The new hot policy among GOP lawmakers at the state level appears to be expanding the sales tax — or, at least, using it to replace other revenue. Virginia Gov. Bob McDonnell has proposed replacing the state’s gasoline tax with an increase in the sales tax and a new annual fee for hybrid and electric cars. Louisiana Gov. Bobby Jindal has proposed eliminating the state’s income and corporate taxes and making up the nearly $3 billion in lost revenue through sales tax hikes. Republican legislators in North Carolina are considering something like the Jindal plan. Arthur Laffer, the conservative economist, has argued that the swap will supercharge growth, more than doubling North Carolina’s rate of personal income growth.
Is he right? Are sales taxes good policy?
This is an easy question to answer in the Virginia case. Economists generally like consumption taxes relative to income taxes because they produce more incentive to save. All else being equal, you should tax stuff you don’t want more than stuff you do want, and we want to promote income-earning more than we want to promote consumption, so consumption taxes are preferable.
But not all consumption is created equal, and there are many good reasons to want people to buy less gas. Driving contributes to global warming and smog and leads to unproductive road congestion. Resources for the Future has calculated that a gas tax of around $1 per gallon would be about optimal. Getting rid of the state gas tax altogether — when fuel taxes in the United States are extraordinarily low already — and partially replacing the revenue by punishing people who buy more environmentally friendly vehicles makes very little sense.
But what about the Jindal plan? He’s replacing income taxes with a higher sales tax, exactly the kind of income-for-consumption swap that conventional economics suggests is worthwhile. That said, it’s much less clear that such a relationship holds at the state level. The taxes are low enough — and the potential to evade sales taxes by crossing state borders easy enough — to mute the effects, says Nick Johnson, vice president for state fiscal policy at the Center for Budget and Policy Priorities.
“There’s been a lot of empirical work — a lot of it was done not super recently but in the 1980s, 1970s, though there’s some since then — both looking at tax rates and looking at different types of taxes, and they tend to find just not very much effect at all,” Johnson says.
State and local taxes take up only a small percentage of most businesses’ revenues, so business income taxes don’t have much of an growth effect. Corporate taxes have a bit of an effect, Johnson says, but whatever reduction in growth they cause is probably canceled out by growth due to the spending they fund.
There are a few other reasons why the traditional “consumption over income” rule doesn’t apply here. One is that sales taxes aren’t particularly good consumption taxes. “They’re not the ideal modeled consumption tax of the economics textbooks,” Johnson explains. “They’re 30 to 40 percent from business-to-business transactions, so economics will say there’s huge efficiency losses there. Conversely, huge chunks of spending, services are not subject to sales taxes. It’s the closest thing we have, but it’s not really a consumption tax.” And state income taxes tend to base themselves off the federal tax, which has numerous savings incentives, which means that income taxes have some limit consumption tax-like properties, as well.
Then there’s the biggest problem with swapping the income tax with the sales tax: It’s very, very regressive. A study from the Institute for Taxation and Economic Policy (ITEP) analyzing a proposal similar to Jindal’s introduced into Missouri’s legislature found that the top five percent of residents would get a tax cut, but working-class residents would get a tax hike of close to 7 percent:
One more thing: Johnson notes that it’ll be easy enough for Jindal to pass the elimination of the income and corporate taxes, since doing so requires only simple majorities of both houses of the legislature. But replacing them is much more complicated, as tax increases require a two-thirds majority of the legislature. That sets up a situation where revenue is lost and not entirely made up for, which risks forcing budget cuts at a time when states are already cutting rapidly.