Sales Tax Slice: Replacing Income Tax with Expanded Sales Tax Is in Lawmakers’ Playbooks, But Is it a Winning Idea for Tax Reform?

Efforts to reform tax codes are in full swing following the 2012 election, which saw a single party wrest control of both chambers of the legislature in many states. One reform tactic that has found its way into lawmakers' playbooks in several states is replacing the income tax with an expanded sales tax that applies to additional services. 

This idea may partly be attributable to "Texas envy," according to a story in the Cleveland Plain Dealer. But as the Tax Foundation's Joe Henchman points out in the article, state tax systems probably should vary because not all regional economies are alike.

Support for the idea of replacing the income tax with a broader sales tax is beginning to fray. For example, Louisiana's Gov. Bobby Jindal (R), who championed the approach for much of the year, scrapped his proposal on April 8 to eliminate the state's personal and corporate income tax and raise sales and service taxes, according to Bloomberg BNA's Daily Tax Report.

Support for the cause of cutting income taxes rests with the idea that it makes the state more attractive for businesses, which bring jobs, money, and growth to the economy. One critic of the strategy is the Center on Budget and Policy Priorities. It recently issued a report saying that dispensing with the income tax would do little to reduce the volatility of state tax revenues, which tend to fluctuate based on economic conditions.

Other opponents say relying more heavily on a sales tax would increase the tax burden for poor families, who would pay a higher percentage of their income to taxes than wealthy families.  

The idea of an expanded sales tax base has also been criticized by a business group. Replacing the income tax with an expanded sales tax is that taxing services can have a disproportionate impact on business purchases, concluded the Council On State Taxation (COST) in a recent report. The report cautions legislators to be aware of the tax policy issues and impacts on state business tax competitiveness as they debate significant expansions of the sales tax base.

In particular, COST explains that extending the sales tax to services generally may have the opposite effect of that intended because typically 70 - 80 percent of such an expansion would be taxes on business-to-business services, and not taxes on consumption. Taxing business-to-business services, COST says, raises numerous problems including arbitrary and hidden differences in effective sales tax rates that distort consumer choices, distortions in firm structure and operations, violations of horizontal and vertical equity principles, detrimental impacts on the state's business competitiveness, and extreme difficulties with compliance.

By Christine Boeckel

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