Kansas has a problem with sales tax exemptions, but the potential revenue boost from reform is not as great as commonly mentioned, unless Kansas wants to place its manufacturers at severe disadvantage.
While the Wichita Eagle editorial board is correct to argue for eliminating sales tax exemptions, the amount of potential revenue is far less than presented, if we want to keep Kansas manufacturers competitive. Here’s what the Eagle editorial held:
As a result, the number of sales-tax exemptions keeps growing — from 30 in 1985 to more than 100 today. And with each added exemption, the state is losing out on more revenue — $5.9 billion this fiscal year, according to the Kansas Department of Revenue. That’s money the state could be using to cover its budget shortfalls, increase funding to public schools or further reduce its income-tax rates.” (Reduce state sales tax exemptions, August 27, 2014)
First, it’s good that the editorial board mentioned — as one possibility — the right thing to do if sales tax exemptions are eliminated, which is to reduce other taxes. Second, the state is not “losing out on more revenue” by granting sales tax exemptions. The state is simply letting people conduct certain transactions without being taxed, thereby letting them keep more of their own money. It’s true that the exemptions are granted in a way that is not equitable and does not promote economic growth, but that’s another issue.
The big problem with the editorial is the amount of money mentioned as up for grabs, which is $5.9 billion. That is a lot of money. It’s almost as much as Kansas annual general fund spending. It’s worthwhile to look in detail at the nature of Kansas sales tax exemptions to understand their nature.
In 2010 Kansas Legislative Division of Post Audit looked at the topic of sales tax exemptions and issued a report titled Kansas Tax Revenues, Part II: Reviewing Sales Tax Exemptions. The data in this report is from 2009, so it’s a few years out of date. But the principles and relative amounts remain the same. At the time of this report, advocates of eliminating sales tax exemptions in Kansas pointed, as they do now, to the great amount of revenue that could be raised if Kansas eliminated these exemptions, estimated at some $4.2 billion per year for 2009. Analysis of the nature of the exemptions and the amounts of money involved, however, leads us to realize that the additional tax revenue that could be raised is much less than spending advocates claim, unless Kansas was to adopt a severely uncompetitive, and in some cases, unproductive tax policy.
Tax exemption policy is an important economic policy matter. In its background discussion, the Post Audit report noted “the U.S. Supreme Court’s opinion that tax exemptions and tax deductibility are a form of subsidy that is administered through the tax system. A tax exemption has much the same effect as a cash grant to the organization of the amount of tax it would have to pay on its income.”
Sometimes these sales tax exemptions are issued to specific organizations. Others are issued to organizations that fall within certain categories. In this case, the exemption is like an entitlement, granted to any organization that falls within the scope of definition of the exemption. Some exemptions are for categories of business transactions that shouldn’t be taxed.
It’s this last category that is important to recognize, because of the large amount of economic activity that falls within its scope. An example is exemption 79-3606 (m), described as “Ingredient/Component parts: Of items manufactured or produced for sale at retail.” The audit report estimates that for 2009, this exemption cost the state $2,248.1 million in lost sales tax revenue.
But this exemption isn’t really an “exemption,” at least if the sales tax is a retail sales tax designed to be levied as the final tax on consumption. That’s because these goods aren’t being sold at retail. They’re sold to manufacturers who use them as inputs to products that, when finished, will be sold at retail. Most states don’t tax this type of sales. If Kansas decided to tax these transactions, it would place our state’s manufacturers at a severe disadvantage compared to almost all other states.
There are two other exemptions that fall in this category of inputs to to production processes, totaling an estimated $461 million in lost revenue.
Another big-dollar exemption is “items already taxed” such as motor fuel. This is an estimated $232.5 loss in revenue.
Two other categories of exemptions are purchases made by government, or purchases made by contractors on behalf of government. Together these account for an estimated $449.9 million in lost sales tax revenue. If these two exemptions were eliminated, government would be taxing itself and no net revenue is gained.
All told, these six exemptions account for $3,391.5 million of the total $4,234.2 million in exemptions for 2009. That’s about 80 percent.
So $4.2 billion has shrunk to $842.7 million. That’s still a lot of money, but not near as much as spending advocates would like to have Kansans believe is lying in wait just for the taking.