The technological change that has dramatically reshaped industries hasn’t stopped at transportation and manufacturing. Almost every facet of the US economy has been touched. And perhaps the most underrated — and important — shift has taken place in consumer spending. From 1929 to the end of the 1960s, consumers purchased more goods than services. 90 years ago, we were more likely to buy a lawnmower and cut our own grass. Now, we are more likely to hire a lawn care service to cut it for us. In 1933, 52% of consumption was on goods. In 2017, that had fallen to 32%. This trend has only continued to increase. Take the growth of the sharing economy: the primary driver of the sharing economy’s growth has been a shift from buying goods to paying someone to perform a task for us.
While much of the technological disruption over the past 30 years has focused on the creation of new markets (and the destruction of entire industries), this has had a serious impact on how states should think about taxes. Take my home state of Utah as an example. Currently, Utah’s legislators are debating how to rethink sales taxes in an economy primarily driven by services. Historically, the state simply increased the sales tax rate.
There’s just one problem with that. Despite double the sales tax rate, Utah has not seen any corresponding revenue increases. Much of this disconnect between sales tax rates and sales tax collections are the result of changing consumption habits. As consumers switched from purchased goods (which was taxed) to services (which are not taxed) the state increased the sales tax on goods to increase the lost revenue. But that only encouraged consumers to move more purchasing from goods to services in an effort to avoid paying increased sales taxes.
That’s not the only problem. Higher tax rates also entail higher economic costs, such as lost purchases from people who would have bought the good or service but decided not to because of the tax. In simple terms, they’re the lost sales to a business and the lost enjoyment from the product or service that the consumer misses out on. Fundamentally, the lower the tax rates, the lower those economic costs.
So what should states do about this change?
Continuing to raise rates on the goods that consumers are buying will likely drive consumers away from those goods and towards untaxed alternatives, so staying the course is unlikely to be a sustainable option. Far from needing a new theory of taxation, a simple return to first principles of tax policy can prepare policymakers for what is the new normal in our modern economy. State legislators around the country can modernize their tax system by combining a broad tax base (including more items to be taxed) with low tax rates (taxing them less).
Combine a broad base with low rates
Tax revenue is a simple combination of what you tax and how much you tax it. For example, in doubling the size of the base, you could half the rate and maintain the same total public revenue. A 1% tax on a $100 billion tax base is the equivalent of a 2% tax on a $50 billion tax base because both raise $1 billion in tax revenue.
Economists agree that taxing a broader base at a lower rate minimizes the economic costs of taxation. That’s because along with public revenue, taxes also generate economic costs. These are called “deadweight loss” or “excess burden” and represent the foregone sales of businesses and enjoyment of consumers. So in the case of a choice between a 1% tax on a $100 billion base and a 2% tax on a $50 billion base, economists choose the 1% tax. Of course, that endorsement of the 1% tax rate comes with the caveat of “all else equal.” That’s because lawmakers often give tax exemptions to important or favored industries.
As Dr. Jeremy Horpedahl and I wrote in a recent piece, each tax exemptions is a policy choice that deserves careful examination. On the one hand, taxing groceries means low-income households pay more for their bread and sales taxes in this regard are generally seen as regressive. On the other hand, each exemption creates an incentive for companies to lobby for their products to be granted an exemption. In fact, one study suggested that every new exemption increases the tax rate by 0.1 to 0.25 percentage points to maintain revenue neutrality. If governments want to keep revenue the same, then consumers will have to cover the costs of the exemptions by paying more in taxes elsewhere.
This drives a vicious cycle similar to the one that’s occurred as consumers have shifted spending from goods to services. As states exempt more consumption items from their tax base, the rate needs to be increased in order to generate the same amount of revenue. As the rate increases, stronger incentives are created for industries to lobby for exemptions specific to the things they sell. That process can feed on itself, as more exemptions lead to higher rates, which leads to more lobbying and more exemptions, which means that rates must increase again to raise the same amount of revenue.
Are exemptions a good idea?
Exemptions should be scrutinized closely, and the economic literature suggests that some make much more sense than others. Business inputs, for example, are a largely uncontroversial exemption. Exempting services, on the other hand, is less clear. In contrast, current exemptions for groceries and other necessities emerge out of concerns for equity that deserve a thorough response from policymakers.
Business inputs are excellent candidates for exemptions because the final consumption of the good will be taxed. Taxing inputs to production by businesses results in tax pyramiding, which is where a tax builds on other taxes, often raising prices for consumers.
