State and local governments often turn to increases in sales taxes to generate additional revenue. Estimates of fresh revenue from the higher tax tend to be overly optimistic, partly because the number of sales tax exemptions tends to rise with the rising tax rate.
Given the fact politicians seek to raise a certain amount of revenue and wish to maximize their chance of reelection, this relationship suggests politicians face a tradeoff when seeking votes from groups that favor sales tax decreases and groups that lobby for certain tax exemptions.
Turning to Carve-Outs
In our study released in August 2014, Sales Taxes and Exemptions, we identified 17 broad exemption categories (some of which also contain subcategories), entity-based, product-based, and use-based exemptions.
Entity-based exemptions are defined as exemptions in which the seller or buyer is an exempt entity, such as a nonprofit organization or a school. Product-based exemptions involve items which are exempt from taxes, such as food or health-related items.
Finally, use-based exemptions are granted when the buyers’ intended use of the item entitles them to an exemption, as with material tools used in manufacturing.
We constructed the exemption categories to be specific enough not to have exemptions overlap, yet broad enough to incorporate a variety of definitions for products or transactions.
The study found the average state’s sales tax rate was 5.6 percent, with values ranging from Colorado’s 2.9 percent sales tax to California’s 7.25 percent sales tax rate.
Exemptions Lead to Tax Hikes
Our analysis of sales taxes and exemptions in each state has some important implications. The results of the regression analysis indicate that the correlation between tax rates and the number of exemptions is both positive and statistically significant.
A single exemption is associated with a 0.10 to 0.25 percent increase in the sales tax rate. Thus, in theory, if a state has a current tax rate of 5.6 percent and adds another five exemptions, then the state can be expected to increase the tax rate to at least 6.1 percent in the future.
Higher sales taxes, in turn, increase the incentive for special interests to lobby for more tax exemptions. Ultimately, the link between sales taxes and sales tax exemptions undermines the certainty of generating additional revenue by increasing sales taxes.
That is why, in the end, estimates of the effects of increasing sales taxes are often overly optimistic. Therefore, agencies should be more alert to the link between sales taxes and exemptions when making predictions of future increases in revenue.
Thomas Stratmann, Ph.D., ([email protected]) is a scholar with the Mercatus Center and a professor of economics at George Mason University.
“Sales Taxes and Exemptions,” Dr. Thomas Stratmann, Mercatus Center, August 2014: http://heartland.org/policy-documents/mercatus-policy-sales-taxes-and-exemptions