Since North Carolina implemented sweeping tax reform in 2013, there has been interest in expanding North Carolina’s sales tax to include services. The idea is to transform the sales tax into an actual broad-based consumption tax that applies equally to all consumption spending. (It should be noted that this could also be done by appropriately reforming the income tax.) In addition, for many, the hope is that this base broadening would bring in enough additional revenue to allow for the eventual elimination of the state income tax. There has been some movement in this direction, such as the expansion of the tax to include selected services levied under certain circumstances, but, by and large, the tax still primarily applies to goods.

But even if this expansion of the sales tax base is ultimately accomplished, it will still include a very serious flaw: a hidden tax that is currently embedded in the system. This hidden tax effectively raises the actual sales tax rate above the statutory rate, and the amount of this tax varies from product to product. This aspect of the sales tax makes it inefficient from an economics perspective and inconsistent with principles of transparent government.

I am referring to the fact that North Carolina taxes final sales of products to the end consumer and business to business on sales. That is, it taxes goods that are inputs into the production process. What this means is that the price of every good and service includes the sales tax that is paid on inputs that are purchased and ultimately included in the sale of the product to the consumer. All of these taxes are embedded in the price that the consumer pays and are therefore hidden. The only tax that appears on the sales receipt and therefore the only tax that the consumer sees is the one that he or she is paying on the final price of the product at check out.

To explain this further, imagine that a consumer goes to a local tire shop to purchase a set of tires for his car. The price of the four tires is $500 and, on top of that price, the customer pays a 7 percent sales tax, possibly higher depending on the county or municipality. When the shop buys those tires from the wholesaler the sale is properly exempt from the sales tax, but there is more that goes into the final price of those tires. This would include all of the sales equipment, such as cash registers, credit card readers, display cases, office supplies, etc. All of these purchases are taxed at the same 7 percent rate as the tires and are included in the $500 price.

This is also true of the wholesale price that the tire shop pays for the tires. Included in that price are the taxes paid on all the equipment that the wholesaler has purchased that make it possible to bring those tires to the retailer. Ultimately, these taxes – in the form of higher prices – also flow down to the consumer in the final price of the tires.

These business-to-business sales taxes have what economists call a “cascading effect,” where taxes are imposed at each stage of the production process and accrue to the point of sale. The final consumer ends up paying a tax on all those taxes buried in the price, as well as conventional retail sales taxes, when they pay for the item at the cash register. This means that the customer in the tire shop is actually paying more than the statutory 7 percent sales tax printed on their receipt.

The additional amount is hidden from the customer’s view. This is why in countries where there is a value added tax (VAT), which is a form of consumption tax that is collected at each stage of the production process but not at the cash register, the taxes that are paid at each stage of production are deducted before the final tax payment is sent to the government. This is to insure that taxes are not being paid on previous taxes. This is not to recommend a VAT for North Carolina, or anywhere else for that matter. The VAT is very complex plus because it is completely hidden from the consumer it is easy for politicians to raise.

This analysis applies not only to goods like tires but also to services that generally go untaxed at the point-of-sale to the final consumer. For example, if a homeowner has landscaping work done at his house, which is not directly taxed, there are still sales taxes included in the price that the homeowner pays. All of the equipment that the landscaper uses – lawnmowers, hedge trimmers, chainsaws, etc. – were taxed when purchased by the landscaper. In addition, the oil, the spark plugs, the filters, and other items used to operate and maintain the equipment are also taxed. All of these taxes raise costs to the landscaper and are embedded in the prices that they charge. Given that all services use goods that are taxed as inputs to the provision of those services, the consumers of those services are, in fact, paying sales taxes.  They just don’t know it.

Before the North Carolina legislature continues on the path of expanding the state sales tax to include more services, something that it has refrained from doing in the 2017 session, it should embark on a plan to fix this flaw in the current system. Taxing inputs into the production process is not only inconsistent with basic economic principles of efficient taxation, but it also violates basic principles of transparent government. Hidden taxes of any kind are antithetical to sound decision making in a democratic process.

Voters cannot make informed decisions about public policy unless they know how much those policies are costing them. This means that citizens should be fully aware of the amount of taxes that they are paying. The taxation of inputs into the production process, i.e., business to business sales taxes, are inconsistent with this basic principle open government.