A seemingly modest 3 percent could turn out to be a big deal for states and many localities. Section 511 of the Tax Increase Prevention and Reconciliation Act of 2005, known as TIPRA, requires states and localities (those cities that do more than $100 million in business) to withhold 3 percent of nearly all payments for goods and services, and remit the money to the IRS for income tax purposes. Delayed several times, Section 511 is now due to start in January 2013 for new contracts, and its potential costs are causing concern in the procurement community. So far, the total is in the tens of billions of dollars -- that’s a major impact on a still-anemic economic recovery.

The intent of Section 511 is to increase revenue without raising taxes. That is an attractive proposition. But as with many unfunded mandates, the compliance measure brings with it a significant shift in costs to state and local governments at a most inopportune time.

“The real cost is lost,” laments Ron Bell, president-elect of the National Association of State Procurement Officials. He warns that the withholding requirement will reduce competition in public procurement and increase costs to taxpayers. When states and localities purchase goods or services now, they pay the vendor in full, leaving it up to them to pay the IRS. Once TIPRA goes into effect, governments will be required to withhold the 3 percent at the time of purchase. The scheme restricts cash flow for all businesses, but could hurt cash-strapped small companies, in particular.

“Businesses often fail because of cash flow issues and this takes 3 percent right out of the cash flow,” he says.

Officials also worry vendors may simply increase their prices by 3 percent or more, in order to minimize their loss of revenue. States and localities will likely have to absorb this increase, seriously impacting their ability to obtain the lowest possible pricing for purchases using public funds. Bell’s concerns are echoed by the Government Withholding Relief Coalition, an industry-backed group that has pushed for repeal of the provision.

States and localities face added costs of $10 billion over five years, according to the coalition, an amount that could rise to as much as $48.4 billion if the IRS fails to exempt credit card purchases. That does not include the liability the legislation imposes on state and local governments to remit the tax to the IRS.

“If we don’t come out of the chute withholding that 3 percent, then the state is liable for it,” says Bell.

“In theory it sounds easy just to put a flag on it and remit those moneys, but it operates much differently in your payroll system,” observes Cornelia Chebinou, who speaks for the National Association of State Auditors, Comptrollers and Treasurers. Her members run the computer systems that have to make Section 511 work, and most would require significant modifications to tables, files, document processes, withholding rules, category codes, exception processing and error tracking.

Given enough time and clear rules, most of the requirements to implement the withholding provision can be accomplished with changes to software code. What cannot be automated will require manual intervention and more staff time.

In addition, contracts with vendors may have to be reopened, renegotiated and reset. Last month, the IRS delayed implementation for the thrid time when it released its final rule on exactly how states and localities should implement the withholding tax.

States and localities -- together with the coalition -- would like to kill the provision once and for all. Repeal legislation has been introduced in both the House and Senate, but its passage relies on finding $10.9 billion over 10 years to make it revenue neutral. That requirement could not come at a worse time either.