Politics

Taxing Services to Ease Budget Woes

Jim Wayne is getting an earful from Kentucky hot air balloon operators these days, and it's easy to understand why. Wayne, a Kentucky state representative,...
by | April 1, 2010

Jim Wayne is getting an earful from Kentucky hot air balloon operators these days, and it's easy to understand why. Wayne, a Kentucky state representative, wants to apply the state's sales tax to hot air balloon ride purchases. They've never been taxed before in Kentucky. "We've had at least two hot air balloonists call to say how awful their business is in this economy," Wayne says, "and that this will only hurt them more." Soon Wayne can expect calls from exterminators, dry cleaners, landscapers and people who drive armored cars for a living--he wants to tax all of them too.

In making these proposals, Wayne is embroiling himself in one of the great perennial debates in state tax policy: Why don't sales taxes generally apply to purchases of services in addition to purchases of goods?

Virtually all economists say they should. But the reason they don't is a combination of history and politics. When sales taxes were established many decades ago, they tended to ignore services, which were then a far smaller segment of the economy. As the service sector has grown, bringing services into the fold has proven quite difficult. Service providers that legislators are targeting tend to oppose proposals to expand the sales tax. Maybe hot air balloonists don't have much influence, but lawyers, doctors and real estate agents do. Sales taxes apply to some services, but generally not the most lucrative ones.

The question now is whether that's about to change. Lawmakers in Arizona, California, Michigan and Pennsylvania have discussed taxing services within the last year. States face such unappealing choices between cutting core government services and raising taxes that suddenly broadening the sales taxes may, in comparison, look like a politically palatable way to balance the budget.

Still, discussions in most states haven't gotten very far. The political obstacles remain formidable. In Kentucky, there's a genuine bipartisan discussion of broadening the sales tax to services, albeit a cautious one. Can states finally get the politics of taxing services right? In Kentucky, we may soon find out.

If there's one point on which liberal economists, conservative economists and non-ideological tax policy wonks all agree, it's that sales taxes should apply to services. Not surprisingly, the left and the right have somewhat different reasons for advocating the same policy. Liberals complain that exempting services from sales taxes costs governments massive amounts of revenue--money that could be used for schools, health care or social services--for no good reason. Conservatives like the idea of getting more revenue from the sales tax because it can allow for reductions in income taxes, which they view as stifling economic investment and growth.

Across the ideological spectrum, there's agreement that the present policy distorts economic activity. The tax exemptions for services encourage the public to buy more services and fewer goods. There's also agreement that the arrangement is completely unsustainable. For decades, the United States has been shifting to a more service-oriented economy--a shift that means sales taxes have been missing out on a broader and broader portion of the economy.

States steadily have raised sales tax rates to try to keep up, but there are limits--both political and economic--on how high the rates can go. One of the most basic rules of tax policy is that the most efficient taxes have low rates and broad bases. Until services are included in the sales tax, in most states it will be the exact opposite: a tax with a high rate and narrow base. "It's essential that states do this," says Michael Mazerov, a senior fellow with the Center on Budget and Policy Priorities. "Otherwise, their sales taxes are going to fall further and further behind."

That argument hasn't won the day yet. In 2008, the Federation of Tax Administrators released a 50-state survey of whether the sales tax applies to 168 different service categories. Only six states had more than 100 of the service categories taxed. States stubbornly have avoided targeting service providers. And, in fact, there are some good reasons why.

One problem is that individuals aren't the only consumers of services. Businesses are too. Taxing services raises the danger of what's known in the tax world as "pyramiding." A food-processing plant, for example, might have to pay a sales tax for the accountant who handles its books, the mechanic who fixes its machines and the exterminator who kills its bugs. These levies add up, creating a "pyramid" of hidden taxes that raise the cost of doing business for industries that rely on service-intensive processes for their production.

Pyramiding can have all sorts of unintended consequences. For example, a state starts imposing a tax on legal services. Businesses would then have an incentive to keep lawyers on their staffs to avoid paying the tax, rather than hiring outside help. The fear is that these sorts of incentives will lead to businesses being structured to avoid taxes, not to operate as efficiently as possible. "Every public finance expert in the world," says David Brunori, a law professor at George Washington University who studies state tax policy, "will say you should not impose taxes on business purchases."

Another reason states are reluctant to tax services is that they don't want to stand out. If one state makes the leap into taxing services, its residents could respond by shifting their economic activity elsewhere. "If I make the sale of accounting services taxable, what I can do pretty well is collect that tax inside of the state," says William Fox, a University of Tennessee economist. "What if the guy from India sells it to you? What if the guy in California sells it to the guy in Virginia? How does Virginia collect that tax? The answer is not very well."

These factors make taxing services technically challenging. Still, they're challenges that can be overcome. Tax codes can be designed to minimize the service taxes that businesses must pay. States also can focus on services that businesses rarely use-most businesses don't need to go to the pet groomer or the dry cleaner. States also can be selective in taxing services that can only be provided locally. A Kentuckian can't outsource his hot air balloon rides to India. Economists acknowledge the difficulties and still say most services should be taxed.

The biggest reasons that states have been reluctant to tax services aren't logistical--they're political. Most of the states that broadly tax services, such as New Mexico and Hawaii, have done so for decades. But tax policymakers speak in hushed tones about what happened in Florida and Massachusetts.

In the late 1980s, Florida broadened its sales tax to include most services. Lawmakers faced an impassioned uprising and reversed course soon after the law went into effect. Nonetheless, the controversy helped defeat Gov. Bob Martinez in 1990. Massachusetts broadened its sales tax to include many new services in 1990, but a backlash led the Legislature to quickly reverse course.

