(Released on 8/10/08)
Although it has been said time and again that Hawaii’s general excise tax is not the same as a retail sales tax found on the mainland, it nonetheless has characteristics like the retail sales tax, largely because it is calculated as a percentage of a sales transaction.
Perhaps the worst aspect of transaction taxes is that it tends to create a heavier burden on those in lower-income brackets making the tax what is known as “regressive.” A sales tax or a tax on transactions is inherently regressive, as the tax is not based on the person’s ability to pay. Some proponents acknowledge that sales taxes place a heavier tax burden on low-income households than on middle or upper-income households, but maintain that exempting necessities such as food, or including low-income tax credits through the income tax, are sufficient to address the problem.
Analyses of sales taxes indicate that it is difficult to offset the regressive impact of a sales tax. Exempting food sales and other necessities makes a sales tax less regressive, but only to a small degree. Most of the state and local tax systems that place the highest tax burden on low-income households have sales taxes that exempt sales of food and other necessities, such as prescription drugs.
Proponents of a sales tax are correct that low-income tax credits are crucial to offsetting the regressivity of a sales tax, but the credits must be refundable, targeted, and sufficiently large. When coupled with an across-the-board income tax rate cut, and despite low-income tax credits, the regressivity of the system is actually exacerbated as rates may be reduced but the floor at which income taxes are imposed is not increased.
The most regressive state and local tax systems rely heavily on sales and excise taxes. These state tax systems have little or no income taxes, or have a flat-rate income tax. Seven of the ten most regressive states, defined by the gap between the effective tax rates on the poorest 20% and richest 12% of households, rely heavily on a sales tax.
Sales taxes are inherently regressive because low-income families generally spend everything they earn, and often more, while high-income families tend to save larger portions of their income or spend it on things like travel which is not subject to state and local sales taxes. The sales tax thus applies to virtually all of the income of a low-income household, but relatively little of the income of an affluent household. Most states with sales taxes exempt some “necessities,” but this only slightly alters the regressivity of a sales tax.
States with sales taxes that exempt food and other necessities still have steeply regressive tax systems. Seven of the 10 most regressive states exempt food. Washington State’s sales tax takes, for example, 4.7% of the income of low-income households and only 0.8% of the income of the richest 1% of households despite the fact that Washington does not tax sales of food. Most of the states with highly regressive tax systems also exempt prescription and/or nonprescription drugs, or both, from the sales tax.
To be effective in countering the regressivity of the sales tax, credits to offset the increased burden from a sales tax must be fully available to low-income taxpayers regardless of their income tax liability. In other words, if the credits exceed the income tax liability of the household, they must be refundable.
Advocates for the poor say a mechanism like the federal Earned Income Tax Credit would help more than targeted income tax credits to offset the general excise tax burden. A refundable Earned Income Tax Credit is targeted in that it does decrease the tax burden on certain low-income households, primarily working families with children, without benefitting the affluent. Families without children get little, if anything, from the EITC and it is only the most destitute working households without children that can obtain that minimal relief. The EITC provides no relief to seniors who have no earned income.
While raising the sales tax rate is an option for raising additional revenues for vital state services or for a large capital project, it should be realized that the tax is inherently regressive, taking a larger share of the income of low-income households. Exempting food and other necessities and adopting an expanded low-income refundable tax credit are insufficient to offset the added tax burden on low-income households as the loss of revenues would probably cause the tax rate to be increased on all other purchases. Thus, the burden remains on the poor for whom 100% of their purchases would be subject to the tax.