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February 19, 2013
Economic Analysis: Can States Swap Sales Taxes for Income Taxes?
by Martin A. Sullivan

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by Martin A. Sullivan


Summary by Tax Analysts®

In economic analysis, Martin A. Sullivan considers the feasibility of several state tax reform plans that would eliminate income taxes and replace the lost revenue with higher sales taxes.

    "Look out, Texas, here comes Kansas!"
-- Kansas Gov. Sam Brownback (R)
January 15


In Republican-controlled statehouses throughout the South and Midwest, there is a lot of bold talk about cutting individual and corporate taxes and replacing lost revenues with higher sales taxes. Although details are vague, Louisiana Gov. Bobby Jindal and Nebraska Gov. Dave Heineman have ignited heated debates in their states about a swap of sales for income taxes. In North Carolina, legislative leaders are pushing a similar idea. And in Kansas and Missouri, last year's efforts to cut income taxes and replace lost revenue with higher sales taxes will continue in 2013.

Findings from revenue data indicate a wide variation in the difficulty of achieving such a tax swap. For most states, the challenge would undoubtedly be daunting. In 29 of the 39 states with both sales taxes and significant income taxes, current sales tax rates would have to more than double to replace revenue lost from repealing state income taxes. To replace income taxes in the 45 states with substantial revenue from those taxes, only five could have revenue-neutral sales tax rates below 8 percent, and only 10 could be below 10 percent. Of the five states (mentioned above) where the proposal seems to be generating the most interest, a complete sales-for-income tax swap is probably feasible only in Louisiana.


Helping Business?

For economists, the concept of swapping consumption taxes for income taxes has enormous appeal. Income taxes are biased against saving; consumption taxes are not. The swap should increase saving among state residents. Increased savings could mean higher investment, which leads to higher wages. That reasoning is the basis of the governors' claims that sales-for-income tax swaps promote economic development. But there is a big drawback. Because low-income people consume a larger percentage of their income than high-income people, any swap will shift the tax burden down the income scale.

Probably the most complete and influential case for a tax swap is a report coauthored by supply-side guru Arthur Laffer ("The Missouri Compromise," in Rich State, Poor State, 2011). At the other end of the political spectrum, many analysts have challenged the claimed economic benefits of a tax swap and have criticized its regressivity. (See, for example, the Citizens for Tax Justice blog post "Beware of the Tax Swap," Jan. 24, 2013.)

So it might appear that we are gearing up for another battle in the age-old war between the progressive income tax and the efficient consumption tax. But it's not likely that the coming debate will be framed in those terms. That's because the retail sales tax of 45 states is a far cry from the efficient revenue machine economists admire. The immediate problem with any expansion of retail sales taxes is not that they are consumption taxes, but how far they stray from true consumption taxation. The proposed tax swaps are likely to fail not because of objections from liberals about regressivity but because of a lack of enthusiasm from conservatives and business groups when the hoped-for economic benefits of sales taxation don't materialize.


Seriously Flawed

Now that it is the 100th anniversary of the 16th Amendment, there's hardly a day that passes without some pundit (like me) saying that our income tax may have outlived its usefulness. But compared with the rickety old sales taxes that U.S. states use to collect more than one-third of their revenue, the income tax is a sleek and sophisticated revenue generator. Although state retail sales taxation, a child of the Depression, is relatively young, it is premised on the old-fashioned notion that finished goods ("personal property," in lawyer lingo) should be subject to tax. This leads to two fundamental flaws with real-world sales taxes.

First, the focus on taxing consumer goods has left most services provided to households outside the tax net. Nontaxable payments for services include such significant items as rent and medical expenses. Legislative relief for goods deemed necessities, such as food and prescription drugs, further diminishes the tax base. The average estimated sales tax base, measured as a percentage of personal income, is 37.4 percent. In the United States, total consumption varies from year to year but is typically well in excess of 90 percent of personal income.

