Costly Inputs: Unraveling Sales Tax's Impact on Businesses

Sales taxes go beyond a few extra bucks at the register. It’s not just about what you pay, but who pays. What are the implications of state sales tax bases across the U.S.? 

Katherine Loughead, Senior Policy Analyst & Research Manager at the Tax Foundation, joins Kyle Hulehan. Together, we'll uncover the core principles behind an efficient sales tax system and examine how taxing business inputs can lead to economic inefficiencies and higher prices for consumers. 

 Links: 

 https://taxfoundation.org/research/all/state/kentucky-sales-tax-reform/ 

https://taxfoundation.org/data/all/state/2024-sales-taxes/ 

 https://taxfoundation.org/taxedu/glossary/tax-pyramiding/ 

Transcript

Kyle Hulehan: 0:00

Today, we're diving into a crucial topic for understanding state revenue systems for both businesses and consumers alike, the structure and implication of sales tax basis across the US. We'll uncover the core principles behind an efficient sales tax system and examine the negative effects of taxing business inputs and how they can lead to higher prices for consumers and economic inefficiencies. Hello, and welcome to The Deduction, a tax foundation podcast. I'm your host, Kyle Hohohan. And today, we are joined by Katherine Lawhead, senior policy analyst and research manager here at TF. Katherine, how are you doing today?

Katherine Loughead: 0:36

Doing well. Thanks. How are you, Kyle?

Kyle Hulehan: 0:38

I'm good. you know, Katherine, I wanted to ask you this question. As a part of TF, you travel a lot. You're on the state team. A lot of state team members do a lot of travel. What's 1 of the best places you got to travel to while working for TF? Maybe a place that surprised you, but if it it's not. Just whatever comes to mind.

Katherine Loughead: 0:55

Yeah. That's a really good question. I've gotten to travel a lot of really fun places and places I wouldn't have gone otherwise. So that's been a really cool part of the job, but I think Wichita, Kansas is high on the list. I had never been to Kansas before working for the Tax Foundation, and I was really impressed with Wichita. The small businesses there were really unique. Some of the restaurants were really great. So just had it all around good experience and people were so friendly. So really had positive experiences there.

Kyle Hulehan: 1:26

That's honestly I'm not surprised. I feel like the Midwest like well well maybe it doesn't always get the best rep. People are so nice and so kind of it changes kind of the experience people have a lot of times And and I I get that. Wichita, Kansas, I wouldn't have expected it, but I'm not terribly surprised. Midwestern people have a real charm, and and they're very kind.

Katherine Loughead: 1:46

They really are. And being from the Midwest, I always love going back there. So that's been a lot of

Kyle Hulehan: 1:52

Wait. Where where are you from in the Midwest?

Katherine Loughead: 1:54

I am from Northern Illinois, just west of Chicago.

Kyle Hulehan: 1:57

Okay. Yeah. I honestly I have literally never been to Illinois so I mean I you're the only person I know from Illinois and if you're any judge You're very nice, and I appreciate you being on the show today. but today's show is actually about sales taxes. Sales taxes, there's something that, a lot of listeners probably feel like they understand and have a grasp on since, they see it on their receipts. And while, that's good to see it on their seats. there's something to be said for how they're designed and implemented. Could you share some of the the key principles for sales taxation that maybe experts agree on and how they make states, their economies better and and their economies grow.

