Burden of sales tax rate increase may fall more heavily on households with higher incomes

Although sales taxation often faces opposition in the United States based on the assumption of a strict relationship between income and taxes paid, sales-taxable consumption actually rises with income, according to an analysis by an expert at Rice University’s Baker Institute for Public Policy.

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Jorge Barro, fellow in public finance, outlined his insights in a new issue brief, “Are Consumption Taxes Really Regressive?”

Barro’s finding implies that the burden of an increase in the sales tax rate may actually fall more heavily on households with higher lifetime incomes. By contrast, excise-taxable consumption (taxes paid when purchases are made on a specific good, such as gasoline) falls with income. This suggests that increases in excise taxes affect lower-income households more than higher-income households, Barro said.

Using the 2015 Consumer Expenditure Survey (CEX), a data set that contains detailed information regarding household expenditures and income levels, Barro found that the share of expenditures included in the sales tax base increases steadily by roughly 5 percentage points — from 18 to 23 percent — for households earning up to $100,000 per year. However, the base declines around 1 percentage point beyond $130,000 and stabilizes at around 22 percent of consumption for households earning above $200,000.

Sales taxation may actually be progressive for most households, Barro said. Data from the 2015 Current Population Survey shows that 73.6 percent of U.S. households had an annual income of less than $100,000, and 87.7 percent of households had an income below $150,000. “Further breakdown of this relationship across different age groups results in a similar pattern, suggesting that lifetime consumption patterns do not show evidence of differential age-dependent tax incidence after accounting for income,” Barro wrote. “This suggests that a shift in taxation toward sales taxation may actually increase a state or municipal tax structure’s progressivity.”

Barro found that the excise tax burden falls more heavily on lower-income households. “As household income increases up to $100,000, the fraction of excise-taxable expenditures falls about 6 percentage points and declines another 4 percentage points as household income rises to $300,000,” he wrote. “As opposed to sales taxation, a shift toward excise taxation reduces the progressivity of a state or municipal tax structure.”

While this study can serve as a quick reference for policymakers considering the effects of changing the sales or excise tax rate, a tax jurisdiction’s actual tax progressivity depends on the unique composition of its tax base, Barro said. “Choosing to restructure the sales or excise tax base through exemptions and inclusions almost certainly changes the tax structure’s progressivity,” he wrote. “To that extent, policymakers wishing to study the progressivity of taxing particular consumption bundles can reconstruct elements of their specific tax base using the CEX to measure the relationship between taxable consumption share and income.”

While each state levies its sales tax on a unique set of consumption goods, several states have many of the same items in their tax bases, Barro said. Of the large expenditure categories, education, financial services and health are generally excluded from sales taxation. Within the housing expenditures category, property payments, such as rent or mortgage, are generally excluded from the sales tax base, but home furnishings and appliances are usually not excluded. This leaves transportation, food, retail and miscellaneous expenditures to comprise the remaining sales tax base.

Consumption items are categorized as excise-taxable based on whether they are generally treated by the tax system uniquely, Barro said. Motor vehicle fuel, alcohol, tobacco, lodging (for example, hotel stays) and home utilities, such as electricity and water, each satisfy the definition of an excise tax and collectively comprise the excise tax base.

In the U.S., state and municipal governments rely heavily on consumption tax revenues to finance their expenditures, Barro said. According to the U.S. Census Bureau, consumption taxation generated $544 billion of revenue in 2015, amounting to 3 percent of gross domestic product and financing roughly one-third of all sub-federal level expenditures. Roughly two-thirds of consumption tax revenue was generated by sales taxes, while the remaining one-third was generated by excise and other consumption taxes. As of 2017, 45 states and the District of Columbia as well as municipal governments in 38 states collect sales taxes, while every state and several municipal governments, as well as the U.S. federal government, levy some kind of excise tax.

“Given this extensive dependence on consumption taxation to finance government expenditures, policymakers should carefully consider who bears the burden of the tax,” Barro wrote.