CALTAX COMMENTARY: Sales Tax on Services Raises Many Issues That Must Be Thoroughly Vetted

Transcription

1 CALTAX COMMENTARY: Sales Tax on Services Raises Many Issues That Must Be Thoroughly Vetted By CalTax Fiscal Policy Director Therese Twomey Every few years, there are discussions of imposing a sales tax on services in California, often proposed in the name of modernizing the economy, closing California s state budget gap, or stabilizing cyclical fluctuations in tax revenue. This year, the discussion is precipitated by talk of tax reform and options to increase revenue in light of the approaching sunset of Proposition 30 s temporary sales/use and personal income tax increases. The idea of taxing services is not new. Proposals to tax a broad array of services have been bandied about in a number of different states looking to erase budget deficits. In California, there have been numerous proposals dating back several decades, and recently there have been about half a dozen measures proposed since the burst of the dot-com bubble. None have been approved. The latest proposal, SB 8 by Senator Robert Hertzberg, was introduced at the beginning of the current legislative session. The bill seeks to impose a broad-based sales and excise tax on services estimated to raise $10 billion a year, with tax exemptions only for healthcare services, education services, and small businesses with gross sales of less than $100,000. The measure also intends to reduce the personal income tax for low-income earners, while evaluating the current corporate tax rate and a possible increase in the state s minimum wage. As with many ideas, what may appear appealing at first often can go awry. A number of states that have attempted a broad-based sales tax on services have either scaled back on the number of services taxed, or have repealed the tax altogether because the tax put in-state businesses at a competitive disadvantage, threatened jobs, or was difficult for tax agencies to administer. Florida, Maryland, Massachusetts and Michigan all repealed their service taxes shortly after they were enacted. While many states tax some services, there is no apparent trend toward expanding the sales tax base to include more services. According to the Federation of Tax Administrators, states have been reluctant to undertake a broad-based expansion of the sales tax base because of the possibility of repeal. Only two states Hawaii and New

2 Mexico have broad-based sales taxes on services, while South Dakota and West Virginia are the only other states to tax more than 100 services. In addition to problems related to competitive disadvantages, job loss and tax administration, taxes on services raise a host of other concerns, including increasing costs for government, disproportionately impacting small businesses, tax pyramiding, etc. As the debate on taxing services continues, it is important that these problems and concerns be fully vetted by policymakers. To that end, CalTax will discuss the more detailed issues individually in future publications and until a service tax is imposed in California, this service will be provided tax-free! February 13,

3 CALTAX COMMENTARY: Taxing Business Inputs Would Put California Companies at a Competitive Disadvantage By CalTax Fiscal Policy Director Therese Twomey In our previous piece on the topic of taxing services, we discussed some of the problems faced by states that have attempted a broad-based services tax, and we enumerated several concerns that require careful consideration by policymakers. Chief among those concerns is the taxation of business inputs. Business inputs are raw materials, resources, information, people and services that are placed in a process to support or produce a desired outcome or product. Within the context of a sales tax on services, business inputs generally refer to the myriad different types of services that are purchased by one business from another to produce a product or service. Architectural design services purchased by a construction company, for example. Since these types of service purchases often occur between businesses, these transactions often are referred to as business-to-business sales (or, in legislative jargon, B2B ). When it comes to taxing services, economists and tax experts generally recommend against taxing business-to-business sales, because such a tax puts in-state businesses at a competitive disadvantage, is difficult and costly to administer, and results in tax pyramiding. Competitive Disadvantage If California were to impose a sales tax on services, California businesses would be placed at a competitive disadvantage, because the tax would make it more expensive for California companies to produce and provide goods and services relative to businesses in other states. Keep in mind, California already is a higher-cost state because of our regulatory requirements, real estate prices, environmental policies, etc. Moreover, certain types of labor related to manufacturing and fabrication of tangible goods already are taxed. For some businesses, a service tax may lead to higher prices and all other factors being equivalent, higher-priced California products or services will be less in demand than their lower-cost, out-of-state counterparts. Lower demand for a product or service often forces businesses to cut operational costs through layoffs and reduced investments.

