New ideas to better the Old Line State
O'Malley's sales tax hike is bad news for Maryland
Originally published in the Washington Examiner
By Scott Moody and Wendy Warcholik
Published on Monday, September 24, 2007
OP-EDS
WASHINGTON - Last week, Gov. Martin O’Malley saw a hike in the state sales tax and expanding its scope as a key part of his solution to Maryland’s $1.5 billion budget shortfall. Before embarking on such a course, Maryland lawmakers should fully understand the negative economic consequences of raising taxes, the sales tax in particular.
First, it is the nature of any tax increase to erode the economy by moving money from private investment and consumption. Taxes have “deadweight losses” that are permanent losses in economic activity.
For example, a study by Harvard’s Martin Feldstein found that the estimated deadweight loss for the poorly designed 1993 federal tax increase was $15.9 billion — which is nearly twice the $8.4 billion in government revenues generated by the increase.
In other words, taxpayers lost $3 ($2 in deadweight loss and $1 in taxation) for each dollar the federal government gained from the increase. Second, retail sales tax increases would be particularly harmful to Maryland’s economy.
Overall, the sales tax performs poorly against the four criteria of a good tax system: transparency, neutrality, simplicity and stability. The main problem with the retail sales tax is what economists call “tax pyramiding.”
Retail sales tax pyramiding occurs when the tax is applied to business inputs. The tax then becomes embedded in the price of goods and services. When the good or service is finally bought by the consumer, the consumer ends up paying a tax on a tax, which means that products with many inputs are taxed more heavily than products with few inputs. Still, there is no clear reason the tax system should favor the latter products over the former. Sales tax pyramiding is no small matter either. In Maryland, 42 percent of state sales tax collections were derived from the sale of business inputs.
Expanding the retail sales tax base to services would also lead Maryland down the path toward a gross receipts tax — one of the most economically harmful taxes ever invented. Gross receipts taxes essentially maximize the negative effects of sales tax pyramiding by taxing all business income with no exemptions for business inputs.
Another concern that Maryland taxpayers should have is that increasing the retail sale tax will raise Maryland’s already high cost of living. According to a study by Timothy Besley and Harvey Rosen, higher sales taxes lead sellers to increase the price level by more than the tax increase itself —economist call this “overshifting.” This creates a double-whammy for consumers who must pay more in taxes and more for the goods and services they use everyday. Finally, the retail sales tax also imposes a large compliance surcharge on businesses. Our estimate for Maryland’s current sales tax compliance surcharge, as of fiscal 2006, ranges from $169.9 million to $202.3 million. A $1.5 billion expansion in the sales tax base would boost the compliance surcharge range by between $75.4 million and $89.7 million.
Overall, balancing Maryland’s budget by increasing the sales tax is an economically harmful policy. Maryland would be better served if state leaders were to reexamine and prioritize state spending.
After all, the current budget crunch is not the product of an economic downturn or a surprise state expense; it is the result of state leaders’ decision to ramp up spending without finding budget offsets or new revenue streams.
Annapolis should put its own house in order by ensuring that the benefit of government spending exceeds taxpayers’ loss of private investment and consumption. If it doesn’t, then the state needs to cut its spending.
Scott Moody is president of Economic Analysts Inc., a public policy consulting group. Dr. Wendy Warcholik is vice president and chief economist of Economic Analysts Inc. This editorial is excerpted from a new study by the Maryland Public Policy Institute.
Examiner
