Why States' Increasing Reliance on Sales Taxes Is Risky

The temptation to cut income taxes and raise sales taxes could leave some states less prepared for an economic downturn than they were for the Great Recession.
by | September 22, 2015

Recessions are scary for governments. But what can be scarier, as far as some fiscal policy analysts are concerned, is what governments do when the revenues start coming back.

In the case of the most recent recession, tax reform has been a hot topic in legislatures -- but that has the Urban Institute’s Kim Rueben worried. She supports simplifying the tax code, but too often, she said at a recent event hosted by the institute, “tax reform is also used as a synonym for tax cuts. And that’s a problem.”

As states have recovered from the recession, seven cut individual income taxes (and increased sales taxes). Others, on the other hand, increased their sales tax after income tax cuts resulted in too little revenue.

This trend has resulted in a heavier reliance on the sales tax than ever before for some states, according to a new report by the institute. The sales tax is less volatile than the income tax, which means it can be easier to forecast accurately from year to year. But it’s regressive, meaning it hurts lower-income earners a lot more than it impacts rich people. And as the economy moves toward technology and services (things that are difficult to tax), the sales tax base is capturing an increasingly smaller piece of what consumers are actually spending. Finally, sales tax revenue as a whole is growing slower than personal income.

Conservative and liberal fiscal policy analysts agree that broadening the sales tax base is a reasonable solution to the tax problem. But while it’s possible to sell voters on a small tax increase on things that are already taxed, it’s proven formidable to extend the sales tax to new categories.

“This is the politics of tax -- and ‘tax’ is a four-letter word,” said David Quam, deputy director of the National Governors Association, at last week’s event.

For the past few decades, attempts at any sweeping changes to broaden the sales tax base have failed or been pared down significantly.

Most recently, the Maine legislature dismantled Gov. Paul LePage’s bill to cut the state’s income tax, raise the sales tax and expand it to services like amusement and historic parks, dating services, and legal and financial services. The final bill kept some of the income tax cuts and raised some existing sales and tourism-related taxes but didn't tax any new services.

To significantly change tax policy, said Quam, “somebody’s ox is going to have to be gored. That is politics; that is the art of change; and that is why it’s hard to do this. And,” he added, “it’s why you see these incremental changes.”

The biggest problem with this shift, according to the Urban Institute report, is that the anemic growth on states’ revenue side of the ledger is countered with rising costs on the expenditure side. In other words, revenues won’t keep up with state spending. This is true despite the fact that every state has also cut expenditure growth to below historic levels.

But though the economy has recovered, the report’s authors warn that does not mean that state finances are what they were before the 2008 recession. Instead, there seems to be an “unwillingness to acknowledge the dilemma,” which is leading to the alarming number of budget showdowns last year and this year.

The trends mean that some states are going to have even more trouble handling a downturn than they had seven years ago.

“States get into trouble not because of what they’re doing in the downturns,” said Rueben, “but because of what they did beforehand.”