The concept of a Value Added Tax (VAT) used to be a popular discussion topic in public policy circles, especially in the past when Americans used to be more sensitive to debt and deficits. Culturally, we no longer have that sensitivity, despite some flaccid political posturing of late that, to me, seems more campaign rhetoric than an assertion of core beliefs. At the federal level, we’re all committed to debt now.

But, back when we weren’t, there were some serious people pushing for a VAT tax. The argument was simple. A VAT is a small tax assessed at each phase of the production stage for a good or service. Republicans could support it, it was suggested, because it was an almost invisible tax. Both parties could support it because VAT is a cash cow.

Local governments can’t take on unlimited debt. They can’t print their own money. They have hard fiscal constraints that the federal government does not have. Yet, some have a nearly invisible revenue source that is also a cash cow: the sales tax.

There are plenty of arguments for cities to use a local sales tax as a primary revenue source. Besides it being a cash cow, it is also nearly invisible. With the exception of large purchases, taxpayers usually don’t mind paying it because it’s a few cents here, a few cents there. There is a sense of solidarity in that everyone contributes, yet those who purchase more items, or more expensive items, pay more tax. And, for communities with a lot of people passing through, a sales tax is a way to tap into outsiders to pay for services for residents.

So, all good, right?

Not exactly. I’ve long been an outspoken critic of the local sales tax, not because I’m against taxation but because, for local governments, it is the most distorting of taxes. Let me elaborate.

Using sales tax as a primary revenue source puts a tremendous burden on local governments to be very intentional about their accounting. Remember that entire thing about sales tax being a cash cow? In real terms, that means there is a wide disconnect between how the city collects its money and what it spends that money on.

For a corporation, a customer purchases a product or service at a price. If the price is too high, there won’t be enough purchases or competitors will emerge that sell at a lower price. If the price is too low, there might be more demand than the corporation can fulfill (thus giving an opening for competitors) or, if the price is way too low, the corporation will lose money. Lose money long enough and the corporation will cease to exist.

What exists for a corporation is direct feedback from the customer. There is no ambiguity about the value of a specific product or service, even when preferences change, even when market conditions shift.

Obviously, much of this is different for a municipal corporation, but not the need for feedback. How does the local government know whether it should build a new city hall or improve the park? How does it know whether money is best spent filling potholes or expanding roadways? Who in city hall is getting the feedback that says, “we’re spending too much on X, we should spend more on Y,” or “we don’t value this undertaking enough to justify its costs”?

The easy answer is to say that elections are feedback, but are they really? Cities undertake long-term investments, projects where the returns are measured in decades. Point to a community that is tracking their finances so competently that they know the return on these investments. This is hard enough to do in a property or land value tax system where there is at least a relationship between the public investment and the adjacent private investment. In a sales tax city, nobody asks these questions because there really isn’t an answer.

This means that sales tax cities make decisions without hard data, without direct feedback. Leadership makes multimillion-dollar allocations of resources based on little more than gut instinct. If we know anything about human reasoning, we know it is full of misperceptions and fallacies. Primary among them is motivated reasoning, the fact that all humans (including me and you) search out facts that confirm our own biases. City halls are full of humans, and so they are full of motivated reasoning.

Another is cognitive discounting, the very human notion to highly value positive feedback today and deeply discount, if not ignore entirely, negative feedback in the distant future. Cognitive discounting is the underlying human failing that has given us the Growth Ponzi Scheme. The lack of feedback in a sales tax system only makes the allure of new growth at the front end of the Ponzi transaction all that much more seductive.

If you are going to rely primarily on a sales tax, you must have outstandingly good local government accounting. You have to go way beyond GASB to track things other places don’t track, comparing your original assumptions on what will happen with different investment choices to the reality as it plays out over multiple decades. This needs to be so open and transparent that it feels like an obsession.

No city does this. And no city should have their primary source of funding be a sales tax.

Instead of being obsessive about their accounting, cities that rely on sales tax follow a predictable pattern. First, they frantically chase commercial development because that is where their new revenue is going to come from. Watch such places and note how they measure and report on success in terms of new business openings, the amount of new retail floor space, and, of course, the amount of sales tax they collect.

These are easy variables to maximize. If I’m willing to take on a million dollars of liability due in 30 years—like maintaining a road—I can easily get $10,000 in sales tax dollars today. That’s not a difficult trick to pull off. Yet, when I only track and report the amount of sales tax dollars I collect right now, what am I really doing? At the very least, I’m lying to myself. At worst, I’m deceiving an entire community of people I am sworn to serve.

At Strong Towns, we believe that local government is not the lowest level of government, but the highest level of collaboration for strong citizens working to build a prosperous place. We believe in citizen government and the relationship between residents of a city and the people who make decisions at city hall. The system works best when the interests of both are aligned.

There is no system of local taxation that undermines the relationship between residents and city hall more than the sales tax. This starts with the way the sales tax devalues residential properties, and people in general, except in their role as consumers.

In a sales tax system, what good is a new family moving to town? A new home simply costs the community money. Same with a new office building. At best, they are loss-leaders in an effort to secure more sales tax revenue. A sales tax city tolerates homes and offices because the people living and working there will potentially buy stuff, but it would be better for the municipal corporation if they all lived just outside the city limits (someone else’s cost) and did all their shopping in the city (where they pay sales tax).

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.

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.

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, for today.

In a future article, I plan to examine the way cities in Oklahoma, where sales tax is the primary source of local government revenue, sneak in a property tax through the referendum process and how that adds to the distortion the sales tax creates in the decision-making process.

No City Should Rely Primarily on a Sales Tax for Funding

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