Sales Tax Rules and Rates Update Part 2: Inflation and a Narrowing Base Pose Limits

As indirect tax leaders consider how substate jurisdictions are increasing rates and instituting new sales taxes, they should recognize several long-term dynamics that hint at what is in store for sale tax rules and rates in the years to come. 

Three trends, in particular, suggest that tax authorities are increasingly likely to make more dramatic sales tax changes moving forward. These factors include:

• Inflation and rising interest rates: While a fair number of states and substate jurisdictions remain flush with budgets that were massively, but only temporarily, boosted through federal COVID-relief programs, some imposing risks raise questions about how long these surpluses will endure. Rising prices and wages means it costs more to operate public sector organizations. Rising interest rates – which are all but assured to continue jumping higher following a robust June jobs report – mean that debt-servicing costs will continue to increase. Governments can either cut costs or raise revenue to address those challenges. Yet many, if not most, governments have little wiggle room to reduce services further. Plus, sales tax revenues will decline if consumers reduce spending in response to higher prices or a recession. 
• The sales tax base continues to narrow. In large part, sales tax rates continue to rise because the tax base continues to shrink. A significant increase in the use of sales tax exemptions represents a primary cause of this narrowing. Research from the Tax Foundation shows that sales tax breadth has declined from a mean of 98 percent in 2000 to 29.52 percent today, “reflecting continued erosion that has largely been offset by an increase in the mean state rate from 5.16 to 6.00 percent over the period.” A report on the research asserts: “Despite the importance of sales taxes to state coffers, and notwithstanding the economic arguments for reliance on a broad-based, low-rate sales tax regime…state sales tax bases are narrowing, forcing states to either raise rates or shift to other sources of tax revenue in response to this continuous erosion.” More states are considering reducing or eliminating income taxes with a broad sales tax. While some of these legislative attempts have failed, more are certainly on the way. Should they succeed, it would make sales tax an even more significant source of revenue.  
• The need for revenue at the state and local level: Consumers in our consumer-driven economy spend the most money each year on housing, healthcare, food, and energy. Setting aside property taxes, only one of those spending categories is subject to taxes. There is growing concern about our current federal and state tax systems’ ability to address the longer-term challenges associated with escalating levels of federal debt, unfunded liabilities for health care and social security (which will intensify as our population ages), and substantial deferred infrastructure investments. “After the pandemic, federal and state tax systems in the United States will face a critical test,” according to an eye-opening (and lengthy) report from the State Tax Research Institute. “And based on the current overreliance on income, social insurance (payroll), property taxes, and under-reliance on consumption taxes, the overall U.S. tax system is not up to the challenge. The United States has no broad-based consumption tax at the national level, and by international standards, only outdated, structurally flawed state and local retail sales tax systems at the subnational level.”

Yes, that’s a lot to chew on. What indirect tax teams should take away from these analyses (which I’m seeing more frequently these days) is not that we’re necessarily headed for a federal value-added tax (VAT) but continued changes in the sales and use tax at state and local levels. We’ll keep you posted as small, large, and systemic changes reshape our “new normal” throughout the rest of the year and into the future.