Katherine Loughead: 2:34

Yeah. Absolutely. 1 of the really interesting things about setting sales taxes Is is that there's actually there tends to be more agreement among public finance experts about how to properly structure a sales tax Then there is about some of the other tax types at the state and local level. So our team at the Tax Foundation has done a lot of Research, reviewing the economic literature on sales taxes, and the overwhelming consensus Among experts on this is that, sales taxes are 1 of the least economically harmful ways to generate revenue for state and local government services. So compared to income taxes, they tend to be less economically distorted. They do less to reduce investment levels and things like labor force participation. They're less likely to negatively affect interstate migration. They also generate a more stable source of revenue. Overall, the sales tax is a really good tax, but That's especially the case when it's well designed, and states have varying approaches to how they structure their sales taxes. So we kind of went through the economic literature and came up with 7 key principles that we think are important for lawmakers and taxpayers to Understand when you evaluate your state sales tax structure. So the first principle is just that an ideal sales tax is imposed on all Final personal consumption. So that includes goods and services. Ideally, most of the things we buy should be subject to the sales tax. Now in reality, that's not how most state sales taxes are. There's a lot of things like groceries and health related products that tend to be exempt. But, ideally, the sales tax would apply to all or almost all final personal consumption. But the second principle is that an ideal sales tax Should exempt all intermediate transactions. So that's things that are purchased by businesses in the course of doing business, also known as business inputs. And this isn't to provide special treatment to businesses, but rather to make sure at the retail sales tax is functioning as it's intended to function, which is to be a tax on final personal consumption, not on intermediate taxes, which ultimately ends up resulting in taxes on the factors of production. So we want sales taxes that apply broadly to personal consumption that exempt business inputs. And of the third principle is that, Ideally, sales taxes should be destination based, meaning they're based on where the consumer lives or where the consumption is taking place, not where the, uh, taxable good or service is originated, not where, that production activity is occurring. The fourth principle is that the sales tax is more economically efficient than many competing forms of taxation including the income tax because it falls On present consumption only, whereas income taxes fall on income that is earned to be spent now, but also on income that is earn now to be spent later, saved or invested now and then spent later. Now of another principle is most people do realize that Sales taxes do tend to be more regressive because lower income individuals do tend to consume a greater portion of their income. But 1 of the ways to make sales taxes less regressive is actually through broader bases that include consumer services. That really helps Push the sales tax in a more progressive direction because higher income individuals are doing a lot more of the purchasing of consumer services, which in many states are not currently being taxed. The sixth principle is that the sales tax scales really well with ability to pay because the amount we pay in sales taxes grows with the amount we consume. Finally, consumption is a more stable tax base than income, Although failure among states to tax most consumer services is kind of leading to gradual erosion of the sales tax revenue over time Since services are growing and growing as a share of final personal consumption. And so as Services have grown as a share of consumption, but services haven't been taxed. That's made sales tax revenue erode over time in real terms and be less stable than it should be otherwise. So there are a lot of good things about the sales tax as a source of state revenue And as a source of supplemental local revenue, you know, to be paired with the property tax, but state's actual sales tax practices really tend to differ from the ideal structure. So we really are trying to get the word out there on how state lawmakers can work to make sure their sales tax better reflects ideal economic design.

Kyle Hulehan: 7:20

Now listeners, this was your bible on sales tax. The principles, this is what she just laid out the ideal way to structure a sales tax and that was very thorough. I'm very appreciative for you to lay it out. I I just wanna quickly jump back because I like to touch on maybe terms or or words that could confuse listeners or just like They're just a little bit, broad or maybe, like, there's something we say all the time, but we don't quite understand. And when you say, distort economic behavior, there's an example in my mind of Of what I'm thinking. And and when you mean that, you mean more practical things, like why people buy things or where they choose to live. And so a a sort of famous example, and we have a blog about this you want to go read about it on taxfoundation dot org, famously, the Dolphins wide receiver Tyreek Hill actually chose to play for the Dolphins in the NFL, and go to Florida because they don't have an income tax. And so he wanted to be a part of that team so he didn't have to pay income tax. Whereas a sales tax, doesn't generally have that kind of impact on what people do. So when you say, distorting economic behavior. Is that kind of what you mean? Is that an example?

