By Robert A. Lawson and E. Frank Stephenson
With a commission examining Georgia’s tax structure and the possibility of legislative action next year, one possible course of action is the adoption of a gross receipts tax, a levy on businesses’ total revenue without any deductions for the cost of hiring labor or purchasing materials or equipment.
Gross receipts taxes have been enacted in recent years in states such as Ohio, Nevada, and New Mexico, but they are hardly new. Adam Smith wrote of a version known as the alcavala, which operated from the 14th through the 18th centuries in Spain. Many European countries relied on gross receipts or “turnover” taxes in the first half of the 20th century, later replacing them with value added taxes.
It’s a misconception that because gross receipts taxes are not an itemized add-on at the cash register, they are absorbed by businesses. Gross receipts taxes are economically equivalent to traditional sales taxes. In this case, the tax simply comes embedded in the price. Consider a store selling a loaf of bread for $2. Under a traditional sales tax, buyers see a $2 price tag on the item and pay $2.14 (assuming a 7 percent sales tax rate) at the checkout. Under a gross receipts tax, the retailer realizes that selling that loaf of bread for $2 would lead to a 14 cent tax liability for the business, so the price is marked up to $2.14.[1] The buyer still pays $2 for the bread and 14 cents of tax, but the tax does not appear as a separate item on the sales receipt.
That the tax is embedded rather than appearing as a separate line item on sales receipts is probably part of the renewed appeal of gross receipts taxes among state politicians. Customers who see the price of bread rise by a few cents may not realize that a new gross receipts levy is responsible for the increase. Another reason that gross receipts taxes may seem attractive is that they are typically broader based than traditional sales taxes. Ohio levies its tax on “activities that contribute to the production of gross income [such as] sales; performance of services; and rentals or leases.”[2] Hence, gross receipts taxes may be viewed as a politically acceptable way to tax services and other activities not normally subject to retail sales taxation. The appeal of such tax base broadening may have increased in part because Internet shopping is eroding traditional sales tax revenue.
The broader tax base of gross receipts taxes may be preferred on public finance grounds, but there are several reasons Georgia should be reluctant to move to this form of taxation. First, as noted above, gross receipts taxes lack transparency and might therefore make it politically easier for politicians to raise taxes and expand the size of state government.
Second, when the tax base is gross receipts rather than net receipts, the tax is effectively larger on low profit margin firms (such as grocers) than on higher profit margin firms. Moreover, the taxation of gross receipts rather than net receipts means that firms incurring losses are still subject to the tax. That could act as an impediment for start-up firms, which often require some time before becoming profitable. Applying the tax to firms incurring losses also means that the gross receipts tax bears no relation to firms’ ability to pay, one of two commonly cited normative criteria for tax equity.[3]
Third, the tax also violates the benefit principle, the other frequently cited normative criterion for taxation. Under this criterion, tax burdens should be related to the benefits received from the government services funded by the taxation. Since a gross receipts tax makes no adjustments for the intensity of firms’ use of government funded services (e.g., roads), it is not consistent with the benefit principle of tax equity.
Fourth, the taxation of gross receipts rather than net receipts means that the tax falls more heavily on goods with multi-firm production processes. To the extent that the tax is shifted forward, the tax pyramids or cascades with each subsequent stage of production. Consider the example contained in Table 1. Suppose Firm C purchases $100 of inputs from a supplier and adds $50 of value before selling the product to a consumer. Applying a 10 percent gross receipts tax to this production process means that the firm would now pay $110 for the inputs that formerly cost $100. The firm would then add $50 of value and sell the product to consumers for $176 (= ($110 + $50) x 1.10).
Alternatively, consider a similar production process with three stages. Suppose Firm A sells $50 of inputs to Firm B. Firm B then adds $50 of value to the product and sells it to Firm C (a retailer). As before, Firm C then adds $50 of value and sells the item to a customer for $150. Applying a 10 percent gross receipts tax to this three-stage process means that B pays $55 to purchase the inputs from Firm A. Firm B then adds $50 in value as before and sells the product to the retailer for $115.5 (= $105 x 1.10). The retailer then adds $50 in value as before and sells the item to the consumer for $182.05 (= 165.5 x 1.10). Hence adding a stage to an otherwise similar production process arbitrarily increases the tax burden by $6.05.
