Expanding Sales Taxation of Services: Options and Issues

PDF of full report (55pp.)

By Michael Mazerov

August 10, 2009

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Summary

Sales of tangible goods dominate most states’ sales tax bases; only a few states impose their sales taxes on a broad array of services. Sales of “non-durable goods” like clothing and light bulbs and “durable goods” like cars and computers generate the vast majority of state sales tax receipts. According to the Federation of Tax Administrators, a majority of states apply their sales tax to less than one-third of 168 potentially-taxable services. Five of the 45 states with sales taxes impose them on fewer than 20 services.[1]

Most states could improve their sales taxes and their tax systems in general with some expansion of the tax base to include services. Levying sales taxes on services makes state tax systems fairer, more stable, more economically neutral, and easier to administer. Moreover, because state sales taxes are a major source of funding for schools, universities, health care, public safety, and other functions of state and local government, adding services to state sales tax bases can help states maintain their support for those functions, for instance during an economic downturn when state revenues are declining. Broadening the sales tax base can also avert other, less sound tax increases that otherwise might be enacted when a state needs new revenue. There are significant economic, administrative, and legal issues that must be addressed in expanding the sales taxation of services. The barriers are not insurmountable, however, and the benefits from a broader sales tax base outweigh the challenges.

Why Tax Services?

Public finance economists and other tax experts have been urging states for decades to include more services in the sales tax base. [2] Levying a sales tax on services satisfies all the criteria by which state tax policy options are normally evaluated.

Taxing additional services can generate substantial new sales tax revenue. Table 1 (see page 5 in the body of the report) indicates that the annual, nationwide revenue yield from taxing all services purchased by households except health care, education, housing, and a few others would be on the order of $87 billion. The new revenue from taxing household services would be less than this, since most states do tax services to some extent. Table 1 suggests, however, that states that do not tax services to any significant degree at present — such as California, Illinois, Massachusetts, and Virginia — probably could increase their sales tax revenue by more than one-third if they taxed services purchased by households comprehensively.

Some states have prepared their own estimates of the revenue gained by expanding the sales taxation of services. In June 2009, Maine became the most recent state to broaden its sales tax base significantly; it expects to generate $41 million in annual revenue by levying its sales tax on entertainment admissions, auto and equipment repairs, and such other services as laundry and car washes. This $41 million represents a 4.4 percent boost in its sales tax collections. In 2006, New Jersey added roughly one dozen services to its sales tax base. The state said this would yield more than $400 million in new revenue each year, a 5 percent increase in sales tax receipts. Note that the Maine and New Jersey expansions covered some but not all potentially taxable services. Other states have estimated the revenue that could be gained by expanding the taxation of services much more extensively than did Maine or New Jersey; these estimates (a sampling of which is shown in Table 4 of this report) confirm that states are losing billions of dollars a year due to the tax-exempt status of most services.

Sales and Use Taxes: An Introduction

Most people are familiar with the sales tax, the charge that is added to the cost of goods and some services purchased in retail stores. The tax is calculated as a percentage of the sales price, collected from the purchaser at the time of sale, and remitted weekly or monthly by the retailer to the state tax agency. Forty-five states and thousands of local governments use sales tax revenue to pay for K-12 education, higher education, public health, public safety, transportation, parks, and a range of other services.

How much revenue is generated by the sales tax depends on both the percentage tax rate and the “tax base” — the goods and services that are subject to taxation. Besides omitting most services from the tax base, many states exempt from taxation categories of goods viewed as necessities of life, such as food and medicine.

In addition to taxing goods and a few services purchased by households at retail stores, sales taxes often apply to purchases by businesses from other businesses. A retailer’s purchases from a manufacturer or wholesaler of items for resale usually are not subject to sales taxation, nor are a manufacturer’s purchases of items that are directly incorporated into its output. Nonetheless, goods and services purchased by businesses that do not fall into either of these categories — such as manufacturing equipment, electricity, and office furniture — are often subject to sales taxation. The policy issues raised by the taxation of such “business-to-business” sales will be discussed at length in the body of this report.

Sales taxes are charged when the seller and buyer are in the same state. States levy “compensating use taxes” on purchases of goods when the seller and buyer are in different states. The use tax is almost always identical to the sales tax with respect to both rate and base. The purpose of the use tax is to eliminate the possibility of avoiding sales tax by purchasing from an out-of-state vendor — and thereby eliminate the incentive to do so. In some cases, the out-of-state seller charges the use tax to the buyer just as if the tax were a sales tax, and the buyer is unaware of the distinction. Even if the seller does not charge the use tax, the buyer is legally obligated to pay the use tax directly to the state in which the purchase will be used. (This obligation is largely ignored by individual consumers but frequently fulfilled by businesses that buy from out-of-state vendors.) Use taxes are imposed only rarely on interstate purchases of services; as will be discussed elsewhere in this report, one consequence of expanding sales taxation of services may be a need to reconsider that policy.

