Forty-five states and the District of Columbia tax retail sales. In addition, many localities impose local retail sales taxes (RSTs) even if no statewide sales tax exists. General sales taxes are one of the largest revenue sources for state and local governments, bringing in about one-quarter of total tax revenues. This share is considerably higher in states that lack a broad-based personal income tax.
In addition to their revenue-raising potential, RSTs are attractive for several reasons. They are relatively easy to administer and provide a stable revenue source, typically fluctuating less than an income tax.
At the same time RSTs have certain drawbacks. For example, they may tax the same goods multiple times. This “pyramiding” occurs when tax applies to intermediate components that go into the manufacture of final goods that are also subject to tax.
Taxes on consumption, including retail sales taxes, are regressive—i.e., they take a higher percentage of income from low-income people than they do from those with higher incomes. This happens because consumption typically represents a higher share of income for lower-income taxpayers, and because the rate of sales tax does not depend on the taxpayer’s income level.
States often attempt to ameliorate the sales tax’s regressive nature by lowering the tax on or exempting certain necessities such as prescription drugs and food purchased for home preparation, which make up a larger share of consumption for lower-income households. Any such exemptions, however meritorious, narrow the tax base and must be offset by higher tax rates or additional taxes elsewhere. In addition they complicate tax compliance and create opportunities for tax avoidance. State and local sales tax systems are also riddled with exceptions based on criteria that have no clear rationale (such as whether a beverage is purchased in a grocery or a convenience store).
Another reason lower-income people tend to pay a larger proportion of their income in sales tax than do higher-income people is that goods (such as a lawn mower) are generally taxed, whereas services (such as a lawn care service) are not. Few states subject services to a retail sales tax, yet doing so has several advantages as a way of raising sales tax revenues:
- Services are the largest part of the economy and their share is expanding, so they cannot be ignored as an important source of needed revenue.
- Taxing goods but not services violates the principles of tax neutrality, because it biases consumer choices against the taxed goods, and of fairness, since only some products are taxed. Moreover, services and goods are sometimes close substitutes: repairing an appliance versus buying an appliance; using a copy service versus buying a copy machine.
Currently sales taxes go uncollected on most Internet and catalog sales to consumers. This situation is a result of a 1986 US Supreme Court decision that states can require out-of-state merchants to collect and remit sales tax only when the merchant has a physical presence, or “nexus,” in the customer’s state. In the absence of nexus, consumers themselves are required to remit the tax, called the “use tax,” to the states, but in general they fail to do so. Enforcement efforts by states often are costly and ineffective. (This issue should not be confused with the “Internet tax” moratorium, exempting Internet access from tax.)
This situation raises concerns among states and traditional retailers. Since the Court’s ruling, Internet commerce has increased substantially. States worry about the possible erosion of sales taxes as a major revenue source. Traditional retailers argue that the failure to tax web-based sales confers an unfair advantage on Internet and catalog retailers. States have been experimenting with various tax regimes to collect taxes on remote sales, while staying within constitutional limits.
Partly in response to these concerns, some states have embarked on the Streamlined Sales Tax Project, designed to simplify and harmonize sales- and use-tax systems across states. Participating states agree to coordinate their tax systems to facilitate collections. As of 2016, 24 of the 44 participating states have passed the conforming legislation.
Though some online merchants have begun voluntarily collecting sales taxes, many observers believe it would take an act of Congress to compel such remote sellers to collect sales tax. Such legislation has been introduced in recent years but has not been adopted.
As ever greater volumes of retail transactions occur online, the resulting erosion of the tax base could adversely affect funding for many state-provided services for older adults and low-income residents. Eventually states might be forced to seek additional revenues through other taxes.
Retail Sales Taxes: Policy
Effects on low-income people
Although state and local sales taxes are major revenue raisers, they are regressive, and raising them should not be the first choice for increasing tax revenues where they already exist.
Legislators should minimize the impact of sales taxes on low-income people.