Abstract

1. IntroductionState and local tax policymakers face a large number of particularly severe public finance conundrums.1 One pressing long-run issue is the slow but steady erosion of state and local general sales and use tax bases.2 With a few well-known exceptions, sales taxes are levied primarily on tangible goods.3 Most services are untaxed, and services have grown as a share of consumption spending.4 Thus, sales tax bases have declined as shares of total spending.5 At the same time, legislators have increased tax rates.6 Since consumers tend to substitute away from products whose relative prices have risen, higher tax rates tend to exacerbate the problem they are intended to address.A number of reforms designed to reduce base erosion have been proposed. These include broadening tax bases, transforming sales taxes to a consumption base, and wholesale replacement of sales taxes with income taxes. Each proposal has some potential to shore up sales tax bases; thus, from an economic perspective, the policy choice should turn on efficiency, equity, and simplicity effects. Very little quantitative information on the efficiency effects of such proposals is available. This paper uses computer simulations to examine the efficiency effects of reforms designed to reduce sales tax base erosion.7Trends underlying tax base erosion appear to be structural and likely to continue. Baumol (1967) argues there is a structural tendency for manufacturing productivity growth to exceed productivity growth in services, so relative prices of manufactured goods tend to decline.8 If demands for both goods and for services are inelastic, the services sector will tend to absorb ever-larger fractions of resources and increase in proportion to total value added. Recent evidence indicates that both taxed commodities (mostly tangible goods) and untaxed commodities (mostly services) are price inelastic (Russo and Wei 2004). Everything else held constant, therefore, the relative price decline in manufactured goods tends to reduce their share in total spending, supporting a continued shift toward services.9 Since older consumers spend relatively large fractions of income on untaxed medical services, aging of the population also could contribute to sales tax base erosion. As a result of the Interstate Commerce Clause, remote vendors often do not collect states' general sales taxes. If Internet sales continue to grow rapidly relative to total purchases, e-commerce could exacerbate the problem.10 This possibility gains support from Goolsbee's empirical work. His results indicate relatively large tax elasticities for Internet sales (Goolsbee 2000a). To make matters worse, tax sensitivity appears to increase over time (Goolsbee 2000b).Structural sales tax reform appears unavoidable. One possibility is to broaden the sales tax to more services. A variation on this theme would transform the sales tax to a true consumption tax. A third approach is to replace sales tax revenue with income taxes (Varian 2000).11 The first and second approaches attempt to shore up the sales tax base so that it adjusts automatically to shifts in the composition of spending and in the location of purchases. The third approach reduces erosion by switching the tax base to one that appears less vulnerable to shifting consumption patterns. Each approach has features that could improve efficiency and features that could reduce it. Efficiency improvements could result from base broadening, which would result in lower tax rates (revenue held constant), and reducing existing distortions due to disparate tax treatment of goods versus services and brick-and-mortar versus remote sales.However, taxing more services could reduce efficiency because firms spend substantial amounts on services (Fox and Murray 1988; Due and Mikesell 1994). …

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