In the coming weeks, several states will exempt customers from sales tax on certain items during “tax holidays.” Ever since Ohio and Michigan created automobile tax exemptions in 1980, states have tried to boost consumption by temporarily removing the sales tax on specific products. While customers are eager for the deals, a new Tax Foundation report by Joseph Bishop-Henchman and Scott Drenkard illuminates how tax holidays disrupt the market and promote cronyism without providing any long-term economic benefits.
The end of summer is the prime time for these holidays. Tennessee will have a tax-free weekend from July 27th through July 29th, while Missouri, New Mexico, Ohio, Oklahoma, South Carolina, and Virginia will have “Back to School” tax holidays from August 3rd through August 5th. In total, 17 states have designated certain days as sales tax holidays this year.
State politicians tout these carve-outs as opportunities for low-income families to purchase seasonal goods, such as school and storm supplies, at reduced rates. A study by Professors Justin M. Ross and Felipe Lozano-Rojas of Indiana University, however, found that more than half of tax savings went to households with income above $50,000 per year. If policymakers are looking to ease the plight of the impoverished, there are surely more effective ways to do so.
Consumption may seem to increase during tax holidays, but the Tax Foundation report reveals these increases are mostly illusory. A 2017 study from the Federal Reserve found that timing of purchases is significantly altered when consumers are presented with tax holidays. Customers rush to stock up on durable goods such as furniture and appliances that they would have otherwise purchased at a later date, distorting shopping patterns. Consequently, stores have to deal with lower sales for the rest of the year.
The flawed logic of tax holidays is similar to that of the “Cash for Clunkers” program undertaken during the Obama Administration. Under that policy, vouchers were given to individuals who sold old cars and replaced them with new, fuel-efficient models during a two-month period. A study by Professors Mark Hoekstra and Steven L. Puller of Texas A&M and Professor Jeremy West of MIT concluded that, even without the subsidy, all purchasers would have bought a new car within eight months of the sale anyway. Since demand did not change in the long run, economic benefits were negligible, while program costs totaled $3 billion.
The Tax Foundation report emphasizes how irregular patterns of spending hurt both consumers and businesses. The sales tax reprieve drives up demand among consumers, but if stores do not respond with an equivalent supply increase, a shortage will ensue. Projecting how much inventory to keep in stock and how many temporary employees to hire, however, is difficult. Businesses could also compensate with an increase in pre-tax prices to bring demand back to equilibrium. That increase, however, would disproportionally push low-income consumers out of the market, once again highlighting the potential pitfalls of a tax holiday.
A more effective solution would be to permanently decrease the sales tax so that consumers can spend more throughout the entire year. States that have no sales tax are more attractive to out-of-state customers. Counties bordering the Connecticut River in Vermont and New Hampshire, for instance, had identical per capita sales until New Hampshire repealed its sales tax, at which point it saw per capita sales triple.
Ending tax holidays would also reduce cronyism. Currently, businesses lobby government to make their products tax-exempt while maintaining restrictions on their competition, leading to absurd discrepancies. During Virginia’s tax holiday, customers must pay sales tax on masking tape and wigs but not on duct tape and costumes. In Wisconsin, tax holiday shoppers are exempt from paying sales tax on scissors but not staplers. By creating lists of eligible items, states are favoring one product over another and opening the door to corporate welfare and favoritism.
Recognizing the numerous flaws of this temporary gimmick, some states have suspended the practice altogether. Citing $70 million per year in lost revenue, Georgia eliminated tax holidays last year. A few weeks ago, Louisiana followed suit by reducing the state sales tax from 5 percent to 4.45 percent while simultaneously canceling future tax holidays.
Other states would be wise to follow their lead. Though tax reductions are generally beneficial, these “holidays” are mirages. Lawmakers should consider cutting taxes to promote economic growth – but only celebrate once the reductions are permanent.
Stephen Vukovits is a contributor to Economics 21. Follow him on Twitter @svukovits.
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