Most states and localities impose a tax on retail sales. Such taxes generate a significant portion of state and local revenue.
Retail sales taxes are attractive because they are relatively easy to administer and provide a stable revenue source, typically fluctuating less than an income tax.
However, taxes on consumption, including retail sales taxes, are regressive (i.e., they take a higher percentage of income from people with low incomes than they do 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 feature contributing to the regressivity of the sales tax is that most states only tax the purchase of goods (e.g., a lawnmower), not services (e.g., a 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 lowering the tax on certain necessities, such as groceries, which 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—providing a credit directly to qualified individuals to offset the burden of the sales tax—avoids these issues but requires a mechanism to issue credits to those who do not file tax returns.
The increase of Internet sales has affected state and local sales tax revenue. Many out-of-state retailers and their customers fail to collect and pay retail sales taxes. As a result, states lose revenue and traditional brick-and-mortar retailers are at a disadvantage.
One additional problem with the sales tax is that the same item may be taxed multiple times. This distortive “pyramiding” 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, the tax is highly inefficient. It results in pyramiding (also known as cascading or double taxation), multiple layers of tax 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, in ways that policymakers generally do not intend. The tax is non-neutral and 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
Effects on low-income people
Although state and local sales taxes are major revenue raisers, they are regressive. And where they already exist, raising them should not be policymakers’ 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.
Exemptions from state retail sales taxes should be narrowly designed for the purposes of reducing their regressive nature and avoiding pyramiding.
Gross receipts taxes should not be used. Other more efficient taxes should be used to raise revenue.
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 traditional brick-and-mortar retailers.