Some states levy special taxes on particular services in lieu of or in addition to the sales tax. For example, some states impose special taxes on car and hotel rentals, admission charges for entertainment and cultural events, and utility services like telephone and electricity. Where such taxes are not imposed in lieu of some other business tax (such as the corporate income tax), and where they legally may be passed on to purchasers like the sales tax through itemization on the bill or invoice, these special taxes may be thought of as sales taxes for purposes of much of the analysis contained in this report.

The District of Columbia and forty-five states — all except Alaska, Delaware, Montana, New Hampshire, and Oregon — levy sales taxes. They are a critical revenue source for state governments, supplying $236 billion in state tax revenue in 2007 — 31 percent of total state taxes. In many states, local governments also levy sales taxes.

  • Taxing services broadly is essential if the long-run revenue adequacy of the sales tax is to be maintained. Household spending has been shifting from goods to services for decades. The traditional sales tax base, purchases of durable goods plus non-durable goods except groceries (which the majority of states exempt), fell from 39 percent of household consumption in 1970 to 32 percent in 2007. Over the same interval, consumption of services rose from 31 percent to 45 percent of total household purchases.[3] (See Figure 1, p. 12.) Largely to compensate for this trend, states have increased sales tax rates sharply over this period. The ability of states to continue raising rates is constrained, however, by such factors as the ease with which consumers can shift their purchases to the Internet — where sales taxes often are not charged. If consumption continues to shift toward services, including services in the tax base will be essential to maintaining sales tax revenues over the long term.
  • Bringing services into the sales tax base may reduce the year-to-year volatility of sales tax collections. Sales tax bases are dominated by purchases of “big-ticket” durable goods (such as cars, appliances, and furniture), which often decline sharply during economic downturns. Limited research finds that purchases of some services do not fall as precipitously as durable goods purchases do when the economy slows nor rise as rapidly when the economy is booming. The research suggests that including more services in the sales tax base could moderate slightly the volatility of sales tax revenues over the course of the business cycle.
  • Expanding the taxation of services will make the sales tax fairer. The sales tax is intended to be a general tax on consumption. There is little reason to distinguish between consumption of goods and consumption of services, which in fact can be substitutes for one another. For example, it is not equitable — it violates the principle of “horizontal equity” — to tax the person who rents a videotape but not the person who watches a pay-per-view movie on cable TV.

    Moreover, sales taxes are regressive; that is, they absorb a greater share of the income of lower-income taxpayers than of higher-income taxpayers. This is largely because higher-income persons do not consume their entire incomes; the portion of their incomes that they save is not subject to sales or other consumption taxes. Ideally, states could consider reducing the regressivity of sales taxes by expanding the sales tax to services purchased primarily by the affluent. While worth doing, the revenue gain would not be substantial. To broadly tax services, states must include services purchased by low-, moderate- and middle-income households as well as those purchased by high-income people. In general, a broad expansion of the sales tax to services will not change relative tax burdens.[4]

    There is one circumstance, however, in which expansion of the sales tax to services could make a state’s overall tax system somewhat less equitable. That can occur if taxing services raises the proportion of total state revenue that is derived from the sales tax and thereby lowers the proportion that is derived from more progressive sources such as personal and corporate income taxes. There are a number of ways this potential to increase the regressivity of the tax system as a whole can be avoided. The sales tax base expansion can be balanced with other changes in the tax code, such as a reduction in the sales tax rate or an increase in the personal income tax. Alternatively, targeted credits administered through the income tax or rebates of sales taxes paid can be used to mitigate the increased sales tax burden low-income families could experience when a sales tax is broadly expanded to include services.
  • Imposing a sales tax on services can improve the allocation of economic resources. The failure to tax services while most goods are taxed subtly distorts resource allocation throughout the economy by creating an artificial incentive to purchase services rather than goods. For example, some consumers may be encouraged to repair older cars and appliances rather than replace them with more energy-efficient and less polluting alternatives — although the effect is probably modest. The failure to tax services has also contributed to steady increases in sales tax rates, which create their own economic distortions. Unnecessarily high tax rates on goods resulting from under-taxation of services stimulate such wasteful activities as tax-motivated interstate shopping.
  • Expanding the taxation of services can simplify the process of administering and complying with the sales tax. Expanding the taxation of services can reduce the effort and costs entailed in enforcing and complying with the sales tax. When retailers sell taxable goods as well as tax-exempt services, it can be difficult and costly for tax administrators and merchants alike to ensure that the proper amount of tax has been collected and remitted. If all of a retailer’s sales are subject to tax, many accounting burdens and disputes diminish or disappear.

