Most states and localities generate a significant portion of state and local revenue from the taxation of retail sales. Such taxes are attractive because they are relatively easy to administer. They provide a stable revenue source, typically fluctuating less than an income tax.
However, taxes on consumption, including retail sales taxes, are regressive. A regressive tax takes a larger percentage of income from people with lower incomes than from those with higher incomes. This happens for three reasons. First, consumption typically represents a higher share of income for taxpayers with lower incomes. Second, the sales tax rate does not depend on the taxpayer’s income level.
A third cause for the regressive nature of sales taxes is that most states only tax the sale of goods, not services. For example, some states may tax lawnmowers while not taxing lawn care service. People with higher incomes are more likely than people with lower incomes to pay for services. Taxing services can reduce the regressivity of the sales tax and broaden the tax base.
In addition to taxing services, policymakers can address the regressive nature of the sales tax in two ways. One is by lowering the tax on certain necessities, such as groceries. Necessities make up a larger share of consumption for households with lower incomes. This approach, however, is poorly targeted and creates administrative complexity. The other approach is to provide a credit directly to qualified individuals to offset the burden of the sales tax. But this requires a mechanism to issue credits to those who do not file income tax returns.
The increase in e-commerce has negatively affected state and local sales tax revenue. For years, many out-of-state retailers and their customers failed to collect and pay retail sales taxes. A 2018 U.S. Supreme Court decision (South Dakota v. Wayfair) reversed this trend. Still, there remains a lot to be done to resolve the problem fully.
One additional problem with the sales tax is that the same item may be taxed multiple times, a situation known as pyramiding. This occurs when tax applies to the sale of intermediate components that are then used to manufacture taxable final goods.
A gross receipts tax applies to all business sales, regardless of whether the item is sold for consumption or intermediate use. It allows no deductions for the cost of producing the item, for previous taxes on the item, or for other costs (as provided for in a value-added or income tax). As a result, the base is simple to measure, and the tax is easy to administer. However, it results in multiple layers of tax being levied as a product goes through production and distribution. The extent of the pyramiding depends on how many times intermediate components are sold before being incorporated in the final product and on the extent to which the tax is passed on to the buyer at each stage. As a result, the total burden of a gross receipts tax varies capriciously, often in ways that policymakers generally do not intend. The tax is likely to distort the behavior of consumers and businesses. In addition, the tax is not transparent to the consumer. Thus, in most cases, consumption taxes represent a superior option to gross receipts taxes.
RETAIL SALES TAXES: Policy
RETAIL SALES TAXES: Policy
Effects on people with low incomes
Due to their regressive nature, raising state and local sales taxes should not be the first choice for increasing tax revenues.
Legislators should minimize the impact of sales taxes on people with low incomes.
Taxes on services
States and localities should include services in the taxable base to reduce regressivity and improve neutrality.
Taxes on out-of-state sales
Goods sold over the internet and through catalogs should be subject to the same sales tax treatment as goods sold by local brick-and-mortar retailers.
Exemptions from state retail sales taxes should be narrowly designed to reduce their regressive nature and avoid pyramiding.
Gross receipts taxes should not be used. Other more efficient taxes should be used to raise revenue.