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STATE LIBRARY

Sales Taxes: An Introduction

Background Taxation-or collecting revenue by requiring persons to make payments to the government-is the most common method of financing govern­ment services.

It is used as a method of raising revenue because most government activities benefit members of the community as a group, rather than as indi­viduals. Government services such as public safety, local roads, air quality, and fraud preven­tion cannot be divided into units that can be sold separately to individuals. They must be provided to the community as a whole. Other services, such as education and public transit, may directly benefit only some individuals at a given time, but they convey substantial benefits to society as well. Thus, these activities-by virtue of their community benefits-are financed entirely or partially by taxation.

In the United States, the three most important revenue sources of state and local government are:

• general sales taxes,

• property taxes, and

• income taxes.

The general sales tax is imposed on the sale of goods and services (with specified exceptions). It is usually added to the retail price of the item or service purchased. The tax is important because it is used by so many jurisdictions and because it is a significant revenue generator.

OREGON October 1993

STATE Ll!RAR'I Forty-five states and the District of Columbia use the general sales tax as a revenue-raising source. More than half of these states (24) adopted a sales tax during the 1930s because of the financial crisis caused by the Depression. Between 1940 and 1960, 11 more states and the District of Columbia began using the sales tax, and 10 more states adopted a sales tax in the 1960s. The last state to enact a sales tax was Vermont in 1969.

Sales tax revenue collected by a state government is used for a variety of purposes. In 1988, more than half the states levying a sales tax earmarked all or a portion of the tax revenue for one or more specific purposes. The most common designated uses were: • local government revenue sharing •education • highways or mass transit.

States that did not earmark the sales tax used the revenue for general government purposes.

Oregon is one of five states without a general sales tax. The other four are Alaska, Delaware, Montana, and New Hampshire. Although Oregon's cities and counties currently have the authority to adopt local general sales taxes (ORS 305.620), none has chosen to do so. On the other hand, the state and many cities and counties in Oregon obtain revenue from a variety of "selec­tive" sales taxes. These include taxes on gasoline , cigarettes, beer and wine;pliblic utilities, and motel and hotel rooms.

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Karen M . Seidel, Univers icy of Oregon , is che author of chis publication. Assistance and review was provided by S ceve Bender, Legislative Revenue Office; Katherine Eaton ,

League of Women Vocers of Oregon ; and Bruce Weber, Oregon Seate University .

Oregon Fiscal Choices is a project of the Program for Governmental Research and Education (PG RE) at Oregon Scace Univers ity, wich financial support from the Northwest Area Foundation. The project pr011ides information about Oregon's cax and public spending decisions and their long-term consequences.

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State and Local Government Tax Revenue United States Slightly more than two-thirds of all locally-generated general revenue collected by state and local govern­ments in Fiscal Year 1991 came from taxes. User charges (such as college tuition, sewer and solid waste charges, and hospital fees), interest earnings, and special assessments contributed most of the remaining revenue.

The property tax-main ly a local government revenue source-provided 32 percent of all tax revenue. General sales taxes and gross receipts taxes contrib­uted 24 percent. Individual income taxes provided 21 percent.

When added together, all other taxes produced 23 percent of state and local government tax revenue. Major components of other taxes were motor fuel taxes, public utilities (franchise) taxes, and motor vehicle license revenue.

Although general sales and individual income taxes are used by both state and local governments, they are predominantly a source of revenue for the state. More than 80 percent of general sales and gross receipts tax revenue went to state governments in 1991.

United States State and Local Governments, FY 1991

~ 50-------------------~ Source: U.S. Bureau of the Census ~40------------------x

"' ~ 30 B 0 20 QI

~10 c:

~ 0 c.. billion billion billion

Property Sales Income Other

Oregon State and Local Governments, FY 1991

~ 50------------------­~ ~ 40 x

~ 30 0 ~ 20

~ 10 c: QI

~ 0 c..

Source: U.S. Bureau of the Census

$2.6 fi@!}------t

billion $0 $2.0 · billion $1.3

billion

Property Sales Income Other

Oregon Unlike most states, Oregon's state and local govern­ments rely on only two of the three major sources of tax revenue.

Because Oregon doesn't have a general sales tax, property and individual income taxes must provide a higher proportion of total tax revenue than in the average stare. Oregon property taxes-used by local governments only-generated 43 percent of the total tax revenue (compared with 32 percent for all states) in FY 1991 (the year before Ballot Measure 5 took effect). Oregon individual income taxes represented 34 percent (compared with 21 percent for all states) .