Katherine Loughead: 8:29

That's right. That's a really good example where in state Taxation, there's a lot of differences between how states structure their income tax codes where you have some states with no income tax at all In some states like California with really high top marginal rates, and so that can be really distorted and cause people to make decisions for tax reasons that they wouldn't make otherwise. So maybe not live in California and live in Florida instead for instance. You know, both both have a good climate, but 1 has a lot worse tax climate than the other. When you think about the sales tax, Uh, it does tend to be less distorted because most states do have a sales tax, and most are levied on similar baskets of goods and services. You might cross state lines if 1 rate in another state is a lot lower than the rate in your state. So you might make major purchases across state lines that can be Sort of, um, and lead to some economic inefficiencies, But, also, when it comes to, you know, Imposing sales taxes on business inputs. This is where that would make the sales tax much more distorted. Say, if your state is taxing your marketing services, your lobbying services, legal and accounting services, all these things are business inputs. You know, they're purchased by businesses in the course of doing business. They're necessary for the functioning of a business. But if you are suddenly a state that tax is all these business inputs. You can avoid those taxes by bringing your legal and accounting and HR and everything in house. If you're a big business, you might be able to do that. But that might not be the most economically efficient decision. It might not be a decision you'd normally make for your business. But, yeah, if the sales tax is extended to apply to all these things, you might either move out of state to a state that doesn't tax those business inputs, or you might just bring things in house vertically it integrate those services so there isn't a taxable transaction, and you can avoid those taxes. So we really want to try to avoid creating tax systems that are distortive like this, we want tax structures to be as economically efficient as possible.

Kyle Hulehan: 10:39

Katherine, you've you've led me perfectly into my next question. I very much appreciate that. I I know that you know what you're doing. So when you're talking about how taxing business inputs affects the state economy and competitiveness. What have you found in the economic literature specifically About taxing business inputs.

Katherine Loughead: 10:57

There's been some reports that have found that approximately 42 percent of total state and local sales tax revenue It's coming not from consumers on our final retail transactions, but from businesses on their business to business purchases. This is nearing 50 percent of the sales tax base. Not quite there yet, but we're on the brink of that potentially happening if states Start moving to bring more digital transactions into their base because that's mostly business to business purchases. So that's 1 of the shocking things that a lot of people don't realize is that sales taxes are already falling not just on consumers, but on a lot of businesses on their own purchases. There are states that do this better than others. States like Indiana and Idaho do a pretty good job of limiting the number of business inputs that are exposed to the sales tax. But then on the other end of the spectrum, you have states like New Mexico that have about 60 percent of their sales tax revenue is coming from b to b transactions. And so that's distortive. It creates this tax pyramid in concept where final consumers end up paying a tax on a tax, and those taxes get embedded in the final cost of goods and services that are being sold. And then when they actually pay the retail sales tax, they're paying more, uh, than they would otherwise if that tax weren't being levied on those business to business purchases.

Kyle Hulehan: 12:25

Could you explain what you mean by tax pyramid and maybe, walk us through an example.

Katherine Loughead: 12:30

Yeah. Tax pyramiding occurs when the same final good or service is taxed multiple times along the production process. So at a basic level, when sales taxes are imposed not just on final personal consumption, But on prior points along that chain of producing a good or service, many of those taxes end up getting passed along to consumers in the form of higher prices on the final good or service. And then when you pay that retail sales tax, say, 6 percent or whatever it is in your state on that final retail sale, but what you don't see, what's hidden to you is the taxes you're paying that are embedded in the final price of the product itself, and then you're paying that sales tax on top of that embedded tax. So Tax pyramiding is already affecting a lot of the goods and services we buy, most of them really, where, the effective tax rate that we're paying is a lot higher in many cases than the 6 percent rate that we're seeing on our receipts.

Kyle Hulehan: 13:33

Yeah. I think a common assumption we might be under is that, like you're when you're talking about tax pyramiding is that, when we see that sales tax on a receipt, that's the only tax. That's it. And I think you explained it perfectly there is that That's not it. the the price might be going up along the way, which is why it's a pyramid. it's constantly going up. I think that really explains it nicely. But Let's let's narrow in here and and why is it important to define business inputs broadly for sales tax and and which transactions do you feel should fall under that category.

