Border sales tax impacts: Do we believe our lying eyes?


Back in 2007 when Growth & Justice was presenting its Invest for Real Prosperity tax proposals to the legislature, I recall a member waxing nostalgically about his parents hauling the family across the North Dakota border to buy untaxed clothing in Minnesota.

The point of his anecdote was that if Minnesota lowered its sales tax and broadened its tax base—as economists recommend—this lucrative cross-border school clothing traffic would dry up, with terrible consequences for Minnesota’s border city retailers.

We’re hearing a version of the same tale, now that Governor Dayton’s tax reform plan has finally taken the advice of both Growth & Justice and Governor Pawlenty’s 2009 tax reform commission to lower the tax rate and extend the sales tax base to a broader range of consumer products and consumer services.

This week, Rep. Pat Garofalo objected on TPT’s Almanac: At the Capitol. He reported that a North Dakota Democrat was proposing eliminating the state’s tax on clothing as a form of tax relief.

“Retail businesses in border communities like Moorhead will be destroyed,” Garofalo said, attracting blogger Dave Mindeman’s skeptical response:

Fact: North Dakota sales tax is currently 5.0%. Fargo, ND which is the booming ND metropolis across the river from Moorhead adds a 2% city tax. So here [are] the facts. Under Dayton’s tax proposal, Moorhead (which adds no city tax) would be 5.5%. Fargo would charge 7.0% Clothing may be exempt in the future, but Moorhead will still have clothing under $100 exempt as well.

Judging from comments left on the post and on Twitter, the border-crossing mythology is too well-entrenched to be swept away by simple math.

But let’s suppose North Dakota finally drops its state clothing tax just when the gap with Minnesota is closing.

Then what? Will Minnesota border towns really suffer? Were North Dakota retailers in the thriving cities of Fargo and Grand Forks suffering in silence all these years?

As the Minnesota legislator said in that 2007 hearing, should I believe you or my lying eyes?

Certainly one person’s personal experience can be more persuasive than actual scientific studies—especially when it confirms his biases—but let’s push ahead anyway.

As you can imagine, economic theory predicts that consumers will seek to lower the costs of goods where a sufficient tax differential exists along with relative ease of acquiring the products from the alternative source.

We think we see this principle at work with internet sales that make it easy to circumvent state sales taxes—but application to the border situation is clouded because the internet sales are often deeply discounted as well.

Looking at the literature studying economic activity in response to sales tax rates, I found research that supports the following points:

Response to differences in the sales tax depends on proximity of border communities. In other words, the farther you have to drive to avoid the tax, the less likely you are to do so.

How much does distance matter? A 2010 Utah study of local option sales taxes PDF* that investigated distance as a variable found increasing the tax rate lowers taxable sales (all else held equal) when there is a jurisdiction with a lower tax rate within 5 km, or about three miles. The effect disappears altogether within about 40 miles. This is to be expected for low-cost goods and everyday commodities. But it also appears to hold for expensive major purchases such as new or used automobiles.

Occasional forays to other markets are probably more memorable than routine local trips to buy the same goods, causing people to overestimate the total economic impact of their trip to buy tax-free products.

Clothing purchases appear less sensitive to tax-influenced decisions. When different types of goods are taken into account, several studies found only modest evidence that consumers would alter their consumption or search for lower tax rates on food, clothing and general consumer goods.

Small tax differentials have small effects. Another study based on a natural experiment compared a local option sales tax increase that resulted in a one-half percent difference between neighboring cities. The town with the higher tax rate showed a modest retail sales decline, but drop did not affect the number of businesses, and the reduced sales revenue for the town was more than offset by the increase in tax revenue.

In cases like cigarette taxes, where cross-border differences are large and the product is regularly consumed, we see clear evidence of cross-border activity.

Bottom line, there’s some support for the economic theory or it wouldn’t be a theory for long, but people tend over-estimate the larger effect of their own behavior and observations.

Dayton’s proposal is a target precisely because it takes on the difficult and sometimes contradictory outcomes of tax reform.

Bruce Nustad, president of the Minnesota Retailers Association, for example, doesn’t like the clothing tax: “We like the idea of lowering the overall sales tax rate. The tradeoffs, though, are a little difficult for us.”

Which is maybe why there have been so few serious attempts at reform, despite the theories.

* The state of Utah has wide diversity in local option sales taxes, enabling researchers to study differences between adjacent communities without distorting effects by comparing different states.

Among the five counties that form the urban core in Utah and represent 70 percent of the state’s population, every major city in each of the counties has a different tax rate. In several rural counties, there are no differences in the tax rates within the counties, but in twenty-six of the twenty-nine counties in Utah, 30 percent of the local taxing jurisdictions have tax rate different from each other.