As in the nation as a whole, all of Oregon 's other taxes produce 23 percent of state and local govern­ment tax revenue. Based on their revenue contribu­tion, the two most important other taxes in Oregon are gasoline taxes and motor vehicle licenses.

General Sales Tax Rates In 1991, 45 states and the District of Columbia collected general sales taxes ranging from 3 percent to 7 percent, with the average rate being 5 percent. The rate variation was related to:

• the sales tax base, that is, whether the sales tax is imposed only on goods or on both goods and services,

• the number and types of exemptions to the tax, and

• the amount of revenue obtained from other tax sources.

The number and kinds of services included under a general sales tax differ significantly from state to state. Information from a 1987 study indicates that slightly more than half the states with a general sales tax either do not tax professional and personal services or tax only a few services. 1 Three states (South Dakota, New Mexico, and Hawaii) tax most services.

The state sales tax rate is not necessarily the total rate paid by consumers. Local sales taxes are added to the state sales tax by about 7 ,000 jurisdictions in 30 states. In these states, the state authorizes local governments to levy sales taxes. Some states stipulate that such a tax is subj.ecr to voter approval or that the tax may not exceed a given rate. A few states also specify the purpose of a local sales tax (for example, public transit , education, infras tructure).

In some local jurisdictions in Alabama, California, Illinois. Louisiana, New York, Texas, and Washington, the total state sales tax plus local sales tax rate reaches 8 percent or more.

1 U.S. Advisory Commission on jntergovernmental Relations, Signi fica nt Features of Fiscal Federalism. 1987 Edition, Report M-151 , June 1987, p.89.

General Sales Tax Exemptions Scates may choose co exempt specified goods or services from taxation. This is frequently done with the intention of making the tax more progressive, chat is, co lessen the tax burden on low-income households. Goods and services most often chosen for exclusion are "necessities," such as prescription drugs, food, consumer electric and gas utilities, and repair charges. Certain purchasers and sellers of goods and services may also be declared exempt from the tax. Sales and purchases by charitable and ocher nonprofit organiza­tions may be exempt, as may most purchases by governmental units.

General Sales Tax Credits Rather than using exemptions, some states have enacted tax credits to make the sales tax progressive. Four states (Hawaii, Idaho, New Mexico, and Ver­mont) provide tax credits in conjunction with the personal income tax. Three states (Kansas, South Dakota, and Wyoming) provide separate refund programs. Credits may be a preferable method of mitigating the tax burden on low-income households since they do not narrow the tax base.

Tax Exporting A tax is exported if its burden is shifted to nonresi­dents of the taxing jurisdiction or to a higher level of government. Scace and local taxes can be exported in three general ways. The first is by requiring persons or businesses living outside the state or local jurisdiction to pay the tax under certain circumstances. For example, the sales tax is paid in part by nonresidents who travel to or own second homes in the state impos­ing the tax and make purchases there. Scates with large tourist travel, such as Nevada and Florida, gener­ate more sales tax revenue relative co their population than do states with few tourist attractions. There is some evidence chat in Oregon nonresidents would not contribute a significant amount of sales tax revenue.

A second way of exporting the sales tax involves businesses chat sell produces co out-of-state consumers. These firms, which pay sales taxes on their business supplies, can include chose coses in the sales price of their final produce, thus exporting the tax co the ouc­of-scace buyer.

The third way taxes are exported is through deduc­tions of some state or local taxes from income tax returns owed to the next higher level of government. Since state sales taxes can no longer be deducted from federal income tax returns, the sales tax is no longer exported through the federal tax code.

State Sales Tax Rates October 1991

Source: U.S. Advisory Commission on Intergovernmental Relations 16--------------------14--------~-......--;

!!12-----7 "' ~10------1 ~8------f 1l 6------f 13 §4---~--f

14 15 -------

z 2 0

3-3.9% 4-4.9% 5-5.9% 6-6.9% 7% or more

Examples of State Sales Tax Exemptions November 1991 g' Source: U.S. Advisory Commission on Intergovernmental Relations "K50--------------------~40----; x "' ,!!30 t! 20 ___,, ___ t-1

0 iii 10

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§ 0 z

Food f\c Utilities Clothing Phone Repairs

Tax Principles and the Sales Tax Since every major tax has its own strengths and weak­nesses, any evaluation of taxes based .on accepted tax principles must be applied co the tax system as a whole. In a well-balanced and diversified tax system, the strengths of one tax should compensate for weaknesses in ochers. The performance of the general sales tax in regard to standard tax evaluation criteria is examined below.

