Special Report No. 147
State governments have traditionally raised revenue from business by 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. ing corporate income. But in recent years the growing difficulty of administering state 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. es has prompted a search for alternative ways of taxing companies. This search for new business taxes has ironically sparked a resurgence in one of the world’s oldest broad-based tax structures: the gross receipts taxA gross receipts tax is a tax applied to a company’s gross sales, without deductions for a firm’s business expenses, like costs of goods sold and compensation. Unlike a sales tax, a gross receipts tax is assessed on businesses and apply to business-to-business transactions in addition to final consumer purchases, leading to tax pyramiding. , also known as the “turnover tax.”
Gross receipts taxes have a simple structure, taxing all business sales with few or no deductions. Because they tax transactions, they are often compared to retail 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. es. However, they differ in a critical way. While well designed sales taxes apply only to final sales to consumers, gross receipts taxes tax all transactions, including intermediate business-to-business purchases of supplies, raw materials and equipment. As a result, gross receipts taxes create an extra layer of taxation at each stage of production that sales and other taxes do not—something economists call “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. .”
Advocates of gross receipts taxes generally defend them on two grounds. First, it is argued that their simple structure makes them easy for states to administer and for companies to comply with, in contrast to notoriously complex state corporate income taxes. Second, because they tax an expansive base of all transactions in the economy, they are able to raise a given amount of revenue at lower rates than any other tax, making them politically attractive to lawmakers.
But while gross receipts taxes appear to be a simple alternative to complex corporate income taxes, this simplicity comes at a great cost. Gross receipts taxes suffer from severe flaws that are well documented in the economic literature, and rank among the most economically harmful tax structures available to lawmakers. The economic problems with gross receipts taxes are not the result of poor implementation by lawmakers. The flaws are inherent in their design. State lawmakers searching for alternatives to complex state corporate income taxes should be wary of gross receipts taxes, and should instead seek more economically neutral ways of taxing business.
• There is a growing trend among states toward replacing corporate income taxes with Depression-era gross receipts taxes.
• Gross receipts taxes are poor tax policy. They lead to harmful “tax pyramiding,” distort companies’ structures, and damage the performance of state and local economies.
• The administrative simplicity and low rates of gross receipts taxes are illusory. Lawmakers are forced to add complexity to correct for their structural flaws, and some industries face high effective tax burdens despite low statutory rates.
• States in search of alternatives to corporate income taxes should not rely on economically harmful gross receipts taxes.