Are state and local revenue systems becoming obsolete? The economy's changing structure is threatening the revenue productivity of state and local government tax systems.

• Author: Tannenwald, Robert

Editor's note: This article was adapted with permission from the September 2002 issue of National Tax Journal, a quarterly publication of the National Tax Association. The author published an earlier version of the article in the New England Economic Review (Issue 4, 2001), a quarterly publication of the Federal Reserve Bank of Boston.

In recent months, we public finance types have become used to nearly universal reports of sharply declining state revenues. Although cyclical factors are mostly responsible, many tax analysts believe that long-term economic and technological developments also are partially to blame and will continue to constrain state and local revenue growth well into the foreseeable future. As a result of these developments, state and local revenue systems are becoming increasingly "out of sync" with the economy's changing structure. The economic stocks and flows that they are designed to "meter" comprise a shrinking faction of the nation's wealth and economic activity. According to some, these factors are so pervasive and persistent that they threaten to make current state and local tax systems obsolete.

This article discusses the impact on state and local revenues of four such factors: (1) the shift in the nation's mix of production and consumption from goods to services, (2) the growing importance of intangible assets in generating output, (3) the proliferation of electronic commerce, and (4) the intensification of interjurisdictional competition. While I provide evidence that all four factors threaten the revenue productivity of state and local taxes, I have no good solutions to offer. Numerous plans to modernize state and local revenue systems have been suggested, but most would sacrifice important tax policy goals. No solution presents state and local policymakers with a clear win-win situation, in which they could halt or reverse the decline in the revenue productivity of their taxes without sacrificing autonomy, competitiveness, neutrality, or administrative simplicity.

The Shift from Goods to Services

The United States spends a much smaller fraction of its resources on producing goods and a much larger fraction on delivering private services than it did 40 years ago. In 1960, 42 percent of U.S. wages and salaries were earned in the goods-producing sector (manufacturing, mining, construction, and agriculture). Forty years later, the share attributed to goods production had fallen to 24 percent. By contrast, the share generated by delivery of private services rose over this period from 15 percent to 37 percent. The mix of personal consumption also shifted away from goods and toward services. In 1960, American households allocated 41 percent of their consumption dollars to services. By 2000, this percentage had risen to 58 percent.

Implications for the General Sales Tax

In order to understand these implications, one must consider all the various types of transactions that are potentially subject to general sales taxation ("total potentially taxable transactions"). (See Exhibit 1.) Such transactions consist of consumption by households and purchases by businesses. Consumed items can be further classified into those usually exempt from taxation or taxed at preferentially low rates ("tax-preferred" items) and items that are usually taxed without preferential treatment ("taxed" items). Tax-preferred items consist of food consumed at home and services. Food consumed at home is taxed preferentially in the majority of states because it is considered a necessity. States generally tax services only to a limited extent for administrative and political reasons.

Since services accounted for a much smaller fraction of the economy than did goods 70 years ago, the revenue consequences of excluding services from taxable sales were not considered significant. These consequences have become much more serious as the importance of professional and business services to the economy has grown. (1) However, the political and administrative obstacles to taxing services remain. Attempts to do so by both Florida (in 1987) and Massachusetts (in 1991) were defeated by vigorous lobbying on the part of interest groups representing those service providers who would have been most adversely affected. As of 1996, only three states--Hawaii, Washington, and South Dakota--taxed a wide array of services. (2)

Purchases by businesses also can be classified into a tax-preferred component (services and purchases of structures) and a taxed component (purchases of intermediate goods, machinery, and equipment). However, even purchases of taxed items are generally exempt from taxation if undertaken by firms in "sheltered" industries (manufacturing, mining, and agriculture). Such firms have been sheltered from sales taxation because, as exporters of goods to other states, they import revenues into a region and, therefore, are thought to drive its economic growth. All the purchases of governmental agencies and of most nonprofit organizations also fall into the tax-preferred category.

Thus, of all the potentially taxable transactions, only items of taxed consumption and purchases of taxed items by unsheltered firms actually enter into sales tax bases. In order to evaluate the impact of shifts in the composition of consumption and production on the revenue productivity of sales taxes, one must analyze how these shifts have affected the size of these two taxable slices of the total transactions pie. Between 1977 and 1997, the percentage of total potentially taxable transactions that fall within taxed categories fell by only 2 percentage points, from 28 percent to 26 percent. Thus, after taking into account...