Does extending the sales tax make economic sense?

MinnEcon note: We're pleased to welcome Louis D. Johnston as a contributor. He's an economics professor at St. John's University and the College of St. Benedict and a regular voice on MPR.

Johnston's good at making economics understandable. Got a topic you'd like him to explain or discuss? Drop me a line.

Here's his first post:

Sen. Tom Bakk recently proposed extending the sales tax to clothing purchases to raise more money for education. Historically, legislatures and governors have resisted this move. A bit of history and some economic analysis can help us think more clearly about this issue.

Minnesota enacted a general sales tax in 1967. The initial rate was three percent. It now stands at 6.5 percent. Cities can add a half-percent for local projects with the Legislature's approval.

The tax raises about $4.6 billion annually, accounting for about 29 percent of general fund revenues. It's collected on purchases of goods and only a few services. Food and clothing have generally been exempt.

The sales tax continues to focus on purchases of goods and not on services, even though buying habits have changed significantly since the law was passed. In the 1960s, consumers spent about two thirds of their income on goods and one third on services. That proportion reversed itself over the past 40 years.

That means if most services continue to be exempt from the sales tax, either more goods must be found to tax or the tax rate must rise.

Economic analysis suggests that it is better to spread the burden of sales taxes across a wider range of goods and services than increase the rate on a shrinking base.

Higher tax rates tend to distort behavior. People change their buying patterns due to changes in the tax rate rather than changes in their own incomes, tastes, and the like. Unless we are raising taxes to change behavior (like raising the cigarette tax to discourage smoking), we should minimize the distortions created by a tax by keeping its rate as low as possible.

This is where Sen. Bakk's proposal enters the picture. By extending the sales tax to clothing, more revenue can be collected without raising the tax rate. We could even collect the same amount of revenue with a lower tax rate.

Sen. Bakk dropped out of the race for governor last weekend. It's too bad, in the sense that his proposal could have sparked a conversation our state needs to have, and it needs to begin talking about these issues sooner rather than later.

As the amount we spend on goods relative to services gets smaller, we will have to raise the tax rate on existing taxable goods just to raise the same amount of revenue, and create more distortions in our state economy.

In fact, the Governor's 21st Century Tax Reform Commission, appointed by Gov. Pawlenty, made exactly this point when it recommended that the state should "extend the sales tax base to a broader range of consumer products and consumer services."

Perhaps the governor and the legislature should go back and take the report down from the shelf as they consider how to deal with our current and future fiscal challenges.

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