Study: Sales tax exemptions spur tax hikes

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State and local governments often turn to increases in sales taxes to generate added revenue. Estimates of fresh revenue from the higher tax tend to be overly optimistic, partly because the number of sales tax exemptions tends to rise with the rising tax rate.

Given the fact that politicians seek to raise a certain amount of revenue, and wish to maximize their chance of re-election, this relationship suggests that politicians face a trade-off when seeking votes from groups that favor sales tax decreases and groups that lobby for certain tax exemptions.

In our recent study, Sales Taxes and Exemptions, we identified 17 broad exemption categories (some of which also contain subcategories), including a variety of exemptions that can be classified as entity-based, product-based, or use-based.

Entity-based exemptions are defined as exemptions in which the seller or buyer is an exempt entity, such as a nonprofit organization or a school. Product-based exemptions involves items which are exempt from taxes, such as food or health-related items. Finally, use-based exemptions are granted when the buyers??? intended use of the item entitles them to an exemption, as with material tools used in manufacturing.

The exemption categories were constructed such that they are specific enough not to have exemptions overlap, yet broad enough to incorporate a variety of definitions for products or transactions.

The study found that the average state???s sales tax rate was 5.6 percent, with values ranging from 2.9 percent in Colorado to 7.25 percent in California.

Our analysis of sales taxes and exemptions in each state has some important implications. The results of the regression analysis indicate that the relationship between tax rates and the number of exemptions is both positive and statistically significant.

Specifically, we found that an exemption is associated with an increase in the sales tax rate, ranging from 0.10 and 0.25 percentage points.

In theory, if a state has a current tax rate of 5.6 percent, and adds another five exemptions, then the state can be expected to increase the tax rate to at least 6.1 percent.

Higher sales taxes increase the incentive for special interests to lobby for more tax exemptions. Ultimately, the link between sales taxes and sales tax exemptions serves to undermine the certainty of generating additional revenue by increasing sales taxes. As with many assumptions made by government, increasing the tax rate may not generate the additional tax revenues expected.

In the end, estimates of the effects of increasing sales taxes are often overly optimistic. Therefore, agencies should be more alert to the link between sales taxes and exemptions when making predictions of future increases in revenue.

Dr. Thomas Stratmann ( is a scholar with the Mercatus Center, and a professor of economics at George Mason University.


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