Arkansas’s Tax Reform and Relief Task Force will continue its job of working to improve Arkansas’s taxA tax is a mandatory payment or charge collected by local, state, and national governments from individuals or businesses to cover the costs of general government services, goods, and activities. system next week. Now that the process of choosing and hearing from the consultant, PFM Group, is done the Task Force is now really getting down to business. The tentative plan for the November meetings is to discuss the sales and use tax in Arkansas.
As coauthors of a major book of Arkansas’s tax system, Arkansas: The Road Map to Tax Reform, we have also studied and thought deeply about how the sales and use tax in Arkansas could be improved. Chapter 6 of our book examined the sales taxA sales tax is levied on retail sales of goods and services and, ideally, should apply to all final consumption with few exemptions. Many governments exempt goods like groceries; base broadening, such as including groceries, could keep rates lower. A sales tax should exempt business-to-business transactions which, when taxed, cause tax pyramiding. in detail, and we will summarize some of our main findings and suggestions here.
One major issue with sales taxes across the country is the eroding sales tax base. The base erosion is partially due to conscious policy changes, such as exemptions for groceries as we discuss below. But another source of sales tax baseThe tax base is the total amount of income, property, assets, consumption, transactions, or other economic activity subject to taxation by a tax authority. A narrow tax base is non-neutral and inefficient. A broad tax base reduces tax administration costs and allows more revenue to be raised at lower rates. erosion is the changing structure of the economy, moving from a goods-based economy to one dominated by services. This change is essential to understanding sales tax base erosion, since nearly all states include goods in the tax base by default (unless exempted) and exclude services by default (unless specifically enumerated).
Arkansas fits well within this national trend. Services are usually exempt from the sales tax (with a few exceptions), while goods are generally included in the sales tax base. In 1977, we estimate that Arkansas was accurately capturing about 77 percent of the logical sales tax base using the basic principles of public finance economics. By 2015, the sales tax base had gradually shrunk to about 43 percent of the appropriate implicit tax base. That 43 percent figure actually places Arkansas in a position of strength, with the eighth broadest sales tax base in the country, and well above the national median of 23 percent. But from that position of strength, Arkansas has much work to do to improve the breadth of its sales tax.
In addition to having one of the broader sales tax bases in the country, Arkansas also has the third highest average sales tax rate in the country (including local sales tax rates). Together, these mean that Arkansas is heavily reliant on the sales tax for funding state and local government services. For example, even though Arkansas is by most measures in the bottom five states in terms of income (and thus consumption) per capita, it has the 10th highest general sales tax collections per capita, more than high-tax, high-income states such as New York and California (the 11th and 15th highest on this measure).
Arkansas also derives about 37.5 percent of all revenue (state and local combined) from the general sales tax, the eighth highest in the nation (or the fourth highest if we exclude states with no general income tax). The national median is around 24 percent for states that have a sales tax. Arkansas relies heavily on the sales tax as changes to the sales tax only require a majority vote of the General Assembly under Amendment 19 to the Arkansas Constitution; increases to income taxes require super-majorities.
The most basic reform that Arkansas can enact is to broaden the sales tax base to include more services. One way to do this is by gradually including more services in the sales tax base. An easy place to start would be service industries that are already taxed in neighboring states, but that Arkansas does not tax. A much more dramatic, though also more economically sound change, would be to include services in the sales tax base by default, unless there are good economic reasons for exempting the service. In other words, treat services the same way goods are treated. Finally, Arkansas could consider including some goods in the sales tax base that are currently excluded, such as groceries (discussed below).
At the same time that Arkansas is broadening the sales tax base, the new revenue should be used to lower existing tax rates. As mentioned above, Arkansas has one of the highest sales tax rates in the country. But other tax rates are high, and may be even better ones to lower with the new revenue. For example, at 6.9 percent Arkansas has the highest personal income tax rate among its neighbors, and the second highest in the South (South Carolina is slightly higher at 7 percent). And the top corporate income taxA corporate income tax (CIT) is levied by federal and state governments on business profits. Many companies are not subject to the CIT because they are taxed as pass-through businesses, with income reportable under the individual income tax. rate is tied with two other states for second highest in the South at 6.5 percent (only Louisiana is higher at 8 percent).
