Income Tax Reductions Affect Sales Tax Rates and Rules

The Wall Street Journal recently reported some good news for taxpayers – “or at least some of you,” according to the publication’s editorial writers. This “partial” good news relates to the fact that a growing number of U.S. states have reduced their income tax rates in recent years. While that’s certainly a positive trend, there’s more to the story – and it involves sales tax rates and rules. 

In its opinion piece, the Journal’s editorial board correctly points out that more states have lowered their individual state income tax rates. This shift is largely due to unexpected state surpluses, driven by a combination of post-pandemic consumer spending, a rising stock market and federal aid.  
 
While relief is being provided on the income tax side, Vertex research shows that sales and use tax rates have steadily risen during the past 30 years, with no end in sight. Our January 2023 Rates and Rules Report (which I discuss here) shows that the combined average sales tax rate –state, county, city, and district sales tax rates – has reached a 10-year high of 10.18%. 

So, what’s going on? Recent data suggests that state policy makers are making a shift to taxing consumption rather than income and capital. There are several reasons for this:

1. In economic downturns, sales tax collections tend to fall faster but recover sooner relative to income and property tax revenues. (This means that the “fall and recovery” curve is more V-shaped for sales tax, and more U-shaped for income and property taxes).
2. From an administrative perspective, sales taxes are collected and remitted monthly and “at the source of the sale.” This helps make the cash flow a genuine (and timely) benefit to state and local governments.
3. Sales tax compliance also tends to be high among sellers because the penalties for non-collection and remittance are onerous. As a result, tax jurisdictions typically can count on collecting a higher portion of sales taxes compared to other types of taxes (e.g., property taxes) with higher non-compliance rates. 

 
While this makes sales tax rate increases and other rules changes an attractive source of revenue for state and local governments, there are clouds on the horizon. One of the biggest sales tax challenges confronting policymakers is the fact that the tax base continues to narrow thanks primarily to the growing number of tax exemptions. Policymakers are unlikely to walk back exemptions due to the backlash associated with doing so. Instead, they are more likely to set their sights on new revenue sources, such as professional, personal services and the digital economy.  

Granularity, which refers to the number of rates applied to a single transaction, also represents a challenge – for taxpayers. Three to five different sales tax rates are typically applied to a single transaction, which causes complexity from a tax calculation and compliance perspective. A growing number of green fees (such as bags, tires and electrical equipment) are applied in addition to the sales tax, which drives additional complexity. 

Long-story short: income tax reductions are good news. Sales tax base-narrowing and sales tax complexity are not-so-good, especially as budget surpluses start to shrink. That’s when state and local governments will view higher sales tax rates and expanding the tax base as a convenient way to raise revenue.

For more information on the standard sales tax rate changes, as well as notable trends and statistics, click here.