First introduced by New York in 1997, a sales tax holiday is a tax relief measure that is now used in fourteen states and the District of Columbia.1 It offers a tem-porary moratorium—usually two to four days in August—on state and usually local sales taxes on back-to-school items such as clothing, supplies, and even computer hardware and software. While the specifics vary among the states, the holiday has proven quite popular with legislators and consumers but unpopular with tax experts, who see it as a gimmick.
Part of the criticism arises because of the obvious inefficiencies that sales tax holidays introduce: a reduction in the tax’s neutrality and an increase in its administrative complexity. From a local government’s perspective, they repre-sent further state-mandated erosion of the tax base and an unwelcome reduc-tion in tax revenues. Local governments point out that while state legislatures fret about the revenue windfalls that local
governments receive whenever the base is broadened, no such fretting seems to vex their deliberations when the base is narrowed—even temporarily—as in the case of sales tax holidays. Tax experts generally agree that sales tax holidays do not increase economic activity and thus do not increase sales tax yields.
Rather, these holidays only spur consum-ers to shift their purchases to the tax-free days.2
The political reality remains that these temporary exemptions are popular with consumers who see them as a targeted relief for working families, particularly those with school-age children. In fact, it is one of the few tax relief measures targeted to this group, with most other measures favoring more politically active groups, such as senior citizens. These moratoriums are also popular with retailers who capitalize on the marketing opportunities from the temporary sus-pension of sales taxes on selected items.
1 Federation of Tax Administrators, “State Sales Tax Holidays” (April 2011), taxadmin.org/fta/
rate/sales_holiday.html.
2 Mark Robyn, Micah Cohen, and Joseph Henchman, “Sales Tax Holidays: Politically Expedi-ent but Poor Tax Policy,” Tax Foundation Special Report no. 193 (July 2011), taxfoundation .org/sites/taxfoundation.org/files/docs/sr193.pdf.
Local government dependence on the tax Expected revenue yield is of par-amount concern to local managers and elected officials contemplating adoption of a sales tax. Revenue from a sales tax is income elastic; its yields grow or decline at rates greater than the growth or decline in the local economy. If the local economy is growing, revenue from the tax tends to increase in importance in a local government’s revenue structure. The tax’s elasticity becomes particularly problematic during recessions, however, when sales tax yields contract at a greater rate than the economy.
Because the tax is procyclical, local governments that depend heavily on it to finance their operating budgets risk incurring revenue shortfalls midyear and greater revenue volatility from year to year. Managers in such communities will want to set aside a larger budget reserve to provide more continuity in service levels during economic slowdowns.
Budget issues and the local sales tax
Once a state legislature grants one or more levels of local government access to the local sales tax, policy makers must resolve several issues in the tax’s design and implementation:
• Does the tax adversely affect local retail sales?
• Does the tax reduce the property tax burden, or does it merely encourage increased local government spending?
• Does the tax shift the overall tax burden away from business and onto households, which purchase most of the taxable items?
• How much of the tax, if any, should be exported to nonresident consumers and businesses?
• Should revenue from the tax be dedicated to funding particular services?
Effects on retail sales The most frequently expressed concern about a local sales tax is that it will hurt retail sales. This issue becomes especially significant when a local gov-ernment has a range of rates to choose from and the proposed rate is higher than those in surrounding jurisdictions, creating a border-city/county effect.
Several studies within the past five years suggest that the impact of rate differentials on a local economy increases as the difference in interjurisdictional tax rates increases, the driving distance to a lower tax jurisdiction decreases, and the cost of a good or service increases.13 In other words, border-city/county effects occur whenever it is economically feasible for shoppers to travel to nearby lower-tax areas to purchase more costly items. Because differences in sales tax rates for large-ticket items, such as cars or major appliances, profoundly affect consumer behavior, several states exclude vehicle purchases—both new and used—from the local sales tax base in order to increase the neutrality of the sales tax. For all other products and services, states should design legis-lation so that local rates are relatively uniform (varying by no more than 1 percent) and local adoption is widespread or, ideally, universal.