Fairness By itself and with no mitigating offsets, the sales tax poses equity problems. Tax burdens fall heavily on low-income households (because they spend a greater proportion of their income than more affluent households) and on large families (because they spend more of their income on goods than do small house­holds in their income group). Noc only do high-

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income householc!s save a larger share of their incomes, but their spending is more concentrated on items and services that are typically exempt from the state sales tax (such as expensive housing and foreign travel) .

The regressive nature of the sales tax is frequently compensated for by exempting necessities (e.g., food, utilities, prescription drugs), refunds or tax credits to

low income households, or combining the sales tax with a highly progressive income tax.

Administrative and Compliance Costs The sales tax requires compliance and administrative activities whose costs are not trivial.

Taxes are collected and processed by retail businesses that sell taxable products. These costs are generally passed on to customers, although some states allow firms to retain a small portion of the taxes they collect ·as compensation. State administration of the tax, including record keeping, field audits, and enforce­ment, has been estimated to cost from 0. 7 to 1.5 percent of tax revenue.2 While the sales tax is difficult to avoid, neither the sales tax nor the income tax is considered easy to administer or enforce.

Adequacy/Stability The sales tax has a large revenue-raising potential. The amount of revenue it can raise is a function of the tax rate as well as the breadth of the tax base. A lower rate is possible if the tax is applied to both goods and services and if the number of exemptions is minimized.

Since sales tax revenue results from retail purchases, revenue is directly connected with consumption levels. Generally, sales tax revenue varies more with the business cycle than does property tax revenue but less than income tax revenue. That is, the sales tax may provide more stability but less sensitivity to economic growth than the income tax, while it tends to be more responsive to economic conditions than the property tax.

However, the particular characteristics of the tax laws may alter these general relationships. For example, an income tax with a single rate for all household income levels will be less volatile than a very progressive income tax (that is, one with graduated rates along the income scale).

Unless all services are part of the tax base, revenue may not grow as rapidly as growth in total consump­tion. In recent years, expenditures for services have in­creased more rapidly than expenditures for goods, and the services that have grown the most (e.g., medical, legal, financial) are those that states rarely tax. 1 Tax Fo1111datio11, /11c., State a11d Local Sales Taxes, New York, I 970.

Economic Neutrality Economic neutrality means that a tax does not influence economic decisions made by businesses or households. The broader the base of the sales tax, the less it interferes with private economic decisions, that is, the less consumers substitute untaxed items for taxed items. The tax does provide some incentive to

reduce spending in favor of saving.

Although it is imposed on businesses, the sales tax is assumed to be shifted to the purchaser. Thus, it will not hinder in-state consumption or overall state competitiveness if the rate is not higher than neigh­boring states' taxes and if the overall state tax burden is not excessive. (However, it may reduce purchases by consumers living in neighboring states.)

If the tax base includes producers goods, it will raise the cost of capital-intensive production methods and make industrial modernization more expensive.

Public Accountability A tax system is accountable to citizens if it includes appropriate limitations and means of voter control. A variety of limits and controls can be placed on the sales tax.

• The state legislative body can place a sales tax measure on the ballot or-in states, such as Oregon, with initiative-and-referendum laws-the measure can be referred to voters.

• A maximum tax rate can be placed in the constitu­tion as can a maximum dollar amount to be collected.

• The tax measure may contain a "sunset" provision, or a date on which it must be approved by voters if it is to continue in force . ·

• A constitutional amendment may also specify goods and services to be exempt from the tax.

A state legislative body can give units of local government authority to enact a sales tax or it can prevent them from doing so. It can also specify whether a state or local sales tax will be for general revenue-raising purposes or earmarked for one or more specific service categories.

A( OREGON STATE UNIVERSITY

~EXTENSION SERVICE

Oregon State Univer>ity Extension Service offer> educational programs, ac tivities, and mate ria ls-without regard to race, color, national origin, sex, age or disabiliry-as required by Title VI of the C ivil Rights Act of I 964, Title IX of the education Amendments of 1972, and Sect ion 504 of the Rehabilitation Act of 1973. Oregon State University Extension Service is an Equal Opportunity Employer.