Why Have Sales Taxes Grown Slower Than the Economy?

Why Have Sales Taxes Grown Slower Than the Economy? MAC TAylor • l e g i s l A T i v e A nA l y s T • AugusT 5, 2013 SUMMARY The sales and use tax is a major source of revenue for the state and many local governments. Historically, consumers spent about the same portion of their income each year on taxable items, meaning sales tax revenue grew about as quickly as the state’s economy. Starting in 1980, however, consumers began to spend a growing share of their income on services, which are not taxed, and a correspondingly declining share on taxed items. This brief details this change in consumer spending patterns, its causes, and what effect it has had on sales tax revenues. In particular, the brief discusses these major findings: • Consumer spending on taxable items peaked in 1979, when consumers spent 53 cents of each dollar on taxable items. • Since then, the state’s sales tax base, “taxable sales,” has grown 1.4 percentage points slower annually than the state’s economy. As a result, consumers now spend 33 cents of each dollar on taxable items. • This shift in consumer spending has occurred primarily because prices for services have grown four times as much as prices for goods since 1980, leading consumers to spend an increasing share of their income on services. • Had consumer spending not shifted toward services, the sales tax would generate the same amount of revenue as it does today at a significantly lower rate—5.2 percent instead of the current rate, 8.4 percent. • This trend in consumer spending appears unlikely to reverse, at least in the next decade. AN LAO BRIEF InTRodUcTIon The sales and use tax is the state’s second shift in spending caused growth in taxable sales to largest revenue source as well as a major funding lag behind growth in the state’s economy each year. source for cities, counties, and some special Figure 1 highlights the key growth rates districts. Broadly speaking, the amount of sales discussed in this brief: taxable sales, state and local taxes generated each year depends on two factors: sales tax revenue, and personal income. (Growth (1) growth in the tax base or taxable sales, the in personal income, the total income earned by total amount of money spent on taxable items in businesses and individuals in California, is a California, and (2) the sales tax rate. Historically, standard measure of economic growth.) As shown growth in taxable sales kept pace with growth in the figure, sales tax revGenruaeps hhaicve Souigtpnac eOd ff in the state’s economy, meaning that sales taxes taxable sales since 1980 because the tax rate was Secretary generally grew along with the economy when the increased during this time. Due to the shift in Analyst tax rate was kept constant (and increased when the consumer spending from taxable goods toward Director tax rate was increased). services, however, neither taxable sales nor sales tax Deputy Starting in 1980, however, California revenue have kept pace with growth in the state’s consumers began to spend a smaller share of economy. their income on taxable goods and a larger share This brief begins with a background on on nontaxable items, especially services such as the sales tax and consumer spending and then healthcare and housing. Although total consumer examines: spending kept pace with the state’s economy, this • Why are consumers spending a growing share Figure 1 of their income on services Taxable Sales Have Grown and a declining share on Slower Than the Economy Since 1980 taxable items? Average Annual Compound Percentage Growth, 1980-2012 • How has this shift 7% affected sales tax revenue 6 for the state and local governments? 5 • Will this trend 4 continue? 3 2 1 Taxable Sales State and Local Personal Incomea Sales Tax Revenues a Growth in personal income, the total income earned by businesses and invidividuals in California, is a commonly used measure of economic growth. 2 Legislative Analyst’s Office www.lao.ca.gov ARTWORK#130466 AN LAO BRIEF BAckGRoUnd How Much Revenue does the and are exempt. Intangible goods are primarily Sales and Use Tax Raise? services—such as healthcare, education, financial planning, and auto repair—and are not subject to California’s sales tax raised about $43 billion in the tax. In most cases, businesses do not pay sales 2011-12. Approximately $20 billion was allocated to taxes when they purchase raw or intermediate the state General Fund. The rest (about $23 billion) goods that are used to construct a final product. was distributed to counties, cities, and some special (This is to prevent the sales tax from being collected districts and used for a variety of purposes. The multiple times on the same good. For example, a statewide base sales tax rate is 7.5 percent. With voter approval, however, local governments may cabinetry business does not pay sales tax oGn rthaep hic Sign Off lumber or hardware used to build its products, nor increase (by up to 2.5 percentage points) the Secretary do stores pay the tax when they purchase goods for local tax rate to generate additional local sales Analyst resale.) tax revenue. Accounting for locally approved rate A taxable sale is a purchase that is subjDecirt etoc ttohre increases, the average sales tax rate in California is sales tax. The total value of all of