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Can Sales Tax Exemptions Be Rationalized With 6 Policy Prerequisites?

author photo of Annette Nellen

I see that in late March, Utah added a 75th exemption to its list of sales tax exemptions. SB 250 allows a sales tax exemption for fuel cells beginning April 1, 2013. (Click here for SB 250 in pdf.) This is not an unusual event; states add new exemptions to the sales tax regularly. I don't mean to pick on Utah lawmakers, but just to use this recent law change as an opportunity to discuss some tax policy considerations with respect to the sales tax.

1) Purpose: I think we'd likely all agree that if there are going to be exceptions to how a tax applies, there should be a reason for the exception. This protects the integrity of the tax and people's understanding of the reasons why it exists. I could not find any documents explaining why this exemption for fuel cells was added.

Given that fuel cells* are "green," I'd guess one reason for the new exemption is to support the development and sale of fuel cells for environmental reasons. Some fuel cells likely already were exempt as a sale for resale because they would be purchased by a manufacturer to use for equipment they make. But some would also be purchased by businesses (and perhaps individual consumers) for use in equipment and for power generation.

2) Avoiding Pyramiding: In the design of a sales tax, businesses should not pay sales tax. This prevents the tax from being incorporated into the price charged by that business, leading to pyramiding of the tax (a tax on a tax).

Ideally, sales tax laws should be written to only apply to consumption by final consumers. One reason why this is not done in any state is because pyramiding was overlooked in the original design (I think). Also, once pyramiding is in the system, it is expensive to remove.  It is estimated that about 1/3 of sales tax collected is derived from business purchases. The Utah fuel cell sales tax exemption seems relatively low cost though. The estimate of lost sales tax was $35,000 per year at the state level and $16,000 per year at the local level. Of course, these figures would grow as fuel cells become more widely used.

3) Strategic Planning: A tax system should support, and at least not work contrary to, a jurisdiction's economic, societal and environmental goals. This may be why the fuel cell sales tax exemption was added.  If Utah is trying to improve its environment and reduce pollutants, the sales tax exemption can help encourage the purchase of fuel cells.

4) Economic efficiency and neutrality: While there may be strategic reasons for the new exemption, when such exemptions only benefit certain taxpayers or industries, it really means that others are paying for subsidizing the exemption. It also means that the tax system is encouraging one investment over another. When taxes play a part in decision-making (or the operation of free markets), there is distortion and possible over-investment in one activity over others.

5) Accountability: When a special incentive is added to the law (which is likely why SB 250 was enacted), there should be some assessment to see if the change is having its intended effect. I did not see any such assessment included in SB 250. This is not unusual though.

6) Simplicity: A tax system should be simple so people understand how the tax works and how much they owe. Special rules tend to add complexity to a tax system because they need to be carefully defined so they are not used beyond their intended purpose. It would be much simpler if the sales tax were just written to cover all consumption by final consumers. This would get rid of pyramiding because businesses would not pay sales tax. And, every time an individual purchased a good or service (unless for business use), they would pay sales tax. But, it is likely that everyone would want some exemptions, such as for medical care. Some might also want an exemption for food, but that tends to provide a bigger benefit to higher income individuals because they spend more on food.  And, people would likely want some business purchases to be subject to sales tax, such as meals and entertainment expenditures.  This could all be done and still have a simpler system without the need to list out 75 exemptions to the sales tax.

What do you think?

* What is a fuel cell?  For the new Utah exemption, "fuel cell" is defined per Utah Section 54-15-102: "a device in which the energy of a reaction between a fuel and an oxidant is converted directly and continuously into electrical energy." For more on fuel cells, see:

Other recent “Sales Tax Policy - Tales & Trends” posts by Annette Nellen, CPA, ESQ:

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