Wednesday, February 23, 2011

Can a 1% Sales Tax on Basic Tax-Exempt Goods Save Rhode Islands Budget?

In light of a $295-million projected deficit next year, Rhode Island Governor Chafee has proposed a 1% sales tax “on the dozens of currently exempt items, including food, clothing and prescription drugs.”[i] This proposal has a potential to raise $89 million in annual new revenue. Other legislators are proposing bills to add sales tax to luxury items including expensive clothing and yachts.

The alternative proposals stand on the ground that basic clothing should not be taxed because it would be regressive taxing, adversely affecting lower-income residents. However, if someone can afford a yacht, they can afford the 7% tax on it (currently exempt as a luxury item). Other proposals suggest lowering the luxury clothing tax from $500 items to $175 items like Massachusetts. This increase will raise the tax on an additional $325 of a $500 item.

The problem with the legislators’ proposal is that luxury items are not efficient. They are highly elastic – where an increase in tax will reduce consumption. Overall fewer of these items are purchased and without running the numbers, an increase in luxury tax will not likely raise the same amount of money as a 1% tax on all basic exempt items.

While a 1% tax on basic items may raise more money to balance Rhode Island’s budget deficit, it would be regressive and inequitable by effectively taxing lower-income people more than higher-income people. As Rhode Island has been facing some of the highest unemployment rates in the nation – before the recession even hit the whole country – the impact of this bill on an already hard-hit segment of the population would be a real blow. What’s a state to do?

The Mikesell article suggested for this week’s reading provides evidence that clothing tax exemptions actually provides “greater relief to high-income as opposed to low-income families. It therefore reduces revenue yield . . . without the desired equity effect.”[ii] Governor Chafee is willing to take recommendations and make changes to his proposal. I would suggest that he refrain from taxing unprepared food and basic prescription drugs, but adding a 1% tax to clothing, and taxing luxury goods – either at $175 instead of $500, or the entire amount – would create significant revenue while balancing equity and elasticity of the tax base.

Link to article:

[ii] Mikesell, John. The American Retail Sales Tax: Considerations on Their Structure, Operations, and Potential as a Foundation for a Federal Sales Tax.

1 comment:

  1. Your blog posting did a great job of explaining the equity and efficiency trade-offs between taxing basic goods and more elastic luxury items!

    A 1991 article in the NY Times shows why taxing only luxury goods does not yield much revenue. It describes how buyers and sellers responded to a 1991 tax on yachts over $100,000. Buyers changed their behavior by buying either used or cheaper yachts to avoid the tax. Sellers who were able to alter production built cheaper yachts, and those who could not adapt went out of business.

    Link to article: