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Time to Expand the Sales Tax Base?

March 18, 2010 By Jeff Van Wychen, Fellow and Director of Tax Policy & Analysis

The topic of sales tax base expansion recently emerged at the State Capitol in the form of a bill introduced by Senator Tom Bakk, chair of the Senate Tax Committee.  Other sales tax proposals may emerge as state lawmakers grapple with the $1 billion state general fund deficit projected for the current biennium and the $7.8 billion deficit projected for the upcoming FY 2012-13 biennium.


Minnesota has a fairly high state sales tax rate but a narrow sales tax base relative to other states.  Senator Bakk's proposal, Senate File (SF) 2980, would expand the state's sales tax base to include clothing.  During the current biennium, the proposal would generate an estimated $258 million to help balance the state's general fund.  In the next biennium, the general state sales tax rate would be reduced by 0.25 percent (from 6.5 to 6.25).  Even after this rate reduction, expanding the base to clothing would still generate additional state revenue.  Beginning in FY 2012, SF 2980 would use this revenue to pay back the school property tax/aid payment shift that Governor Pawlenty implemented last July using his unallotment authority.

SF 2980 represents one possible combination of changes to the state's sales tax base and rates.  In addition to or as an alternative to expanding the sales tax to include clothing, the base could be expanded to include some or all services or any of a number of goods that are currently exempt; in addition, the sales tax rate could be adjusted so that a targeted amount of revenue is generated.

Using information from the 2010 Minnesota Tax Expenditure Budget (TEB), Minnesota 2020 has estimated the impact of various combinations of sales tax base expansions and rate reductions. 

The table below shows the estimated impact of these changes in fiscal year (FY) 2011, which begins on July 1, 2010. 
Download Table: FY 2011 Sales Tax Table (pdf)

Click here for technical notes regarding the information in this table.
(pdf)
The first column of each table shows the estimated revenue increase assuming that the state sales tax rate remains at 6.875 percent.  This 6.875 percent rate includes the general sales tax rate of 6.5 percent plus the 0.375 percent rate that is constitutionally dedicated to environmental and arts funding per the 2008 "legacy amendment." Throughout both tables, it is assumed that the state exercises its authority to reduce the dedicated sales tax rate so that all new revenue generated from base expansion goes to the state's general fund and not to the environmental and arts funds specified in the legacy amendment.

Subsequent columns show the estimated revenue change of reducing the rate to 6.375 percent, 5.875 percent, 5.375 percent, and 4.875 percent.  In many instances, the revenue gained from the base expansion is not sufficient to offset the revenue lost through the rate reduction, thereby producing a net loss of revenue.  Combinations of base expansions and rate reductions that produce a net loss of revenue appear in red in the tables.

For example, expanding the sales tax base to include consumer services (the second row) would generate an estimated $371.6 million in additional revenue in FY 2011 if the total state sales tax rate is left at 6.875 percent.  If the base is expanded to include consumer purchases and the rate is lowered to 6.375 percent, an estimated $39.2 million would be generated; if the rate was further lowered to 5.875 percent, the revenue increase resulting from the base expansion would be more than offset by the revenue loss due to the rate reduction, so the state would experience an estimated net revenue loss of $293.2 million.

With the exception of the amounts in the first column, it is not possible to sum the amounts from two or more rows to get a reliable estimate of the cumulative impact of multiple changes.  The bottom section of both tables shows the combined revenue estimate of multiple sales tax base changes.

Economists generally oppose special tax exemptions for particular goods and services on the grounds that they distort economic decisions and reduce market efficiency by creating artificial winners and losers; on this basis, most 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.

On the other hand, 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 excise tax.  In short, the expansion of the sales tax base to include all exempt items listed in the 2010 TEB is likely to be politically unattainable.

Increased dependence on sales tax revenue will likely make the overall state tax system more regressive, meaning that an increased share of the state taxes 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.  This and other pros and cons of sales tax base expansion were discussed in a previous Minnesota 2020 article.

Minnesota needs a balanced solution to the state's massive deficit problem that includes both spending reductions and revenue increases.  Sales tax base expansion should be among the alternatives that state policymakers consider when addressing the state's budget mess.
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