Tax rate differentials among local governments may also shift more consumers to the Internet until out-of-state vendors are required to collect local and state sales taxes.
Economists James Alm and Mikhail I. Melnik examined the effect of changes in sales tax rates on the shift to Internet purchases and found it to be modest but consistent.14 The shift was highest for higher-income consumers. Alm and Melnik estimate that taxing Internet sales would, on average, “reduce online purchases, but only by 6 percent.”15 Effects on the property tax and on government spending Although reduc-ing the property tax is one common justification for adoptreduc-ing a local sales tax, some critics contend that the sales tax only increases local government spending. A study of Texas
cities found that dependence on the sales tax has no effect on property tax burdens levied for operating purposes.16 However, a study of Illinois municipalities found that those in nonmetropolitan areas in particular substituted increased revenue from their sales tax for the property tax.17
Impact on the distribution of tax burdens Another concern about the imposition of a local sales tax is that it shifts a greater share of the local tax burden onto households, especially renters, and reduces the burden borne by the business sector. While consumers perceive that they bear a major portion of state and local sales taxes, in fact most states impose the tax on a wide range of business purchases. A 1999 study on this issue found that, nation-ally, consumers’ share of the sales tax was 59 percent, although state-by-state variations ranged from 28 percent in Hawaii to 89 percent in West Virginia, depending on the composition of a state’s tax base and exemptions.18 The remainder of the sales tax fell on business purchases.
However, the trend in the past two decades toward narrowing the sales tax base—
especially by removing machinery, tools, and building materials—undoubtedly shifts a greater proportion of the sales tax to households. Even the portion paid by business may be shifted forward to consumers in the form of higher prices for finished goods and services. Firms in the same industry that incur the same tax burden can more easily shift that burden forward to the final buyer as a price increase. The concern that a local sales tax will increase the overall tax burden of households thus has some justification.
Exportability of the tax burden Exporting the sales tax to nonresident con-sumers—commuters, tourists, and nonlocal businesses—is one means of reducing the burden on local households. For example, local governments whose economies are based on recreational services or tourism can export a significant portion of their sales tax burden because consumer demand for their goods and services is inelastic; in other words, because tourists lack information on where to find the lowest prices, they typi-cally pay higher prices than local residents. For this reason, Colorado resort cities such as Black Hawk, Crested Butte, Estes Park, Steamboat Springs, Telluride, and Vail levy the highest rates in the state: 4.0–5.5 percent. Utah authorizes an additional 1 percent levy for its resort cities, and Idaho limits local sales taxes to specific resort communities.
A 2004 study of Fort Collins, Colorado, found that 30 percent of the sales tax revenue came from purchases by nonresident households and businesses.19
Where state law does not allow local governments to share sales tax revenue with each other, jurisdictions with sales tax authority have a strong incentive to pursue regional shopping centers that attract nonresident buyers. If they can export the tax burden to nonresident patrons, they can provide better public services without raising the cost to residents. Local governments in some states try to lure mall developers by devoting a por-tion of the sales tax revenue to tax abatement incentives. But these “beggar-thy-neighbor”
measures create sales tax winners and losers among local governments. The North Caro-lina approach, described in the next section, minimizes these economically costly maneu-vers while preserving local autonomy and promoting interjurisdictional equity.
A 2004 study of county sales taxes in six states—Florida, Georgia, Indiana, Ohio, South Carolina, and Tennessee—offers a few particularly useful insights into the impli-cations of local sales tax policies for economic development.20 First, the largest benefit in increased sales taxes for this sample of counties came from the relocation of construc-tion firms. Second, the addiconstruc-tion of jobs in the service, agricultural, and public utilities sectors also had a favorable impact on sales tax yields. However, virtually no tax benefits were derived from the relocation of manufacturing firms or the preservation of military
bases, which, the study’s authors speculate, was because of the extensive exemptions and abatements afforded manufacturers and their finished goods generally being sold in mar-kets outside the local community. The study also found that commuters—both those working in the county but living outside (in-commuters) and those living in the county but working outside (out-commuters)—had significant but inverse effects on sales tax yields. For this sample of counties, in-commuters added an average of $2 to county sales tax receipts for every $1 lost by out-commuters. Urban counties experienced this impact more than rural ones.
