Think Rick Knobe’s nuts for proposing a state income tax to raise teacher pay? Think again. A new report suggests that a state income tax would be better for South Dakota than the increased sales tax our Blue Ribbon K-12 panel is talking about:
The sales tax is less volatile than the income tax, which means it can be easier to forecast accurately from year to year. But it’s regressive, meaning it hurts lower-income earners a lot more than it impacts rich people. And as the economy moves toward technology and services (things that are difficult to tax), the sales tax base is capturing an increasingly smaller piece of what consumers are actually spending. Finally, sales tax revenue as a whole is growing slower than personal income [Liz Farmer, “Why States’ Increasing Reliance on Sales Tax Is Risky,” Governing, 2015.09.22].
Farmer draws these conclusions from this new report from the Urban Institute, which explains in more detail why we can’t rely on sales tax for long-term revenue growth:
General sales tax revenue tends to grow more slowly than personal income because households typically save a greater portion of their income as it increases. Erosion of the sales tax base has exacerbated that lag. Even though consumption has grown as a share of the economy, the sales tax base has declined (Fox 2012). In many states, the sales tax base excludes a large share of consumption, typically including services and groceries. Few states have made any progress in broadening their tax bases to include services, and only 19 states tax groceries (6 of them tax groceries at rates lower than the general rate). And finally, electronic commerce, which grew from almost nothing in 1998 to about 6 percent of retail sales in 2013, is more difficult to tax at the state level because of interstate commerce issues (Fox 2012). There has been some progress but states are waiting on Congress to act to be able to capture sales taxes owed on remote transactions [Norton Francis and Frank Sammartino, “Governing with Tight Budgets: Long-Term Trends in State Budgets,” Urban Institute, September 2015].
Opponents of the income tax may cry volatility!, but that’s nothing a little smart governing can’t fix:
Overall, however, the income tax is a more powerful tax than the sales tax and faces less erosion over time. The sales tax has become less efficient because of consumer patterns shifting more toward services, eroding the tax base. Replacing income taxes with sales taxes would risk even more anemic revenue growth. A better solution to the volatility of the income tax might be to increase rainy-day funds or smooth spending growth during boom periods. California, for example, has dedicated any additional tax revenue from capital gains above 8.5 percent growth to a stabilization fund, mitigating the volatility on general revenue sources but not sacrificing the revenue [Francis and Sammartino, 2015].
Think ahead, don’t spend it all at once, and a progressive income tax makes more sense for South Dakota’s budgetary aspirations than more regressive sales tax.
p.s.: The Urban Institute report notes that federal grants made up 31% of state budgets in 2013, up a bit from 28% in 1977. In South Dakota, federal dollars make up 38.7% of our state budget.