Maxing out: an analysis of local option sales tax rate increases.

INTRODUCTION

New York City adopted the first local general sales tax in 1934 partly because of widespread dissatisfaction with real property taxes following the depression. City and county governments in 34 states increasingly turn to the sales tax, often to add diversity and stability to their revenue structure. The number of local governments with sales taxes has grown from just under 3,000 in the early 1970s to over 9,000 today. General sales taxes have become the second largest local revenue source, accounting for approximately 12 percent of local tax revenue in 2002, a 20 percent increase over the previous decade.

At the same time, sales tax bases are shrinking, primarily due to growth in remote sales (Bruce and Fox, 2000), technological changes, legislated exemptions, and changing purchasing patterns (Merriman and Skidmore, 2000). (1) Sales tax bases as a percentage of personal income have declined nearly 27 percent, down from 53. (2) percent in 1979 to 39.1 percent in 2003. Local governments must offset the shrinking base and corresponding revenue losses by raising the sales tax rate, exploiting other revenue sources, or reducing spending. Local government tax bases are particularly at risk because of the ease with which people can shop in other nearby jurisdictions or remotely.

In many places the sales tax has moved from simply adding diversity to state and local tax structures to becoming an integral component of local tax revenue, and this presents a set of unique compliance problems in the modern era when dealing with remote sales. For example, the Streamlined Sales Tax Project (SSTP) is a national effort by states to harmonize the entire sales tax system by developing uniform definitions of the tax base, simplifying audit and administration procedures, and developing technologies that make compliance feasible for the thousands of remote vendors. Fifteen states have conformed to the SSTP and begun operating together. Officials in several other states, including Tennessee, Texas, and Washington, have delayed full adoption of the SSTP Agreement in part because of concerns that local governments will lose sales tax autonomy as states move toward uniform local structures with destination-based sourcing of the revenues.

Using data on local sales tax rates in Tennessee, we identify the economic and political forces that lead local governments to fully exploit sales tax options by raising local sales tax rates to a legal maximum, and we also examine how these forces have changed over time. The sales tax environment in Tennessee is interesting both because of the state's heavy reliance on the revenue source and the fact that eight states border Tennessee, all of which have lower overall sales tax rates. (2) In addition, Tennessee imposes a statewide limit on local sales tax rates that it periodically increases in discrete steps that apply uniformly to every county. Because of the state--mandated rate limit, rate increases are a natural but limited tool for addressing sales tax base erosion (Mikesell and Zorn, 1986; Ferris, 2000; Bruce and Fox, 2000). However, counties that quickly raise their sales tax rates to the maximum--allowed rate have signaled a strong preference for the sales tax relative to their neighbors, many of whom never reach the maximum rate.

We employ a duration model to study the decision to increase the local rate to the maximum, during a span of time in which the average local option rate increased by 100 basis points from 1.3 percent to 2.3 percent. We further divide this time span into two shorter periods, characterized by different maximum local option sales tax rates. Our focus is on spells of time in years that a county remains below the maximum local option rate, where the end of a spell (or "failure" in duration model terms) occurs when the county reaches the maximum rate. Our results show that in the earlier time period, counties with larger sales tax bases were less likely to raise their sales tax rates to the maximum allowed by law. This was not found during the latter part of our study when a higher local maximum rate was allowed. For that period, counties with a lower property tax base or a larger share of Republican voters were more likely to raise their local sales tax rate to the state maximum.

This study contributes to the literature in a number of important ways. First, the paper provides an empirical contribution to the literature on the determinants of local government tax structure. The paper provides a setting where one can observe how state-driven tax policies may have an affect on local governments' tax rate decisions. In this particular case, we examine the factors that lead a county to adopt the maximum--allowed local option sales tax rate. Further, the paper adds to the limited empirical literature on vertical externalities at the state and local level in the U.S. as we consider the factors in separate time spans where state--level constraints differ. (3) Finally, we use modern duration analysis methods, which allow us to examine the effects of a county's characteristics on the time it takes to reach the maximum rate. This method is preferred to other statistical techniques because it allows us to not only examine characteristics of counties that choose to move to the maximum, rate but also explore the timing of those decisions relative to other counties. Taken together, our research represents a contribution to the literatures on revenue determinants, tax competition, and responses to state-imposed revenue limitations.

This paper is organized as follows. In the next section, we briefly discuss the relevant literature. The third section includes an explanation of Tennessee's sales and property tax structures. We then introduce a model for examining the role of economic and political factors and describe the data used. Following a discussion of the results, we conclude with a summary and suggestions for future research.

PRIOR RESEARCH

Tax rate decisions involve both political and economic considerations. Elected representatives must choose tax rates sufficient to fund desired expenditures but competitive enough to keep the tax base from fleeing. As a result, legislators must consider the tax options (e.g., sales or property taxes), taxable bases in their jurisdiction, and the tax rates necessary to raise the desired amount of revenue. Prior research has found that local option sales tax adoption is a function of expenditures, other revenue sources, neighbor's adoption and fiscal stress (Sjoquist and Wallace, 2003; Sjoquist, Smith, Wallace and Walker, 2005). Seligman and Hou (2006) also find some evidence that adoption of the local sales tax to substitute for the property tax can lead to slower revenue growth.

Prior research also shows that sales tax rate increases may reflect a desire to increase spending, to reduce property taxes or to follow neighboring rate-increasing jurisdictions (Sjoquist, Walker and Wallace, 2005; Luna, 2004; Case, 1993; Rork, 2003; Hill, 2005). Substitution effects may be more prevalent at the local level since every county has a border, but the response to sales tax rate differences differ depending on the type of good being purchased (Cornia, Nelson and Walters, 2005).

While this study does not directly test for vertical externalities, it does provide some evidence about how counties react when faced with changing state tax policies. (4) Empirical research on vertical externalities is limited and finds mixed results. For example, Besley and Rosen (1998) find that states raise tobacco and gasoline tax rates in response to federal tax rate increases, and Esteller--More and Sole--Olle (2001) find that states increase personal income and sales tax rates following an increase in federal income tax rates. However, others have also concluded that a tax interaction between the levels of government exists but find an opposite sign on the interaction (Hayashi and Boadway, 2001; Goodspeed, 2000).

Another important line of research examines how local governments respond to state-imposed tax and/or spending limits. At the state level, limits on local governments have been found to increase the state's role in combined state and local activity (Joyce and Mullins, 1991). At the local level, Shadbegian (1999) found that governments increased other forms of revenue (e.g., user fees) when state law limited increases in local property taxes. Stine (1998) takes a different approach and examines what factors influence a jurisdiction's decision to repeal a tax when given the choice. The results of these studies indicate that local governments do not respond uniformly to limits or changes in their taxing options. Fiscal pressures, political forces, and various demographic characteristics all appear to influence taxing decisions.

TENNESSEE LOCAL FINANCE OPTIONS

Tennessee enacted a state-level sales tax in 1947 and added the local option sales tax in 1963. (5) Local sales taxes can be adopted and the rate can be changed when County Commissioners initiate a referendum and a majority of voters approve the proposal. (6) Local rate increases have been extremely common--the general sales tax comprised nearly 19 percent of total local tax revenue in Tennessee in 1972 (compared to a national average of 5.5 percent) and grew to 29 percent by 1985 before sliding to 22.5 percent today (as opposed to less than 12 percent for the U.S.). We revisit the post-1985 decline in our discussion of the results.