Second, many finished goods subject to a sales tax are purchased by businesses that do not get a refund. If a retail sales tax is to be a true consumption tax, only final purchases by consumers should be subject to tax. Taxation of business-to-business sales either raises final consumer prices by a percentage above the sales tax rate (because extra tax is layered into intermediate sales) or cuts profits, because businesses -- particularly those competing with out-of-state and foreign businesses not subject to tax -- cannot pass along tax costs to consumers with higher prices. These business-to-business transactions would be exempt from a true consumption tax. Prevention of this pyramiding is exactly what a VAT is designed to avoid.

So like individual and corporate taxes on business profits, state sales taxes can damage competitiveness, job creation, and economic development. According to a 2005 study, 43 percent of sales taxes are collected from business purchases (Robert Cline, John L. Mikesell, Thomas Neubig, and Andrew Phillips, "Sales Taxation of Business Inputs: Existing Tax Distortions and the Consequences of Extending the Sales Tax to Business Services"). And a recent report from the business-supported Council On State Taxation estimated that in 2011 states collected $101 billion in general sales taxes on business input, about two and a half times the $41 billion they collected in corporation tax (Andrew Phillips et al., "COST's Fiscal 2011 State and Local Tax Burden Study").

Of course, the solution to these problems is sales tax reform. But exempting more business-to-business transactions reduces revenue and would make it more, rather than less, difficult to cut income taxes. And the political problem of expanding the sales tax base to services is seemingly insurmountable. Florida tried it in 1987, and the tax lasted six months before it was repealed. In his retrospective on that tumultuous episode, Billy Hamilton, former deputy comptroller for the Texas Office of the Comptroller of Public Accounts, wrote:


    Although the states should add more services to their sales tax bases to preserve its growth and stability, the notion that the base can be vastly expanded to allow the reduction or elimination of other taxes, like the income or property taxes, is a fantasy. It isn't going to happen. Revenue can be raised by expanding the sales tax base -- by including services or goods like groceries that states commonly exempt -- but large, complex base expansion like the one Florida attempted simply creates too many enemies and too much political blowback work.

["Florida's Service Tax Fiasco: A Silver Anniversary Memory Book, State Tax Notes, May 28, 2012, p. 655."]

Some of the calculations that follow illustrate the revenue potential of broadening the sales tax base. But there is little reason to hope that political or financial pressures have changed so much that significant base broadening is more feasible than it has been in the past. Already in Louisiana, Jindal has taken the taxation of professional services like accounting services and doctor visits off the table ("Jindal Seeking to Expand Sales Tax," The Monroe News-Star, Feb. 6, 2013). And the Louisiana Constitution prohibits sales taxation of food and utilities ("Jindal Seeks Income-Sales Tax Swap but Is There a Better Option?" The Louisiana Weekly, Jan. 28, 2013). In Nebraska, Heineman has promised that his proposal would not expand the tax base to include food ("Governor Calls for Eliminating State Income Tax," KHAS-TV (Hastings), Jan. 15, 2013, http://www.khastv.com). And a release from Heineman's office states that his plan would have "no taxing of additional services" (http://www.governor.nebraska.gov/news/2013/01/docs/Tax_Proposal.pdf).


What the Data Tell Us

Table 1 shows the effects of using existing state sales taxes to replace state individual and corporate income taxes. It ranks states by the estimated sales tax rate that would be required for the existing sales tax base to raise the amount of revenue raised from each state's combined sales, individual, and corporate taxes. If states swapped their individual and corporate income taxes for sales taxes, all this revenue would have to be raised through sales taxes.

Several states are already where Laffer and many Republican tax reformers would like their states to be. Texas, Florida, Washington, Nevada, and South Dakota have minimal or no state income taxes. Interestingly, they appear at the top of our rankings. If sales tax revenue were a good substitute for income tax revenue, the no-income-tax states would be spread more evenly through the rankings. Their bunching at the top means that low levels of government spending and revenue sources other than conventional taxes play a significant role in eliminating income taxes.

