Public finance experts have long identified the failure of states to collect sales taxes on most services purchased by households as a major shortcoming of state tax systems. A 2009 Center report lays out the case for expanded sales taxation of services, including its potential to mitigate erosion of the sales tax base and improve the fairness of existing sales tax practices. The text box on the next page summarizes the major arguments in favor of taxing services.
One of the first questions state policymakers are likely to ask when they consider adding services to the sales tax base is: what would be the impact on sales tax revenue? This is not easy to answer. To make such an estimate, tax policy analysts need to know the gross sales of those services in the state. A first approximation of the potential revenue that would be generated by taxing them is gross sales multiplied by the statutory sales tax rate. Moreover, since states have tended to expand their sales tax bases incrementally, a few services at a time, revenue estimators need to know the in-state gross receipts of services at a disaggregated level. For example, a state might want to tax the fees charged by lawyers for preparing a will or reviewing a real estate contract, but not for representing criminal and civil defendants in court. Just knowing the overall gross receipts of law offices in the state would not permit a reliable estimate of the revenue yield of taxing that narrower group of services.
Fortunately, the U.S. Census Bureau has been collecting and reporting an increasing amount of state-specific data on the gross sales of specific services as part of the Economic Census it conducts every five years. Comprehensive data for the 2007 Economic Census, providing more details than were available in previous versions, were finally published in late 2010 and early 2011. The purpose of this report is to explain:
- what data are available from the 2007 Economic Census that can be used to estimate revenues from expanding the sales tax base to include additional services;
- how to extract the relevant data from the Census Bureau website;
- the types of adjustments needed to translate the data into actual revenue estimates; and
- the limitations of the data.
- Levying a sales tax on services satisfies most the criteria by which state tax policy options are normally evaluated. Taxing additional services can generate substantial new sales tax revenue. The annual nationwide revenue yield from taxing all services purchased by households except health care, education, housing, and a few others would be between $50 billion and $100 billion. States that do not tax services to any significant degree – such as California, Illinois, Massachusetts, and Virginia – probably could increase their sales tax revenue by more than one-third if they taxed most of the services that households consume.
- Taxing services broadly is essential to preventing the long-term erosion of sales tax revenue. For decades, household spending has been shifting from largely taxable goods to services that are mostly tax exempt. To maintain sales tax revenue in light of this trend, states have had to increase sales tax rates sharply. The ability to continue that practice 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 them 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. Purchases of some services do not fall as sharply as durable goods purchases do when the economy slows, nor rise as rapidly when the economy is booming, limited research shows. Including more services in the sales tax base could slightly moderate the volatility of sales tax revenues over the course of the business cycle, the research suggests.
- 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 unfair to tax the person who rents a videotape but not the person who watches a pay-per-view movie on cable TV.
For more detail, see Michael Mazerov, ?Expanding Sales Taxation of Services: Options and Issues,? August 10, 2009; https://www.cbpp.org/files/8-10-09sfp.pdf.
Consistent with the analysis and conclusions of the Center's 2009 report, this report will focus on estimating the potential revenue yield of expanding the sales tax base to services primarily purchased by households rather than businesses. As the 2009 study discusses at some length, there are compelling economic, distributional, and practical administrative reasons for avoiding sales taxation of services that are sold exclusively from one business to another, such as data processing or rail freight transportation. Accordingly, this report will generally not use such services as examples and will explain how some Census data can be used to separate business-to-business from business-to-household sales of a particular service. That said, states do frequently choose to tax some business-to-business sales of services; moreover, as the 2009 report discusses, they can be justified in doing so under certain circumstances. The Census data do cover such services, and the methodology set forth in this report is equally applicable to estimating the potential revenue yield from taxing them should a state choose to do so. [1]
To avoid getting lost in some of the detail that will be laid out later in this report, it may be helpful to keep in mind the following roadmap that will be presented for estimating the potential revenue yield of extending the sales tax to a particular service. If the state is contemplating expanding the tax base to include a number of services, this methodology needs to be repeated for each one of them:
- Carefully identify what is and is not encompassed in the specific service being considered for taxation. This step will rely upon the detailed descriptions of service industries in the North American Industry Classification System (NAICS) and specific service products in the North American Product Classification System (NAPCS).