Such compounding of the tax with each business-to-business transaction in the production process belies gross receipts tax advocates’ claim that it is a low rate tax applied evenly to all goods and services produced. Goods and services with more stages in their production process would incur heavier tax burdens. For example, a study of Washington’s gross receipts tax found that the tax pyramids 2.5 times for the average industry examined, but that the cascading ranges from 1.4 times in the computer programming and data processing industry to 6.7 times in the food manufacturing industry. [4] Of course, this also implies that gross receipts taxes create an artificial incentive for firms to vertically integrate.
Fifth, the gross receipts tax is even more arbitrary because its burden can be affected by the timing of the value added in a multi-stage production process. Value added that occurs earlier in the production process will be subject to more pyramiding and ultimately lead to a higher tax burden. Consider, for example, a three-stage production process which begins with Firm A selling $10 of material to Firm B. (See Table 2.) Firm B then adds $170 of value to the product and sells it for $180 to Firm C which finishes the product and sells it to a consumer for $200. Adding a 10 percent gross receipts tax, assumed for simplicity to be fully shifted to consumers, to this production process results in sales prices of $11 from Firm A to B, $199.1 (= $181 x 1.10) from Firm B to C, and $241.01 (= $219.1 x 1.10) from Firm C to the consumer.
Suppose instead that more of the value added occurs earlier in the production process: Firm A sells $170 of material to Firm B. Firm B refines the product and sells it for $180 to Firm C which finishes the product and sells it to the consumer for $200. Applying a 10 percent gross receipts tax to this process yields prices of $187, $216.70 and $260.37 at the respective stages of the production process, thereby illustrating that production processes with the same number of stages and the same value added will be taxed differently based on the timing of the value added in the production process.
Finally, the application of a gross receipts tax to business-to-business sales means that, to the extent the tax is shifted forward, suppliers located in the state have higher prices than do suppliers located outside of the state. The gross receipts tax, then, creates an incentive for in-state firms to find suppliers located outside of the state; obviously, this incentive is mitigated by any accompanying increase in transportation costs.
So should Georgia’s tax study commission urge the state to adopt a gross receipts tax? At first, a gross receipts tax seems appealing from a base-broadening perspective. But it comes with a lack of transparency and with much arbitrariness in the tax burden across industries because of the tax pyramiding caused by business-to-business transactions. Hence, focusing on broadening the base of the traditional retail sales tax would be a superior option.
|
Table 1 An Example of Tax Pyramiding |
||||
| Two Stage Process | Three Stage Process | |||
| Panel A: No Gross Receipts Tax | ||||
| Value Added | Gross | Value Added | Gross | |
| Firm A | 100 | 100 | 50 | 50 |
| Firm B | 50 | 100 | ||
| Firm C | 50 | 150 | 50 | 150 |
| Panel B: With 10% Gross Receipts Tax | ||||
| Value Added | Gross (incl. tax) | Value Added | Gross (incl. tax) | |
| Firm A | 100 | 110 | 50 | 55 |
| Firm B | 50 | 115.50 | ||
| Firm C | 50 | 176 | 50 | 182.05 |
|
Table 2 The Timing of Value Added in the Production Process and the Gross Receipts Tax Burden |
||||
| Value Added Late | Value Added Early | |||
| Panel A: No Gross Receipts Tax | ||||
| Value Added | Gross | Value Added | Gross | |
| Firm A | 10 | 10 | 170 | 170 |
| Firm B | 170 | 180 | 10 | 180 |
| Firm C | 20 | 200 | 20 | 200 |
| Panel B: With 10% Gross Receipts Tax | ||||
| Value Added | Gross (incl. tax) | Value Added | Gross (incl. tax) | |
| Firm A | 10 | 11 | 170 | 187 |
| Firm B | 170 | 199.10 | 10 | 216.70 |
| Firm C | 20 | 241.01 | 20 | 260.37 |
This Issue Analysis was written for the Georgia Public Policy Foundation by Robert Lawson, associate professor of finance at Auburn University and co-author of the widely cited Economic Freedom of the World annual report, and Frank Stephenson, who chairs the economics department at Berry College in Rome, Ga. The Georgia Public Policy Foundation is an independent think tank that proposes practical, market-oriented approaches to public policy to improve the lives of Georgians. Nothing written here is to be construed as necessarily reflecting the views of the Georgia Public Policy Foundation or as an attempt to aid or hinder the passage of any bill before the U.S. Congress or the Georgia Legislature.
