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Why Replacing State Income Taxes with Bigger Sales Taxes Doesn’t Make Sense

January 22, 2013 at 4:55 PM
BY
Elizabeth McNichol

In an alarming trend, governors in Louisiana, Nebraska, and North Carolina have proposed eliminating their state's personal and corporate income taxes and raising the sales tax to offset the lost revenue. These proposals are similar to so-called "FairTax" proposals that several states have considered -- and rejected -- in recent years. We outlined the problems with those proposals in a 2010 report.

Proponents claim that eliminating income taxes and expanding the sales tax would make tax systems simpler, fairer, and more business-friendly, with no net revenue loss. In reality, they would tilt state taxes against middle- and lower-income households and likely undercut the state's ability to maintain public services. Specifically, they would:

  • Raise taxes on the middle class. These proposals would significantly change the distribution of state taxes: lower- and middle-income families would pay more, while businesses and high-income households would pay less. That's because repealing the income tax would disproportionately benefit high-income families (since they generally face higher tax rates), while a sales tax hike would hit low- and middle-income families the hardest (since they pay a bigger share of their incomes in sales tax than wealthier families do).
  • Require huge sales tax hikes. Income taxes raise 40 percent of states' tax revenue, on average -- an amount equal to total state spending on highways, prisons, state police, public hospitals, public health, and parks. To fully replace the lost revenue, sales tax rates would have to be markedly higher than they are now, and often higher than proponents claim.
  • Levy those new, higher rates on a much larger number of transactions. While these proposals vary, many call for examining all exemptions to the sales tax with an eye to extending the tax to many more goods and services. These could include everything from food to prescription drugs, child care, and home sales, as well as a range of business-to-business transactions. Bringing large numbers of goods and services into the tax base at the new, significantly higher rates would cause a number of technical, economic, and political problems.

  • Create an unsustainable spiral of rising rates and widening exemptions. A large expansion of the sales tax would spark furious efforts to exempt many purchases from the tax. But if a state granted such exemptions, it would have to compensate by raising the sales tax rate even higher. The ultimate result, most likely, is that the new tax would fail to meet its revenue-neutral promise -- forcing cuts to education, transportation, and other essential services to meet state balanced-budget requirements.
  • Fail to boost state economies. Replacing income taxes with an expanded sales tax would do little or nothing to improve a state's business climate or economic performance. On the contrary, the resulting high sales tax could hurt in-state businesses as residents shift purchases to neighboring states or the Internet. And if a state had to curtail public services because the expanded sales tax failed to make up the lost revenue from the eliminated taxes, these cuts could curtail economic development.
  • Make state revenues much less stable. By making a single tax a state's sole significant revenue source -- rather than the mix of sources now utilized -- these proposals would deprive a state of a balanced revenue portfolio and jeopardize its ability to collect enough revenue for future needs.