Why Replacing State Income Taxes with Bigger Sales Taxes Doesn’t Make Sense

January 22, 2013 at 4:55 pm

In an alarming trend, governors in Louisiana, Nebraska, and North Carolina have proposed eliminating their state’s personal and corporate income taxes and raising the sales tax to offset the lost revenue.  These proposals are similar to so-called “FairTax” proposals that several states have considered — and rejected — in recent years.  We outlined the problems with those proposals in a 2010 report.

Proponents claim that eliminating income taxes and expanding the sales tax would make tax systems simpler, fairer, and more business-friendly, with no net revenue loss.  In reality, they would tilt state taxes against middle- and lower-income households and likely undercut the state’s ability to maintain public services.  Specifically, they would:

  • Raise taxes on the middle class. These proposals would significantly change the distribution of state taxes:  lower- and middle-income families would pay more, while businesses and high-income households would pay less.  That’s because repealing the income tax would disproportionately benefit high-income families (since they generally face higher tax rates), while a sales tax hike would hit low- and middle-income families the hardest (since they pay a bigger share of their incomes in sales tax than wealthier families do).
  • Require huge sales tax hikes. Income taxes raise 40 percent of states’ tax revenue, on average — an amount equal to total state spending on highways, prisons, state police, public hospitals, public health, and parks.  To fully replace the lost revenue, sales tax rates would have to be markedly higher than they are now, and often higher than proponents claim.
  • Levy those new, higher rates on a much larger number of transactions. While these proposals vary, many call for examining all exemptions to the sales tax with an eye to extending the tax to many more goods and services.  These could include everything from food to prescription drugs, child care, and home sales, as well as a range of business-to-business transactions.  Bringing large numbers of goods and services into the tax base at the new, significantly higher rates would cause a number of technical, economic, and political problems.

  • Create an unsustainable spiral of rising rates and widening exemptions. A large expansion of the sales tax would spark furious efforts to exempt many purchases from the tax.  But if a state granted such exemptions, it would have to compensate by raising the sales tax rate even higher.  The ultimate result, most likely, is that the new tax would fail to meet its revenue-neutral promise — forcing cuts to education, transportation, and other essential services to meet state balanced-budget requirements.
  • Fail to boost state economies. Replacing income taxes with an expanded sales tax would do little or nothing to improve a state’s business climate or economic performance.  On the contrary, the resulting high sales tax could hurt in-state businesses as residents shift purchases to neighboring states or the Internet.  And if a state had to curtail public services because the expanded sales tax failed to make up the lost revenue from the eliminated taxes, these cuts could curtail economic development.
  • Make state revenues much less stable. By making a single tax a state’s sole significant revenue source — rather than the mix of sources now utilized — these proposals would deprive a state of a balanced revenue portfolio and jeopardize its ability to collect enough revenue for future needs.
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More About Elizabeth McNichol

Elizabeth McNichol

McNichol is a Senior Fellow specializing in state fiscal issues including methods of examining state budget processes and long-term structural reform of state budget and tax systems.

Full bio | Blog Archive | Research archive at CBPP.org

4 Comments Add Yours ↓

Comments are listed in reverse chronological order.

  1. Scott #
    1

    The writer provides zero evidence to support any of her claims, and makes a few assumptions, such as saying the state could start exempting some purchases from the tax. That is 100% speculation, yet that doesn’t stop her from throwing it in there as “evidence” anyway.
    The rhetorical point that this would raise taxes on the poor is also purposefully misleading. Taxes on the rich and poor would be the same, which is the definition of equality and fairness. The liberal dogma that higher income people HAVE to pay a higher share of taxes is also responsible for so much backlash to the idea of a consumption tax. In a day and age where deficits seem to be the new norm, we should all be celebrating any efforts to try and reduce corporate welfare, streamline the tax code, and for try to raise revenue in the best ways possible.

    While I don’t believe eliminating business or income taxes is necessary, lowering them and instituting a sales tax would definitely boost revenue.
    Also, a lower corporate tax will attract businesses which will bring jobs. Last I checked this was something only democrats claimed to be trying to do…

    • Elizabeth McNichol #
      2

      Scott,

      Our 2010 paper contains more detailed research and analysis on these points. Let me address them briefly here:

      First, experience shows that a broad-based sales tax would spark calls for exemptions. For example, when a proposal to eliminate income taxes and replace them with a broader sales tax was considered in Missouri, a number of lobbyists immediately began to push for exemptions and the proposal was very quickly amended to exclude private school tuition. We are already seeing similar developments in Nebraska.

      Second, there is considerable research that shows that low and middle income families pay a larger share of their income in sales taxes than high-income families because they spend a larger share of income. Thus a shift from even a flat-rate income tax to a sales tax that collected the same amount of revenue would lower taxes for those at the top of the income scale.

      And on your final two points. Shifting from an income tax to a sales tax would not raise more revenue – the proponents of these measures themselves are calling for revenue neutrality. Thus the amount of revenue raised initially would be at best the same and over time sales revenues would grow more slowly than income tax revenues would have. In addition, as we addressed in another report cutting the corporate income tax is very unlikely to improve a state’s economy.

  2. 3

    “Make state revenues much less stable”

    I don’t believe the evidence supports this. “portfolio” theory indicates that variability is not reduced if movements in the components of the portfolio are fully correlated. The variability of the components themselves is decisive and on that count retail sales are highly stable relative to, say, stock market profits.

  3. 4

    There is another reason not to replace income taxes with sales taxes, especially in poorer states such as West Virginia. The vast majority of sales taxes are paid by in-state individuals and businesses, while much of the income tax savings would flow to out-of-state corporations that merely do business here. For instance, income tax savings for Wal-Mart, WV’s largest employer, would be repatriated to Wal-Mart headquarters in Arkansas with little likelihood of it being reinvested in WV. The net effect would be to drain wealth and reduce demand in a state that already has too little of both.



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