White House Report on Replacing State Income Taxes: Analysis

Could states replace their current income and sales taxes with new, broad-based sales taxes at an average rate of 6.23 percent? That’s the assessment of the White House Council of Economic Advisors (CEA), but that attractively low rate does not withstand scrutiny. I estimate that the national average replacement rate could be as high as 17.51 percent.

The CEA report highlights the economic benefits of shifting from income to consumption taxes, citing studies showing that consumption taxes are more efficient than income taxes. Here, the CEA’s analysis is correct, and we have cited some of the same studies (and many more) in our own analysis. Reducing income 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. burdens and shifting toward well-designed sales taxes is pro-growth tax policy, and many states have adopted income tax relief in recent years, enhancing their tax competitiveness.

In the report, White House economists also provide estimates of the GDP effects of eliminating state income taxes and replacing them with a broadened 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. . These estimates, which assume an average of a 1.44 to 1.56 percent increase in GDP from a revenue-neutral shift from income to sales taxes, are consistent with the economic literature, and are built into their estimates of replacement rates. The report also estimates impacts on wages and startups, again drawing from, and consistent with, findings in the broader economic literature.

The CEA is, in short, right about the benefits of reducing reliance on individual and corporate income taxes. But it goes badly awry in its rate calculations.

The report provides state-by-state estimates of the rates necessary if states were to replace their current income and general sales taxes with new broad-based sales taxes that fall on a much wider range of final consumption. The CEA estimates that, under a strict scenario where states commit to constraining the growth of government, a national average rate of 6.23 percent on a broad-based sales tax would be sufficient to replace current income and sales taxes.

Unfortunately, the CEA’s calculations omit important factors and envision a 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. that violates federal law, among other serious impediments.

In designing a broadened sales tax, the CEA models a tax that applies to all final goods and services with only “a few modest exceptions”:

The sales tax would not apply to rent or housing more generally.
The sales tax would not apply to groceries.
The sales tax would not apply to any category of good that is already taxed under an excise taxAn excise tax is a tax imposed on a specific good or activity. Excise taxes are commonly levied on cigarettes, alcoholic beverages, soda, gasoline, insurance premiums, amusement activities, and betting, and typically make up a relatively small and volatile portion of state and local and, to a lesser extent, federal tax collections. or other selective tax (gasoline, alcohol, tobacco, etc.).

My own calculations confirm that the CEA did, in fact, assume a base of all personal consumption expenditures outside these three categories. That means their base includes:

All healthcare expenditures, including those covered by private insurance (funded by premiums subject to separate excise taxes) and those paid for by government through Medicare, Medicaid, and other programs (which cannot be taxed as a matter of law).
Consumption that does not involve a financial transaction, including the full imputed value of banking services that are largely funded by banks’ reinvestment of depositor funds, not by direct fees from depositors.
The value of services provided by nonprofits at free or subsidized rates, including scholarships and endowment subsidies that reduce college tuition, free or subsidized medical care, aid provided by charitable organizations, and the full operating expenses of houses of worship (none of which are transactions and none of which could be subject to sales tax).
Other purchases that are not legally taxable, including internet access and purchases from the US Postal Service.

The portion of healthcare services not furnished by government is at least legally taxable, but the rest of the above is not, either due to a legal prohibition or the absence of any actual transaction. All of it, however, is counted as taxable consumption in the CEA’s estimates, vastly overstating the potential tax base.

The CEA’s figure also assumes 100 percent compliance under the new tax, even though they calculate revenue replacement levels against actual collections under existing income and sales taxes, which fall well short of full compliance. Assuming that sales tax would be collected on 100 percent of the tax base is unrealistic.

Additionally, while this does not affect the CEA’s state-by-state calculations, their national averages seem to cover all states, even those that already forgo an income tax, a sales tax, or both. In the five states without sales taxes, the replacement sales tax rate to cover their existing income and sales taxes will, of course, be much lower than expected in other states. Including personal consumption expenditures in states that already forgo an income tax likewise skews the figures.

Even then, the CEA’s estimates of revenue replacement seem low. In fact, my attempts to replicate their findings, based on their assumptions as I was able to interpret them, yielded a very close approximation when only considering individual income taxes, but dramatic underestimates—even adjusting for the deficiencies outlined above—when including 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. collections as well.

Using their results, but adjusting for legality and the presence of a transaction, assuming 89 percent compliance against personal consumption estimates (a generous assumption), and limiting the analysis to states with both an income and a sales tax, I estimate an average replacement rate of 12.08 percent, not 6.23 percent.

Under a full recalculation using the latest available data, while incorporating the economic growth they anticipate, I get a far higher rate: 17.51 percent.

The CEA accounts for additional behavioral effects that could well reduce the revenue-neutral rate, and which are not considered in this analysis. But the size of their error in identifying the consumption base reduces the salience of elasticities that could adjust the result by a percentage point or two, however meaningful that might be in other contexts.

Whatever the rate, moreover, it relies upon taxing a broad base of final consumption, covering some healthcare costs and personal consumption of financial services, legal services, private school tuition, and more. Adding existing average local rates in these states increases the rate by about 1.58 percent, even assuming local governments adopt revenue-neutral rate reductions to account for the broader base.

Interestingly, once these necessary adjustments are made, the new sales tax base is narrower than the existing one. If income taxes were replaced by simply raising the rates of existing sales taxes, I estimate that the average state-level replacement rate would be 15.66 percent.

The reason: the CEA’s proposed sales tax includes a broader base of final consumption, but excludes all intermediate transactions (“business inputs”). This is correct as a matter of economic policy, and reducing the taxation of these business-to-business purchases is a valuable pro-growth reform. But with business inputs currently accounting for 40 to 50 percent of many states’ sales tax bases, their elimination undercuts the revenue potential of the proposed sales tax on a broader range of final consumption.

The CEA is directionally correct on policy. States should remove business inputs from the sales tax base wherever possible. Taxes on business inputs are production taxes, not consumption taxes, penalizing in-state business activity. And states should prioritize income tax relief wherever possible.

But through flawed estimates, the CEA dramatically overstates the ease with which states could replace their income taxes. Real reform is worth doing—but that starts with realistic figures.