© Georgia Public Policy Foundation (September 8, 2010). Permission to reprint in whole or in part is hereby granted, provided the authors and their affiliations are cited.
[1] We assume for simplicity that all taxes are fully shifted to buyers; the analysis would be similar if, say, only half of the tax was borne by consumers. We also ignore the fact that the tax liability under the gross receipts tax would be slightly more than 14 cents because the 7 percent tax would be levied on the tax inclusive price ($2.14 in our example) rather than the $2.00 tax-exclusive price.
[2] Ohio Department of Taxation 2008 Business Tax Guide 19, available at http://tax.ohio.gov/divisions/communications/publications/documents/Ohio_Business_Tax_Guide_2008.pdf (last visited March 11, 2010).
[3] It’s worth remembering here that businesses don’t pay taxes, people do. Since firms are merely intermediaries that pass along taxes borne by suppliers, customers or owners, the applicability of the ability to pay criterion to business taxation is unclear.
[4] Andrew Chamberlain and Patrick Fleenor, “Tax Pyramiding: The Economic Consequences of Gross Receipts Taxes,” Tax Foundation Special Report No. 147 (2006).
By Robert A. Lawson and E. Frank Stephenson
With a commission examining Georgia’s tax structure and the possibility of legislative action next year, one possible course of action is the adoption of a gross receipts tax, a levy on businesses’ total revenue without any deductions for the cost of hiring labor or purchasing materials or equipment.
Gross receipts taxes have been enacted in recent years in states such as Ohio, Nevada, and New Mexico, but they are hardly new. Adam Smith wrote of a version known as the alcavala, which operated from the 14th through the 18th centuries in Spain. Many European countries relied on gross receipts or “turnover” taxes in the first half of the 20th century, later replacing them with value added taxes.
It’s a misconception that because gross receipts taxes are not an itemized add-on at the cash register, they are absorbed by businesses. Gross receipts taxes are economically equivalent to traditional sales taxes. In this case, the tax simply comes embedded in the price. Consider a store selling a loaf of bread for $2. Under a traditional sales tax, buyers see a $2 price tag on the item and pay $2.14 (assuming a 7 percent sales tax rate) at the checkout. Under a gross receipts tax, the retailer realizes that selling that loaf of bread for $2 would lead to a 14 cent tax liability for the business, so the price is marked up to $2.14.[1] The buyer still pays $2 for the bread and 14 cents of tax, but the tax does not appear as a separate item on the sales receipt.
That the tax is embedded rather than appearing as a separate line item on sales receipts is probably part of the renewed appeal of gross receipts taxes among state politicians. Customers who see the price of bread rise by a few cents may not realize that a new gross receipts levy is responsible for the increase. Another reason that gross receipts taxes may seem attractive is that they are typically broader based than traditional sales taxes. Ohio levies its tax on “activities that contribute to the production of gross income [such as] sales; performance of services; and rentals or leases.”[2] Hence, gross receipts taxes may be viewed as a politically acceptable way to tax services and other activities not normally subject to retail sales taxation. The appeal of such tax base broadening may have increased in part because Internet shopping is eroding traditional sales tax revenue.
