Can cutting sales taxes increase spending?

Evidence from Ohio

The sluggish economic recovery is forcing businesses, households, and all levels of government to make tough choices about how to meet our priorities with waning resources. The spirited discussions at state and national levels about how much government spends and on what and where that money comes from indicate that a serious reconsideration of how governments manage their obligations and how this will impact their constituents is at hand.

At the upcoming Association of University Business and Economic Research (AUBER) conference in Indianapolis, IN, Professor Benjamin Passty and Research Associate Jennifer Pitzer will be presenting their research looking at one aspect of this very topic, specifically at the relationship between sales tax rates and consumer spending. Their research asks a simple question - why didn't consumers dramatically increase spending in response to the State lowering the sales tax rate from 6 to 5.5 percent in 2006? This question arose out of a relationship with a client of the Economics Center, which led to work analyzing the impact of changes in the State sales and use tax on consumer spending and tax revenues.

Sales taxes are one of the primary revenue generating tools of state and local governments. Conventional wisdom, and economic theory, suggests that increasing a tax will harm consumers by decreasing their ability to purchase and distorting the relative prices between markets. Conversely, removal or reduction of a tax would increase consumers' ability to pay, allowing them to buy more. In the course of our client-driven project, however, we found that this conventional wisdom didn't seem to hold with Ohio's tax rate changes during the past decade. We wanted to explore why.

In looking more closely, we discovered a complicating factor: the behavior of county governments, many of which actually raised their own local permissive rates around the same time of the State-level decrease meant that over one third of consumers in Ohio did not actually experience a lower sales tax rate. Thus, conditions that seemed to be ripe for a change in consumer behavior actually gave them little reason to make that change; rather than generating wealth from increased consumer activity, these changes in tax policy amount to a transfer from state government to county governments.

There are many important considerations for legislators, businesses and citizens to take into account when the question of revenues for government functions and changes to policies are on the table. Businesses and individuals may be impacted differently by an increase in the sales tax, some may be more hurt than others. This, and other factors, influence the effectiveness of a change to the sales tax rate in stimulating consumer activity and eventually generating new revenues. This research highlights that, in Ohio, the decisions made by different levels of government, State and Local, are not always coordinated and can have unintended consequences or lead to unanticipated results.

To learn how the Economics Center can provide the analysis needed to make important decisions in an organization or for the community, contact Jennifer Pitzer at jennifer.pitzer@uc.edu.