In addition to raising the sales tax rate, broadening the sales tax base could be used to raise revenue. To get an idea of the revenue potential from base broadening, Table 1 shows revenue-neutral sales tax rates where the implicit sales tax base has been expanded to 50 percent of state personal income (in states where the base is below that figure). The implicit sales tax base is computed as the ratio of sales tax revenue divided by the state sales tax rate. It is not a precise measure of the sales tax base, but it does measure the extent to which exemptions and preferential rates affect it. Only five states have an implicit sales tax base in excess of 50 percent. The median implicit sales tax base is 34.9 percent of state personal income.

With Table 1 as our guide, let's now see what swapping sales for income taxes would mean for various states.

If Louisiana repealed its individual and corporate income taxes, its sales tax revenue would need to nearly double -- from 1.6 percent to 3.1 percent of state personal income. If it did not broaden its tax base, the revenue-neutral sales tax rate would increase from 4 percent to 7.7 percent. If it broadened its implicit sales tax base from 39.8 percent to 50 percent of state personal income, the revenue-neutral sales tax rate would be 6.9 percent.

Texas has a sales tax rate of 6.25 percent and an implicit sales tax base of 39.4 percent. Florida has similar numbers. With these two states as benchmarks, it would seem that replacing sales and income taxes in Louisiana is entirely feasible. However, there is one big fly in the ointment. The last column of Table 1 shows estimates of the share of state sales taxes on sales to businesses. It turns out that Louisiana, at 66.8 percent, has the highest share of any state. This means that a sales-for-income tax swap will probably do little to increase the competitiveness of Louisiana business.

In Nebraska, a sales tax swap would require sales tax revenue to increase from 1.8 percent to 4.2 percent of state personal income. With the same sales tax base, Nebraska would have to raise its sales tax rate from 5.5 percent to 12.9 percent. With a base broadening that would increase the implicit sales tax base to 50 percent of personal income, the rate would have to rise to 10.4 percent.

How high can sales taxes go, realistically? There is the problem of increased tax evasion as rates rise, but the degree to which evasion increases with high rates of sales tax is not known. In a review of the evidence, Matthew Murray concluded: "On balance, the lack of experience in administering a high-rate, broad-based indirect tax means that it is impossible to say whether evasion and avoidance would be more or less pronounced under a [high-rate national sales tax] than under an income tax (or VAT) regime." (See "Would Tax Evasion and Tax Avoidance Undermine a National Retail Sales Tax?" Nat'l Tax J. 177 (Mar. 1997).)

Probably a far more critical factor than administrability is political feasibility. The maximum rate that the public will tolerate and that legislators will approve is difficult to judge, but we have some useful points of reference. State sales tax rates in 2013 vary from 2.9 percent in Colorado to 7 percent in five states (Indiana, Mississippi, New Jersey, Rhode Island, and Tennessee). The average rate is 5.5 percent. The California state sales tax rate is now 6.25 percent, but this does not include the mandatory 1 percent add-on collected by the state and distributed to local governments. And until mid-2011, the state's rate was temporarily set an additional percentage point higher, subjecting Californians to an 8.25 percent rate, plus whatever tax local governments added. Of course, voters might be willing to tolerate significantly higher rates than these if other state taxes are cut as part of the bargain. But states without income taxes do not seem to have a substantially greater tolerance for high sales tax rates. Among states that do not have significant income taxes, sales tax rates vary from 4 percent in Wyoming to 6.85 percent in Nevada.