Dedicated sales taxes The proliferation of local sales tax authority has been accompanied by more widespread dedicating of tax revenues to particular purposes.
The chronology of Ohio’s county sales tax is illustrative. As is typical, the initial autho-rization in 1987 imposed no restrictions on the use of the revenue. Then in 1993, the legislature expanded county powers to levy an additional incremental tax with revenues earmarked for detention facilities. Sports facilities were added in 1995, and acquisition of agricultural easements was added in 2001.21 The use of dedicated sales taxes for law enforcement/crime control is particularly popular among local governments in Illinois, Louisiana, Missouri, Ohio, and Texas.
In 1994, Allegheny County and Philadelphia, Pennsylvania, were granted authority to become the first—and thus far the only—local governments in Pennsylvania to levy a local 1 percent sales tax, piggybacked onto the state’s sales tax. Allegheny County’s reve-nue is dedicated to the preservation of regional assets: libraries, parks, zoos, sports arenas, museums, and performing arts facilities.22 But while legislative dedication of revenue increases political support for rate increases, it complicates local budgeting. Because of the volatility of the tax, services benefiting from the dedication experience fluctuations in funding that typically vary inversely with their expenditure needs.
Coordination of local sales tax rates Locally levied general sales taxes assume many forms, particularly in terms of their coordination with a state sales tax (Figure 4–1). Five states—Alaska, Delaware, Montana, New Hampshire, and Oregon—levy no statewide sales tax. Alaska is unique within this group in permitting its boroughs and cities to levy a local general sales tax while not imposing a tax at the state level.
States that authorize local sales taxes usually make its adoption optional, and many provide a range of rates from which the local governments may choose; this creates the potential for significant disparities in interjurisdictional revenue capacities. A further complication occurs when more than one overlapping level of local government levies a sales tax. Within a city’s borders, if the city, county (or parish), and transit authority all collect a sales tax, the three overlapping tax rates can have a significant impact on
con-No local
control (15) Local discretion
over base (4) Local discretion
over rates (22) Local discretion
over liability (3) Local
administration (7)a Note: Figures in parentheses indicate the number of states.
a Local administration is available in seven states. In Alaska, which has no state sales tax, and Louisiana, local governments must collect their own sales tax. Most smaller local governments in the other five states opt for state administration while the more populous cities and counties prefer to collect and enforce the tax locally.
Figure 4–1 Variations of local control over the general sales tax
sumer behavior.23 States have resolved interlocal rate disparities and overlapping tax rates in a number of different ways (Figure 4–2).
At one extreme is the approach used by North Carolina, where all one hundred counties levy a 2.00 or 2.25 percent state-mandated tax (three urban counties add a 0.50 percent tax for transit services)24 but share it with their incorporated cities and, in a few cases, their transit authorities. Fifty-eight counties share sales tax revenues with cities on a per capita basis, and the other forty-two do so on the basis of a pro rata share of the property taxes levied. This approach reduces intercity competition for retail business because the sales tax benefits are distributed countywide rather than to the city where the sale occurred—a tax base–sharing plan at the county level.
Several states resolve the problem of rate overlap by restricting the tax to only county or municipal governments. In Nebraska and South Dakota, the two states where only cities levy the tax, households and businesses have an incentive to shop in or relocate to unincorporated areas. However, this is not a serious problem where rates are kept low.
California uses still another approach to overcoming overlap while promoting uniformity in local rates. Cities may adopt a rate of up to 1 percent, which is credited against the county’s rate of 1.25 percent. Revenue from the unused portion of the county rate within the city limits and from the entire 1.25 percent rate in unincor-porated areas goes to the county’s general fund. All counties and most of the cities have adopted the tax, making the local rate nearly uniform statewide. The exception occurs in areas served by a transit district, which may levy an additional 0.5 percent rate.25 Tennessee uses a similar approach, but the county rate takes precedence over the municipal rate within city corporate limits, and the county redistributes a portion of the revenue back to cities according to the point of sale.
