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Contemplating a Fair, Equitable Tax Base

October 09, 2009 By Jeff Van Wychen, Fellow and Director of Tax Policy & Analysis

Part 1 of 4

From the FY 2002-03 budget cycle through the current FY 2008-09 biennium, real per capita state general fund total resources are projected to fall by seven percent and by another four percent the following biennium.  At the same time that resources are falling, state leaders have shifted huge new funding obligations-such as general education-into the state general fund.  These factors, combined with a floundering economy, have led to an anticipated $2.1 billion shortfall* in the state general fund for the next biennium.

Options for confronting this shortfall are limited.  Real per capita state general fund spending has declined sharply since FY 2003.  After adjusting for inflation, state aid to Minnesota counties, cities, and school districts has been slashed.  On the revenue side of the equation, Governor Pawlenty has repeatedly ruled out income tax increases.

One option for addressing the state budget deficit is to expand the list of goods and services subject to the state sales tax.  Currently the State of Minnesota taxes most goods except for food, drugs, and clothing, but very few services.

State Sales Tax Bases in Minnesota & Other states

According to the Federation of Tax Administrators (FTA), five states have no general state sales tax: Alaska, Delaware, Montana, New Hampshire, and Oregon.  However, some of these five states do allow local sales taxes.

The table available here (PDF) lists state sales tax rates and the goods that are exempt from the sales tax in the 45 states which have a general state sales tax.  Information in this table was gleaned from the FTA and from various on-line sources, including the budget websites of various states.

Minnesota's 6.5 percent general sales tax rate places it among the top seven states in the nation in terms of sales tax rates.  (However, this analysis excludes local sales taxes, which tend to be low in Minnesota relative to most other states.)  While Minnesota has a high statewide sales tax rate, it has a relatively narrow sales tax base; Minnesota is one of only four states with a general state sales tax that exempts food, clothing, and both prescription and non-prescription drugs.

According to the FTA, only a handful of states impose a sales tax on a broad array of services.  Hawaii and New Mexico lead the nation in having "broad-based sales taxes that include almost all services," followed by South Dakota and West Virginia.  Other states that tax a large number of services include Arkansas, Connecticut, Iowa, Kansas, Mississippi, Nebraska, Texas, and Wisconsin.  (In addition, Delaware and Washington tax a large number of services through their business gross receipts tax.)

Minnesota taxes only a limited number of services specifically enumerated in state statute.  These include:

  • Admission to amusement and recreational events
  • Lodging (excluding rents for a continuous period of more than 30 days)
  • Non-residential parking
  • Membership in organizations that provide to members exclusive access to athletic facilities
  • Laundry and drycleaning
  • Motor vehicle washing, waxing, and cleaning
  • Building cleaning, maintenance, and exterminating
  • Rustproofing, undercoating, and towing of motor vehicles
  • Detective, security, and armored car services
  • Pet grooming
  • Lodging and care of animals
  • Lawn, garden, tree, and indoor plant care
  • Massages, except when deemed medically necessary

The vast majority of services in Minnesota are not subject to the sales tax.  Given the significant number of states that tax a broad array of services, expanding Minnesota's sales tax base to include services would not be setting a national precedent.

Personal Consumption Shifting from Goods to Services
 A sales tax base that consists almost exclusively of goods will tend to erode over time as an increasing share of personal consumption spending shifts from goods to services.  The table below shows the distribution of U.S. personal consumption expenditures between goods and services over the last forty years based on data from the

U.S. Bureau of Economic Analysis.

 

[This table is no longer available - we apologize for the inconvenience]

In 1967, goods comprised 57 percent of personal consumption spending, while services comprised 43 percent.  By 2007, this position had been reversed, with goods comprising just 40 percent of personal consumption and services comprising 60 percent.

Information from the nonpartisan Minnesota House of Representatives Research Department indicates that a similar shift in personal consumption away from goods and toward services has occurred in Minnesota.  In 1967, the year that Minnesota enacted its sales tax, services comprised 40 percent of Minnesota personal consumption spending; more recently, the situation has been reversed, with services comprising approximately 60 percent of personal consumption.

According to the Minnesota Department of Revenue's 2007 Tax Incidence Study, 43.8 percent of the sales taxes in Minnesota are paid by businesses instead of individuals.  However, even business sales have shifted more toward services over time.  Based on BEA data, goods and services contributed equally to U.S. gross domestic product (GDP) in 1967; by 2007, the contribution of services to U.S. GDP was nearly double that of goods.  There is no reason to believe that the direction of the trend in Minnesota is different.

As the purchase of goods continues to shrink as an overall percentage of the state's economy, the revenue generated from a sales tax based almost exclusively on goods will continue to erode.  Information from the Department of Finance and Employee Relations demonstrates that from fiscal year 2006 to 2008, state general sales tax collections increased by 2.5 percent, less than half the rate of inflation.

While Minnesota has a relatively high sales tax rate, it has a relatively narrow sales tax base.  The state could generate additional public revenue by expanding its sales tax base to include goods and services that are currently exempted.  In fact, if the sales tax base expansion is sufficiently broad, new revenue for the state could be generated even if the sales tax rate is lowered.

Part two of this series will quantify the net change in state revenue that will occur as a result of expanding the state sales tax base and lowering the sales tax rate.

Click here to read part two.

 



* The estimate of a $2.1 billion revenue shortfall for the FY 2010-11 biennium is based on projections from the May 2008 end-of-session general fund fund balance analysis (prepared by the Minnesota Department of Finance and Employee Relations) adjusted for inflation in state government purchases.  These projections do not take into account recent changes in state revenue collections or the impact of the ongoing economic crisis.


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