Definition: Consumption taxes on sales of products principally paid by end users but collected by sellers and forwarded to the government
Significance: Sales taxes are a burden to businesses in the sense that they must be collected by the retailer, whose cost of collection must be considered as a cost of doing business. However, collecting these taxes may be preferred by businesses to paying the higher income or property taxes that would be necessary in their absence.
Sales taxes are a form of consumption tax. They are used in forty-five of the fifty states within the United States: Only New Hampshire, Delaware, Montana, Oregon, and Alaska have no sales tax, and Hawaii’s sales tax is charged to businesses rather than directly to consumers. For the first 130 years of American history, state governments were small and relied on taxes on businesses or property for their revenue. The first state to use a sales tax was West Virginia in 1921. The number of states using a sales tax jumped during the Great Depression, and by 1940, some thirty states had a sales tax.
Consumption Taxes
Sales taxes are one of several kinds of consumption taxes used in the United States. Other consumption taxes are business or vendor taxes, luxury or consumer excise taxes, tariffs, and value added taxes. Business or vendor taxes are used in many states. They are sometimes regarded as business privilege taxes, but because they can be passed on to the consumer in most cases, they are in fact a form of sales tax. Luxury, consumer excise, or excise taxes are also used with some frequency, but total revenue gain from such taxes tends to be small. Tariffs, especially revenue tariffs as opposed to protective tariffs, were imposed throughout the nineteenth century by the federal government, but they have been substantially reduced or eliminated as the United States attempted to promote international free trade.
Value-added taxes (VATs) are a major source of government revenue in Western Europe, Mexico, and in certain other countries around the globe. In Western Europe, the value-added tax requires all businesses to remit taxes on their total sales, although they can recoup the amount of the value added tax that they pay to manufacturers and suppliers. This avoids cascading taxes and simplifies the government’s job because it does not have to determine which items are taxable. Refunding the amount of the value-added tax paid to manufacturers by the final seller creates a paperwork problem for businesses in European countries, but it is generally believed that this paperwork is less onerous than the federal corporate and individual income taxes paid in the United States.
Advantages and Disadvantages
Although all taxes have some negative impact on total economic activity, taxes are clearly necessary if the government is going to provide the safe environment that makes it possible for businesses to avoid theft and destruction. The sales tax is a fair tax in the sense that the percentage of the tax paid at the point of purchase is uniform. A sales tax is difficult to avoid, is easy to calculate, and therefore has a high compliance rate. In the United States, the tax is paid only by the final purchaser, which avoids any cascading that might occur if the tax were imposed at several stages in the process of manufacture and sale. Because businessmen collect the tax and forward it to the state, it is highly attractive to state governments. State legislatures can exempt some industries from the application of the sales tax. Such exemptions are very widespread among the forty-five states that impose a sales tax, although granting exemptions makes the tax less fair.
State Sales Tax Rates as of January 1, 2008
Source: Data from Federation of Tax Administrators
Note: Tax rates for California and Virginia include a 1% statewide local tax. Scheduled changes for 2008 included increases in the state tax to 6% for Maryland and to 4.5% for North Carolina, and a decrease in the food tax rate to 3% for West Virginia. Food sales are subject to local sales taxes in Arkansas, Georgia, Louisiana, North Carolina, and Utah.
One of the most important advantages of the sales tax is that it encourages saving rather than spending. While encouraging spending is important for the consumer part of the economy, most economists recognize that the United States has the lowest savings rates in the world. Therefore, the sales tax can be said to have a beneficial impact on the total economic strength of the nation, even if it limits consumer purchases that are important to some businesses.