Based on these data, it seems reasonable to say that either a 12.9 percent sales tax rate (with the current tax base) or a 10.4 percent rate (with an expanded base) would be an extremely tough sell in Nebraska. That conclusion seems borne out by facts on the ground. At a recent Nebraska Senate hearing that lasted more than 10 hours, the governor's proposal was repeatedly criticized ("Most Testifiers on Tax Reform Bill Opposed to the Plan," Lincoln Journal Star, Feb. 6, 2013). Even the Greater Omaha Chamber of Commerce voiced opposition: "The effect of the proposals on manufacturing and processing, hospitals, non-profits, and a number of others would be counter to their intent and carry risk of driving some businesses out of Nebraska." (See "President's Message: Governor's Tax Reform Bills Statement," Feb. 5, 2013, available at http://www.omahachamber.org/news.)

According to the data in Table 1, a swap from income to sales taxation would be more difficult in North Carolina than in Nebraska. It would require sales tax revenue to increase from 1.8 percent to 4.9 percent of state personal income. With the same sales tax base, North Carolina would have to raise its sales tax rate from 5.75 percent to 15.9 percent. With base broadening that would increase the implicit sales tax base to 50 percent of personal income, the rate would have to rise to 12 percent.

             Table 1. Revenue-Neutral Replacement of Individual and
                     Corporate Income Taxes With Sales Tax
             (States with no or minimal income taxes are in bold.)
 ______________________________________________________________________________

                    Sales Tax         Sales Tax Rate
                      as a       ________________________
                   Percentage
                    of Income              With Tax Swap
                  ____________            _______________
                                                            Implicit   Business
                          With   Actual*  Current   Broad   Sales      Share of
 State            Actual  Swap   (2011)   Base      Base    Tax Base   Tax
 ______________________________________________________________________________

