Off the Charts Blog | Center on Budget and Policy Priorities

In recent testimony to the North Carolina legislature supporting tax cuts, the Tax Foundation asserted that “rarely does empirical economic literature speak so strongly in unison as it does about the effect of taxes on economic growth.”  But that assertion is simply false, at least with respect to the literature on the effect of state and local taxes on state economic growth.  There’s no clear research evidence that lower taxes help state economies grow, as our new paper explains.  With tax cut proponents making similar claims in states across the country — and as North Carolina’s Senate considers a damaging tax cut plan this week — it’s important to set the record straight.

We’ve taken a closer look at the Tax Foundation’s recent review of the economic literature on the impact of taxes on economic growth — the basis for its statement to the North Carolina legislature.  (We did not look at the national-level tax studies they cited, although these two surveys show that their claims here are equally suspect.)  We found that:

• The Tax Foundation mischaracterized or exaggerated the findings of three of the seven articles it cited, and the conclusions of a fourth article it cited are contradicted by a much more recent paper by the exact same author (which the Tax Foundation failed to include in its review).
• The Tax Foundation omitted from its review at least 20 relevant articles that have been published in major journals or edited compilations since the beginning of 2000, 18 of which either conclude that state and local tax levels have essentially no effect on various measures of state economic performance or suggest that adverse impacts are minimal or limited to particular taxes or time periods.

Some studies by reputable economists find that above-average state and local taxes have a measurable and consistently adverse impact on state economic performance.  However, many equally reputable studies reach the opposite conclusion, and the results of many more are mixed, ambivalent, or show that any adverse impacts are small.  There’s simply no consensus that cutting taxes is a good strategy to boost state economic growth and create jobs.

Click here to read the full paper.

The Senate’s overwhelming (74-20) vote last night to open debate on the Marketplace Fairness Act (MFA) all but guarantees that it will soon approve the bill, which would enable states and localities to require all large Internet retailers to charge any applicable sales taxes on their interstate sales.

Right now, as a result of 1967 and 1992 Supreme Court decisions, a state can require out-of-state companies to charge its sales tax only if they have a physical presence in the state like a store, warehouse, or sales force.  The tax is still legally due, and consumers are supposed to pay it directly to their state, but few people know about or comply with this requirement.

MFA would largely solve the problem.  It authorizes states to require out-of-state sellers with more than $1 million in nationwide interstate sales to charge the applicable taxes — provided that states simplify their sales taxes and give merchants free software that automatically calculates the correct tax.

This long-overdue legislation would:

• Give state and local governments as much as $23 billion in annual revenues that they are owed under current law. That will help them maintain public services and possibly reinvest in services they cut during the recent recession — rehiring teachers, freezing college tuition increases, and resuming road and bridge maintenance, for example.

• Create a more level playing field for local store-based retailers. Because combined state and local sales tax rates typically range between 5 and 10 percent, Internet retailers that don’t collect sales taxes outside their home states start out with that much of a price advantage over their local competitors.  This makes it harder for Main Street merchants to create local jobs.  It also has a ripple effect on local economies, as depressed sales at the neighborhood book or musical instrument shop lead to fewer purchases by their owners and employees at the farmers’ market and dry cleaner.

• End the unfair sales tax treatment of consumers who don’t shop online. Low-income people who lack the computers, Internet access, or credit cards needed to conveniently shop online pay more than their fair share of sales taxes because online shoppers can avoid these taxes.

Last night’s vote is just the first step towards the MFA’s enactment.  Senate opponents will likely to offer amendments to weaken or kill it, and the measure will likely get a cooler reception in the House.  But, for now, kudos to the majority of senators from both parties who recognize that Internet retailers should play by the same tax rules as local retailers.

Earlier this week, I applauded a recent “test” vote in the U.S. Senate that signaled overwhelming and bipartisan support for pending legislation that would require large Internet merchants to collect state and local sales taxes.  Yesterday, New York’s high court upheld the constitutionality of a 2008 state law designed to achieve the same goal.

First, some background:  the U.S. Supreme Court ruled in 1992 that out-of-state sellers cannot be required to charge sales taxes on sales to residents of states in which the merchant lacks a “physical presence.”  (Buyers are obligated to pay the sales taxes directly to their states when the seller doesn’t charge them but, of course, very few do.)  But an earlier Supreme Court decision held that in-state independent sales representatives who solicit sales on behalf of out-of-state merchants can satisfy this physical presence requirement.

The New York law at issue asserts that online companies like Amazon and Overstock have that “physical presence” — that is, the cyberspace equivalent of door-to-door salesmen in the state — when they have marketing partners known as “affiliates” in New York; thus, they must charge sales tax on all sales in New York.  Affiliates are businesses and nonprofits that link to an Internet retailer from their own site and receive a commission when readers click on the link and then make a purchase at the retailer’s online store.

I’ve urged states with sales taxes to enact laws modeled on New York’s.  Eight states have done so (Arkansas, California, Connecticut, Georgia, Illinois, North Carolina, Rhode Island, and Vermont), and a ninth, Pennsylvania, is enforcing the same policy with respect to Internet retailers with in-state affiliates under its existing sales tax law.  Amazon or Overstock may appeal to the U.S. Supreme Court, but we hope that the final decision in the New York court system will encourage additional states to act.  The Supreme Court has declined to review several state court decisions on the obligations of out-of-state merchants to charge sales taxes since its 1992 decision; it’s likely to deny this case as well.

