Maine’s Governor Proposes to Replace the Income Tax with a Broader Sales Tax

November 20, 2014

After winning reelection this month, Maine’s Governor, Paul LePage, announced that he wants to completely eliminate the state’s individual income tax. He would replace the lost revenue by broadening the sales tax base.

This sort of swap is generally good tax policy. Individual income taxes have a few problems. One, they tend to create labor force disincentives and two, they are applied to a significant amount of business and capital income, which harm state economic performance. The second issue is especially acute for Maine, given that more than 60 percent of the private sector workforce is employed by businesses that pay tax through the individual income code, not the corporate income tax code.

Sales taxes, when levied properly, are consumption taxes, which do not have these issues. They promote more economic growth while raising adequate revenue for government programs.

The big questions about this plan are whether the sales tax base could be expanded enough in order to pay for the lost revenue and if it could not, would it require an even higher rate (the current rate is 5.5 percent).

According to the Maine 4-Year Budget Forecast, the income tax is projected to raise $1.437 billion in FY 2013. This is approximately 46 percent of general fund revenue.

That is a lot of money.

In contrast, the sales tax (excluding excise taxes) raises about $1 billion. This number would have to increase substantially in order to make up for the loss of $1.4 billion in income tax revenue.

The good news, however, is that Maine’s sales tax base is very narrow to begin with and could be broadened. What this means is that it is levied on few goods and services that are legitimately personal consumption and should be taxed.

With a quick look at the tax expenditure estimate report by the Maine Bureau of the Budget, it seems like replacing the income tax may be possible. The combined value of sales tax exemptions is $1.87 billion, which is more than the $1.4 billion the income tax currently raises.

However, there are three challenges with such a huge expansion of the sales tax that need to be considered:

First, many sales tax exemptions are good tax policy and should remain, which puts a limit on how much revenue a base expansion is going raise. Specifically, business-to-business transactions should not be taxed, otherwise the sales tax will create tax pyramiding. Pyramiding is when sales taxes start applying to themselves through the production process, creating high effective rates, especially in industries with many steps in the production process. Taking a rough look at the expenditure list shows that there is at least $250 to $400 million in business-to-business transactions that should remain, leaving about $1.6 to $1.4 billion left, which makes replacing the income tax a heavier lift (and may even require a rate increase).

Second, sales tax base expansions are politically tough. Industries are typically unwilling to sit quietly as their special sales tax exemption goes away. This sort of industry lobbying was problematic in D.C. when they recently expanded the sales tax base. However, D.C.’s successful reform effort shows that it is possible to overcome industry opposition.

Finally, sales tax base expansions also create the perception of unfairness. If the sales tax is expanded to groceries and other goods deemed as necessities, many see that as an unfair tax increase on low- or middle income individuals. This concern could be dealt with on the spending side with increased transfers to low-income individuals.

With these challenges, it may be easier to meet half way: broaden the sales tax base in a more limited way as a way to reduce the income tax, but not get rid of it. Specifically, Maine could start taxing services purchased by individuals. According to my rough calculations, the Maine government loses about $1.2 billion in revenue from exempting services. These services include things such as legal services, amusement & recreational services, and beauty parlors. (Again, it is unlikely the state would get the full $1.2 billion, given that some businesses may utilize services and should be exempt from the sales tax).

While there are certainly concerns about whether this plan is feasible (both politically and mathematically), discussing a move from the income tax to the sales tax is a good starting point for restructuring Maine’s taxes so the state can be more economically viable.

More on Maine here.


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