Potential Drop in Sales Tax Collections

–Local governments face major budget problems as sales tax collections will drop significantly in the first half of 2020

–The sales tax base is quite different among cities, with construction, brick and mortar retail and auto sales being large variables.

–All taxable sales categories will fall in the coronavirus downturn, but it is not clear how fast any of them will recover.

–Over time, less and less economic activity is subject to sales tax, calling into question is long term viability as a pillar of local revenue

Local governments in Washington are highly dependent on sales tax, with these taxes supporting between a quarter and a third of a typical city’s general fund revenue needs. Sales taxes are also a primary source of revenue for transit agencies. As economic activity plummets, local governments are scrambling to figure out how badly their budgets will suffer this year from a drop in taxable sales. It’s going to be tough, but how tough remains to be seen.

We are seeing a sharp reversal from the trend of the past decade. Since the depths of the Great Recession, sales taxes have been on a tear. Figure 1 shows growth in sales taxes for seven cities in King County with the largest sales tax receipts, which account for about 70 percent of taxable sales in the county. The combined receipts of the seven cities increased almost 60 percent, in real, inflation-adjusted terms, between 2010 and 2018. On a per-capita basis, tax receipts increased nearly 30 percent in real terms. (Kirkland and Kent both annexed large residential areas during this period, significantly increasing the denominator in the per-capital calculation)

What gets taxed?

But before we can think about what might happen in the medium term future—how far sales might fall and how far and fast they will recover—it is helpful to know just what is being taxed. While most of us see sales taxes as a 10 percent item tacked onto a retail sales slip, the sales tax base is much larger than just stores. Figure 2 shows the 2018 tax revenue for these seven cities broken out into some basic categories of activity that are taxed in Washington.

Figure 2 shows quite a lot of variation among the four basic categories. We can think of the first two categories—retail trade, leisure and hospitality—as being the most vulnerable to disruption by the current economic crisis. Tukwila, which has a large base of traditional retail in the Southcenter area, as well as a large number of restaurants and hotels, gets over 75 percent of its sales tax revenue from these sources. Redmond and Seattle, in contrast, get around half of their revenue from retail and hospitality.

The major variable is construction, nearly all of which is taxable. Seattle has been experiencing a boom in office and apartment construction, while Redmond is in the middle of the major rebuilding of the Microsoft campus. Tukwila has seen far less construction.

There is also quite a bit of variation within the retail trade category itself, as the mix of retail outlets differs from one retail center to another. Figure 3 show a breakout of the retail trade category for the seven cities.

The obvious variation here is motor vehicle sales. Some cities have a lot of car dealers, and others have few or none. There is also variation in the general merchandise store category that includes big boxes like Fred Meyer and Walmart, and the “Other” category that includes Costco and category-killers like Office Depot. The broad category of food, health and gasoline includes retailers at which much of the merchandise is not taxable (food, gas, medicine) but that also sell taxable items.

Where will sales taxes drop?

So how will all these categories be affected by the coronavirus slowdown? Clearly, the hospitality business is in the tank. Many retailers remain open, but traffic is scarce. Grocery stores, drug stores and other places that sell the essentials, will remain busy, but much of this activity is not taxable. As suppliers divert food from restaurants to grocery stores, that food shifts from a taxable status to a non-taxable status. Retail sales also includes sales to businesses, and we can expect sales of office furniture, computers and office supplies to remain slow while offices are closed.

How fast any of this activity bounces back is an unknown. Customers’ willingness to return to malls and big box stores will be a function of confidence in safety, and no matter how often employees wipe down the counters, people will be reluctant to undertake activities not strictly required. But there are two more factors working in opposite directions.

First is the inevitable return to enjoyable activities like shopping. Cabin fever will set in and some people will gradually return to stores to have some human contact and purchase items they had put off. At the same time, many consumers will be reluctant to spend money, due to unemployment, wealth effects from the crash of the stock market and general uncertainty. This will lead many people to put off non-essential purchases, especially large ones like cars and appliances until jobs return and markets bounce back.

Online shopping will substitute for some of this activity, but the sales tax flow will be different. With brick and mortar retailers, the local sales tax stays in the jurisdiction where the store is located. With on-line sales, the destination-based sales tax system remits the local portion of the sales tax to the jurisdiction where the item is delivered. Thus, small cities with very weak retail presences may be the only winners in this whole mess, as their residents shop online and send their sales tax payments to their own cities rather than to the cities where they normally shop.

Looking ahead

As we contemplate the easing of the coronavirus crisis we will face a “new normal,” that reflects social changes that take root during this crisis. Governments in Washington will need to think again about the future of the sales tax. Over time, less and less of household income has been going toward taxable spending and shifting to non-taxable services like healthcare, and the current downturn in retail may accelerate that trend. The golden rule of tax policy—broad base, low rates—becomes harder and harder to achieve with the sales tax.

Questions going forward are:

• When we have learned to live without things for several months, will we decide we maybe don’t really need them after all?
• Will the drop in sales tax give rise to renewed discussion about the lack of a state income tax.
• Will local governments work toward a more equitable sales tax distribution that reflects the residence of the taxpayer?