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Running the Numbers on a Sales Tax Change

October 10, 2008 By Jeff Van Wychen, Fellow and Director of Tax Policy & Analysis

Part 2 of 4 (read part 1)

In the first part of this series, Minnesota 2020 examined the sales tax base in Minnesota.  While Minnesota's state sales tax rate is higher than in most other states, the base of goods and services to which the sales tax is applied is narrower.  Minnesota exempts food, clothing, and prescription and non-prescription drugs, as well as nearly all services.

In light of the anticipated $2.1 billion revenue shortfall, expanding of the state's sales tax base should be examined.  Expanding the sales tax base could generate more revenue for the state even if the overall rate is lowered.

Tax Base Expansion Table
The table below shows the estimated state revenue impact resulting from a sales tax base expansion.  Specifically, the table shows the revenue impact from eliminating various sales tax exemptions for the upcoming state budget cycle, fiscal years (FY) 2010 and 2011.  In addition to showing the revenue impact assuming no reduction in the general state sales tax rate (currently 6.5 percent), the table also shows the impact of ending exemptions at the same time that the sales tax rate is reduced to 6.0 percent, 5.5 percent, 5.0 percent, and 4.5 percent.  In some instances, the base expansion will not be sufficient to offset the impact of the rate reduction; in these instances a negative amount (in red) indicating a net revenue reduction will be shown.

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

The table shows the impact of ending many different types of sales tax exemptions, including some exemptions that are popular and strongly defensible.  For example, no one has proposed eliminating the sales tax exemption for food. Food is a necessity and including it in the tax base would increase the sales tax's regressivity.  Nonetheless, in the interest of comprehensiveness the impact of ending the sales tax exemption for food is shown in the table.  Inclusion of an exemption in the table does not imply support for repealing the exemption.

Revenue From Base Expansion
The complete elimination of all sales tax exemptions for all goods and services listed in the tax expenditure budget would generate an estimated $10.6 billion in the FY 2010-11 biennium, more than doubling state sales tax collections.  Even if the sales tax rate were lowered to 4.5 percent, the base expansion would generate an estimated net revenue increase of $4.4 billion, roughly double the amount needed to close the anticipated budget shortfall for the FY 2010-11 biennium.

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 exemptions listed in the tax expenditure budget is likely to be politically unattainable.

A more modest expansion of the sales tax base-for example, including clothing-would generate an estimated $809 million.  This would eliminate approximately 40 percent of the state revenue shortfall.  However, it would not be sufficient to allow for much of a reduction in the state sales tax rate.  For example, if the sales tax base was extended to include clothing and the tax rate was lowered to 6 percent, only $15 million in additional revenue would be generated, less than one percent of the projected shortfall.

To expand the sales tax base and reduce the sales tax rate in a manner that would make a significant contribution to resolving the state revenue shortfall, the state will need to consider to (1) expanding the sales tax base to include goods other than just clothing and/or (2) expand the base to include services.

Expanding the sales tax base to include the "selected services" listed in the tax expenditure budget and lowering the tax rate to 5.0 percent would generate an estimated $1.691 billion in new revenue, which would be sufficient to fill the vast majority of the anticipated shortfall.  If the base was expanded to include both services and clothing and the rate was lower to 5.0 percent, the additional revenue generated would be somewhat greater than the anticipated shortfall.

Expanding the sales tax base merits debate. From a policy perspective, there are various pros and cons to expanding the sales tax base.  These will be explored in the next installment of this series.

Click here to read part three.
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