Sales Tax Flaws

I've been writing for some time about the numerous flaws in most state sales tax - particularly that of California. Most recently - the weakness in California's system in that we exclude way too much consumption from the sales tax, particularly consumption by higher income individuals which makes the sales tax very inequitable. (See 7/27/10 post on digital goods.)

Alan D. Viard of the American Enterprise Institute (AEI) recently had an article in State Tax Notes - "Sales Taxation of Business Purchases: A Tax Policy Distortion." He lays out the premise for a sales tax - taxing personal consumption, notes that states tend to exclude several types of personal consumption and have the added flaw of taxing business purchases. I encourage you to read this 7-page article (here).

A sales tax is flawed when it applies to business purchases because it causes the tax to pyramid in that all of part of that sales tax will be embedded into the price of the goods sold and you'll then have a tax on a tax. Taxing business purchases also violates the transparency principle. For example, in most states, food purchased at the grocery store is "tax-exempt." The rationale for the exemption is that food is a necessity of life. But, the grocery store has paid sales tax on the equipment and furnishing in the store and perhaps on the utilities it pays to keep the lights on. That sales tax is embedded in the price charged for the food, so the food really is not exempt from sales tax - some is buried in the price.

And I can't leave that statement without noting that while food is a necessity of life - high income individuals spend more on it than do lower income individuals. So the exemption is of greater benefit to high income folks than to others. I advocate making it all taxable (which also eliminates the need to distinguish taxable food such as perhaps soda, from non-taxable food) and providing a refundable income tax credit to low-income individuals.

I have more on this topic here.

What do you think?