The Impact of a Sales Tax Increase on the Merrimack Valley Economy

Robert J. Cuomo, Ph.D

Dean of the Girard School of Business and International Commerce

Merrimack College

This is the first in a series of articles that will address the impact of national, state, and local economic policies on the Merrimack Valley economy.  In this article, I assess the impact of the recently passed legislation raising the state sales tax from 5 to 6.25%.  This increase will also apply to restaurant meals and allow cities and towns to increase the tax on meals by an additional 0.75%.  In addition the legislation expands the sales tax base to include alcohol.  Cities and towns can also apply a 2% tax to lodging establishments.

Let me explain what I perceive to be the implications of enactment of this legislation on the Merrimack Valley economy.  In general raising taxes in a recessionary economy is bad economic policy.  Raising taxes drains dollars and spending from the economy at a time when we need to increase spending to encourage economic growth.  In addition to thwarting economic growth, the sales tax increase will have a damaging effect on the sale of certain goods and services in addition to reducing sales in the Merrimack Valley communities which border New Hampshire.

The restaurant industry will certainly be adversely affected as consumers must pay an additional 0.75% or potentially 2.00% when they eat out.  Firms in this industry are already working on very thin profit margins.  Small liquor stores will be affected in the same way.  Applying an increased sales tax to the hotel industry will further depress low vacancy rates.

How will the sales tax increase affect local merchants?  We know that consumers will purchase goods and services where they can maximize what they can purchase with their limited disposable incomes.  Therefore, if the consumer can purchase the same good or service in New Hampshire rather than Massachusetts at a lower price, he/she will do so.  There is little doubt that local merchants will experience reduced sales.  Merchants that are barely profitable now will probably have to close their doors. Sales in local communities will fall more than the initial decrease in spending. The “multiplier” effect will be to reduce spending by more than the initial reduction in spending.  Assuming that every dollar of spending leads to an increase in income for local merchants, we know that these merchants will spend some of that income on goods and services in the local economy.  This local multiplier has been estimated conservatively at 1.5.  This means that each $1 of spending reduction will ultimately lead to a total spending reduction of $1.50.

We know that the sales tax increase was passed to generate additional revenue for the Commonwealth to address the projected budgetary deficit.  The revenue raising projections may very well be over stated.  The issue can be understood by what economists call “static” as opposed to “dynamic analysis.”  In static analysis, one assumes that consumers will behave in the same way as they did before the sales tax increase.  In this scenario Massachusetts sales will not be affected by the imposition of a sales tax increase.  However, dynamic analysis indicates that consumers will change their behavior when faced with an increased sales tax in Massachusetts and increase their purchases in New Hampshire and reduce their expenditures in Massachusetts.  If this occurs Massachusetts will not realize the projected sales tax revenues.  It is difficult to assess the precise impact, but it could be significant.

In summary, it is not clear if increasing the sales tax to 6.25% is the best way to address the state’s budget deficit.  Some very well crafted revenue enhancement as well as spending reduction approaches need to be evaluated.  I will address these issues in future articles.

Robert J. Cuomo, PhD

Dean

Girard School of Business and International Commerce

Merrimack College

North Andover, MA 01845