4 Let s look at one example. Company A is a California-based consulting services provider that would have to add a sales tax on top of its normal fees. The tax increases the overall cost of Company A s service, putting it at a pricing disadvantage. Purchasers of these services can go to an out-of-state consulting firm to avoid the tax, or scale back on use of the service. Due to decreased sales, many businesses faced with situations similar to Company A would be inclined to reduce their workforce, cut operations or relocate to a lower-cost state. Some businesses may be unable to pass along the cost because they compete in national and international markets. These businesses may be forced to move their operations to lower-cost states to remain competitive. In this example, Company B is a California-based purchaser of taxed product-design services. The service tax increases the cost of doing business for Company B, but since the company produces goods that are similar to others that are sold in the national market, Company B cannot raise its prices without losing market share. To remain competitive, businesses like Company B tend to reduce or eliminate investment in the taxing state and relocate out of state. It is because of the competitive disadvantages created by a service tax on business-tobusiness sales and the resulting threat to jobs and economic growth that states like Florida, Maryland, Michigan and Massachusetts repealed their sales tax on services. Costly and Difficult Administration Taxing business inputs also poses significant and costly administrative, auditing and compliance challenges for both the state and taxpayers. It would be difficult, if not impossible (especially for multi-state businesses), to determine where a particular service is consumed. For example, at what point would the service be taxed if computer software development/consulting services are contracted in one state, performed in a second state, delivered to clients in a third state, and distributed by the client to business locations in additional states? I posed this question to Senator Bob Hertzberg, author of this year s sales tax on services measure (SB 8), and he half-jokingly announced to the informal group of stakeholders that I was not allowed to ask any more questions! From a cost perspective, the State Board of Equalization indicated that it would cost upward of several hundred million dollars a year to administer taxes for just a few dozen services and that doesn t include collection and remittance costs borne by sellers. Tax Pyramiding Effect Finally, from a tax policy perspective, a tax on services leads to tax pyramiding taxing an input as it moves through the various stages of production, and taxing it again when purchased by a consumer. This not only reduces tax transparency, but also causes distortion, making it impossible for policymakers to determine the final effects of the tax on the consumer. February 27,

5 Impact on the Economy As California lawmakers revisit the idea of taxing services, it is important to keep in mind the experiences from other states that have been there and done that only to subsequently undo it. Imposing taxes on business-to-business services increases costs for in-state businesses, making them less competitive and more inclined to cut costs by reducing their workforce, decreasing investments or relocating to lower-cost states all of which hurt our state s economy. February 27,

6 March 13, 2015 CALTAX COMMENTARY: Other Competitive Disadvantages Caused by a Tax on Services By CalTax Fiscal Policy Director Therese Twomey A couple of weeks ago, we discussed concerns over imposing a sales tax on business inputs and business-to-business sales (B2B), and how such a tax would be costly to administer and would result in tax distortion. We also looked at the different ways in which a tax on services would put California businesses at a competitive disadvantage relative to out-ofstate companies. This week, we ll look at how a service tax also creates competitive disadvantages between in-state businesses that contract for services vs. those with in-house staff; between businesses of different sizes; and between private service providers vs. federal providers. Contracted vs. In-House Services A sales tax generally is triggered at the point of sale. This means a business that procures product design/consulting services, for example, would be subject to a service tax because a sale has occurred, while a competitor with in-house staff would not be taxed. Obviously, this would create cost disadvantages between the two businesses. For example, Company A is a manufacturer that employs in-house engineers because it produces only one product. Company B manufactures a product that competes with Company A s product, but also manufactures other cutting-edge products that involve highly specialized and changing product designs. Company B, like other similarly situated companies, tends to outsource its engineering work because specialized engineering firms may be better suited to serve its business needs. A service tax would increase overall production costs for Company B, but not for Company A, putting Company B s product at a pricing disadvantage. Some argue that a service tax would increase employment by incentivizing businesses to hire in-house staff. While this may be true in limited situations, this approach does not work for all business models, and may eliminate cost efficiencies associated with outsourcing specialized services. Also, some businesses can t afford to hire additional staff. Small businesses, especially, would be least able to afford hiring in-house employees for functions such as accounting, repair, maintenance, payroll, and legal representation. Moreover, when a business hires in-house staff to perform previously

