Monday, March 4, 2013

Issues with Base Expansion and Adequacy


Like any proposed change to the tax system, Governor Dayton’s tax proposal is the subject of many debates.  As part of Dayton’s “Fair and Balanced Tax System” the state sales tax rate would drop to 5.5% but the tax base would be drastically increased to include clothing and services (including business-to-business) 1.   This new tax base and rate is estimated to raise $2.083 billion1. There are many issues that opponents have identified like regressivity and pyramiding, but others like “tax decisions,” use payments, and the decline of border cities may lead to decreased adequacy and a continued budget deficit.

Sales tax is generally regressive.  In the past, Minnesota has fought regressivity by exempting necessities, helping low income families spend less in taxes as a percent of their income. While the overall tax plan will help make Minnesota more progressive, the sales tax base expansion is definitely more regressive than the current system2.  The increased sales tax is intended to cross-subsidize a $500 property tax rebate1.

We’ve discussed tax pyramiding in previous blogs; it’s the concept that at each stage of production the product is taxed, adding cost to the product.  This cost is then passed on to the consumer.  Tax pyramiding may result in lower purchasing power as costs rise.  With lower purchasing power, the state should expect fewer purchases and lower sales tax.

Another criticism of Dayton’s base expansion is that it may force internalization of services to avoid the business-to-business services sales tax.  The example given by a University of Minnesota economics professor: “A business that uses a lot of legal services and usually purchases those services outside of their own firm might just decide they will hire lawyers and bring that in-house3.”  If this becomes reality, the services the state anticipates taxing, will no longer be taxable and the state forfeits that income.

Part of the proposed sales tax is a tax on services.   These services will range from haircuts to over-the-counter drugs, legal work to bank charges4.  For many of these newly taxed services, they will be sold by an out of state firm.   If the buyer and seller are located in Minnesota, a regular sales tax will apply with the seller collecting the tax and paying it to the state.  But, if the buyer is in Minnesota and the seller is not, the buyer is responsible to pay the sales tax to the state.  And when the seller is in Minnesota but the buyer is not there is no applicable sales tax.  These different scenarios may result in some administrative difficulties in collection.

Border cities may be additionally concerned with the tax base expansion.  There is very little research that measures the impact tax-exempt items have on sales in border cities, but it is easy to imagine that if Minnesota cities do not continue to have a large tax advantage, some portion of their sales will decline.  Even with the 20% decline in the sales tax rate, a 5.5% is still higher than the four bordering states3.


With all these concerns, it is easy to see where the base expansion may lead to revenue projection shortfalls.  There will still be many opportunities to avoid the tax through on-line purchases and out of state service purchases.  We should all be wary of the projections based on the expanded base.




4.     http://www.revenue.state.mn.us/tax_reform/Documents/Sales%20Tax%20Base%20Broadening.pdf

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