these purDcheapseus ty 8.4 percent. in California each year is taxable sales. California What Is Taxable? taxable sales were $558 billion in 2012. Figure 2 shows that California’s taxable sales increased The sales tax applies to the retail purchase of moderately in most years since 1970 and at an most tangible goods. Some tangible goods, such as average rate of 4.4 percent beginning in 1980. groceries and medicine, are considered necessities Figure 2 Taxable Sales Have Increased Moderately in Most Years (In Billions) $600 500 400 300 200 100 1970 1975 1980 1985 1990 1995 2000 2005 2010 Shaded areas represent years during which recessions took place. www.lao.ca.gov Legislative Analyst’s Office 3 ARTWORK#130466 AN LAO BRIEF How do california Households taxable goods makes up a smaller share of consumer Spend Their Money? spending than it once did. As consumer spending shifted from taxed goods to untaxed services, the As shown in Figure 3, Californians spend their share of purchases subject to the sales tax declined. money on various types of goods and services. (Most Increased online purchases, many of which go also save a portion of their income.) Each type of untaxed, also contributed to this decline. spending—on housing, transportation, education, The Sales Tax Base Has Contracted Relative and so on—represents a percentage of a household’s to the Size of the Economy. Over time, the share of total spending. Spending on transportation, for consumer income spent on taxable items has declined, instance, accounts for about 15 percent of the average causing taxable sales to grow less quickly than the household’s total spending. state economy. Beginning in 1980, taxable sales have Consumer Spending Has Shifted Away From grown about 1.4 percentagGe rpaoipnths isclo wSeirg, onn aOvefrfage, Taxable Items and Toward Nontaxable Ones. than the state’s economy. As shown in Figure 4, Consumers today spend a greater share of their Secretary taxable sales as a share of personal income (a ratio income on services like housing and healthcare than Analyst used to track the size of the sales tax base relative to they did in the past. Commensurately, spending on Director the economy), declined from a peak of 53 percent in clothing, electronics, household items, and other Deputy 1979 to 33 percent in 2012. WHY HAS SpEndInG on TAxABlE ITEMS GRoWn RElATIvElY SloWlY? Spending on taxable items has grown slower taxable items have become less expensive relative than the economy in recent years primarily because to nontaxable items. Consumers are therefore able to buy the same Figure 3 amount of taxable goods How Do California Households Spend Their Money? with a smaller share of Percentage of Total Spending on Various Items, 2010-11 their income, resulting in “savings” that can be Housing spent elsewhere. While Transportation consumers have used some Food of these savings to purchase Social Security, Pensions, more taxable goods, and Life Insurance much of these savings Healthcare have been used to pay for Entertainment nontaxable items because these purchases have Apparel and Services become relatively more Othera expensive. Consumers 5 10 15 20 25 30 35 40% therefore spend a larger a Includes education, donations, reading, tobacco, personal care and services, alcoholic beverages, share of their income and miscellaneous. 4 Legislative Analyst’s Office www.lao.ca.gov ARTWORK#130466 AN LAO BRIEF on untaxed items and a correspondingly smaller or costlier transportation. Inflation occurs, in part, share on taxable items. Overall, the vast majority because higher prices are needed to compensate for of the 20 percentage point decline in Figure 4 higher production costs—whether labor, materials, has occurred because taxable items have become transportation, or other business inputs. In general, relatively cheaper while nontaxable items have the upward pressure on prices from these factors become relatively more expensive. The rest of this has been particularly mild for tangible goods, most decline, less than 5 percentage points, has occurred of which are subject to the state’s sales tax. Though because Californians are purchasing relatively more prices for goods have increased over time, they untaxed goods and services than they used to. have done so much less rapidly than inflation, the Prices for different types of goods and services average price change for all goods and services. increase (or decrease) at different rates. (The Figure 5 (see next page) shows how prices for Graphic Sign Off average overall rate of change in prices from one different types of goods have increased since 1980. year to the next is the inflation rate.) Since 1980, As shown in the figure, prices for some gooSdes chraevtea ry prices of services, which represent the bulk of grown very little. For example, clothing priAcensa lyst nontaxable purchases, have increased much faster increased just 7 percent since 1980, and the prices Director than prices for taxable goods. Below, we discuss the of durable goods have actually declined slightly. Deputy forces underlying these trends. While overall inflation increased about 150 percent during this time, the increase for all goods was only prices of Taxable Goods Have Increased Slowly about 60 percent. The line “all goods” is a federal The price of a particular item can