At the same time Arkansas is broadening its sales tax base, one caution must be kept in mind: don’t make it too broad. Specifically, business purchases should be exempt from the general sales tax. Many business purchases are exempt, though some are taxed, and caution must be exercised to not include any new business services.
The reason for exempting business purchases of goods and services from the sales tax base is not to give preferential treatment to businesses. Instead, it is to avoid the practice of tax pyramidingTax pyramiding occurs when the same final good or service is taxed multiple times along the production process. This yields vastly different effective tax rates depending on the length of the supply chain and disproportionately harms low-margin firms. Gross receipts taxes are a prime example of tax pyramiding in action. , where taxes are placed on multiple stages of production. Not only does this practice lead to higher taxes than the stated rate suggests, it can lead to distortions across industries. For example, some industries may only have two stages of production, while others have six stages. The six-stage industry would be paying over three times as much in sales taxes as the two-stage industry, which is not only unfair, it may distort business investment decisions. A good sales tax base treats all industries equally.
Lower Sales Tax Rate for Groceries
One major example of an exemption that narrows Arkansas’s tax base is the lower rate imposed on groceries (technically food and food ingredients). The normal statewide sales tax rate of 6.5 percent is reduced to 1.5 percent for items that qualify under this exemption, though local sales tax rates still fully apply to groceries. In an April 2012 report, the state’s Department of Finance and Administration estimated that this lower rate costs Arkansas about $197 million annually, compared to taxing groceries at the full sales tax rate.
The current lower rate for groceries is part of a series of changes, starting with a 3 percent rate in 2007, which was a campaign promise of then-Governor Mike Beebe (D). While the bill passed both houses of the General Assembly unanimously, support was not universal across the state. For example, the Arkansas Advocates for Children and Families (AACF) initially argued that the cut in the grocery tax was a poor way to assist low-income families, since it also benefits millionaires and non-Arkansans. Their preference was the establishment of an Earned Income Tax CreditA tax credit is a provision that reduces a taxpayer’s final tax bill, dollar-for-dollar. A tax credit differs from deductions and exemptions, which reduce taxable income, rather than the taxpayer’s tax bill directly. , a much cheaper way to provide the same level of benefits to low-income Arkansans. Many members of the governor’s own party also initially supported measures more directly targeted at low- and middle-income families, such as income tax credits.
The debate over the grocery tax between left-leaning AACF and then-Governor Beebe highlights an important difference between arguments for exempting groceries from the sales tax. The first is that groceries are a necessity, and therefore it may be a good idea to exempt them for purchase by both rich and poor alike. The second argument is that the poor spend a disproportionate amount of their income on consumption generally, but especially necessities such as groceries.
While the two arguments are similar, they have very different implications for public policy. If taxing necessities is generally a poor policy choice, exempting groceries from the sales tax is a good idea. But if the primary goal is to help those families who are struggling to make ends meet, it may not be the best policy. First, because it is an expensive way to help a targeted group as all individuals benefit, and second, because it may not actually help many poor families. Those at the very bottom of the income distribution who purchase their food with government benefits such as Supplemental Nutrition Assistance Program (SNAP, known colloquially as food stamps) and Women, Infants, and Children (WIC) already enjoy tax-free purchases, and there is no additional benefit to lowering the sales tax rate on groceries for them.
There are better ways to help Arkansans make ends meet than by partially exempting groceries from the sales tax. For the lowest-income Arkansans, grocery tax credits or an earned-income tax credit would be a more effective and targeted way to provide them with additional income support. For all Arkansans, lowering one of their tax rates, such as the personal income tax, would also be a better way of helping them. Instead of saying “we’ll only give you a tax break on your groceries,” Arkansas could say “we’ll give you a general tax break, and you can then choose where you spend your income.”Share