Expanded sales taxation of services can contribute to the realization of all of these arguably desirable tax policy objectives. There are tradeoffs involved, however. For example, moving toward very comprehensive taxation of services with less than 12-18 months of lead-time could strain the administrative capabilities of state tax departments since many businesses that previously did not collect sales tax would need to be brought into the sales tax system. Thus, achieving an optimal balancing of these goals requires an understanding of all of the potential effects of expanding taxation of services and careful choices about which services to tax.

Which Services Could States Tax? Which Services Should They Tax?

As policymakers contemplate which currently-exempt services they might bring into the sales tax base, it can be useful to think of services as falling into three categories:

  • services primarily purchased by businesses, such as payroll processing and television advertising;
  • services primarily purchased by households, such as diaper service and cable TV; and
  • services frequently purchased by both households and businesses, such as landscaping and pest control.

Economists generally counsel states to forgo taxing the first category of services, so-called “business-to-business” sales. They point out that taxing the goods and services businesses buy to use as inputs into the production of other goods and services often leads to “tax pyramiding.” Tax pyramiding refers to the situation in which an input is taxed when purchased and then effectively taxed again when its cost is passed through into the price of a taxable good or service into which it has been incorporated. Tax pyramiding results in the actual sales tax imposed on a particular good or service bought by a household being higher than what is added at the cash register. Because the sales taxes imposed on inputs are hidden in the selling price of the item, states may tend to rely on this revenue source more than they otherwise would. Moreover, some research suggests that the hidden sales taxes are even more burdensome for low-income families than the visible sales tax that is imposed on the final sale, because necessities like food and utilities that often are tax-exempt nonetheless can have substantial sales taxes hidden in their prices.

Taxation of business inputs also tends to complicate sales tax administration. For example, rules need to be developed for taxing services like accounting that are purchased by businesses for company-wide use in multiple states.

The greatest concern of economists regarding sales taxation of services purchased by businesses is that it can distort the allocation of economic resources. Since services provided to an employer by an employee are rarely subject to sales tax, taxation of business-to-business sales of services can encourage businesses to provide services using their own employees even if they could be produced more efficiently by an independent firm. In addition, if purchases of services subject to sales tax are major cost items for a business (for example, data processing services for a financial institution), a more efficient business that tries to pass those taxes into its prices could lose business to a less efficient competitor located in another state that exempts those inputs from sales taxation. Alternatively, a business that makes substantial purchases of taxable services might choose to expand in a state that is sub-optimal from an economic efficiency standpoint but that exempts those services from sales tax.

While these arguments against taxing business purchases of services have merit, there are at least two countervailing considerations:

  • State sales taxes already apply to numerous purchases of goods by businesses. Assuming that the concerns of economists about the distorting effect on resource allocation of taxing business inputs are valid, economic theory implies that the distortion grows as the tax rate increases. If the choice is between increasing the tax rate at which business-to-business sales of goods are taxed and taxing some business-to-business sales of services in order to hold down the tax rate, the latter could actually have a less adverse impact on the efficient allocation of resources.
  • In an economy in which a growing number of people run their own businesses, exempting all purchases of goods and services by businesses would open the door to substantial tax evasion. Business owners could claim that purchases of many services — such as telecommunications, hotel rentals, and auto and computer repair — were for business use when they were actually for personal use. Preventing this abuse would require that substantial additional resources for tax enforcement be provided to state tax departments. The costs of preventing tax evasion could exceed the economic benefits of exempting business inputs from taxation.

In broadening their states’ taxation of services, policymakers generally have struck what arguably is a reasonable balance among the resource allocation issues raised by economists, their states’ revenue needs, and practical tax enforcement considerations. States largely have avoided taxing services purchased almost exclusively by businesses (like advertising and accounting); instead, to the extent they have taxed services, states have targeted household services (like haircuts) or mixed household/business services (like landscaping). Where a particular industry has made a credible case that taxation of a service in the latter category has an adverse economic impact (for example, telecommunications purchased by a bank’s “call center”), elected officials also have been willing to enact industry-specific exemptions. Such an approach may make more sense than an across-the-board exemption for all services that happen to be purchased by both businesses and households.

Even if states forgo taxing services that are predominantly purchased by businesses, there is a wide array of services to which the sales tax can be applied. Appendix I of this report lists over 200 types of services purchased by households or by both households and businesses, organized into 20 broad categories including personal care, home cleaning and maintenance, recreation and travel, and lawn and garden. As entrepreneurs perceive new profit-making opportunities, new services will continue to be invented. States can either implement taxation of services in a way that will incorporate newly emerging services or can monitor the evolution of the service sector and update their tax policies accordingly.