increase from measurement of price changes for all tangible one year to the next for many reasons, including goods. The list of goods included in this line is higher labor costs, more expensive raw materials, almost identical to the list of goods that are taxed Figure 4 Taxable Sales as a Share of Personal Income Has Declined Since 1979 55% 50 45 40 35 30 25 1970 1975 1980 1985 1990 1995 2000 2005 2010 Shaded areas represent years during which recessions took place. www.lao.ca.gov Legislative Analyst’s Office 5 ARTWORK#130466 AN LAO BRIEF in California. Due to this similarity, we use this quotas, and embargoes—were reduced. data to measure how the average prices of taxable Correspondingly, the majority of goods goods have changed over time. Below, we describe purchased in California today are manufactured in detail the two main economic causes of this elsewhere. (Imports consist predominately of trend: (1) increases in manufacturing productivity tangible goods, most of which are subject to the and (2) expanded international trade. state’s sales tax.) Manufacturing Productivity Has Outpaced This trade expansion has been due primarily Average Productivity. Manufacturing productivity to lower production costs in developing has increased more rapidly in recent years than economies. Relatively inexpensive labor, energy, productivity in other sectors, as shown in Figure 6. regulatory, and facilities costs allow firms to Manufacturing improvements, led by technological produce goods at lower costs. These goods are Graphic Sign Off developments and automation, have reduced the then imported to the U.S. and sold at relatively amount of time and number of people it takes lower prices. The influx of low-price goodSs efrcormet ary to make physical goods. These advances allow developing countries helps to keep prices for Analyst businesses to produce goods more cheaply. This has these goods from rising quickly. This influx also Director helped keep price pressure on physical goods, most forces domestic producers to cut production Deputy of which are taxable, at a low level. costs, and thereby prices, resulting in further Increased Imports of Low-Cost downward pressure on goods prices. Manufactured Goods. International trade prices of nontaxable Items expanded significantly during the past Have Increased Quickly half-century, as developing countries established manufacturing sectors, global shipping became The prices of nontaxable items—especially more efficient, and U.S. trade restrictions—tariffs, services such as education, healthcare, legal Figure 5 Prices for Goods Have Increased Slower Than Prices for All Goods and Services Total Percentage Change Since 1980 160% All Goods 140 and Services 120 100 80 Vehicles 60 All Goods 40 20 Clothing 0 Durable Goodsa -20 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 a Durable goods include major household purchases like washing machines, furniture, and refridgerators. 6 Legislative Analyst’s Office www.lao.ca.gov ARTWORK#130466 AN LAO BRIEF and financial advising, and auto repairs—have import relatively few services, meaning increased faster than prices for all goods and low-cost imports have not put downward services. In addition, between 1980 and 2012, pressure on service prices. service prices grew annually about 2.5 times • Customization. Many services are faster than prices for goods. As a result, service designed for a particular customer prices have increased four-times more than goods under unique circumstances. Legal or prices over this period, as shown in Figure 7 accounting services purchased by a (see next page). Whereas productivity gains corporation that is acquiring a smaller and low-cost imports put downward pressure firm, for example, are unique to the on goods prices, similar downward pressures business structure and acquisition on service prices have not materialized. Several strategy of that corporation. ThesGe tryappesh ic Sign Off unique characteristics have led service prices to of services are not easily automated increase rapidly over time, including: Secretary and therefore benefit less from the • Proximity. Services typically are Analyst technological advances that have purchased within close proximity to Director increased manufacturing productivity. the buyer. This occurs because most Deputy services either improve physical property • Labor Intensive. Unlike goods, the owned by the buyer (car maintenance, prices of which are determined largely landscaping, or dry cleaning) or rely by nonlabor production costs, the costs on frequent in-person communication of most services are based primarily on (financial, legal, and business advising, the labor used to provide the service. For for example). Californians therefore example, a car owner who takes his or Figure 6 U.S. Manufacturing Productivity Has Outpaced Average Productivity Total Percentage Increase in Productivity Since 1987 150% 125 100 75 Manufacturing Sector 50 All Sectors 25 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011 www.lao.ca.gov Legislative Analyst’s Office 7 ARTWORK#130466 AN LAO BRIEF her car to a nearby mechanic purchases income on discretionary services—such the experience, training, and time needed as leisure, recreation, and entertainment. to repair the vehicle. Industries that are California real per capita