close up of a hand holding a calculator and a grocery cart

Could Reducing Taxes on Bread Create a Hot Potato?

Tennessee’s legislators are faced with a decision—what do they do with a surplus of almost $900 million in recurring revenue? Many will want to spend it on “improving” existing government programs by growing them. Last week I said they could consider using the money to buy some freedom from the federal government. Another possibility getting lots of discussion is to “spend” it by cutting taxes. But if that’s what legislators do, then they better be careful.

The problem I’m envisioning relates to the choices we will be left with when the next economic downturn occurs, and it will occur at some point. I am particularly sensitive to this, since I spent four of my years in the state Senate discussing what to do in an economic downturn when our recurring expenditures were exceeding recurring revenue.

The question then was whether we could cut our way out of the income-expenditure discrepancy. But we ran into problems with that.

I no longer remember the exact percentages, but I know that the amount of the budget we could cut without unwanted or very unpleasant ripple effects was limited, mostly because of federal mandates and the effect a state cut would have on the receipt of matching federal dollars.

For example, a $1 reduction in spending related to TennCare resulted in the loss of $2 in federal matching funds, meaning we had to actually cut TennCare by $3. There were similar problems relative to any number of budget categories, from education to even state parks where federal funds had been received to make park improvements.

So cutting is hard. It is not always as simple as just cutting state spending across the board by some percentage. When you can’t cut some program because of federal mandates and federal matching funds, then those programs that can be cut have to be cut at drastically higher rates.

If you can’t cut your way out, then that leaves a sales tax increase as the alternative. And here is where the problem will come if taxes are now cut the “wrong” way.

If legislators focus their sales tax cuts on one of the most stable parts of the sales tax base, then the amount of sales tax increase needed will have to be higher than it otherwise would be to meet the revenue need. For example, in an economic downturn, people will still buy groceries, but they will put off buying a new car, television, or refrigerator. When that happens, the amount of sales tax revenue drops even more precipitously because fewer items subject to the sales tax are being purchased.

The chart below provides a hypothetical that, for the sake of simplicity, assumes the tax on groceries is eliminated and consumers put off the the purchase of other items while the economy is down.

 Sales Tax Rate  No. of Food Units Subject to Tax  No. of New Cars Subject to Tax  No. of New TVs Subject to Tax  Total Revenue for Units Subject to Tax
 7%  100  100  100  $21
 7%  sales tax on food units eliminated  50  50  $7

 

As you can see, the sales tax rate would have to go up substantially in order to continue generating $21 annually. In fact, the rate would have to increase to 21 percent to generate the same amount of revenue. Of course, when sales pick up, the government will have another revenue windfall.

So if legislators greatly reduce the sales tax on food (or some other relatively stable part of the sales tax base), as is being discussed by some, when the next income downturn comes, they may find themselves in a bigger mess than if they had made an across-the-board cut in the sales tax rate.

Cuts, as explained, will be hard. It will be very unpopular to put the sales tax back on food and it will be equally unpopular to really jack up the sales tax rate on everything still in the tax base, particularly given how high it already is.

While many may think a big cut in the sales tax on groceries would be the best thing since sliced bread, if legislators aren’t careful, they may wind up with a political hot potato in the years to come. I should know; I got caught holding one years ago.


David Fowler served in the Tennessee state Senate for 12 years before joining FACT as President in 2006. Read David’s complete bio.

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