The lessons learned in Florida and Massachusetts still shape conventional wisdom about taxing services, even though the incidents are close to ancient history. The lesson seems to be that there's no constituency in favor of taxing services. To any one individual, the benefits of taxing services--a more equitable, efficient tax code--are small.

In contrast, taxing services is seen as a major threat to industries that always have been exempt. They resist fiercely. "These major overhauls are very difficult to sell," says Jim Eads, executive director of the Federation of Tax Administrators. "If you are in the group that is suddenly pulled kicking and screaming into the tax system, you will cry out. The people who are burdened make their feelings known." Since the Florida and Massachusetts failures, change has occurred at a glacial pace. The topic has been something close to a political taboo.

That is until now. Michigan Gov. Jennifer Granholm proposed a budget that relied on expanding the sales tax to services to balance her state's budget. Gov. Ed Rendell did the same in Pennsylvania. The idea was part of the budget proposals of the Democratic minority in the Arizona Legislature. And a blue ribbon commission in California recommended instituting a European-style value-added tax (VAT)--another mechanism for taxing businesses regardless of whether they sell goods or services.

Why are all these proposals coming at once? It's not that taxing services has become any less politically perilous. It's just that in the present fiscal environment, every budget decision that state lawmakers make comes with political risk. If the alternatives are angering voters by raising taxes or angering voters by cutting funding for popular programs, suddenly expanding the sales tax doesn't look like such a bad deal. If every state broadened its sales tax, states would collectively raise tens of billions of dollars. Many states would have enough money to plug their current budget holes and mend their structural deficits.

The potential revenue is enough, in fact, that Rendell and Granholm have sold their proposals with a silver lining: lower sales tax rates. By broadening the base, their states can add more revenue and still afford lower rates. The California VAT proposal was even more ambitious. It promised to generate enough money that the state could eliminate its sales tax and corporate income tax, and slash its income tax rates.

All of that might sound like a great bargain-cutting taxes and boosting revenue at the same time--but it hasn't sounded that way to state lawmakers. The California VAT was instantly pronounced dead on arrival, opposed by both business and labor. The proposals from Granholm and Rendell, both of whom are Democrats, were dismissed by Republicans. They note that the switch would raise the tax rate on the sale of services, since the rate is currently zero. Neither proposal appears likely to pass. The recession and accompanying budget problems have been enough to get states to think about extending the sales tax to services. So far, they haven't been enough to get them to act.

Wayne hopes the story plays out differently in Kentucky. The state has a narrow sales tax. According to the Federation of Tax Administrators survey, it only taxes 28 of 168 service categories. As the economy has shifted toward services, sales tax revenue has struggled to keep up. In response, lawmakers have used nonrecurring revenue sources to fund recurring expenses. "We go into a number of places stealing money," Wayne says. "Every board and commission in the state has been robbed by the Legislature." Wayne's pitch for taxing services is that this approach is unsustainable.

Wayne is a Democrat, but Republican Rep. Bill Farmer agrees with him. Farmer is an accountant, but he still thinks accounting services should be taxed. In fact, he supports taxing virtually all services that individuals use, other than medical care. "We're broke," Farmer says. "Our tax system is not keeping up with the economy. If the economy grows 6 percent, the revenue doesn't grow 6 percent."

This agreement has created promising signs for an overhaul. A bipartisan group of lawmakers has met to try to work out a deal. In a moderate-to-conservative state, could Democrats and Republicans come together in favor of a broader sales tax?

Maybe, maybe not. Wayne proposed his legislation to broaden the sales tax as a way to help Kentucky plug the $1.5 billion shortfall in the upcoming biennium. Farmer prefers a plan that, at least in the short-term, would be revenue neutral. He'd use the extra money from taxing services to eliminate the state income tax. To Wayne's disappointment, House Democratic leaders advanced budget plans without a broader sales tax in March.

Even if those differences can be ironed out, the end product will be controversial, especially with the businesses that are affected. David Adkisson, president and CEO of the Kentucky Chamber of Commerce, is skeptical that the Kentucky tax code is as broken as lawmakers make it out to be. He notes that general fund spending has consistently been between 5 and 6 percent of the gross state product for the last 20 years. "While revenues are tight, there's a reason they're tight. It's called the national recession," Adkisson says. "We don't immediately conclude that the issue is lack of revenue or an outdated tax system."

Adkisson is suggesting ways Kentucky could cope with runaway spending on corrections, Medicaid and public employee health care. He thinks the biggest immediate need is to tackle those issues, not the tax code.

Due to the obstacles, there's a better chance that Kentucky does something incremental than radical. The biggest money is in taxing professional industries: lawyers, doctors, accountants and real estate agents. But those groups tend to have the most political clout. Wayne's bill doesn't target those professions. He goes after a variety of lower-profile businesses such as window cleaners, chartered pilots, landscapers, tailors and exterminators. He'd also tax greens fees and country club memberships.

Kentucky wouldn't be the first state to go the incremental route. Maine expanded its sales tax to include things such as car repairs and dry cleaning last year. In 2006, New Jersey targeted tanning salons, tattoo parlors and country clubs, among others.

But given the history of previous forays into this field, there's no guarantee that Kentucky will do anything at all. The hot air balloonists and their brethren may have more political power than they let on. "The politics of this is going to get really ugly in the end," Farmer says. "Anytime you do any kind of tax reform, you're going to have winners and losers."

Josh Goodman
Josh Goodman  |  Former Staff Writer
mailbox@governing.com

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