Understanding the Shortcomings Of Current Sales Tax Systems: A Three-Pronged Solution for CPG Companies

In conversations regarding taxation in the consumer packaged goods (CPG) sector, the focus often gravitates towards sales tax rates, overshadowing the fundamental structure of sales taxation. Yet, it is imperative to shed light on this aspect as it reveals three significant challenges undermining present-day sales tax frameworks. Policymakers hold the key to addressing these concerns and ushering in a more efficient system.

Experts in public finance widely agree that an effectively designed retail sales tax should encompass all final consumption, providing a broad base that facilitates a lower tax rate. However, in reality, most states fall short of this ideal, grappling with three primary hurdles.

Exemption of Consumer Goods

There is a common inclination to exempt certain "essentials" from sales taxes, such as groceries, clothing, and medication. While well-intentioned, these exemptions substantially diminish the tax base, as these items represent a significant portion of consumer expenditure. For example, groceries and clothing alone constituted 10 percent of personal consumption expenditures in 2016.

Though intended to benefit low-income individuals, these exemptions apply universally, including to high-income earners. A more targeted approach would entail incorporating these products into the sales tax ambit while simultaneously implementing relief measures for low-income groups, such as income tax credits or targeted spending initiatives.

Exclusion of Services

Most states do not levy comprehensive taxes on services, primarily due to historical reasons. The inception of sales tax, initiated in Mississippi during the Great Depression in 1930, focused on transactions involving tangible personal property, i.e., goods. In subsequent decades, as the American economy evolved, services emerged to constitute approximately two-thirds of consumption. Despite this shift, state sales taxes largely overlook this sector, resulting in a contracting tax base and declining revenue as a proportion of the economy. The remedy lies in broadening the tax base to encompass services, with the resultant revenue utilized to lower the sales tax rate or offset more economically detrimental taxes.

Taxation of Business Inputs

Another challenge relates to the taxation of business inputs or business-to-business transactions that ideally should be exempt from sales tax. Businesses frequently procure raw materials from one another to manufacture products, and these transactions do not signify final consumption. Hence, they should not attract sales tax.

When states do impose taxes on business inputs, these costs trickle down the production chain and inflate consumer prices, albeit less transparently. This practice disproportionately impacts industries with extensive production chains and may even encourage vertical integration for tax purposes, regardless of its economic viability.

By confronting these three challenges, states can institute a sales tax system characterized by a broad base and "right-sizing," ensuring each dollar of consumption is taxed once and only once. The result would be consistent revenue generation and the ability to maintain a lower sales tax rate while adequately funding essential government services.

Contributed by Kintsugi CPO Barkin Doganay