Why State Budget Officials Worry About COVID-19's Impact on Sales Taxes

Sales taxes have provided a relatively stable source of revenue for states in previous downturns, helping to smooth out the ups and downs in taxes collected from more volatile economic activities such as capital gains, corporate income, or oil extraction. But the coronavirus pandemic and its sudden hit to the economy may be different. With consumer spending severely limited by social distancing and orders for people to stay at home, sales tax revenue is likely to plummet, creating deep holes in state budgets.

Nationwide, the U.S. Census Bureau reported April 15 that retail sales fell a seasonally adjusted 8.7% in March from February, the largest monthly decline on record. Such a sharp drop in consumer spending poses problems for states and their budget writers because general sales taxes raise nearly one-third of their general tax revenues, according to the latest census survey figures.

Only personal income taxes raise more. General sales taxes are particularly crucial for the six states where they accounted for more than half of all fiscal 2018 tax collections: Florida, Nevada, South Dakota, Tennessee, Texas, and Washington.

In past economic downturns, sales taxes helped to ease at least some of states’ losses. For example, Michigan, which typically derives about an equal portion of revenue from sales and individual income taxes, struggled during the Great Recession as major automakers and parts suppliers implemented massive layoffs. Net individual income tax revenues dropped about 9% in fiscal 2010, but sales tax revenues recorded a marginal increase and helped to mitigate other declines.

A review of tax revenue volatility data over the past two decades from Pew’s Fiscal 50 research shows that sales taxes have been a more stable source of revenue than several other taxes—personal or corporate income, severance, and property—in all but four states where they are levied.

Sales taxes have traditionally been more stable than other taxes because household spending usually doesn’t drop quite as dramatically as household income. Families don’t spend all of their income on taxable retail sales and can use personal savings or debt to maintain spending during tough times.

In the current climate, however, this scenario likely won’t hold true. Stores, restaurants, car dealerships, and countless other types of businesses that normally generate tax revenues are either closed or only partially open for business. Many of their customers are opting—or required by local or state governments—to stay at home.

To be sure, sales taxes weren’t immune from steep declines in the last recession. Consider Washington—one of the states most reliant on these taxes to fund its budget. Purchases of goods and services subject to the state’s sales tax decreased by 4% in 2008 before dropping another nearly 12% when the economy bottomed out in 2009. By 2010, they had fallen a total of more than 15% from their prior peak.

However, loss of sales tax revenue in that period was largely concentrated in specific areas of the economy. As the housing bubble burst nationwide, related spending fell dramatically. The market for auto sales collapsed during the same period.Washington experienced a 31% total drop in taxable retail sales in construction, two related retail industries (furniture stores and building material stores), and auto sales between 2007 and 2010. The decline in all other industries combined was only 6%.

Complicating today’s situation, several industries now subject to state-mandated closures or restrictions because of the spread of the novel coronavirus managed to avoid major losses during the Great Recession. Washington’s restaurants and bars, hotels, general merchandise stores, and other types of retail establishments recorded at least slight gains in total taxable sales from 2007 to 2010. These businesses, however, find themselves confronting far greater challenges in the current economic climate. A broader hit to sales taxes—an increasingly likely scenario given all the restrictions in place to mitigate the outbreak—would pose even greater financial hurdles for states than those faced a decade ago.

Although it’s difficult to gauge the eventual fiscal impact of the pandemic, early signs aren’t promising. Nearly all types of brick-and-mortar retail establishments sustained losses in the government’s March sales report. Only grocery stores recorded large gains, but groceries aren’t subject to sales taxes in most states. In addition, the latest projections from Moody’s predict that sales tax collections will remain depressed throughout most of 2020. If these projections all hold true, what has generally been a dependable source of funding won’t provide as much relief for states this time around.

Jeff Chapman is a director and Mike Maciag is an officer with The Pew Charitable Trusts’ state fiscal health project.