Resist the Temptation to Tax Gross Receipts
In the United States, gross receipts taxes (GRTs) had their heyday shortly after the Great Depression as states desperately chased revenue, but by the 1960’s they had nearly disappeared from state tax codes because of their resounding unfairness. Many learned the hard way what the father of economics, Adam Smith, explained when he wrote in 1776 that Spain’s gross receipts tax was to blame for the economy’s dismal performance. Unfortunately, the lesson was short lived—gross receipts taxes began to reappear in the 2000s, although some states adopted them only to abandon them again just a few years later. This tax does not belong in the modern budget toolkit for the following reasons: it imposes an effective rate magnitudes higher than the deceptively low statutory rate, levies taxes upon taxes, lacks transparency, distorts business decision making and imposes burdensome administrative costs. For these reasons, a consensus of economists through the centuries warned that gross receipts taxes are the epitome of bad tax policy.
Though the statutory rate of a gross receipts tax is typically low, the effective rate is magnitudes higher. This occurs because the tax base is broader than the entire economy; The tax is levied against every single transaction from the first step of production to the final purchase by a consumer. The resulting phenomenon—tax on tax on tax—is referred to as tax pyramiding and is a major violation of sound policy. For example, in Washington state, one of the few that still employs a GRT, the effective rate averages 250 percent of the statutory rate and for some types of manufacturing the effective rate is more than 600 percent of the statutory rate.
Just imagine how expensive a loaf of bread could become if at every step a tax was levied. A farmer sells her grain to a miller who turns it into flour; the miller sells the flour to a baker who purchases other ingredients and bakes the bread; the bread must then be packaged, stored, and distributed to a grocer, who then sells the bread to the final consumer.
Under a retail sales tax, the tax is only levied when the loaf of bread is sold to the final consumer. Contrastingly, the gross receipts tax is levied multiple times as the bread is made. Each new step in the production cycle is faced with a new tax; the tax burden grows and grows until it reaches the final consumer. Unlike a sales tax, clearly visible at the bottom of a receipt, the gross receipts tax is baked into the price along each transaction, masking the tax burden borne by the final purchaser.
Not surprisingly, the gross receipts tax distorts business decisions. Many are incentivized to engage in vertical integration—that is, bring more steps of the supply chain in house—to avoid paying tax at each step. While this can sometimes be a good business decision, when it’s motivated by tax avoidance it can result in an inferior end product and damage economic performance. For instance, a local bakery subject to a GRT may decide to store and deliver its own inventory to avoid paying a tax on these costs. Absent this tax incentive, it may have been more cost effective to outsource these activities to other firms that utilize economies of scale by serving numerous other customers. Instead, scarce resources were wastefully devoted to these activities—resources that could have been directed to more economically productive activities.
Gross receipts taxes unfairly disadvantage businesses with complex supply chains and are particularly harmful to start-ups and businesses with low-profit margins. Because tax liability is calculated from gross receipts, not profit, businesses owe taxes whether they have a successful year or not. Under this tax structure, firms with the same amount of profit could face drastically different tax burdens depending solely on their volume. For instance, a recent measure of net profit margin for beverage manufacturing was just 0.8 percent. In other words, for every $10,000 of business, the average firm made only $80 in profit. Even a 0.25 percent GRT would cost $25 per $10,000 of business, or a whopping 31 percent of profits—rivaling even the current corporate income tax rates. Gross receipts taxes bear little relation to a firm’s consumption of government services.
Theoretically, the tax can be administered at a low cost, but in practice, this is not the case. Instead of accepting that the structure is inherently flawed, policymakers often attempt to fix the gross receipts tax by tinkering with rates, exemptions, and loopholes. What emerges from these changes is an administrative nightmare that increases the economic cost and complexity of collecting the tax while simultaneously reducing potential revenue.
A gross receipts tax appears to have a low rate, a broad base, and low administrative cost. This appearance—though patently false—makes a gross receipts tax sound palatable to the average citizen. However, the costs associated with a gross receipts tax—violations of transparency, neutrality, fairness, equity, simplicity—are greater than any perceived benefits.
Economic history plainly demonstrates this fact, and legislators would do well to resist the political temptation and instead embrace sound policy tools fitting for the modern economy.