Sales Tax Exemptions and Credits: Time to Reevaluate

By Derrick, Frederick W.; Scott, Charles E. | Atlantic Economic Journal, December 1995 | Go to article overview

Sales Tax Exemptions and Credits: Time to Reevaluate

Derrick, Frederick W., Scott, Charles E., Atlantic Economic Journal

I. Introduction

Legislators face conflicting goals between vertical equity and revenue generation with the sales tax. Gold [1992] argues that the equity issue is of growing importance to legislatures due to increased public exposure of the tax burden of the poor, since poverty is increasing and the states lag behind the federal government in responding to the regressivity of taxes. Revenue generation is important, and the sales tax is the largest source of state revenue. Hamilton and Mikesell [19921 argue that one of the most important challenges in state tax policy discussions will be expanding the sales tax base without dramatically increasing the inequities of the system. In addressing the inherent regressivity, states have chosen between taxing broadly and offering credits to income-qualified groups or narrowing the base by exempting certain items which are more likely to be purchased by the poor. These approaches offer the negative choices of requiring the poor to pay the tax and take action to get a rebate or having the state lose significant revenue.

The authors offer two new options which solve some of the problems encountered in the above, while providing a broad sales tax base. One solution is the administration of tax credits by directly providing the credit to the poor via the debit card system. The other is a negative tax credit which exempts selected items from the sales tax and collects the lost sales tax revenue from higher income individuals. The use of a debit card delivery system for credits solves some of the administrative problems of traditional credits by using current technology. The negative credit offers a theoretical and practical mechanism for reducing the regressivity while increasing revenue. The negative credit is conceptually opposite to a credit, placing emphasis on the collection from those capable of paying instead of on reimbursement to those incapable of paying.

To verify the relative merit of the sales tax options, credits, exemptions, and negative credits are evaluated for their advantages and disadvantages. The impact of each on regressivity and on revenue generation is empirically compared using the Maryland tax code with differing tax treatments of food expenditures. Food is used in the example because of its large share of expenditures, especially for the poor. A variety of sales tax methods are used in the states to address food expenditures. The results indicate that credits are no more effective than exemptions in affecting regressivity if the credit reaches fewer than 70 percent of the low-income individuals. With the increased interest in the use of debit cards for income assistance, this system provides a method for credits to reach a large percentage of the poor. The negative credit is more effective in reducing regressivity than the other various credit methods while recapturing most of the revenue unnecessarily lost with the exemption.

II. Exemptions and Credits

Exemptions and credits have significant limitations when judged against the criteria of sound tax policy.(1) Credits are theoretically preferable with respect to efficiency, horizontal equity, and revenue stability but are difficult to administer. Frequently, they fail to reach those in need.(2) Gold [1992] notes that less than 80 percent of those eligible received earned income tax credits and that one-third of those eligible for food stamps did not file. The poor are often poorly informed about their entitlements and are difficult to reach. Participation by the poor is crucial and the credit must be refundable for credits to be effective [Due and Mikesell, 1983]. Gold [1992] indicates that strong outreach programs can impact the proportion of eligible individuals who receive benefits.

Exemptions are politically preferable to credits. They do not require action by the poor and, hence, give certainty of tax relief. Also, they do not deny the poor the use of tax dollars during the year. …

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