August 21, 2014

Sales Taxes and Exemptions

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State and local governments often turn to increases in sales taxes to generate added revenue. Estimates of fresh revenue from the higher tax tend to be overly optimistic, partly because the number of sales tax exemptions tends to rise with the rising tax rate. Given the fact that politicians seek to raise a certain amount of revenue and wish to maximize their chance of re-election, this relationship suggests that politicians face a trade-off when seeking votes from groups that favor sales tax decreases and groups that lobby for certain tax exemptions.

Assuming that higher tax rates increase the incentive to lobby for tax exemptions, agencies that estimate the effects of sales tax increases should take into account the expected increase in tax exemptions as well. Ultimately, the link between sales taxes and sales tax exemptions serves to undermine the certainty of generating additional revenue by increasing sales taxes.1

PUBLIC CHOICE MODEL

Public choice economics explains how  politicians seek to maximize votes given that competing groups of voters vie for political support.2 For instance, one group of constituents may want taxes raised on a certain group or a certain type of transaction, while another group may favor reductions in taxes or increases in tax exemptions. In order to maximize votes, politicians can satisfy both groups by simultaneously increasing taxes and expanding the number of exemptions, or loopholes. While the net result on tax revenue generated may be negligible, a politician can secure additional votes from both groups.

University of Chicago economist Sam Peltzman’s analysis of the regulation of firms offers insights that are relevant to the study of sales taxes and exemptions.3

Given that firms demand price regulations that increase their profits and consumers desire regulations that lower prices, Peltzman analyzed how politicians approach regulating firms in order to maximize votes. This model presents a situation in which both groups can’t be simultaneously satisfied, just as is the case with sales taxes and exemptions. In a recent paper,4 we use Peltzman’s model, showing that politicians seek to maximize support from competing groups, to analyze the relationship between sales taxes and sales tax exemptions.

We analyze the equilibrium relationship between the sales tax rate and the number of sales tax exemptions in each state that levies sales taxes. Our theory suggests that as tax rates rise, so do lobbying activities, and therefore the number of exemptions. In this model, in order for a politician to maintain a certain amount of revenue, that politician is not able to satisfy all groups. In other words, when a politician decreases taxes— thereby increasing support from one group—that politician is forced by the revenue constraint to decrease tax exemptions as well—hence losing support from the other group. In this way, the wealth of one interest group increases at the expense of the other group. Given this state of affairs, the politician is faced with choosing a tax rate and a number of exemptions that maximizes the politician’s chance of re-election.

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