Broadening the Base: How Recent Sales Tax Reforms Affect State Revenues

• In Event: Tax Policy Design: Exemptions, Subsidies, and Revenue Effects

Abstract

Sales taxes have a century-long history in the United States and remain one of the two major sources of state tax revenue. The composition of personal consumption, however, has changed dramatically since sales taxes were first established in the 1930s: services accounted for slightly more than a third of consumption at that time but now represent more than two-thirds. Yet many states continued to tax goods while exempting both final consumption and business-to-business services. As a result, tax bases have narrowed over time and average tax rates have increased considerably. A recent wave of modernization efforts has focused on base expansion, with many states beginning to remove existing exemptions. Approaches vary widely, however. Some states have broadened their bases radically, simultaneously adding dozens of final consumption and intermediate services, including digital services. Others have taken a more cautious approach, adding only a few services at a time, mostly on the final consumption side. The intensity of these reforms and their revenue implications may therefore differ considerably across states.
In this paper, we address two related questions: (1) how broadening the sales tax base affects the revenue-generating potential of sales taxes and their volatility, and (2) whether the type of reform matters — specifically, whether expanding to intermediate versus final consumption services, or to digital versus non-digital services, produces different outcomes from a revenue adequacy and stability perspective.
To answer these questions, we use a novel hand-collected dataset tracking the evolution of sales tax bases across all U.S. states over the past decade. Our starting point is the 2007 and 2017 Federation of Tax Administrators (FTA) Survey of Services Taxation and its detailed classification of taxable and nontaxable services. We supplement this with data from the National Association of State Budget Officers (NASBO) and the National Conference of State Legislatures (NCSL) to identify when specific reforms occurred and what each reform entailed. We then conduct statutory analysis of state tax codes using LexisNexis to construct a panel dataset capturing all major sales tax base changes over this period, with a particular focus on the service sector. Various aggregation approaches allow us to track how each reform affects the taxability of final consumption versus intermediate services. Empirically, we assess how tax base reforms affect state tax collections and their volatility using panel data analysis. We begin by regressing measures of total and sales tax collections and volatility on shares of taxable services, broken down by type (digital vs. non-digital, final consumption vs. intermediate, and functional category), to identify how a broader base affects revenues and stability. We then use a quasi-experimental design that exploits the staggered timing of reforms across states to estimate the effects of changes in the taxability of major digital services on our outcomes of interest. We conclude with evidence-based policy recommendations for state-level decision-makers on the optimal structure of the sales tax base.

Author

• Andrey Yushkov, University of Illinois, Chicago
  Presenting Author