Katherine Loughead: 14:03

This is a really important question because there are a lot of different discussions happening right now about what exactly makes something a business Input. So say there's a company in your state that manufactures kitchen utensils. Lawmakers might wonder which of that manufacturer's business purchases should be considered business inputs that are exempt from the sales tax. So if you're manufacturing kitchen utensils, you're going to make a lot of different purchases in the course of producing those goods. You're going to need to purchase the metal and other raw materials that are used in the utensils themselves, But you're also going to need to buy machinery and equipment to cast or mold or cut those utensils. You're going to need to buy electricity and fuel to power that machinery. You'll need to buy packaging for the utensils, maybe contracts to ship and distribute the utensils, Maybe marketing contracts to advertise the products unless you decide to do that in house, for instance. And then you actually have to operate the business. So that's gonna require maybe accounting services, legal services, HR and IT services. You're gonna need to buy desks and computers for your staff in the corporate office. You might need a subscription for your sales database, cloud storage services, all those things. so you're making all these purchases in the course of that final transaction. And anytime You as a business are exposed to having to pay sales taxes on any of those intermediate transactions, that's gonna raise the cost of production. So those, You know, forks and knives you're selling are going to have to potentially cost more for the consumer than they would otherwise. Or another potential effect is that you would just have less in profits to be able to reinvest in your business, upgrade your machinery. You might not be able to give staff, raises or, hire new employees to expand your operations. So all of these things have an impact on real individuals. So even though these are hidden taxes that we as consumers don't see on our receipts, They are impacting, us as consumers, but also employees and shareholders and business owners in many different ways. So, Ideally, that's really why we'd like to move toward a system that exempts those b to b transactions and really focuses just on Loving that 1, ideally, lower rate on the final retail price of the good or service being sold. Because if you broaden the sales tax base And it's applying to most final goods and services. Rates could be a lot lower than they are now, and that's a conversation that Lawmakers in several states are having right now, and I think it's a conversation that needs to be happening.

Kyle Hulehan: 16:47

So what are are the risks of taxing major business inputs, and and what could this mean for state economies and for small businesses?

Katherine Loughead: 16:57

1 of the things to understand about how a lot of state sales taxes work is that most states have destination sourcing. So that means they are collecting the sales tax based on the destination of the consumer, not where transaction is originating. So that is very important to keep in mind, especially for interstate transactions where you have a difference in tax rates And, also, oftentimes, the difference in tax base or what exactly is exposed to the sales tax. So in states that use destination based sourcing. You're going to put in state businesses at a competitive disadvantage if you start exposing a lot of business services and other business inputs to the sales tax because that business therefore becomes the purchaser, of these tax transactions. So if you expose, say, marketing services to the sales tax, you're going to end up affecting any of your in state businesses regardless of industry that are taking out marketing services. Whether you are a, manufacturer or a small local or you're a retailer, a little boutique, mom and pop shop, you might decide it doesn't make sense to, you know, take out these marketing contracts because now you're going to have to pay sales tax on that, and that puts you at a disadvantage compared to your competitors in other states where marketing services aren't being taxed. And so that's going to affect, you know, businesses at first on a small scale, but if you bring a ton of different inputs into the base, I mean, marketing is a big 1, but things like accounting and, telemarketing and, cloud computing and all these things into the base, you're gonna tax a lot of inputs across a ton of different industries, and that's hurting your own state's businesses. And so it's really important for lawmakers to understand as they're considering, especially, expanding sales taxes into kind of the digital realm because most of the digital transactions, most of the money from digital transactions is not our Netflix accounts or our, uh, streaming services as consumers, but it's b to b transactions that's where a lot of the revenue would be generated. So just because there's revenue there doesn't mean that that's a good decision for states to make.

Kyle Hulehan: 19:18

And when you're talking about this, I feel like there's a little bit of alignment with with some of our our principles as tax foundation. know, we like to talk about simplicity and neutrality When we're talking about that, we're trying to use those principles to not distort the behavior like we were talking about earlier. Taxes are more simple and neutral when we're not distorting the behavior or choices of businesses. And and what you're talking about is is maybe, businesses changing how they're deciding to do things or handle things because of taxes. That really falls in line with what we talk about a lot here at the tax foundation. And so I'm I'm gonna transition here to like What do you feel like the challenges are that we face with expanding the sales tax to digital purchases like you just mentioned, especially with so many being business to business.

