The Not-So-Dependable Sales Tax

Washington State has long been an attractive place to live — and not just because of its evergreen trees and snow-capped mountains. It’s one of nine states without a personal income tax, and this can translate into substantial savings for residents.

But the state has always had to make up the lost revenue somehow. It has done so by relying more heavily than any other state on the sales tax, which is levied at a 6.5-percent rate — more than that in some localities — and generates nearly 62 percent of the state’s overall revenue.

The problem is, the sales tax is no longer paying Washington’s bills. Receipts dropped sharply during the Great Recession, forcing Governor Chris Gregoire to make a series of deep spending cuts. The latest round of budget-slashing, announced last month, amounts to a 6.3 percent spending reduction across state government, and is expected to result in hundreds of employee layoffs.

Meanwhile, a citizens’ initiative next month asks voters to do the unthinkable: bring Washington more in line with the rest of the country by creating an income tax, albeit only for the wealthiest residents. Initiative 1098, as the proposal is known, would create a 5-percent tax rate on annual income above ,000 a year for individuals and ,000 for couples, and a 9-percent rate on income exceeding ,000 for individuals and million for couples. The proposal has been polling surprisingly well.

“We’ve got a fairly strong history against the income tax in our state,” says Marty Brown, the state budget director. “I don’t think anybody would have guessed that (Initiative 1098) would be doing as well as it is.”

That Washington is seriously considering an income tax is a stark reflection of just how poorly its sales tax collections have fared. This is the same reality being discovered by budget writers in other states. More than economists expected, the current downturn has rattled consumer confidence and challenged the commonly held notion that the sales tax, unlike personal and corporate income taxes, is a relatively stable one for state budgets. Eight states — Arizona, Florida, Hawaii, Nevada, South Dakota, Tennessee, Texas and Washington — rely on a sales tax for more than half of their overall revenue collections.

In Tennessee, sales tax receipts declined in 2009 for the first time ever. In Texas, plummeting sales tax revenue has opened up a hole in the budget that could exceed billion over two years, as Stateline reported earlier this month . Even in Wyoming, which has coasted above the fiscal crisis for much of the last few years because of strong severance tax collections on natural resources, sales tax revenue came out million short of projections last fiscal year — a significant number considering Wyoming’s total budget is less than billion a year. Jim Robinson, a state economist, says “it’s going to take four or five years at least to get back to where we were a year ago” in sales tax collections.

Why such poor results?

Economists are surprised by the deep shortage of consumer confidence that has been at the root of poor sales tax collections. Jim Eads, the outgoing head of the Federation of Tax Administrators, an organization of state tax collectors, believes that the combination of a deep recession and a media environment that obsesses over each economic report has frightened consumers into saving more and spending less, even if they have the money to make purchases. “Bad news travels fast, and in this day and age, it travels ubiquitously to everybody,” Eads says. “The reinforcement of bad news can become a kind of self-fulfilling prophecy.”

But Eads and others acknowledge there are policy reasons for poor sales tax collections, too. For one thing, 36 states do not collect sales tax on groceries . Many of the other 14 states tax groceries at a reduced rate or provide some form of tax rebate on them. While lawmakers from both political parties defend grocery exemptions, arguing that they help poorer residents, it is hard to dispute that taxing necessities — which sell reliably even during tough times- would provide a more stable source of revenue for states.

South Carolina and Wyoming are among the states that decided to exempt groceries from the sales tax when times were good. Now, such exemptions have helped turn the sales tax into “a roller coaster that very much resembles the income tax,” says Bill Ahern, communications director of the Tax Foundation, which advocates for lower tax rates. “I don’t think it has really sunk in that by enacting (grocery tax exemptions), these states have left their sales tax base dominated by discretionary purchase items that people do without in a crunch,” Ahern says.

Another piece of the puzzle is the way states treat the broad range of services that now make up a huge portion of the national economy. Sales taxes initially were designed when the economy was based on manufacturing, and tax structures have not kept up with the continuing evolution toward services. The rise of the Internet has further allowed many goods and services to go untaxed.

Pennsylvania Governor Ed Rendell drew attention to his state’s peculiar tax structure in February, when he launched an unsuccessful push to lower the sales tax but apply it to more services. “If you do your own laundry, the laundry detergent is subject to the sales tax,” Rendell noted in his executive budget address to lawmakers . “But if you have your laundry done, it’s sales tax free.”

Will policymakers react?

One of the underpinnings of sound tax policy, according to experts on both sides of the political spectrum, is diversification: taxing many sources, but at rates as low as possible. Having a diversified tax base allows governments to minimize their risks in economic hard times.

Some states have responded to flagging sales tax collections this year by trying to broaden their base — or, failing that, by raising existing rates. New York, for example, eliminated sales tax exemptions for clothing and footwear, while Arizona voters signed off on a temporary, 1-cent-per-dollar increase in the sales tax in May .

Many of the states that have suffered worst during this downturn, economists point out, are those that have too many of their eggs in one revenue basket. Oregon, for example, has no sales tax and relies more heavily than any other state on the volatile personal income tax, which is closely tied to unemployment. Since Oregon’s jobless rate is among the highest in the nation, its revenue drop has been steep, forcing lawmakers to raise income tax rates to the tune of million just to keep up. But creation of a sales tax does not appear to be on the horizon: Voters in Oregon have rejected a statewide sales tax nine times.

Next year’s legislative sessions are sure to bring more discussion of how to stabilize and diversify state tax systems. Already, there is talk in Idaho of reducing or eliminating the state’s grocery tax credit, which helps residents pay their bills but costs the state million a year. In South Carolina, a tax reform commission has recommended re-instituting the state’s tax on groceries to provide more reliable revenue.

Many tax and budget experts, however, see little chance of lawmakers kicking off 2011 by raising taxes, particularly on such basic items as food. “It doesn’t look good for much tax reform in this upcoming session,” says Burnie Maybank, the chairman of the South Carolina tax commission — though he is holding out hope for changes later down the line.