The New York law only partially solves the problem of interstate sales that escape taxation, because some Internet retailers don’t operate affiliate programs and because others have responded to these laws by terminating their programs in some states rather than collect sales taxes.  The federal legislation that the Senate endorsed in its recent vote is still needed to solve the problem comprehensively.  Policymakers should enact that legislation soon.  In the meantime, the remaining states should emulate New York’s law, and its court victory should be celebrated.

The Senate signaled support for requiring large Internet merchants to collect state and local sales taxes, just like Main Street retailers must do, voting overwhelmingly in its budget resolution to “allow states to enforce state and local use tax laws.”

Allowing states to do so would not impose new taxes.  State and local sales taxes are already due on any items a consumer buys online that would be taxable if he or she bought it in a local store.  But, as I’ve explained, a 1992 Supreme Court ruling allows Internet and catalog sellers to avoid charging sales tax to a customer if they do not have a “physical presence” in the customer’s state.  In those cases, customers are supposed to pay the taxes directly to their states but, of course, very few do.

The Court’s decision left the door open for Congress to set rules under which states and localities could require even non-physically present merchants to charge sales taxes.  That’s what the Marketplace Fairness Act — which the Senate signaled support for Friday in an amendment to its budget plan — would do.

While the budget plan isn’t legally binding, the fact that the amendment passed on a 75-24 vote suggests that if the actual bill reaches the Senate floor, it will have no trouble attracting the 60 votes needed to overcome a filibuster.

The Marketplace Fairness Act authorizes states and localities to require large Internet, catalog, and other “remote sellers” with nationwide sales over $1 million annually to collect and remit their sales taxes, provided that states both pay for the software that facilitates nationwide sales tax collection and harmonize and simplify state and local sales tax rules to make tax collection easier for retailers.

Legislation along these lines is long overdue.  States’ inability to require large sellers like Amazon and Overstock to charge tax in every state hurts local economies and costs jobs.  Sales taxes typically range from 5 to 10 percent, so local businesses start out at a 5 to 10 percent price disadvantage compared to Internet retailers that don’t collect taxes.

Public services suffer, too.  Each year, about $11 billion in taxes on Internet sales goes uncollected; roughly the same amount is lost from catalog, infomercial, and other remote sales.  That revenue could help support schools and hospitals, pay and equip police, build and repair roads, and provide the many other services that all residents use.  And, as online shopping continues to grow, so will the revenue losses.

Finally, the unequal treatment of online sales shifts more taxes to those who can least afford them.  Even apart from the Internet sales tax issue, poorer families pay a larger share of their income in sales taxes than better-off families do because they have to spend almost everything they earn just to make ends meet. Tax-free Internet shopping compounds the problem:  many low-income families can’t shop online because they don’t own a computer or don’t have high-speed Internet access.

The only comprehensive solution is federal legislation akin to the Marketplace Fairness Act.  Friday’s vote makes clear that the Senate will likely approve the bill relatively soon.  Let’s hope the vote also sends a strong message to the House.

Lawmakers are seriously considering cutting or even repealing the personal income tax in at least ten states:  Indiana, Kansas, Louisiana, Missouri, Nebraska, North Carolina, Ohio, Oklahoma, South Carolina, and Wisconsin.  One of the most common arguments for these tax cuts is that they’d encourage small businesses to grow and create jobs, since most small firms pay taxes on their profits under the personal income tax.

In reality, personal income tax cuts would likely be counterproductive, as my new paper explains.  They are a very poor way to stimulate job creation among small businesses, and, by weakening state revenues, they impair states’ ability to provide the educated workforce, well-maintained roads and bridges, and adequate police and fire protection that businesses demand.

• The vast majority of those who would get a personal income tax cut are in no position to create small-business jobs.  As the graph shows, only 2.7 percent of personal income taxpayers own a bona fide small business with any employees other than the owner or owners, according to a Treasury Department study.  Most high-income households — the group that likely would get the most money back from a personal income tax cut — are not small business owners.



• Most small businesses make too little money for tax cuts to produce enough income to pay new employees. Nearly nine in ten small businesses have less than $50,000 in taxable income in a given year.  State income taxes for these businesses already are so low — just a few thousand dollars in most cases — that even eliminating the tax wouldn’t come close to paying one full-time worker’s salary.
• Most small business owners aren’t significant “job creators.” Even among the small fraction of taxpayers who are true small business owners, most wouldn’t create jobs in response to a state income tax cut.  For example, many small business owners — such as lawyers, accountants, and real estate agents — don’t need other employees other than perhaps an office administrator.  Many others are passive investors who don’t have the authority to hire additional workers.
• Small businesses hire employees based on product demand, not tax levels. As the non-partisan Congressional Budget Office has observed with respect to federal tax cuts for businesses:  “[I]ncreasing the after-tax income of businesses typically does not create much incentive for them to hire more workers in order to produce more, because production depends principally on their ability to sell their products.”  Also, employee wages are fully deductible from state income taxes, so the presence of taxes is not likely to discourage hiring.
• Studies show that state personal income taxes have almost no relationship to small business growth. For example, a careful empirical study commissioned by the U.S. Small Business Administration found “no evidence of an economically significant effect of state tax [policy] portfolios on entrepreneurial activity.”
• State income tax cuts risk eroding public services that are important to small businesses. States have to balance their budgets, so when they cut taxes, the money has to come from someplace.  That “someplace” will likely be state support in areas crucial to businesses, particularly K-12 and higher education.  A recent National Governors Association report points out that “states that have a higher average level of education tend to have greater levels of economic success.”

In short, cutting state income taxes in the name of boosting small business job creation and entrepreneurship represents a quintessential violation of the “first, do no harm” principle.