The advantages and disadvantages of sales taxes need to be compared with those of income and property taxes, which are the chief alternatives to consumption taxes. Many economists favor income taxes, because income is required for any money to be available to pay the tax. Because an income tax can be proportional or progressive (with higher rates for higher incomes), an income tax can be viewed as the fairest tax. However, the process of calculating income is far more difficult than determining a sales price, and evasion is a very significant problem. Property taxes are problematic in that owning property, whether real or personal, is not the same as having cash. When property taxes are used to generate revenue, most local governments make exceptions for elderly, low-income property owners, who might be forced to sell their homes if they lack the money to pay the taxes. A number of economists also object to property taxes as taxes on accumulated wealth. In general, the federal government gains most of its revenue from income tax, states gain most of their revenue from sales taxes, and local governments receive most of their revenue from property taxes. When the system is viewed as a whole, it appears that the United States generally seeks a moderate outcome by using all three forms of taxes.
This chief objection to sales taxes is that they are regressive in their effect on low-income people because they are not proportional to income. High income people can avoid paying sales taxes by simply curtailing their purchases—something low-income people cannot do—and therefore low-income people end up spending a higher percentage of their income on sales tax. Two qualifications to the regressive nature of sales taxes need to be recognized. First, some of the savings made by high-income people may ultimately be used to purchase goods that are subject to the sales tax. This has the effect of making the sales tax less regressive. Second, if the percentage of the tax is applied to the tax base (that is, purchased goods), then the sales tax is proportional, not regressive.
Impact
As a percentage of purchases, sales tax rates are not extremely high in the United States. In 2008, the highest state-based sales tax was in Tennessee, which has a 5.5 percent sales tax on groceries and a 7 percent tax on other items. Tennessee counties are allowed to add increments of 0.25 percent sales tax above the state levy up to a maximum of 2.75 percent total. Although the 9.25 percent sales tax in force across most of Tennessee is the highest state based sales tax, it is important to remember that Tennessee has no income tax. As of 2008, the highest sales tax paid in any jurisdiction in the United States was in Chicago, where the consumer must pay 10.25 percent when the state, county, and city sales taxes are combined, and the second highest sales tax was in Baton Rouge, Louisiana, where a 5 percent local rate is piggybacked on top of a 4 percent state rate. For purposes of comparison, it is useful to note that in a number of Western European countries and the value-added tax can be as high as 25 percent.
Generally speaking, the greatest burden on most businesses comes in the form of the requirement that they collect sales taxes, maintain careful records of the taxes collected, and forward them to the state. High-income individuals who own businesses are genuinely willing to pay for this expense because they believe they are paying less tax than they would if income taxes were used in place of sales. However, when sales tax rates differ between neighboring states, businesses in the state with higher rates lose an undetermined amount of sales to businesses in the neighboring state, particularly if the variation in tax rates is significant.
Richard L. Wilson
Further Reading
Baiman, Ron, Heather Boushey, and Dawn Saunders. Political Economy and Contemporary Capitalism: Radical Perspectives on Economic Theory and Policy. Armonk, N.Y.: M. E. Sharpe, 2000. This collection of essays examines economics and tax policy from a perspective sympathetic to socialism.
Brunori, David. State Tax Policy: A Political Perspective. 2d ed. Washington, D.C.: Urban Institute Press, 2005. Discusses state tax policies and includes a chapter on sales and use taxes.
Dow, Louis A., and Fred Hendon. Economics and Society. Englewood Cliffs, N.J.: Prentice Hall, 1991. These coauthors are strongly influenced by the free-market economics of Adam Smith and examine economics in a societal context.
Kurian, George T., ed. A Historical Guide to the U.S. Government. New York: Oxford University Press, 1998. A very useful guide to understanding the three branches of the federal government and the bureaucracy in a historical context.
Willis, James. Explorations in Macroeconomics. 5th ed. Redding, Calif.: North West, 2002. This mainstream text examines taxation from a macroeconomic perspective, explaining the impact of taxation on society.
See also: corporate income tax; personal income tax; Internal Revenue Code; Retail trade industry; Whiskey tax of 1791.
Whiskey tax of 1791
Supply-side economics
Internal Revenue Code
Personal income tax
Bush tax cuts of 2001