Katherine Loughead: 20:04

Yeah. You know, a lot of The reason we're even discussing this issue right now of sales taxes being levied on business inputs is because of the rapid Progress we're seeing with the advancement of digital technology and how rapidly that's being deployed, especially for business purchases. Things like, you know, our music and movie streaming, their final personal consumption, it makes sense to apply the sales tax to those things we purchase in the digital realm in our personal capacity, especially because in a lot of of cases, they're replacing you know, ebooks are replacing physical books for some of us, or music streaming is replacing buying a CD. So it makes sense to extend the sales tax to those final personal consumption expenditures. But if you don't craft the legislation in the right way, you're gonna bring in a Ton of business to business transactions. So things like commercial cloud computing and digital controls for, manufacturing or inventory management, automated production lines, digital payments, machine learning, software as a service, digital advertising, data processing, all those things could get roped in if lawmakers aren't careful, And that would end up creating a much more economically harmful sales tax system than you have right now. And that would really transform the sales tax from being a tax on consumption, and make it much more economically harmful and potentially even more harmful than the state's income tax. This is a conversation that's being had in a lot of different states right now. The multistate tax Commission is kind of an interstate agency considering making or that is is working on definitions for digital products, and they've been insisting that that isn't for tax purposes necessarily, but there's this risk that if these broad definitions of digital products are made and deployed to states that a lot of states might choose to bring some of these things into their tax base and really transform sales taxes from something that they are meant to be into something they were never meant to be at all and make them much more, like, really high rate gross receipts taxes, which many public finance scholars think those are even more economically harmful than corporate income taxes.

Kyle Hulehan: 22:23

Now, Katherine, I'm going to throw us a little bit off base here because I just have 1 quick question for you that that's a little bit fun and a little tangent from this. I I heard you mention, digital books and that being a part of sales tax. Are you are you an do you wanna read a book? Do you wanna physically hold a book? Or are you do you have a Kindle? Just wanna know this real quick.

Katherine Loughead: 22:42

I'm kind of old fashioned. I really like having a physical book where you can mark it up with a pen. I'm 1 of those annotators, There is, you know, former English major. So, yeah, I'm not gonna switch over anytime soon, but the I like the option of being there, being able to, you know, listen to eBooks and things like that when you're on the go.

Kyle Hulehan: 23:01

It is nice to have the option, but, yeah, I'm totally with you. I I prefer the real book. I I'm sorry. I know I'm getting way off track, but it's a podcast. This is what tangents are for. We have time. It's okay. but I'll I'll get us back to the point and and thank you the excellent answer. how does the US, stand globally in terms of taxing inputs And what do maybe, something like VATS have over our system, a value added tax?

Katherine Loughead: 23:24

This is really 1 of the interesting things about this Whole conversation we're having in the US right now is as we grapple with how many business inputs are already exposed to the sales tax and as we think about how this could get even worse. Most of the rest of the world is not dealing with this issue because while consumption taxes are nearly universal, They are, you know, levied in 180 out of the 193 UN member states right now. So consumption taxes are very, common throughout the rest of the world, but the retail sales taxes that you and I are very familiar with in the US are not common at all. They're actually really rare. After the US and then Canada, the next most populous nation that uses kind of the normal retail sales tax is Myanmar. So these are not very common. Most of Europe, a lot of the rest of the world uses value added taxes, which avoid the issue of exposing, uh, intermediate transactions to the sales tax at all. There's many different ways of structuring of that, but 1 of the most common is called our credit invoice method that where taxes imposed at each stage of production, but a credit is provided against taxes paid at the prior levels. And this creates a simpler system, but it also has the effect of just taxing that final consumption. And so a lot of Europe and the rest of the world avoids this exposure of, business inputs to consumption taxes, and the rest of the world is, you know, taxing consumption. Um, So by US states, trying to impose these sales taxes on business to business transactions. That's really departing from what the retail sales tax was designed to do. So when we're thinking about foreign direct investment, you know, if foreign companies aren't being exposed to taxes on business to business transactions in the rest of the world. That's gonna make them not really wanna operate in the US as much when suddenly they'd be placed at a competitive disadvantage here because their inputs would be taxed here. So if states wanna continue working to try to attract foreign direct investment and the job creation opportunities that would come about as a result of that. It's important for states to really get this issue right and think about how the US compares to the rest of the world on this front.

Kyle Hulehan: 25:49

Yep. Value added taxes from what you're saying make a lot of sense. You're really avoiding, that pyramid, that scaling issue that we're seeing. So do you feel like VATS are something that will be able to be implemented here in the US?