The broader tax base of gross receipts taxes may be preferred on public finance grounds, but there are several reasons Georgia should be reluctant to move to this form of taxation. First, as noted above, gross receipts taxes lack transparency and might therefore make it politically easier for politicians to raise taxes and expand the size of state government.
Second, when the tax base is gross receipts rather than net receipts, the tax is effectively larger on low profit margin firms (such as grocers) than on higher profit margin firms. Moreover, the taxation of gross receipts rather than net receipts means that firms incurring losses are still subject to the tax. That could act as an impediment for start-up firms, which often require some time before becoming profitable. Applying the tax to firms incurring losses also means that the gross receipts tax bears no relation to firms’ ability to pay, one of two commonly cited normative criteria for tax equity.[3]
Third, the tax also violates the benefit principle, the other frequently cited normative criterion for taxation. Under this criterion, tax burdens should be related to the benefits received from the government services funded by the taxation. Since a gross receipts tax makes no adjustments for the intensity of firms’ use of government funded services (e.g., roads), it is not consistent with the benefit principle of tax equity.
Fourth, the taxation of gross receipts rather than net receipts means that the tax falls more heavily on goods with multi-firm production processes. To the extent that the tax is shifted forward, the tax pyramids or cascades with each subsequent stage of production. Consider the example contained in Table 1. Suppose Firm C purchases $100 of inputs from a supplier and adds $50 of value before selling the product to a consumer. Applying a 10 percent gross receipts tax to this production process means that the firm would now pay $110 for the inputs that formerly cost $100. The firm would then add $50 of value and sell the product to consumers for $176 (= ($110 + $50) x 1.10).
Alternatively, consider a similar production process with three stages. Suppose Firm A sells $50 of inputs to Firm B. Firm B then adds $50 of value to the product and sells it to Firm C (a retailer). As before, Firm C then adds $50 of value and sells the item to a customer for $150. Applying a 10 percent gross receipts tax to this three-stage process means that B pays $55 to purchase the inputs from Firm A. Firm B then adds $50 in value as before and sells the product to the retailer for $115.5 (= $105 x 1.10). The retailer then adds $50 in value as before and sells the item to the consumer for $182.05 (= 165.5 x 1.10). Hence adding a stage to an otherwise similar production process arbitrarily increases the tax burden by $6.05.
Such compounding of the tax with each business-to-business transaction in the production process belies gross receipts tax advocates’ claim that it is a low rate tax applied evenly to all goods and services produced. Goods and services with more stages in their production process would incur heavier tax burdens. For example, a study of Washington’s gross receipts tax found that the tax pyramids 2.5 times for the average industry examined, but that the cascading ranges from 1.4 times in the computer programming and data processing industry to 6.7 times in the food manufacturing industry. [4] Of course, this also implies that gross receipts taxes create an artificial incentive for firms to vertically integrate.
Fifth, the gross receipts tax is even more arbitrary because its burden can be affected by the timing of the value added in a multi-stage production process. Value added that occurs earlier in the production process will be subject to more pyramiding and ultimately lead to a higher tax burden. Consider, for example, a three-stage production process which begins with Firm A selling $10 of material to Firm B. (See Table 2.) Firm B then adds $170 of value to the product and sells it for $180 to Firm C which finishes the product and sells it to a consumer for $200. Adding a 10 percent gross receipts tax, assumed for simplicity to be fully shifted to consumers, to this production process results in sales prices of $11 from Firm A to B, $199.1 (= $181 x 1.10) from Firm B to C, and $241.01 (= $219.1 x 1.10) from Firm C to the consumer.
Suppose instead that more of the value added occurs earlier in the production process: Firm A sells $170 of material to Firm B. Firm B refines the product and sells it for $180 to Firm C which finishes the product and sells it to the consumer for $200. Applying a 10 percent gross receipts tax to this process yields prices of $187, $216.70 and $260.37 at the respective stages of the production process, thereby illustrating that production processes with the same number of stages and the same value added will be taxed differently based on the timing of the value added in the production process.
