An auto dealership is a prime catch for a community dependent on the sales tax. (Click for original).Unless you are a modern day Istanbul and sit at the crossroads of trade and commerce with the ability to skim margins off the goods flowing through your community, why would a city rely heavily on the sales tax? The only reason is because it is easy. Unfortunately, for building a strong town, easy is not always productive.

The sales tax does a number of destructive things to a community, the worst of which is the way it devalues residential properties, and people in general, except in their role as consumers.

For the local government financing itself with sales tax, there are mostly negative financial implications from residential and other non-retail development. A new residence simply costs money. Same with a new office building. At best, they are loss-leaders in an effort to secure more sales tax revenue, although there is no way to track return-on-investment or correlate revenues with expenses.

The sales tax fails to align the interests of a local government and its residents, putting them in tension with one another. The optimum outcome for a local government reliant on the sales tax is for residents to spend their money prolifically then, when they run out, borrow money to spend more. Then, when the household is completely broke, move out of the community and make way for someone else who will spend more.

Photo by Andrew Jameson (click for licensing), via Wikimedia Commons

Photo by Andrew Jameson (click for licensing), via Wikimedia Commons

Housing and people....what a burden. If residents are thrifty and attempt to build their wealth, local government revenues are harmed. Better to encourage those on fixed incomes or with frugal minds to leave and cater to those with more discretionary income and free spending ways. Some might argue that this doesn’t happen, yet the incentives are all in place to promulgate it.

Like a bad bank in the run up to the 2008 financial crisis, cities reliant on the sales tax find it hard to be concerned about the long term implications of present actions. Operations become transactional because transactions are what keep the city flush. At least today.

The sales tax is also quite volatile, especially when it is narrowly applied to discretionary items. These things – automobiles, jewelry, electronics and the like – are the first thing consumers put off purchasing when economic conditions tighten.

An over reliance on sales tax also creates an unnatural competition between cities. Desperate for transactions, local governments use the very revenue they are trying to obtain to bribe retail businesses to move to their communities. The goal here is to steal revenue from neighboring communities with consumers (note I did not call them “residents” or “people”) and state/regional transportation authorities subsidizing the transportation costs. This is not survival of the fittest but a race to the bottom, one that savvy retailers know how to exploit.

Note that states get their sales tax revenue regardless of which local government shares it. Healthy competition is the cornerstone of a healthy economy, but states that micromanage local governments and allow them only a sales tax are creating all the wrong incentives. The sales tax system works for large corporations too, just not local governments.

Understand that the optimal outcome for a local government funded by sales tax is to have all of the area’s strips malls, big box stores and auto dealerships within their boundaries and all the residences, offices and service businesses in the neighboring cities. How can that possibly be considered healthy, let alone stable?

An otherwise healthy and prosperous city, one that has a mix of housing in good proximity to a downtown full of professional services, trades and crafts (but not necessarily heavy on retail) would be a major loser in a place reliant on the sales tax. Even a traditional town with a Main Street surrounded by walkable neighborhoods – the mainstay of civilization for thousands of years – would fail if it was funded exclusively with a sales tax.

So why do so many local governments rely so heavily on the sales tax? Why have so many states found it so convenient to give local governments only this kind of taxing authority? Simple: the sales tax is both stealthy and a real cash cow. Those two attributes are really seductive for places caught in a cycle of bad financial decisions.

Sales taxes do have a role to play. It is a really good source for funding one-time expenditures or items that are discretionary from year to year. Sales taxes just shouldn’t be the sole or predominant mechanism of funding for most local governments.

Whether or not officials are conscious of the distortions brought about by reliance on the sales tax, they exist. With a sales tax, there is little to no correlation between the financial health of the community and the financial health of the local government. Reliance on the sales tax is not how strong communities are built.