Consider a hypothetical company making chocolate. It purchases cocoa powder from a supplier and is untaxed on that purchase. After making the chocolate, however, the chocolatiers collect and remit the sales tax to the state government. If a sales tax was collected at both points of sale, however, the purchase of the cocoa powder and the final sale of the chocolate, then the effective tax rate on the final chocolates would be higher than that of the cocoa powder sales. Such differential taxation rates distort consumer choices and, if other states have lower tax rates, would put in-state businesses at a disadvantage.
The Tax Foundation’s graphical example of pyramiding provides a clear depiction of the problem. The consumer often pays a much higher effective tax rate because the good’s price is being raised each time it is taxed on its way to them.
Exempting business inputs isn’t exempting businesses from taxes, but rather concentrating the sales tax on the final sale of the good so that the final good is not taxed multiple times before reaching the consumer.
Although many states exempt business inputs, exempting services does not make economic sense. In Utah, for example, the state taxes car repairs, but not limousine services. This is the result of applying a goods-focused 1930s tax policy to a world where services are now the dominant part of consumer expenditures. Both car repairs and limousine services get consumers where they want to go, but only one of them is taxed.
The limousine example also highlights the regressive effects that the outdated policy can sometimes have. Regressive taxes are taxes that disproportionately affect low-income groups. In the case of limousine services and car repairs, the costs of the sales tax fall only on those who take their vehicle to a mechanic, and not to those who are driven around by others. And even though everyone must get their car repaired when it’s broken, the wealthiest 10% spend almost four times as much on personal services than the bottom 10% does.
There are other necessities that are vitally important to every part of society, but taxes on them hit low-income people hardest because they spend more of their overall budget on those goods and services.
A common response to this problem is to exempt groceries and prescriptions from the sales tax or to tax them at a lower rate. That can be both ineffective and expensive since it is not targeted at the problem. Every consumer pays lower taxes on groceries regardless of their income level. For Utah, back-of-the-envelope calculations show that the state lost $200 million in revenue in 2017 because it taxes groceries at a lower rate than other goods. Those public revenue losses that constitute lower taxes paid by poorer consumers still reached the intended target. But exempting groceries from sales tax is not an effective welfare policy because it casts too wide a net. Many people who are not low-income receive the same tax exemption. Further, buying filet mignon receives the same exemption as lunch meat despite the fact that only the wealthy are buying more expensive groceries.
Some potential solutions to the sale tax conundrum
A better policy response would be more targeted exemptions for low-income people. Three more focused options are: exempting only groceries on the Women, Infants, and Children Program approved list, implementing a grocery tax credit, and implementing an earned income tax credit (EITC).
The WIC program provides a shorter and more limited list of groceries and necessities that could be exempted. It would limit the amount of revenue given up by the state to limit its lower tax rate or tax exemptions to only the foods contained in the WIC program.
Still, this entails more administrative work and compliance costs for low-income people. Another option would be to implement a grocery tax credit, as four states already have. These programs work by taxing groceries at the normal rate but then issuing a credit through a taxpayer’s income tax return. Although consumers must wait until they file their taxes, grocery tax credits can reach those who are not working as well as seniors.
For those who are working, however, a better option may be implementing a version of the earned income tax credit (EITC). The EITC is available to low- and middle-income working families, with much smaller benefits to households without children. The credit phases in up to a certain income level (about $15,000 for households with two or more children), then phases out gradually after about $54,000. Because families with two or more children still receive a small credit even if they earn more than $50,000 in income, it also benefits middle-class families.
Regardless of the specific reforms legislators pursue, keeping the total tax revenue collected the same (or lowering it) is a must. After all, boosting a tax base to finance more spending should be viewed skeptically. The economic benefits of a broad tax base disappear if the overall rate rises too.
It’s important to remember that a broad base with low rates is focused only on the costs of taxation. Once state legislators raise the revenue, it’s now up to the state’s legislators to ensure that those additional funds are spent well. As Scott Drenkard of the Tax Foundation pointed out in an appearance on C-SPAN’s Washington Journal, the ideal situation is to “live in a state where the cost side of the equation is relatively low and the benefits side is particularly high.”
What is the fundamental insight from tax policy research? tax a broad base at low rates. Considerations for the effect of taxes on low-income consumers should be carefully examined as well. As well-intentioned as many exemptions are, each exemption means that taxed goods and services must be taxed at higher rates to produce the same level of public revenue.
Efforts to alleviate the regressive effects of taxing necessities may be concentrated more effectively on tax credits or lowering other taxes like the income tax than on making special exemptions. For example, improved tax credit programs such as an EITC for low-income individuals and families can be used to offset changes that adversely impact them (e.g., if groceries were taxed at the full rate).
It is imperative that today’s tax codes match today’s economy. In resisting the urge to grant exemptions, and narrowly targeting social safety net programs for those who need them, legislators can ensure that state tax policy maximizes the benefits of public programs and minimizes the costs of the taxes that fund them.