Katherine Loughead: 26:01

You know, State lawmakers here could really benefit from looking at the economic effects of that and trying to mold retail sales tax more in that direction. There are a few reasons VATs would be difficult to implement here in the US, and just 1 of them is that there isn't a federal VAT to piggyback off of. So that would make it more difficult to make that a reality here. But, nevertheless, it's really important to look at the Economic effects of VATs and the relative competitiveness of a VAT structure compared to the reality of how a lot of retail sales taxes are currently functioning here and look for ways over time to reduce the exposure of business inputs to sales taxes here. And in reality, even if we don't end up with that here, we're creating our retail sales tax to have the same economic effects as of that, which is a good goal to work toward.

Kyle Hulehan: 26:58

Absolutely. And and a wise woman once told me, steal good ideas. And I think maybe that, it's not gonna be the exact thing, but, you know, you can look at it, you can analyze it, and you can think about how maybe some of those things could work in our system. And so as we're we're coming up to a close here, I just want to ask, are states looking at making changes the taxation on business inputs? what's what's the future there? What are we looking at?

Katherine Loughead: 27:22

Yeah. So we have seen various bills introduced recently in several states that would modify states' taxation of business inputs. They look different in different states, but in some states, they're looking at proposals to modernize the sales tax base to bring in more revenue in order to reduce tax rates, whether the income tax rate or the sales tax rate. And so they're trying to expand to more consumer transactions, but in the process are sometimes bringing in some b to b transactions as well or some transactions that are sometimes purchased by businesses and sometimes as consumers. So that's something to look out for. And then 1 of the things that, It's currently happening too. It's just that there's some states that really want to vastly increase the amount of revenue they're bringing in, and so they want to tax All these b to b transactions and are just, thinking that the economic harms won't be as bad as folks like us are saying. This is problematic. We haven't seen states go extremely far yet. For instance, Maryland's has a digital advertising tax, which is of a separate excise tax issue, but we are seeing proposals to apply, uh, sales taxes to digital advertising specifically in some states. But, overall, I think there is this energy brewing in a number of states to try to vastly increase revenue in ways that they think look like it'll just impact businesses, but, really, know, there's a big difference between the legal incidence of a tax and the economic incidence of a tax. So Businesses would be the ones legally paying those sales taxes on their inputs. But as I mentioned earlier, it'd be the consumers, the shareholders, the employees, uh, who would be facing the economic effects of these taxes. So It's something we're, uh, keeping a really close eye on right now. There are also good examples of states that have gone in the opposite direction. And while business inputs are a big part of tax bases right now, Utah legislators over the past several decades have made really good progress in taking a sequenced approach to removing inputs 1 industry in 1 category at a time. And then also in Iowa, you know, they aren't necessarily a good example of business inputs taxation at the moment because they do expose a lot of tangible business inputs to the sales tax, but they've taken a really proactive approach to saying that they don't want to tax certain business transactions of digital consumption. So they are saying, things like prewritten computer software and software as a service, if that's being purchased by a business in their business capacity, they've taken steps to amend the statute to exempt that already even before broadly trying to expand to additional consumer goods and services. So that's a good direction to head. Um, you know, states are making progress on the edges of trying to remove business inputs from the base. But because that does cost and revenue, it can be a bit of a challenge.

Kyle Hulehan: 30:27

Katherine, thank you for being on the show today and helping us break this down as we're doing this. This is, you You know, sales tax are a little bit more complicated than I would have realized and especially the structure and everything that's going on. Thank you for making it very clear and simple for us. Just wondering if there's anything that you wanna plug or promote that you're working on right now. Anything coming up that you wanna let the listeners know that they should go check out.

Katherine Loughead: 30:49

Yeah. If you'd like to read more about this issue, we wrote a or that you can find on our website. It's titled Kentucky sales tax modernization, keeping the sales tax on sales, not production. And while it's a report specific to some of the considerations in Kentucky right now and in the past few years, Uh, a lot of the substance of that report really applies to states no matter what. So as long as your state has a sales tax, those principles apply to you. So definitely encourage listeners to check out that report. there's a lot of a good review of the economic literature that I've mentioned here. So Hope you enjoy that resource.

Kyle Hulehan: 31:26

Katherine, thank you for being on the show today.

Katherine Loughead: 31:28

Thanks for having me.

Kyle Hulehan: 31:30

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