PPIC Logo Independent, objective, nonpartisan research
Press Release · June 8, 2011

Shift Toward Consumption Taxes Could Reduce Revenue Volatility, Improve Business Climate

SAN FRANCISCO, June 8, 2011—California could reduce its revenue volatility and improve its business climate by moving toward a greater reliance on consumption taxes—those based on goods or services consumed in the state rather than on income earned here—according to a report released today by the Public Policy Institute of California (PPIC).

The difficulty of balancing California’s budget has focused attention on a key problem: The state’s revenue is volatile because it depends heavily on income taxes, particularly capital gains and corporate income. Revenue from a broad-based consumption tax would likely be more stable because consumption tends to fluctuate less than income, the PPIC report points out.

As a tax on the purchases of goods and services, rather than on their production, a consumption tax could also make California a more attractive place for businesses to locate and employ workers than does our current system, which relies heavily on taxes levied on the income from production in the state.

Author Alan Auerbach, Bren Fellow at PPIC and director of UC Berkeley’s Burch Center for Tax Policy and Public Finance, reviews concerns about the current tax system and evaluates potential consumption tax reforms in the report, Consumption Tax Options for California.

There are a number of ways to tax consumption, and the report evaluates the advantages, disadvantages, and ease of implementation of five options. Auerbach notes that these five options are not mutually exclusive and concludes that reforming the existing tax structure may be the most promising approach.

“It would be possible to implement reforms in the retail sales tax and corporate income tax together,” he says. “That might well be the most straightforward path to reform in light of the difficulties of introducing an entirely new tax system.”

  • Reform of the state retail sales tax. This is the closest California has to a broad-based consumption tax but it excludes many consumer purchases—including services and Internet sales—a problem that has worsened over time. Statistics suggest that only one-fifth of household consumption is subject to this tax. And a large share of the sales tax comes from purchases by businesses, which raises the cost of doing business in California.

    Congressional and possibly judicial action would be needed for the state to tax most Internet and mail-order sales by out-of-state vendors. But the retail sales tax could be reformed by increasing taxes on services and reducing taxes on business purchases. In addition, blanket exemptions for necessities, such as food and clothing, could be replaced with targeted aid for lower income residents who spend a larger share of their income on these items than do higher income Californians.
  • Reform of the state corporate income tax. Currently, the state taxes corporate income using a formula that apportions liability based on the location of assets, payroll, and sales. Corporations also have the option of paying based on sales alone. If this option were to become mandatory and if the tax were extended to include a larger part of the business sector, the corporate income tax would have an effect more like a broad-based consumption tax. The advantage of the corporate income tax is that it is progressive because it excludes wage and salary income from the tax base. The disadvantage is that revenues from the tax would still be volatile.
  • A gross receipts tax. This tax, recently introduced in several other states, would apply to all business sales, including sales to other businesses. It would broaden the tax base and provide greater stability in state revenue. But its major flaw is that it would raise production costs, particularly on goods that involve several stages of production, as the retail sales tax to some extent does now.
  • A state-level value added tax. Common around the world, this is a true consumption tax. It is like a retail sales tax based only on sales to consumers. But unlike the sales tax, this tax is imposed as production occurs. A producer at each stage pays taxes on sales but receives credits to offset the taxes paid on purchases. In the absence of a national value added tax, the advantages of introducing one at the state level would have to be weighed against the administrative costs of imposing a tax in California that differs fundamentally from those in other states.
  • A sales-apportioned tax based on value added. The Commission on the 21st Century Economy, a bipartisan panel set up in 2008 by state government, proposed this variation on the value added tax, which it called a business net receipts tax. It would be based on national value added with California’s share apportioned by sales in the state. It would not be as effective as a state-level value added tax at promoting production within California but would be easier to implement without national coordination. It would apply to all businesses over a certain size, not just corporations. Its revenue stream would be less volatile than the corporate income tax. However, unlike the corporate tax, this tax would provide no deduction for wages so would be less progressive.

Consumption Tax Options for California was supported with funding from the Donald Bren Foundation.


PPIC is dedicated to informing and improving public policy in California through independent, objective, nonpartisan research on major economic, social, and political issues. The institute was established in 1994 with an endowment from William R. Hewlett. As a private operating foundation, PPIC does not take or support positions on any ballot measure or on any local, state, or federal legislation, nor does it endorse, support, or oppose any political parties or candidates for public office.