The Trouble with Tax Holidays

Consumers and politicians love them, but state sales tax holidays are becoming a major headache for businesses.

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It all started in New York at Macy's. In 1997, in an effort to spur consumer spending, Gov. George E. Pataki put his signature on a novel law: For a week in January, the state would suspend its 4% sales tax on most purchases of clothing and shoes. At a kickoff shopping trip at the famous department store, the governor boasted that the measure would "put more than $20 million in the pocketbooks and wallets of New Yorkers."

Ever since then, a growing number of states--especially those with high sales taxes--have followed New York's lead, declaring sales tax holidays that often coincide with back-to-school or Christmas shopping. George W. Bush signed one into law in 1999 when he was governor of Texas. His brother Jeb created a holiday in Florida in 1998. In all, 11 of the 45 states that have sales taxes, plus the District of Columbia, will hold tax holidays this year, and two states plan to add them in 2006.

But if consumers jump at the chance to shave a little off the $200 billion a year they pay in general sales taxes, some critics are now saying that the state holidays are good for consumers but have no effect on the economy--and actually hurt retail businesses. For example, although retail sales will rise during the week of a tax holiday, the net economic impact may be limited because retail sales often fall in the weeks preceding a tax holiday.

And whether or not tax holidays boost the economy, they certainly wreak havoc in other ways. The administrative issues of figuring out what should and shouldn't be taxed can be a nightmare. For companies that do business in multiple states, the patchwork of rules makes tax accounting complicated, though software can help. Finally, the holidays may even confuse or discourage investors because they can create financial reporting discrepancies that make it hard to judge retailers on same-store sales comparisons from one month to another. "Sales tax holidays make the tax code unstable," says Curtis Dubay, an economist at the Tax Foundation, a nonpartisan tax policy research group based in Washington, D.C. "You are essentially operating under two tax codes for the year, so it is difficult to comply."

Still, there's one thing on which pretty much everyone now agrees: Tax holidays are here to stay because consumers and politicians love them. "It is awfully hard to speak out against something that appears to be cutting taxes," says John Mikesell, a professor of public finance and policy analysis at Indiana University, "even when it doesn't make much sense."

Belts Without Buckles

To understand how much trouble sales tax holidays can cause businesses, it helps to understand just how complex sales taxes are to begin with. The difficulties start with the sheer number of them: Not only does each state have its own rules, but so, too, do many cities, counties, municipalities, and transportation districts within those states. Across the country, there are roughly 7,500 sales tax jurisdictions, creating an estimated 70,000 possible sales tax combinations. If Pataki were to shop at Macy's today, for example, he would typically pay 8.375% in sales taxes (4% for the state, another 4% for the city, and the final 0.375% for the metro transit district).

Not only do the states set their own rates, they often differ on what product categories should be covered by a sales tax, and what specific items belong in those categories. To take one ludicrous and oft-cited example, a Twix bar may be considered food, which is not taxed, or candy, which is. "The retailers are dealing with a complex nightmare right now," says Steve Kranz, tax counsel at the Council on State Taxation, a trade group in Washington, D.C., that represents 600 businesses on state and local tax issues. "And that puts retailers in the position of having done the job incorrectly and getting audited and paying tax out of pocket for not collecting enough, or of collecting too much and being sued by consumer groups in class-action litigations."

In that environment, the tax holidays--by making exceptions for a day or a week in a certain jurisdiction for certain items--just add one more layer of complexity. Consider a handful of Twix-like rules from this year's crop of tax holidays. In Iowa, clothing under $100 is exempt from tax, but belts without buckles are still taxed. In New York state, the tax-free spending limit is $110, but localities can choose to opt in or opt out of the holiday entirely. In North Carolina, textbooks and reference books get the tax break, but novels do not. And in Texas, clothes and shoes get the break, unless they're used for sports.

Five years ago, looking to clean up this mess, revenue officials from a number of states joined forces to establish a group called the Streamlined Sales Tax Project. The policymakers originally hoped to get tax holidays off the books completely, says Diane Hardt, Wisconsin's tax administrator and co-chair of the project, but they were rebuffed by legislators. So now, Hardt and her allies seek to simplify sales tax issues, including problems created by the holidays, in other ways.

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