The True Cost of State Sales Tax Holidays

'Tis the sales-tax-holiday season, when states give the gift of tax-free shopping for clothing, computers and other back-to-school supplies.

It seems like a good thing: Take a little pressure off the pockets of cash-strapped parents, make retailers smile and make politicians look good for supporting tax relief.

But as states grapple with huge budget deficits, the debate is on over whether states should be more like Scrooge than like Santa.

Last year, Illinois passed legislation creating a sales tax holiday. Now the state is sitting on the sidelines because it "just cannot afford it this year," according to State Sen. Toi Hutchinson (D-Chicago), who was the chief sponsor of the state's holiday last year.

What It Costs

It's expensive to be generous. When states give up their portion of the sales tax, they give up much-needed revenue for a weekend or, in some cases, for up to a week. Massachusetts will see a revenue reduction of $20 million to $25 million, projects Sujit CanagaRetna, senior fiscal analyst with the Council of State Governments. That's not far-fetched considering that last year's loss was about $20 million, according to Tom Astore, tax director at Rodman & Rodman.

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Another example is North Carolina. According to press reports, the state department of revenue last year estimated that it gave up $14.5 million during the its back-to-school tax holiday and $1.7 million during its November tax holiday for Energy Star appliances.

"Our sales-tax holiday results in the loss of $12 million each year, money that could support early childhood education or improve the educational attainment level of the state's young work force -- both of which were cut this year because of the failure to take a balanced approach to closing the budget shortfall," wrote Alexandra Forter Sirota, director of the North Carolina Budget and Tax Center, a public-interest organization, in The News & Observer. "The sales-tax holiday simply further undermines the adequacy of the revenue system to support shared investments."

Administering the sales-tax exemptions also creates significant red tape. Retailers and revenue departments, as well as local governments, must monitor and document the distinction of eligible and ineligible products, for example. In her opinion piece, Sirota calls for better, long-term solutions that will lead to real improvements in the state's revenue system.

Some States End the Holidays

In 2011, 17 states will conduct back-to-school sales tax holidays, down from a peak of 18 states in 2010, according to Mark Robyn, staff economist and co-author of the Tax Foundation's,

Sales Tax Holidays: Politically Expedient but Poor Tax Policy.

The dip is not surprising. "Any effect on revenue must be a consideration for lawmakers, especially in light of the flailing economy," says Carol Kokinis-Graves, a state tax analyst for CCH.

Several states considered canceling their sales-tax holidays for that reason. "Texas broached the topic, but as far as I know, Illinois was the only state that cancelled it," CanagaRetna says. Aside from school supplies, some states also include Energy Star appliances, hurricane-preparedness products, firearms and hunting supplies in their sales-tax holidays.

Most states have to balance their budgets, and -- in this past fiscal year -- most have had to cut millions from public schools, universities, health services and municipal budgets, Matt Gardner, executive director of the Institute on Taxation and Economic Policy (ITEP) tells DailyFinance. That's left many states scrambling to keep police on the beat and public pools open, he says. "A governor might say they can absorb, for example, the $20 million hit to the budget, but $20 million would buy a lot of new textbooks, keep a lot of social workers on staff to protect kids and help a lot of seniors afford their property taxes."

Why Many Lawmakers Can't Say 'No'

With millions at stake, why don't the states just say no? "By and large, dropping the sale tax holiday is considered a "tax" and given that raising taxes is so politically radioactive, policymakers in most states have continued with the holiday," CanagaRetna says.

Critics say those good intentions may be sorely misplaced and downright fiscally foolish. Furthermore, the sales-tax holiday may be more hype than help.

"It allows politicians to pretend they are doing something helpful for working families and for their state's businesses, but there just aren't reliable numbers out there backing up this claim," Gardner says.

The Tax Foundation's key findings in its report concluded that sales-tax holidays do not promote economic growth or significantly increase consumer purchases. The evidence shows that they simply shift the timing of purchases and that some retailers raise prices during the holiday, reducing consumer savings.

"Some economists have questioned whether customers are actually saving money, as retailers have an incentive to hold the line or prices (no discounts or sales) during holiday periods. This may be why retailers tend to like sales-tax holidays and advocate for holding them," says Ron Alt, senior research associate with the Federation of Tax Administrators.

Then there's the matter of which customers benefit most. "The only consumers who benefit from sales-tax holidays are the ones who have the money at hand to shop on the designated weekend. If you are in a household living, literally, paycheck to paycheck, you go shopping when you have money in the bank, not when some politician tells you it's fun," Gardner says.

Is There a Better Way?

"I think the state should study the net effect of this tax holiday along with a comprehensive review of our entire tax code, says North Carolina State Sen. Richard Stevens (R-Wake County). "It is time to review this holiday."

Sirota writes about what she says would likely help North Carolina: "Extending the sales tax to include purchases of services, as well as goods, would include more business activity and ensure revenues keep pace with our growing economy. The best tool to achieve greater equity in the tax system is a strong state Earned Income Tax Credit. The EITC reaches 800,000 primary wage earners across the state who are paying a greater share of their incomes in taxes, primarily through the sales tax, than higher-income households. Strengthening and increasing the value of the state's EITC should be a top priority of policymakers."

ITEP has a few ideas of its own to help working families make ends meet. ITEP is looking for permanent reforms, including targeted tax credits which it says are more cost-effective because they ensure the benefit goes specifically to taxpayers.

Targeted sales-tax credits help compensate for the relatively high cost of basic necessities for lower-income households. Using Bureau of Labor Statistics data, ITEP estimates that while the wealthiest families spend only one-sixth of their income on items that are subject to sales taxes, low-income families spend three-quarters of their income on taxable purchases. Households in the middle spend about half of their income on taxable items. Put differently, a 6% sales tax amounts to roughly a 1% income tax rate for families in the highest income brackets, a 3% tax on middle-income families and a 4.5% tax on the poorest families.

"This is what makes the flat sales tax a textbook case of a regressive tax," Gardner said in a prepared statement. "A dollar costs a poor person more than it costs a rich person." Targeted sales tax credits generally give a flat dollar amount for each family member and are available only to taxpayers with income below a certain threshold. Eight states currently provide sales tax relief in this form, according to ITEP.

If retailers and hard-pressed consumers do benefit in any significant way from sales-tax holidays, the burden is on lawmakers to demonstrate those benefits – and the costs, ITEP says. "There is sexy tax policy and popular tax policy, and then there is good tax policy," Gardner says. "Sales tax holidays are popular. Targeted tax credits and Internet-transaction taxes are decidedly unsexy, but they are great policy."