 Wyoming           3.2%   3.2%    4.00%    4.0%      4.0%     80.3%      53.6%
 South Dakota      2.2%   2.3%    4.00%    4.1%      4.1%     58.9%      51.7%
 Hawaii            4.0%   6.3%    4.00%    6.2%      6.2%    100.9%      32.2%
 Texas             2.4%   2.4%    6.25%    6.3%      6.3%     39.0%      47.7%
 Washington        2.5%   2.5%    6.50%    6.5%      6.5%     38.5%      57.7%
 Florida           2.6%   2.8%    6.00%    6.6%      6.5%     42.8%      33.9%
 Nevada            2.9%   2.9%    6.85%    6.9%      6.9%     41.2%      41.1%
 Louisiana         1.6%   3.1%    4.00%    7.7%      6.9%     39.8%      66.8%
 North Dakota      2.7%   4.5%    5.00%    8.4%      8.4%     55.5%      43.2%
 Tennessee         2.6%   3.2%    7.00%    8.4%      8.1%     37.8%      34.8%
 New Mexico        2.8%   4.6%    5.13%    8.5%      8.5%     53.8%      55.3%
 Alabama           1.4%   3.2%    4.00%    9.3%      7.7%     34.9%      36.0%
 Colorado          1.0%   3.1%    2.90%    9.5%      7.3%     33.2%      49.4%
 Oklahoma          1.5%   3.4%    4.50%   10.1%      8.4%     34.4%      51.8%
 Michigan          2.6%   4.6%    6.00%   10.5%      9.9%     43.8%      32.1%
 Georgia           1.4%   3.8%    4.00%   10.6%      8.7%     35.8%      43.5%
 Missouri          1.3%   3.4%    4.23%   11.1%      8.5%     30.6%      44.9%
 Utah              2.0%   4.7%    4.70%   11.2%     10.0%     41.2%      34.4%
 Mississippi       3.1%   5.0%    7.00%   11.3%     10.8%     43.7%      37.5%
 Arkansas          2.8%   5.4%    6.00%   11.8%     11.3%     45.7%      32.5%
 Ohio              1.8%   3.9%    5.50%   11.9%      9.7%     32.4%      43.0%
 Arizona           1.8%   3.3%    6.60%   12.1%      9.5%     26.8%      47.0%
 South Carolina    1.8%   3.8%    6.00%   12.7%     10.0%     29.8%      32.8%
 Idaho             2.3%   4.8%    6.00%   12.8%     11.1%     37.5%      28.1%
 Indiana           2.7%   5.0%    7.00%   12.9%     11.6%     38.7%      32.5%
 Nebraska          1.8%   4.2%    5.50%   12.9%     10.4%     32.9%      51.4%
 Maine             2.0%   5.2%    5.00%   13.1%     11.5%     40.1%      37.1%
 Kentucky          2.2%   4.9%    6.00%   13.2%     11.3%     37.1%      45.8%
 Kansas            2.1%   4.6%    6.30%   13.8%     11.4%     34.0%      43.8%
 Pennsylvania      1.7%   3.9%    6.00%   13.9%     10.4%     27.6%      39.0%
 Wisconsin         1.8%   5.0%    5.00%   13.9%     11.4%     35.9%      39.7%
 Iowa              1.8%   4.2%    6.00%   14.3%     11.0%     30.0%      39.1%
 Virginia          1.1%   3.8%    4.00%   14.3%      9.6%     26.9%      34.9%
 West Virginia     2.2%   5.4%    6.00%   14.6%     12.3%     37.1%      28.4%
 Maryland          1.5%   4.0%    6.00%   15.9%     11.0%     25.2%      41.0%
 North Carolina    1.8%   4.9%    5.75%   15.9%     12.0%     30.8%      40.1%
 Vermont           1.5%   4.1%    6.00%   16.0%     11.0%     25.3%      39.5%
 Rhode Island      1.8%   4.3%    7.00%   16.9%     12.0%     25.5%      49.2%
 Illinois          1.3%   3.6%    6.25%   17.3%     10.9%     20.9%      41.8%
 New Jersey        1.8%   4.5%    7.00%   18.0%     12.5%     24.8%      39.2%
 Minnesota         2.2%   5.7%    6.88%   18.2%     14.0%     31.4%      43.8%
 New York          1.1%   5.1%    4.00%   18.8%     12.2%     27.6%      50.3%
 Connecticut       1.6%   5.0%    6.00%   19.2%     13.0%     26.6%      49.5%
 California        1.9%   5.5%    7.25%   21.3%     14.4%     25.5%      45.1%
 Massachusetts     1.4%   5.3%    6.25%   22.9%     13.9%     23.0%      40.1%
 Median            1.80%  4.20%   6.00%   12.66%   10.36%     34.87%     41.10%
 Mean              2.01%  4.19%   5.59%   12.35%    9.84%     37.44%     42.27%
 ______________________________________________________________________________

 Sources: State sales tax revenue used in column 1 is from John L. Mikesell,
 "State Retail Sales Taxes in 2011," State Tax Notes, Dec. 24, 2012, p. 961,
 Table 1. Individual and corporate income tax revenue is from the Department of
 Commerce, Census Bureau, "2011 Annual Survey of State Government Tax
 Collections." State personal income is from the Department of Commerce, Bureau
 of Economic Analysis, Regional Economic Accounts
 (http://www.bea.gov/regional/). The implicit state sales tax base, expressed
 here as a percentage of state personal income, is from Mikesell, Table 2. All
 these data are for 2011. The estimated share of sales tax paid by business is
 from Robert Cline et al., "Sales Taxation of Business Inputs: Existing Tax
 Distortions and the Consequences of Extending the Sales Tax to Business
 Services," State Tax Notes, Feb. 14, 2005, p. 457. These calculations are for
 2003.

                              FOOTNOTE TO TABLE 1

 * Since 2011 three states have changed their sales tax rates: California
 (to 6.25 percent), Connecticut (to 6.35 percent), and North Carolina (to 4.75
 percent).