- Using NAICS, NAPCS and the analyst's own knowledge, identify all the NAICS industries that produce the specific service that will be taxed. Specific goods and services are defined as taxable under state sales tax laws, not the total sales of particular industries. It is not uncommon for a particular service to be provided by businesses that fall into different NAICS industries. For example, car dealerships and gas stations often perform auto repairs, as do dedicated auto repair shops. The former are classified in NAICS as retail trade industries, while the latter are classified as being in one or more service industries.
- Use the Census Bureau's American FactFinder website search tool to access state-specific data from the 2007 Economic Census for the industry or industries identified in Step 2 as producing the service to be taxed. The relevant Economic Census databases for each industry are those titled "Product Lines Statistics." For each industry, identify the specific "product line" that corresponds most closely with the service to be taxed, and total the in-state gross receipts for that product line across the industries that provide or produce it. (For some industries, no state-specific data for individual service product lines are available; only national-level data are available. In those circumstances, it will be necessary to calculate that service's share of total nationwide industry receipts, assume that this share is applicable in each state, and multiply the share by total industry receipts for the state to calculate estimated gross receipts from that service in that state.)
- The Product Lines Statistics cover only businesses that have at least one employee in addition to the owner of the business. However, many service businesses (such as barber and beauty shops, car and appliance repair shops, and dry cleaners) may be operated only by their owners but still account for a significant portion of total state sales of those services. The Census Bureau reports the gross sales of such businesses in a separate data series, "Non-Employer Statistics," which is derived from an annual survey. Unfortunately, while that database does include state-level data, it does not report the gross receipts attributable to specific services. However, such an amount can be estimated by calculating the share of total industry gross receipts in the state that the specific service represents for businesses with employees (from the Product Lines data used in Step 3) and then applying that percentage to the total gross receipts for the non-employer businesses in that industry in that state. These estimates would then be added to the estimates derived in Step 3 to estimate the total gross sales of the service in the state by businesses with employees and those without employees, combined.
- For some industries, the Census Bureau produces a separate publication reporting the share of business gross receipts from sales of the service to household versus business customers. If the state proposes only to tax the service when it is purchased by households, the household share in this report can be multiplied by the total state gross receipts for the service calculated in Step 4 to determine total in-state gross sales of the service to households.
- The most recent Economic Census reports business gross receipts for calendar year 2007. These data can be "aged" or updated to a more recent year using another Census Bureau database, the "Services Annual Survey." This database, which reflects an annual sample of businesses rather than a comprehensive census, reports the gross sales of particular NAICS industries for the U.S. as a whole. The percentage increase or decrease in gross receipts between 2007 and the most recent year in the Services Annual Survey (currently 2010) for the industry that is the primary producer of the service under consideration could be assumed to apply to the state gross receipts calculated in Step 4 or Step 5. Alternatively, a broader measure of state economic growth since 2007, such as the change in total personal income, could be used for this purpose.
- Collecting a sales tax on the purchase of a particular service for the first time is equivalent to increasing its price by the same percentage as the nominal or statutory sales tax rate. That is likely to result in a modest decrease in the amount of the service the consumer will buy, and this should be taken this into account in estimating the revenue yield. The magnitude of the decline in total gross sales is uncertain, however. In the absence of clear data, states could reduce the risk of overestimating the revenue yield if they assumed the amount of the service purchased would decline by the same percentage by which its price increased. Thus, if auto repairs were subjected to a 6 percent sales tax, a state could assume that total purchases of auto repair services would decline by 6 percent. Accordingly, the in-state sales or gross receipts of the service being considered for taxation, as calculated following Step 6, should be discounted by the state statutory sales tax rate.
- The in-state gross receipts for the service calculated in Step 7 is then multiplied by the statutory sales tax rate to estimate the potential revenue from taxing the service.
- Finally, some reasonable reduction in the potential revenue should be made to account for the fact that there is never 100 percent compliance with any tax, and that compliance with a sales tax is likely to be especially imperfect in the first one to two years until retailers are adequately educated about their tax collection obligations. Recent state experience suggests that a compliance-related discount in the estimate on the order of one-quarter to one-third of the projected revenue for the first one to two years would be reasonable and conservative. A discount of this magnitude would substantially reduce the risk that a state would approve new spending or tax cuts based on a revenue target it would be unlikely to reach.
These nine steps represent the broad outline of a methodology that produces usable and reasonable estimates of the revenue yield from extending the sales tax to a particular service. The full report, available at the link below, provides more specific examples using actual data, explains additional adjustments that need to be made in the case of certain services, and offers cautions about the limitations and quirks of some of the Census data.
