The Shifting Landscape of Sales Tax Bases

Springtime has traditionally been a fertile period for state tax proposals. This year, some important debates have flourished regarding the scope of state sales tax bases.

In their purest form, sales taxes apply to nearly all of the goods and services purchased by final consumers. Maintaining a broad base and low rate helps these taxes bring in relatively steady revenues and minimizes any interference they may have with the economy. The real world, however, is much more complicated as most state sales tax bases are riddled with special exemptions.

Some of those exemptions have been crafted to advance important policy goals such as limiting the disproportionate impact that sales taxes typically have on low-income families. Others have more to do with the political influence of a given constituency than with principled tax policy. And still others are essentially historical accidents—as the economy and consumption patterns have changed, sales tax laws haven’t always kept up and initially inconsequential tax exemptions have sometimes ballooned in size. 

Shifting Ground 

It’s well-known that the nation’s service sector has grown significantly in recently decades. Today as much as two-thirds of consumer spending is on services rather than goods, and spending on services is the fastest growing area of consumption. But when lawmakers initially designed most state sales taxes in the 1930s, services were a relatively small part of the economy and were typically left out of tax bases. States have been slow to adapt to this change, though there have been some modest steps toward sales tax modernization in places such as North Carolina, as well as ongoing discussions of similar reforms in Arizona, California, Oklahoma, and West Virginia.

While few developments in sales tax policy are as important as the service sector’s growing prominence, the recent growth of online shopping has created another high-profile challenge to state sales tax systems. Under current federal law, states can only force e-retailers to collect the sales taxes their customers owe if those retailers have some kind of “physical presence” in the state. To take just one example, this means that Amazon.com (the nation’s largest e-retailer) is only collecting sales tax from customers in about half the states. For the other half, customers are supposed to be paying the sales taxes they owe directly to the state, but this requirement is unenforceable and very few do so in practice. Ultimately, the sales tax only functions if sellers are collecting and remitting the tax. For years, states have searched for ways to bring a larger number of e-retailers within their sales tax collection systems, and 2016 has been no exception in this regard. Bills taking steps to rein in the untaxed nature of online purchases have moved in Utah and in Oklahoma this year, and a recent federal court case has given states new hope of collecting these taxes as well.

Compared to the growth of the service sector and of online shopping, the rise of websites like Airbnb and apps like Uber and Lyft are extremely new developments with sometimes unclear implications for state and local tax policy. For example, it is not always clear whether Airbnb room rentals are subject to state and local hotel and lodging taxes, or whether Uber and Lyft rides are subject to sales taxes and airport pickup taxes, nor who is responsible for collecting and remitting those taxes if they are due. To their credit, some states and cities are attempting to be pro-active in updating their tax laws and regulations to account for these changes. Gov. Ducey of Arizona took executive action to help ensure that the state’s regulations adapt to the rise of the “sharing sector,” and other jurisdictions such as Cleveland, Philadelphia, San Francisco, Pennsylvania’s Allegheny County, and the state of Alabama have begun grappling with this issue as well.  

Exemptions old and new 

In contrast to the above attempts to ensure that sales tax bases can grow in line with the economy, states are also considering creating new exemptions from their sales taxes. Most state sales taxes already exempt some items deemed to be necessities, such as groceries and prescription drugs. This year has seen many calls to create similar exemptions for other necessities, particularly tampons. Tampon exemptions have already been enacted in a few states and have been the subject of vigorous debate around the country, including a lawsuit in New York, legislative proposals in California, Connecticut, Tennessee, and Wisconsin, and stories in The New York Times, Washington Post, and National Public Radio. 

But determining which items are truly necessities deserving of a tax exemption is not an easy task. As some lawmakers seek to broaden these exemptions, others are arguing that the exemptions already on the books for items such as groceries are too broad because they exempt not just bread and milk, but candy bars and soda pop as well. Last year Vermont removed soda from its broad exemption for groceries and California is considering removing its exemptions for candy and snack food. At the same time, lawmakers in Louisiana and Philadelphia have discussed implementing special excise taxes on soda.          

Healthy debates 

Ensuring that sales tax bases are not eroded as the economy changes is vital to securing adequate revenues for public services such as schools and public safety. But sales taxes are far from perfect, particularly in the way that they tend to hit lower- and moderate-income families the hardest. One tool for lessening sales tax regressivity is to exempt more necessities from the tax, but doing so can also force rates up and increase revenue volatility if the tax collects a larger share of its revenue from “unnecessary” items that people are less likely to buy during economic downturns. With that in mind, lawmakers should keep in mind that there are many tax policy solutions aside from sales tax exemptions that can benefit low-income families in more targeted ways.