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Time to Reconsider Sales Tax Change?

October 14, 2008 By Jeff Van Wychen, Fellow and Director of Tax Policy & Analysis

Part 4 of 4 (read part 3)

During the 2001 legislative session, Governor Jesse Ventura proposed a bold initiative: replace the general education property tax with state dollars generated by expanding the state's sales tax base to include services.  The net result would be a significant reduction in local property taxes and a significant increase in sales tax revenue.

The legislature-spearheaded by the House of Representatives-jumped at the opportunity to reduce property taxes, but balked at the notion of expanding the sales tax base.  The net result was a large increase in state aid to school districts which led to a large (albeit temporary) reduction in school property taxes; however, without a sufficiently large increase in state revenue to pay for the new state spending obligations in future years, the state's budget situation became increasingly untenable over time.

This forced the legislature to adopt new measures to address looming budget deficits.  In 2002, the legislature opted to ignore inflation in state expenditure forecasts.  In a feat of fiscal skullduggery that would make the accountants at Enron blush, the legislature chose to count growth in state revenues resulting from inflation, but ignore the impact of inflation on state expenditures.  This created the short-term illusion of a long-term balanced budget.

After 2002, the state raided various other funds to fill the hole in the state general fund.  For example, dollars from the state tobacco settlement that had been dedicated to health-related areas were diverted to the state general fund.  However, the use of one-time dollars to address a permanent gap between state revenues and expenditures achieved only a temporary resolution to the state's budget problems.

Other actions to address the ongoing deficit problems were large cuts in aid to Minnesota counties, cities, and school districts.  In fact, a significant portion of general education funding, which the state took over in 2001, has been shifted back on to local property taxes.  Through aid cuts and the shifting of funding responsibilities to local governments, the state found a back door way to address its budget problems through property tax increases.

Are Minnesotans content with the specter of ever-increasing property taxes, as the state deals with its budget problems by cutting aid to schools and other local governments?  If not, it is time to reconsider the approach suggested by Governor Ventura back in 2001: increase state revenues by expanding the sales tax base.  Two items that are primary candidates for inclusion in the sales tax base are services and clothing.  Both items are currently exempted.

As noted in the first installment in this series, Minnesota has a high sales tax rate but a relatively narrow sales tax base (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.

The graph below shows the estimated revenue that could be generated in the FY 2010-11 biennium under five different scenarios based on information presented in the second article in this series.  The revenue generated is shown relative to the projected state shortfall for the FY 2010-11 biennium, indicated by the dashed red line.  For example, increasing the sales tax base to include services and lowering the sales tax rate to 5.0 percent would generate an estimated $1.691 billion, which would go a long way toward closing the projected $2.1 billion shortfall.

These estimates are based on projections prepared before the current financial turmoil now gripping Minnesota and the nation.  New projections should be available before the start of the 2009 legislative session.

Expanding the state's sales tax base has potential advantages and disadvantages, described in part three of this series.  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.

On the downside, 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.

In light of the current economic crisis, projections of Minnesota's revenue shortfall for the upcoming biennium are likely to get worse before they get better.  Is expansion of Minnesota's sales tax base a politically and economically viable solution to the state's fiscal woes?  The answer is not yet clear, but at a minimum the subject of base expansion merits serious consideration from state policymakers.
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