Finally, the application of a gross receipts tax to business-to-business sales means that, to the extent the tax is shifted forward, suppliers located in the state have higher prices than do suppliers located outside of the state. The gross receipts tax, then, creates an incentive for in-state firms to find suppliers located outside of the state; obviously, this incentive is mitigated by any accompanying increase in transportation costs.
So should Georgia’s tax study commission urge the state to adopt a gross receipts tax? At first, a gross receipts tax seems appealing from a base-broadening perspective. But it comes with a lack of transparency and with much arbitrariness in the tax burden across industries because of the tax pyramiding caused by business-to-business transactions. Hence, focusing on broadening the base of the traditional retail sales tax would be a superior option.
|
Table 1 An Example of Tax Pyramiding |
||||
| Two Stage Process | Three Stage Process | |||
| Panel A: No Gross Receipts Tax | ||||
| Value Added | Gross | Value Added | Gross | |
| Firm A | 100 | 100 | 50 | 50 |
| Firm B | 50 | 100 | ||
| Firm C | 50 | 150 | 50 | 150 |
| Panel B: With 10% Gross Receipts Tax | ||||
| Value Added | Gross (incl. tax) | Value Added | Gross (incl. tax) | |
| Firm A | 100 | 110 | 50 | 55 |
| Firm B | 50 | 115.50 | ||
| Firm C | 50 | 176 | 50 | 182.05 |
|
Table 2 The Timing of Value Added in the Production Process and the Gross Receipts Tax Burden |
||||
| Value Added Late | Value Added Early | |||
| Panel A: No Gross Receipts Tax | ||||
| Value Added | Gross | Value Added | Gross | |
| Firm A | 10 | 10 | 170 | 170 |
| Firm B | 170 | 180 | 10 | 180 |
| Firm C | 20 | 200 | 20 | 200 |
| Panel B: With 10% Gross Receipts Tax | ||||
| Value Added | Gross (incl. tax) | Value Added | Gross (incl. tax) | |
| Firm A | 10 | 11 | 170 | 187 |
| Firm B | 170 | 199.10 | 10 | 216.70 |
| Firm C | 20 | 241.01 | 20 | 260.37 |
[1] We assume for simplicity that all taxes are fully shifted to buyers; the analysis would be similar if, say, only half of the tax was borne by consumers. We also ignore the fact that the tax liability under the gross receipts tax would be slightly more than 14 cents because the 7 percent tax would be levied on the tax inclusive price ($2.14 in our example) rather than the $2.00 tax-exclusive price.
[2] Ohio Department of Taxation 2008 Business Tax Guide 19, available at http://tax.ohio.gov/divisions/communications/publications/documents/Ohio_Business_Tax_Guide_2008.pdf (last visited March 11, 2010).
[3] It’s worth remembering here that businesses don’t pay taxes, people do. Since firms are merely intermediaries that pass along taxes borne by suppliers, customers or owners, the applicability of the ability to pay criterion to business taxation is unclear.
[4] Andrew Chamberlain and Patrick Fleenor, “Tax Pyramiding: The Economic Consequences of Gross Receipts Taxes,” Tax Foundation Special Report No. 147 (2006).
This Issue Analysis was written for the Georgia Public Policy Foundation by Robert Lawson, associate professor of finance at Auburn University and co-author of the widely cited Economic Freedom of the World annual report, and Frank Stephenson, who chairs the economics department at Berry College in Rome, Ga. The Georgia Public Policy Foundation is an independent think tank that proposes practical, market-oriented approaches to public policy to improve the lives of Georgians. Nothing written here is to be construed as necessarily reflecting the views of the Georgia Public Policy Foundation or as an attempt to aid or hinder the passage of any bill before the U.S. Congress or the Georgia Legislature.
© Georgia Public Policy Foundation (September 8, 2010). Permission to reprint in whole or in part is hereby granted, provided the authors and their affiliations are cited.