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Sales Tax Base Expansion Revisited

April 03, 2009 By Jeff Van Wychen, Fellow and Director of Tax Policy & Analysis

In October 2008, Minnesota 2020 ran a four part series that explored the option of expanding the state sales tax base. Since that time, the state's projected structural budget deficit has mushroomed from a formidable $2.1 billion to a whopping $6.4 billion (excluding one-time federal recovery dollars). In light of the soaring state deficit, the search for new revenue options-including possible sales tax base expansion-has taken on even greater urgency.

As noted in part 1 of the October series on sales tax base expansion, Minnesota has a high state sales tax rate but a narrow sales tax base relative to other states.  (In addition to a narrow sales tax base, Minnesota has relatively few local sales taxes.)  The state could generate significant new revenue by expanding the sales tax base.  In fact, if the base expansion is broad enough, additional state revenue could be generated even if the overall sales tax rate is lowered.

However, the same forces that have driven the projected state budget deficit upward have also caused the projected revenue generated by extending the state's sales tax to currently untaxed goods and services to fall.  The table below updates the revenue projections for the FY 2010-11 biennium that appeared last October based on data from the 2008 Minnesota Tax Expenditure Budget (TEB) adjusted for the economic deterioration that has occurred since the release of the 2008 TEB.

Because the option of expanding the state sales tax base is often accompanied by a discussion of lowering the sales tax rate, the table shows the projected net revenue impact of various base expansions at various sales tax rate levels.  Numbers in red indicate that the specific combination of base expansion and rate reduction will lead to a projected loss in state tax revenue.
View Table Online

For more information on the data and assumptions used in this table, click here. 

The table shows the impact of ending many different types of sales tax exemptions, including some exemptions that are popular and strongly defensible.  Inclusion of an exemption in the table does not imply support for repealing the exemption.

Economists generally oppose special tax exemptions for particular goods and services on the grounds that they distort economic decisions by creating artificial winners and losers; on this basis, economists would favor a broadening of the sales tax base, all other things being equal.  In addition, expanding the sales tax base to services would likely contribute to more robust growth in sales tax revenues in the future, as an increasing share of consumption shifts from goods to services.

The complete elimination of all sales tax exemptions for all goods and services listed in the 2008 TEB would generate an estimated $8.5 billion in the FY 2010-11 biennium, considerably less than what was projected back in October but still more than enough to eliminate the projected structural budget deficit.  Even if the sales tax rate were lowered to 5.5 percent, expanding the sales tax base to include all items listed in the 2008 TEB would generate an estimated net revenue increase of $6.0 billion, which would come close to eliminating the $6.4 billion deficit.

However, the complete elimination of all sales tax exemptions is unlikely.  Many of the current sales tax exemptions-such as the exemptions for food and prescription drugs-are both popular and sensible.  For other items-like gasoline-the imposition of a sales tax would be problematic since Minnesota already has a separate fuel tax.  In short, the expansion of the sales tax base to include all exempt items listed in the 2008 TEB is likely to be politically unattainable.

On the other hand, the table shows that there are some sales tax base expansion alternatives short of the complete elimination of all exemptions that will generate significant new revenue for the state.  For example, expanding the state sales tax to include 16 services listed in the 2008 TEB combined with a reduction in the state sales tax rate from 6.5 percent to 5.0 percent would generate an estimated $2.4 billion in the FY 2010-11 biennium-enough to eliminate over a third of the projected structural deficit.

However, as noted in part 3 of last October's sales tax series, expanding the state's sales tax base has potential disadvantages.  Increased dependence on sales tax revenue will likely make the overall state tax system more regressive, meaning an increased share of the state's tax burden would shift to low and moderate income households and away from high income households.  Given the growth in Minnesota's tax regressivity during the current decade, this is a very serious concern.  However, targeted tax credits could be used to offset or eliminate the regressivity increase.

In addition, the growth of internet sales threatens to erode sales tax revenues in the future.  In an attempt to halt this trend, Minnesota and eighteen other states have enacted the Streamlined Sales and Use Tax Agreement (SSUTA).  Only time will tell if the SSUTA will be successful in halting the erosion in the sales tax base resulting from internet sales.

The elimination of tax exemptions that benefit some taxpayers at the expense of others has been a focus of Representative Ann Lenczewski, chair of the House Tax Committee.  Whether broadening the state's sales tax base through the elimination of specific sales tax exemptions will be part of the solution to Minnesota's current budget problem has yet to be determined.  However, it is an option that deserves consideration.

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