                           END OF FOOTNOTE TO TABLE 1

 Table 2. Revenue-Neutral Replacement of Individual and Corporate Income Taxes
        With a Synthetic (Average) Sales Tax in States Without Sales Tax
 ______________________________________________________________________________

                                          Sales Tax Rate
                                      ___________________________
                    Sales Tax as a
                    Percentage of                With Tax Swap
                       Income                 ___________________  Implicit
                  _________________                                Sales Tax
                                              Average              Base
 State            Actual  With Swap   Actual  Base     Broad Base  (percentage)
 ______________________________________________________________________________

 New Hampshire     0.0%     1.1%       0.0%     2.9%      2.2%          37.4%
 Alaska            0.0%     2.2%       0.0%     5.8%      4.4%          37.4%
 Montana           0.0%     2.6%       0.0%     7.0%      5.2%          37.4%
 Delaware          0.0%     3.4%       0.0%     9.1%      6.8%          37.4%
 Oregon            0.0%     4.1%       0.0%    11.0%      8.2%          37.4%
 ______________________________________________________________________________

 Sources: State sales tax revenue used in column 1 is from John L. Mikesell,
 "State Retail Sales Taxes in 2011," State Tax Notes, Dec. 24, 2012, p. 961,
 Table 1. Individual and corporate income tax revenue is from the Department of
 Commerce, Census Bureau, "2011 Annual Survey of State Government Tax
 Collections." State personal income is from the Department of Commerce, Bureau
 of Economic Analysis, Regional Economic Accounts
 (http://www.bea.gov/regional/). The implicit state sales tax base, expressed
 here as a percentage of state personal income, is from Mikesell, Table 2. All
 these data are for 2011. The estimated share of sales tax paid by business is
 from Robert Cline et al., "Sales Taxation of Business Inputs: Existing Tax
 Distortions and the Consequences of Extending the Sales Tax to Business
 Services," State Tax Notes, Feb. 14, 2005, p. 457. These calculations are for
 2003.

Given the magnitude of these changes, it seems unlikely that a majority of legislators in North Carolina would ever agree to a tax swap. Already the idea has run into tough criticism, most notably from the governor's Republican budget director, Art Pope, who expressed concern about expanding the tax base. "To switch to a pure sales tax on all services, it almost becomes a gross income tax, a gross transaction tax without any regard to whether you're actually making any money," Pope said at the University of North Carolina-Charlotte. He added: "I think that's going to hurt the economy." (See "NC GOP Takes Control of Legislative Agenda," The Daily Tar Heel, Jan. 31, 2013.)

To round out the picture, Table 2 shows what sales tax rates might be in the five states without sales taxes if those states adopted sales taxes with tax bases as broad as the average in those states with sales taxes. Each of these states is assumed to have an implicit sales tax base equal to 37.4 percent of state personal income, the average for the 45 states with sales taxes. The results show that because New Hampshire, Alaska, and Montana are low-tax states, they could repeal their relatively low income taxes and have sales taxes with rates below 8 percent if they adopted income taxes with bases of average breadth. Delaware could only achieve that goal with a base of above-average breadth -- that is, with an implicit sales tax base equal to 50 percent of personal income. Among the states without sales taxes, it would be most difficult to implement one in Oregon.


Conclusion

Among the 44 states with significant income tax revenue, only a few could repeal their income taxes, replace the lost revenue with sales taxes, and keep sales tax rates below 8 percent with their current sales tax base (or, for those without sales taxes, with a tax base equal in breadth to the average of other states). They are New Hampshire, Alaska, Montana, Hawaii, and Florida. Two more states, New Mexico and Alabama, might also be able to repeal their income taxes and keep sales tax rates below 8 percent if they aggressively expanded their sales tax base. In general, states where a tax swap is most likely have relatively low income tax collections and relatively low sales tax rates.

If states already had broad-based consumption taxes in place, a widespread phaseout of state income taxes might be a real possibility. Concerns about regressivity could be addressed with a sales tax rebate to low-income households. But as long as states rely on sales taxes that exclude most services and include business inputs, the difficulties in most states will be insurmountable and the desirability questionable.



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