An efficiency analysis of proposed state and local sales tax reforms.

• Author: Russo, Benjamin

1. Introduction

   State and local tax policymakers face a large number of particularly severe public finance conundrums. (1) One pressing long-run issue is the slow but steady erosion of state and local general sales and use tax bases. (2) With a few well-known exceptions, sales taxes are levied primarily on tangible goods. (3) Most services are untaxed, and services have grown as a share of consumption spending. (4) Thus, sales tax bases have declined as shares of total spending. (5) At the same time, legislators have increased tax rates. (6) Since consumers tend to substitute away from products whose relative prices have risen, higher tax rates tend to exacerbate the problem they are intended to address.

   A number of reforms designed to reduce base erosion have been proposed. These include broadening tax bases, transforming sales taxes to a consumption base, and wholesale replacement of sales taxes with income taxes. Each proposal has some potential to shore up sales tax bases; thus, from an economic perspective, the policy choice should turn on efficiency, equity, and simplicity effects. Very little quantitative information on the efficiency effects of such proposals is available. This paper uses computer simulations to examine the efficiency effects of reforms designed to reduce sales tax base erosion. (7)

   Trends underlying tax base erosion appear to be structural and likely to continue. Baumol (1967) argues there is a structural tendency for manufacturing productivity growth to exceed productivity growth in services, so relative prices of manufactured goods tend to decline. (8) If demands for both goods and for services are inelastic, the services sector will tend to absorb ever-larger fractions of resources and increase in proportion to total value added. Recent evidence indicates that both taxed commodities (mostly tangible goods) and untaxed commodities (mostly services) are price inelastic (Russo and Wei 2004). Everything else held constant, therefore, the relative price decline in manufactured goods tends to reduce their share in total spending, supporting a continued shift toward services. (9) Since older consumers spend relatively large fractions of income on untaxed medical services, aging of the population also could contribute to sales tax base erosion. As a result of the Interstate Commerce Clause, remote vendors often do not collect states' general sales taxes. If Internet sales continue to grow rapidly relative to total purchases, e-commerce could exacerbate the problem. (10) This possibility gains support from Goolsbee's empirical work. His results indicate relatively large tax elasticities for Internet sales (Goolsbee 2000a). To make matters worse, tax sensitivity appears to increase over time (Goolsbee 2000b).

   Structural sales tax reform appears unavoidable. One possibility is to broaden the sales tax to more services. A variation on this theme would transform the sales tax to a true consumption tax. A third approach is to replace sales tax revenue with income taxes (Varian 2000). (11) The first and second approaches attempt to shore up the sales tax base so that it adjusts automatically to shifts in the composition of spending and in the location of purchases. The third approach reduces erosion by switching the tax base to one that appears less vulnerable to shifting consumption patterns. Each approach has features that could improve efficiency and features that could reduce it. Efficiency improvements could result from base broadening, which would result in lower tax rates (revenue held constant), and reducing existing distortions due to disparate tax treatment of goods versus services and brick-and-mortar versus remote sales.

   However, taxing more services could reduce efficiency because firms spend substantial amounts on services (Fox and Murray 1988; Due and Mikesell 1994). To the extent that a tax on services falls on service inputs to production, distortions in production decisions could increase, increasing the excess burden of the tax system. A potential disadvantage of taxing e-commerce could occur because ecommerce consists predominantly in business-to-business transactions (Goolsbee and Zittrain 1999; Bruce and Fox 2004). Further, firms purchase tangible goods, including machinery and equipment, via ecommerce. The sales tax on these purchases increases the cost of capital and distorts investment decisions (Due and Mikesell 1994). Published empirical evidence indicates that capital input markets tend to be imperfectly competitive (Appelbaum 1982; Hall 1986; Domowitz, Hubbard, and Petersen 1987). Price markups appear particularly large in markets for machinery and equipment. With this in mind, Judd (1997, 2002) argues that policymakers should be particularly careful not to tax these inputs.

