2023 Sales Tax Trends: Three Policymaking Focal Points

Despite the many changes to U.S. sales and use tax rate changes last year, tax leaders should prepare with more tax policy making volatility looming on the horizon. Economic conditions tend to play a foundational role in driving fiscal policy shifts and drive regulatory tax adjustments to keep up with state budget outflows and expenditures.

While slowing down, primary data continues to indicate that the U.S. economy remains strong and precarious. Regardless of when the next recession arrives – whether moderate or not – state, city and local tax authorities will eventually make fiscal and budgetary corrections in reaction to current and developing conditions. This means that tax leaders and executives should keep their eyes on indirect tax policy trends, as well as nexus changes and digital taxation developments. These trends can signal the direction of certain tax rates or base-broadening moves as well as the substantial litigation that will influence future tax policy making.

States implement sales tax rates and base rules changes that are grounded on the overall health of their local economies and budget requirements. While most states’ economic health generally has been robust since the brief COVID-triggered recession in 2020, it appears likely to change in 2023. 

Until recently, states have been flushed with much “stimulus and recovery” cash, but shortfalls are now being forecasted and in some states it is already being felt. While concurrently, some states are reducing tax rates or eliminating categories entirely. Research from the National Association of State Budget Officers and Pew Research shows that annual state tax revenue growth will decrease substantially in 2023 as temporary factors (e.g., funding from the 2021 American Rescue Plan) that bolstered growth fade. Since higher interest rates translate to higher debt-servicing costs, many state and sub-state jurisdictions will need to pull other levers – namely, sales tax rate increases -- to satisfy revenue needs amid higher prices and labor costs.

To get a read on possible 2023 tax policymaking actions, tax leaders should monitor:

1. Inflation: On March 14, 2023, inflation dropped to 6.0%. However, in January 2023, inflation had reached a 6.5% increase over the past 12 months. While this was the smallest 12-month increase since the period ending in October 2021, inflation nonetheless remains high and unlikely to return to pre-2021 levels any time soon. Inflation has provided some benefits to states and sub-state governments (e.g., inflated prices translate to more sales tax revenues) it also presents challenges (e.g., higher energy prices). Aside from the consumer and corporate taxpayers, inflation is also an embedded “tax” upon governments, and the cost of public services.  
2. A recession: The probability of a global recession occurring this year remains high, according to the National Association for Business Economics (NABE). While most states currently are well-positioned to contend with a milder recession, several wildcards – including the recession’s depth and duration – could negatively impact their ability to do so. 
3. State budgets: New concerns about long-term costs are emerging in some states. In September, California Governor Gavin Newsom vetoed a bill that would have replaced a partial manufacturing sales tax exemption in that state with a full exemption. While noting that the full exemption would have resulted in “substantial revenue loss to local governments, which impacts essential health, safety, welfare, and transportation services,” Newsom estimated that local agencies would have lost more than $500 million a year. In Kentucky, a broad sales tax expansion to help fund a reduction in the state’s individual income tax rate took effect Jan. 1.

In some states the shrinking sales tax base also qualifies as a challenge to state and local governments – and therefore another driver of future tax policy changes. Consequently, as states and regions readjust to economic conditions, we can expect continuing tax policy corrections, mainly related to the ongoing volatility and developing economic events.