This year, the Kentucky state legislature could give citizens a chance to a vote on allowing time-limited local sales taxes for dedicated projects. These would be optional at the local level, probably a 1-percentage-point rate added to the 6 percent rate now levied by Kentucky state government. As economists, we write not to recommend higher taxes overall, but to explain why local sales taxes are both popular around the United States and a useful addition to the financial toolbox of local communities.
Economists see many advantages to local sales taxes compared to other taxes. One axiom of economics is that if you tax something you get less of it. Thus, taxing consumption encourages saving, while taxing income punishes effort and achievement. Moreover, households tend to view sales taxes as associated with the voluntary act of purchasing something desirable, but view income taxes as a forced extraction from their hard earned wages and salaries. Hence, voters are more likely to approve sales tax increases, particularly when they see the funds dedicated to an important public good or service, but to reject income tax increases.
Local governments around Kentucky need some financial flexibility. They are on the front lines of services to residents and businesses, including public safety, fire protection, EMS, sanitation, roads, sidewalks, libraries, parks and recreation facilities. Yet, they are increasingly squeezed by huge employee pension costs required by state government. Local governments rely on property tax revenues, which have been flat for many years, and occupational and business taxes that discourage work and risk taking. And, being closest to voters, local public officials hear the “no new taxes” message the loudest and most frequent.
A more subtle, but equally important, point is that communities around Kentucky aspire to grow and prosper in different ways. Some want more safety, some more parks, some more libraries, convention centers, bike paths, arts facilities, buses, or swimming pools. Some want less. Kentucky state government has traditionally provided many of these economic- development and quality-of-life amenities for communities. But state government has its own fiscal constraints and should spend its growth dollars on truly statewide issues, like highways, bridges, higher education, health care for the poor, and prisons.
With the option of adding, say, a penny to the sales tax, local governments could place on the ballot a proposal to spend the extra money on a specific package of public services most in demand by local citizens. If they approve it in a referendum, clearly the community wants to tax itself to get items in the package. If the referendum fails, the tax would not go into effect. The complicated state-local funding structures to build the Louisville downtown arena and the rebuilding of Rupp Arena in Lexington are great examples of projects that could more cleanly be funded by a local sales tax.
Under one format, the additional sales tax revenues are used to service the debt on a bond issue, typically with a 20-year life, with the bond proceeds dedicated to some community enhancement projects rather than core local public services like police. When the bonds are paid off, the local sales tax expires unless voters re-authorize it for new projects.
The local sales tax option also creates the possibility of changing the structure of taxation without raising overall taxation. For example, a community could vote to reduce or get rid of its occupational license tax or net profits tax and replace the revenues with those from a sales tax.
Thirty-seven U.S. states allow local sales taxes. Eighty of the largest 108 American cities have local sales taxes. Of our bordering states, only Indiana and Virginia do not allow them. Tennessee uses local sales taxes extensively, with rates up to 2.25 percent (on top of the state rate of 7 percent), and is thus able to function without taxation of wages and salaries anywhere. Kentucky’s constitution currently allows general sales taxation only at the state level. But an amendment to the constitution, allowing local sales taxes, has been offered to the legislature, and with approval from the General Assembly will be submitted to voters later this year. We believe adding this tool to the toolbox of communities in Kentucky makes good economic sense.
Paul Coomes, Ph.D., is Emeritus Professor of Economics at University of Louisville. William Hoyt, Ph.D., is a Gatton-Endowed Professor and Chair of Economics at the University of Kentucky.