Spend some time around a discussion of tax policy and you will surely hear the call for reform: “Lower the rate; broaden the base.” This concept has been a rallying cry for conservatives who seek to simplify the tax code and lighten the bureaucratic burden created by complicated schemes.
Throughout the 2017 legislative session, Utah’s Republican Legislature debated several proposals seeking to accomplish this goal. Legislators chose to defer action and make tax reform an issue for study during the interim, but the proposed changes could shape the discussion moving forward. A proposal to modify Utah’s sales tax was one piece of reform up for consideration. While it has been set aside, now is a good time to reflect on the economics of taxes, review the principles of an effective sales tax, and outline the questions lawmakers should be asking as they tackle this critical issue.
Civilized society has long since resigned itself to Benjamin Franklin’s maxim regarding the certainty of taxes, but the optimal way to levy taxes remains a contentious issue. Because taxes artificially alter the markets they are imposed upon, they carry side effects that must be considered. By altering incentives, a tax changes behavior. These distortions can be positive or negative, but policymakers should be aware of them and seek to reasonably minimize such distortions. The sales tax is one area where lawmakers can seek opportunities for improvement.
Originally instituted by Mississippi to compensate for revenue shortfalls during the Great Depression, the sales tax is now a major source of revenue in 45 of the 50 states. However, the scope and magnitude of sales taxes vary significantly between states. For instance, Alaska has no state sales tax and instead allows each municipality to set its own rate, while others, like California, have a uniform rate statewide.
With so much variation in approach, it can be helpful to identify the right questions to ask for sound sales tax policy. The nonpartisan Tax Foundation conducts a regular comprehensive analysis of the tax climate in each state. As a part of this analysis, the foundation identified three areas where states can improve their sales tax approach: the treatment of services, the unequal treatment of specific classes of goods, and the treatment of business-to-business transactions. Lawmakers’ thoughtful consideration of each of these issues, as well as how proposed changes will likely impact citizens who ultimately bear the cost of taxation, will help produce good sales tax policy reform.
SHOULD THE SALES TAX APPLY TO SERVICES?
In most states, Utah included, the sales tax applies only to tangible goods sold to a final consumer. Services, such as legal or financial advice, are excluded. This made sense when sales taxes were first instituted and goods accounted for most economic activity, but with the shift toward a service-based economy over the last several decades, the exclusion of services leaves most economic output exempt from the sales tax. Taxing services would represent a dramatic shift in policy, and it should be studied extensively for the economic impacts and unintended consequences. But it is also most likely the biggest step the state could take on sales tax to broaden the base under a revenue-neutral approach.
SHOULD THE SALES TAX APPLY TO ALL GOODS EQUALLY?
Many states have chosen to exclude entire classes of goods from the sales tax, and some choose to apply lower rates to some goods. The most common exclusions include food, clothing, prescription drugs, and gasoline. The trade-off that comes with this special treatment, as with the exclusion of services, is a smaller tax base. Currently Utah has exceptions in place for prescription drugs and gasoline (which has its own dedicated tax), while unprepared food is taxed at an alternative rate far lower than the standard 4.7 percent. Applying a similar rate to more goods would broaden the tax base and allow for a lower rate while reducing year-to-year variation in revenue. However, new data recently indicated that raising sales taxes on unprepared food would not stabilize revenue as much as expected, meaning this issue requires more careful consideration than suggested by conventional wisdom.
SHOULD THE SALES TAX APPLY TO INTERMEDIATE BUSINESS-TO-BUSINESS TRANSACTIONS?
Some states, like Hawaii, have very low sales tax rates; however, the tax base is so broad it includes not only final goods sold to retail consumers but also inputs and intermediate goods bought and sold by businesses. This policy has the effect of taxing some goods more than others. In some cases, a final good purchased by a consumer as already been effectively taxed one, two or even three times in addition to the sales tax they will pay on the purchase (Utah, fortunately, exempts most business-to-business transactions). For instance, under this system, the taxes paid on cheese would be much higher than those paid on milk. The cheese maker pays tax on the milk used to make cheese and the consumer again pays tax on the price of the cheese, effectively double-taxing the final good. While creating a very broad tax base with low rates, these policies create adverse incentives for producers, and it is worth considering alternative means that produce similar outcomes while avoiding the negative side effects.
HOW WILL CHANGES TO THE SALES TAX AFFECT BUSINESSES, ECONOMIC GROWTH, AND THE POOR?
Any proposal to modify tax policy should be examined closely in the context of Utah’s needs and policy objectives. Any tax reform package will have myriad impacts that could possibly affect economic growth. Utah must also consider the effects that changes could have on vulnerable groups. Because they spend a much higher proportion of their income on basics such as food and clothing, low-income households will be more dramatically affected, for good or bad, by any sales tax modifications.
Utah currently boasts top rankings in several lists of the best states to do business, and the state’s tax climate is a large component of that status. Even so, there are always ways to improve Utah’s tax code consistent with the goal of broadening the base and lowering the rate. By taking a holistic view of the tax code as they debate the critical issue of tax reform, state legislators will do much to ensure a process that produces a better tax system for Utah’s economy, communities and families.