   Replacing sales with income taxes could reduce efficiency because income taxes distort saving and investment decisions. Recent empirical work by Carroll et al. (2000) indicates that the personal income tax discourages small-business spending on machinery and equipment. Although state marginal income tax rates appear low relative to federal rates, by the square rule the two marginal rates together determine the excess burden of income taxes. Therefore, an increase in the relatively high state plus federal income tax rate could increase excess burden out of all proportion to the relatively small state income tax rate.

   This paper uses a computable general equilibrium model to evaluate the efficiency of reforms designed to reduce base erosion. Simulations of the model indicate that (i) broadening sales tax bases could increase economic efficiency, (ii) moving to a consumption tax dominates base broadening, (iii) replacing sales taxes with higher income taxes could produce large efficiency losses, (iv) base broadening could generate efficiency gains even if untaxed remote sales become a "sizable" (25% in the simulations) fraction of total purchases, and (v) even partial base broadening could produce sizable efficiency improvements.

   Section 2 describes the analytical model and the tax structure used in the simulations. The Ramsey model of long-run economic growth is used here. A long-run model is appropriate for the issues studied here because a substantial portion of sales tax base erosion stems from long-run secular trends. Income taxes, which could play a role in sales tax reform, affect capital accumulation and standards of living in the long run. (12) A long-run model, therefore, should be informative on the issue. Section 3 reports on the simulation results and describes sensitivity analysis. Section 4 summarizes the main points, draws conclusions, and describes important qualifications.

2. The Model and Tax Structure

   The Analytical Model

   The model used for the simulations basically is a Ramsey long-run growth model augmented by a detailed tax structure and a monopolistically competitive sector for business inputs. (13) Monopolistic competition is used here because empirical evidence suggests large markups on machinery and equipment (Appelbaum 1982; Hall 1986; Domowitz, Hubbard, and Petersen 1987). The model, which is described in detail in Appendix A, includes a household sector, a final output sector, and a business input sector.

   The household sector includes equations describing the household budget constraint and preferences for saving, consumption of services, and consumption of tangible goods. The household first chooses how much to save and the level of current consumption and then decides how to divide consumption between services and tangible goods. The model's parameters are calibrated so that the fraction of spending on services is 60% of total consumption spending, which is approximately equal to the proportion of untaxed personal consumption spending observed in the United States recently. This part of the model conforms to the life cycle hypothesis: Saving is chosen optimally to smooth consumption over the lifetime. Households use saved funds to purchase ownership titles to physical capital. Also, firms choose investment in physical capital optimally to maximize the present discounted value of owners' shares.

   The final output sector includes an equation describing firms' after-tax cash flows from purchasing inputs and producing and selling output. Given the wage rate and the price of business inputs, final output producers choose how much labor and business inputs to employ. The final output sector, the labor market, and the physical capital market are perfectly competitive.

   The business input sector includes an equation describing firms' after-tax cash flows. Input producers purchase physical capital from households and use the capital to manufacture business inputs. Since the business input sector is monopolistically competitive, input producers choose the price to charge for inputs, which are sold at a markup over marginal cost. Input producers also choose how much capital to employ.

   The efficiency of tax reforms can be affected by the openness of the economy. The U.S. states are small, open economies. A central feature of small, open economies is that posttax interest rates and posttax commodity prices are fixed by world markets, so economic policy in small economies cannot alter posttax returns or prices. The Ramsey model used here does not incorporate a separate set of equations for separate economies. Nevertheless, the model reflects the central economic features of open economies required to evaluate efficiency effects of reforms designed to reduce sales tax base erosion.

   To see this, assume the world economy is in equilibrium. Now suppose government in economy X increases its tax rate on capital income. Initially, X's posttax interest rate declines, causing capital to migrate to locations where the interest rate remains higher. In order to restore equilibrium, X's pretax interest rate must rise sufficiently to deliver the unchanged world posttax interest rate...