On Tech Tax, Can Massachusetts Succeed Where Others Have Failed?

As services take over the economy, the traditional sales tax has become less helpful to state revenues. Despite several states' failed attempts to tax services, Massachusetts is trying it again.

A man working on his computer.
Massachusetts' new law extends the state's sales tax to software services like third-party website design.
It’s tough being a tax collector these days. An eroding sales tax base has made the job more complicated as lawmakers try to drum up new ways to squeeze revenue out of their state’s economy.

Nowhere in the country is that job harder right now than in Massachusetts, where administrators have found themselves scurrying to apply a new tax on software services that passed in late July and went into effect July 31. A groundswell movement is now underway to repeal the tax as opponents say it burdens small businesses and is too vague to be applied consistently and fairly in a complicated industry. An attorney representing software startups has even threatened to sue the state on the grounds that the tax is unconstitutional.

It’s not the first time the Bay State has tried to extend the sales tax to a service. Lawmakers tried to do so on a much grander scale in the early 1990s but the effort failed miserably. The failure came on the heels of a similarly disastrous attempt in Florida to do the same. Maryland also passed a so-called tech tax in 2007 and the implementation proved to be so complicated and unpopular, it was repealed the following year. With so many failed attempts, it begs the question: can lawmakers find a suitable substitute to the sales tax, which has become less relevant in state revenue streams as services take over the economy?

In Massachusetts, the tech tax has made an auspicious start. Passed as part of a package of new taxes to fund transportation, its implementation immediately proved to be confusing. Simply put, the new law extends the Commonwealth’s 6.25 percent sales tax to software services, like third-party website design, and was projected to bring in $161 million in revenue its first fiscal year. But the reality of such a tax on an industry that is constantly evolving is much more complicated.

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For example, one of the first questions to hit the state’s Department of Revenue: is website design now taxable? Websites created from scratch – that is entirely developed with original HTML coding – are not taxable, says the department’s Revenue Commissioner Amy Pitter. But what if a designer turns around and sells that coded software to five other businesses? That’s when it gets hairy. Take that question, multiply it by about 100, and that’s what the DOR has been trying to sort out over the last two months.

“We’re really in learning mode,” says Pitter. “The only way we can help the public is to get a lot of input from the community [to] tell us what their business practices are. If we don’t understand the model of website design, the process you go through in all that, we can’t start to interpret the law.”

The confusion isn’t just in the implementation. As DOR has issued a few rounds of preliminary guidance for the new tax and continues to refine its advice, those who are supposed to report the tax say doing so is becoming a burden for small businesses.

“It’s administrative chaos,” says Andrew Bagley, the Massachusetts Taxpayer’s Association’s director of research and public affairs. “It affects just about every industrial sector from restaurants, insurance, retail, to farms and manufacturing. All are major purchasers of software … and all are subject to taxation.”

On Monday, the association, which is organizing a repeal effort, released a report that examines the range of software services taxed in Hawaii, North Dakota, Connecticut and New Mexico, and found that none go as high as 6.25 percent. Not only is it the nation’s highest such tax, it cuts into an economic sector that Massachusetts has worked hard to cultivate, says the tax association’s president, Michael Widmer.

“If you were to design a tax that had maximum harmful impact on the Massachusetts economy,” Widmer says, “you could hardly do better than this.”

And while it may not surprise some that Massachusetts, a state whose tax-happy reputation has earned it the moniker Taxachusetts, is seeking sales tax revenue from new streams, it’s not the only state to try to do so.

In 1987, Florida passed an expanded sales tax on services including advertising, legal, accounting and construction services. The backlash was immediate – major corporations like Coca-Cola and Procter & Gamble canceled or reduced their advertising in the state to protest the tax while business groups canceled at least 60 conventions they had booked in the state. The tax lasted just six months until it was repealed. A similar Massachusetts law in 1990 extended its then-5 percent sales tax to nearly 600 additional services, but lasted less than a year before it was repealed. And more recently, Maryland passed a 6 percent tax on computer services that was met with such hostility from the business community, it was repealed in 2008 before it ever went into effect.

Meanwhile, once reliable revenue streams for states – the sales and gas tax – continue to erode as vehicle mileage improves and the economy becomes more service-based. The aggregate sales tax base for the nation as a whole is still slightly less than the $4.34 trillion high in 2008, according to an Indiana University analysis, and economists say the base is likely to continue shrinking. Still, lawmakers’ attempts to place a meaningful tax on services have consistently been rebuffed. (On a smaller scale, however, some services are taxed in some states.)

“This is the way the economy’s going -- we know we ought to be taxing this stuff but the question is how we do it?” says economist Carol O'Cleireacain, a member of the State Budget Crisis Task Force.

In Massachusetts, services make up roughly 80 percent of the economy, according to Bagley. While it’s a big chunk of activity to miss out on, O'Cleireacain says a state with “porous borders” like many in the Eastern U.S., can ill afford to single out an amorphous industry that is easily transportable to another, friendlier jurisdiction.

“I think the best way to solve this is nationally,” she says.

Widmer says it’s not as if a tax on services is entirely impossible in Massachusetts. But he takes issue with the fact that the tech tax was included in a tax package rather than made to withstand the scrutiny of public hearings on its own merit.

“We haven’t had the debate on [a tax on] services,” he said. “We’re singling out our most important economic sector to walk down this road and I think that’s the reality of what’s going on here.”

Liz Farmer is a former GOVERNING fiscal policy writer.