The Legal Mechanics of Imposing a Sales Tax on Services

Legislators can expand the taxation of services in two different ways. The comprehensive approach is to apply to services the typical language used to tax goods. Under most state sales tax laws, all sales of goods are taxable unless they are explicitly identified as exempt. Hawaii, New Mexico, and South Dakota apply this same treatment to sales of services. Hawaii and New Mexico adopted this approach from the inception of their sales taxes; South Dakota did so to expand the taxation of services well after the sales tax had been enacted.

The remaining states that tax services do so by specifically enumerating taxable services. The enumeration often can be found in the definition of a taxable “retail sale.”

Each approach to taxing services has its own advantages and disadvantages. A key advantage of the comprehensive approach, for example, is that newly-developed services are immediately taxable without legislative action. This is appropriate given the role of the sales tax as a general tax on consumption. It also ensures that the revenue yield of the sales tax is maintained as new services displace old goods and services (for example, as downloading an update for a GPS device substitutes for buying a new road atlas).

The major disadvantage of the comprehensive approach to expanding the sales taxation of services is that it is likely to bring a large number of services into the sales tax base in one fell swoop. The services subjected to taxation are likely to include many business-to-business services that policymakers might not wish to tax because of the potentially adverse economic effects discussed previously. Moreover, state revenue departments may not be equipped to integrate numerous new services and the merchants selling them into their sales tax administration systems in a short period of time. These factors likely explain why all the states that have expanded their taxation of services in recent years did so incrementally, a few services at a time.

The greatest challenge facing legislators who choose to extend their state’s sales tax to specifically-enumerated services is defining unambiguously the services they intend to tax. Many services are technologically complex and industry-specific, and legislators and their staffs cannot be expected to be business experts. Clear definitions are essential, however, because providers of a newly-taxed service often will look for every legal opportunity to avoid having to add a 4-10 percent sales tax to their prices. In a 2009 case, for example, a bank disputed New York’s claim that an online credit scoring service to which it subscribed constituted a taxable information service rather than a tax-exempt consulting service. An explicit reference to credit-scoring services as taxable would have made it less likely that the bank would have brought the case.

A question often arises as to whether it is preferable to write the law to identify taxable services in broad terms (such as “fees for participant sports”) or specifically (such as “admissions, equipment rental, and other fees for bowling, batting cages, skiing . . .”). The answer is that states would be well-advised to do both. (“Taxable sales include admission, equipment rental, and other fees for participant sports, which include but are not limited to bowling, batting cages, skiing. . . .”) Broad definitions can serve as a good “backstop” for more specific listings that may inadvertently omit a particular service. A broad definition can also provide a basis for taxing a newly-invented service until such time as the legislature has an opportunity to identify it explicitly. Nonetheless, broad definitions are not sufficient to ensure taxability in the face of a taxpayer determined not to charge sales tax.

One promising approach to enumerating taxable services is to piggyback on standardized lists and definitions developed for other purposes. The North American Industry Classification System (successor to the well-known SIC system) and the North American Product Classification System (under development) could be referenced for sales taxation purposes.[5] South Dakota’s sales tax statute already references SIC definitions, for example. In addition to taking advantage of careful definitional work, using NAICs or NAPCS to establish the state sales tax base could make it easier to gauge the revenue impact of taxing services; state-by-state data on the dollar volume of sales of services are already categorized by NAICS and will be further categorized by NAPCS beginning with the upcoming release of data from the 2007 economic census.

Click here to read the full-text PDF of this report (55pp.)

End Notes:

[1] Federation of Tax Administrators, Sales Taxation of Services: 2007 Update, October 2008; www.taxadmin.org/fta/pub/services/services.html. See report for extensive footnotes that affect classification as taxable or exempt.

[2] In a majority of states with sales taxes, some local governments are also authorized to impose them. In most instances, the local sales tax base — the group of items subject to tax — is substantially similar or identical to the state sales tax base. In the interest of readability, this report will refer to “state” sales taxes, but nearly all of the discussion applies to local sales taxes as well (including the sales tax of the District of Columbia).

[3] The remaining household consumption not accounted for in these figures is composed of housing and food for use at home. The source of the data is the personal consumption expenditures component of the Gross Domestic Product Accounts published by the Commerce Department.

[4] Such generalized taxation of services would have to exempt health care services for this statement to be fully accurate, however. Research suggests that imposing sales taxes on health care services in addition to most other household services would increase the regressivity of the sales tax.

[5] Information about NAICS is available at www.census.gov/eos/www/naics/. Information about NAPCS is available at www.census.gov/eos/www/napcs/napcs.htm.

 

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