income labor intensive, including most service has increased about 50 percent since industries, benefit less from productivity 1980—from $25,600 to $39,000— gains because training and expertise are likely increasing demand for untaxed difficult qualities to automate. discretionary purchases. Demand for Services Has Increased, Despite • Finally, numerous state and federal Rapid Price Increases. Consumer demand for policies lower the cost of certain services, services has grown steadily over the past several causing consumers to purchase more decades. When consumer demand increases—in of those services than they otherwise this case, for nontaxable services—the price of would. For example, the mortgage interest the product in demand typically increases. Under deduction, by which homeowners reduce normal circumstances, these price increases their taxable income by the amount temper demand somewhat. With services, paid in mortgage interest, reduces the however, consumer demand has grown despite “price” of homeownership (a form of consistent price increases. This has occurred housing service). In addition, employer- because cheaper goods prices have freed up some provided health benefits encourage consumer income, much of which has been spent employees to consume more healthcare on services. In addition, various factors have services than they otherwise would otherwise increased demand for services in recent (because employee compensation in the years even as consumers face higher prices. form of health insurance is untaxed, • First, a growing share of Californians, whereas other compensation is subject those in the “baby boomer” generation, to income and payroll taxes). Regarding are entering retirement. In general, older higher education, merit and need-based consumers use more healthcare services scholarships, as well as various than younger consumers do. As a result, preferential tax treatments, reduce tuition consumption of healthcare services (and prices consumers face and the cost of therefore its demand) tends to increase as borrowing. Together, these trends and a growing share of the population enters policies have helped boost consumer retirement. demand for services, despite rapidly increasing prices. • Second, as people’s incomes increase, they tend to spend a larger share of their 8 Legislative Analyst’s Office www.lao.ca.gov Graphic Sign Off Secretary Analyst Director Deputy AN LAO BRIEF Figure 7 Services Prices Have Grown Four-Times More Than Goods Prices Total Percentage Change Since 1980 400% Healthcare 350 300 250 All Services Housing 200 Recreation 150 All Goods and Services 100 All Goods 50 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 HoW HAvE THESE dYnAMIcS AFFEcTEd ARTWORK#130466 SAlES TAx REvEnUES? Since 1980, consumer spending in California Had spending on taxable items kept pace with the has shifted strongly toward nontaxed services and state’s economy since 1980, the sales tax would away from taxed goods, primarily because services generate the same amount of revenue for state have become relatively more expensive while goods and local governments as it does today at a much have become relatively cheaper. As a result, sales lower rate—5.2 percent instead of the current tax revenues grew annually about 0.6 percentage rate, 8.4 percent. Alternatively, if the current rate points slower than the state’s economy between remained unchanged, the sales tax would generate 1980 and today, despite periodic increases in the 61 percent more revenue than it does today. state and local sales tax rates during this time. WIll THIS TREnd conTInUE? The economic forces underlying rapid labor-intensive nature of services—appear service price increases and slower goods price unlikely to change, at least in the near future. In increases—namely manufacturing productivity general, we expect increases in service prices will gains, international trade expansion, and the continue to outpace increases in goods prices, www.lao.ca.gov Legislative Analyst’s Office 9 Graphic Sign Off Secretary Analyst Director Deputy AN LAO BRIEF as shown in Figure 8, over the next ten years. tax rate or expansion of its base, sales tax revenue Taxable sales are therefore likely to make up a for the state and local governments are likely to declining portion of the state’s economy over the grow slower than the economy for at least the near next decade. Absent further increases in the sales future. Figure 8 Difference in Price Increases Forecast to Continue Forecasted Percentage Increase in Prices From 2012 35% 30 Services 25 Goods 20 and Services 15 10 5 Goods 0 -5 -10 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021 2022 2023 ARTWORK#130466 10 Legislative Analyst’s Office www.lao.ca.gov AN LAO BRIEF www.lao.ca.gov Legislative Analyst’s Office 11 An LAO B R I E F LAO Publications This brief was prepared by Chas Alamo, and reviewed by Marianne O’Malley. The Legislative Analyst’s Office (LAO) is a nonpartisan office that provides fiscal and policy information and advice to the Legislature. To request publications call (916) 445-4656. This brief and others, as well as an e-mail subscription service, are available on the LAO’s website at www.lao.ca.gov. The LAO is located at 925 L Street, Suite 1000, Sacramento, CA 95814. 12 Legislative Analyst’s Office www.lao.ca.gov