Economist Alan Viard is one of the leading scholars of tax policy in the United States. In this article, first published in State Tax Notes in 2010, Viard explains the logic behind the broad consensus of economists that state sales taxes should generally exclude business to business purchases to avoid tax pyramiding.
Viard’s article, Sales Taxation of Business Purchases: A Tax Policy Distortion, is required reading for any serious student of state tax policy.
Here are some highlights of Viard’s careful analysis and rejection of sales tax on intermediate business purchases:
actual state and local sales taxes diverge dramatically from the popular and textbook vision of the tax. One major flaw is the exclusion of a wide range of consumer services from taxation, which renders the consumer tax base much narrower than the textbook description suggests. The other crucial flaw, which is the focus of this article, is the imposition of tax on a wide range of business purchases; taxes on those purchases account for roughly 40 percent of nationwide sales tax revenue. The taxation of business purchases impedes economic efficiency and hides the true tax burden from the public…
A wide range of authors have discussed the economic distortions arising from taxation of business purchases. The following sources of inefficiency have been noted:
• The taxation of capital goods imposes a penalty on saving and investment, replicating the key flaw of income taxation. A recent Cato Institute report finds that state sales taxes, along with asset-based taxes on property, add about 7 percentage points to the effective corporate income tax rate in the United States.
• The choice between production processes is distorted, because firms have an incentive to use inputs and capital goods that are exempt from sales tax in place of those that are subject to sales tax.
• Firms have an incentive to vertically integrate, because production within a single firm is not subject to the tax imposed on sales between firms.
• The tax on inputs pyramids into the price of the final goods in an uneven manner, causing effective tax rates to vary across goods subject to the same statutory tax rate, which can distort consumers’ choices between different goods.
Evidence from statistical studies and simulations of economic models suggests that that the taxation of business purchases significantly impedes economic efficiency…
In 2002 Charles E. McLure Jr. identified the taxation of business purchases as one of many ‘‘nutty’’ features of state and local tax systems. Hellerstein et al. list the taxation of business purchases as a ‘‘structural flaw’’ of state sales taxes. State Tax Notes contributing editor David Brunori noted the ‘‘near unanimity among public finance scholars’’ against the practice and nominated it as one contender for the most egregious flaw of state tax systems…
Despite their image as consumption taxes, state and local retail sales taxes are actually imposed on a large volume of business purchases, resulting in significant economic inefficiency. Whether reform is pursued within the sales tax context or outside it, a reduction in the taxation of business purchases should be a high priority in efforts to improve state and local tax systems.