Shifting from Income to Sales Taxes Won’t Boost State Economies

Governors in Maine and Ohio want to shift their states’ revenue mix away from income taxes and toward sales taxes by cutting the former and raising the latter, arguing that will boost economic growth.  But these proposals would do more harm than good. 

In the short run, raising sales taxes would likely hurt in-state businesses by discouraging consumer purchases.  And because sales tax revenue tends to grow more slowly than income tax revenue over the long run, relying more on sales taxes would impair a state’s ability to finance critical building blocks of a strong economy, like good schools, roads, and health care.

Shifting from income taxes to sales taxes can harm in-state businesses in several ways:

• In most cases, the shift will raise overall taxes on low- and middle-income households, leaving them with less to spend locally.
• A higher sales tax encourages people to buy more from out-of-state Internet merchants who don’t charge sales tax, and to take other steps like eating out less often and washing their own cars.
• Regardless of whether the sales tax increase takes the form of a rate increase or broader taxing of services, businesses would make a large share of the purchases — of computers, shipping supplies, and payroll services, for example — that would now be taxed more heavily.  Those extra costs would at least partly offset the income tax cut that some small business owners would receive.
• Businesses also would likely pay higher property taxes.  Few recent tax-shift proposals would raise sales taxes enough to fully pay for the income tax cuts.  As a result, states very likely would have to cut funding for schools and other services that local governments provide.  This could force cities, towns, and counties to raise property taxes for businesses and homeowners, which generally fund education, to try to make up the difference.

These tax-shift proposals could prove even more economically damaging in the long run.  Cuts in critical services are almost inevitable because sales tax revenues don’t keep pace with economic growth as income tax revenues do.  One reason is that sales taxes generally don’t apply to many of the fastest growing sectors of the economy, like health care and many Internet-related services.  Also, a growing share of the benefits of economic growth is going to wealthy people, who spend a much smaller share of their income on in-state products and services than less-affluent people do.  

States with insufficient long-run revenue growth will have trouble investing in public goods that businesses need to create good jobs — an educated workforce, well-maintained roads, and effective police and fire protection. 

Partially offsetting income tax cuts with sales tax increases is less fiscally irresponsible than simply cutting income taxes, as Kansas and a few other states have done in recent years.  But both policies are based on the same false premise: that state taxes have a major effect on job creation and economic growth.  Instead of looking for a magic tax-policy change that will spark an economic boom, policymakers should invest in the economy by providing high-quality education, health care, public safety, and transportation as cost effectively as possible.  That’s the best recipe for healthy economic growth.