The least coordination occurs in states such as Texas and Louisiana, where local rates are stacked on top of each other, with a maximum combined rate usually imposed by state law. For example, Louisiana municipalities may generally levy a rate of up to 2.5 percent.
Parishes and school districts may levy a combined tax of 6 percent within city borders, but the city rate takes precedence. This approach creates border-city effects that skew business development, and it complicates tax compliance for vendors with multiple out-lets, who must keep records on the various tax rates levied in each jurisdiction.
Considerable variation exists in the way that states resolve the problem of tax rate overlap. North Carolina’s approach offers the most benefits, including universal par-ticipation by local governments, more equitable distribution of sales tax revenue, and reduced interlocal rivalry for retail business.
Minimum overlap Maximum overlap
Only counties levy tax, but cities receive a share of revenue
Only one level is given access, with no sharing of revenue
City rate takes precedence over county rate within city’s boundaries
County rate takes precedence over city rate
Local rates are stacked on top of each other
North Carolina South Dakota (cities) Wisconsin (counties)
California Tennessee Louisiana
Texas Figure 4–2 Strategies for interlocal coordination of sales tax rates
Local discretion in sales tax administration
In granting local governments access to a sales tax, state legislatures must address three issues concerning the adoption and collection of the tax:
• How much discretion should local governments have in choosing a tax rate?
• Should tax liability be based on the point of sale or the point of delivery?
• Should the state collect and enforce the local tax?
Setting of tax rates Most states give their local governments a range of tax rates from which they may choose and then limit the combined overlapping rate of all local governments. For example, Nebraska limits the total state-city rate to 7 percent, with 5.5 percent claimed by the state and the remainder available to cities in 0.5 percent in-crements: 6 percent (2 cities), 6.5 percent (108 cities), 7 percent (96 cities), and 7.5 percent (2 cities).26 Arkansas imposes a somewhat different cap: it limits city and county levies to
$25 per transaction per 1 percent rate. But local governments define what constitutes a single transaction, and that definition varies by jurisdiction. Florida limits the 1 percent county tax to the first $5,000 of a single sale.
Alabama and Arizona have the highest combined state-local rate of up to 12 per-cent.27 When only local rates are considered, combined local tax rates generally cluster around 2–3 percent, although there are several notable exceptions. For example, com-bined local rates in Alabama range as high as 8 percent and in Colorado up to 7 percent.
Local governments in Alaska, Louisiana, Missouri, and Oklahoma follow with maximum combined local rates of more than 6 percent. In the remaining states, maximum local rates are substantially less.
Tax liability If sales tax revenue is not redistributed countywide on a basis like that used by North Carolina, the state legislature must determine whether sales tax receipts are credited to the jurisdiction where the sale occurred or to the jurisdiction where deliv-ery is made. The benefits of the latter approach are that (1) taxpayers have no incentive to shop in lower-tax jurisdictions and (2) communities that have little or no commer-cial activity receive a share of the revenue. However, this approach greatly complicates tax compliance for retailers, who must maintain records on taxpayer residency, and it provides significant opportunities for tax evasion by taxpayers who claim residency in lower-tax areas. Furthermore, it complicates the auditing of tax returns and increases the chances of allocating revenue to the wrong jurisdiction. Because of these disadvantages, sales tax experts recommend that tax liability be based on the point of sale and not on the buyer’s jurisdiction of residence.
State collection and enforcement A final set of issues concerns the collection, distri-bution, and enforcement of the local tax. Most states require state administration of the local sales tax. A few states, such as Arizona, Colorado, and Minnesota, allow local governments
State collection and enforcement A final set of issues concerns the collection, distri-bution, and enforcement of the local tax. Most states require state administration of the local sales tax. A few states, such as Arizona, Colorado, and Minnesota, allow local governments