to expand its sales tax base.