7 outsourced work, this usually causes a shift in employment, and not necessarily employment growth. Different-Sized Businesses The downsides associated with a service tax tend to be more pronounced and disproportionate for smaller businesses. Take, for example, two competing grocery stores, both located in California. Business A has a single store, and contracts with a local accountant for its bookkeeping and tax-filing functions. Business B has multiple locations and, due to higher bookkeeping and taxreporting volume, employs an in-house accountant. A tax on accounting services increases costs for Business A, but not B, and exacerbates the competitive disparity between the two (Business A already operates at a different price point due to B s ability to purchase merchandise at volume discount prices). The gap could be even greater, depending on the structure of the competitors. Just imagine the disparity that would be created between a local mom-and-pop grocer that would have to pay taxes for all kinds of outsourced services, and a larger competitor that would not be subjected to these cost increases because it employs in-house workers and benefits from other economies of scale. Federal vs. Other Service Providers In some instances, a service tax also favors federal service providers over other service providers. Take, for example, the repair and maintenance of California s levee system, which sometimes is performed by the U.S. Army Corps of Engineers and sometimes is contracted out to private companies. Who would have the upper hand if the private contractor s cost is 7.5 percent to 10 percent higher (based on the current sales tax rates in various California localities) because the private contractor is subject to a service tax while the federal agency is not, due to the U.S. Constitution s Supremacy Clause, which prohibits states from imposing taxes on the federal government? This competitive disadvantage also would extend to shipping and delivery services provided by FedEx, UPS, DHL, etc., vs. those provided by the U.S. Postal Service; admission prices for parks owned and operated by the state or non-profit concessionaires vs. national parks; and others. Who Loses? Good public policy dictates that taxes be imposed in a manner that promotes market neutrality, and does not competitively disadvantage one industry or group of taxpayers to the benefit of another. A service tax runs counter to the principles of sound tax policy. It exacerbates competitive disadvantages among in-state businesses, puts California businesses at a competitive disadvantage relative to out-of-state businesses, and sometimes tips the scale in favor of the federal government over California companies. Who loses the competition if a service tax is imposed? California residents, because they will end up paying higher taxes California businesses, because of increased operational costs and California workers, because of lost jobs and opportunities. March 13,

8 April 10, 2015 CALTAX COMMENTARY: Disadvantaged Families and Communities Would Bear Brunt of Tax on Services By CalTax Fiscal Policy Director Therese Twomey Tax reform was the topic of one of the featured panels at this year s CalTax Annual Meeting, and of course, the topic of taxing services was discussed. While the panelists had differing perspectives on the issue, they and other policymakers, scholars and tax experts tend to agree on a number of overarching principles that constitute sound tax policy. Among those tenets is tax equity. Tax equity refers to the idea that taxes should be neutral. An equitable tax should neither be regressive imposing a greater burden on lower-income taxpayers nor steeply progressive, imposing a far greater burden on higher-income taxpayers simply because they are deemed to have the ability to pay excessive rates. In general, higher-income households tend to spend a smaller portion of their income on goods and services than do lower-income households. When a tax is imposed on purchases of everyday goods like clothing, shoes and household supplies as is the case with California s retail sales and use tax it is considered to be a regressive tax, because working families and disadvantaged communities tend to pay a larger portion of their income for these taxes than do higher-income taxpayers. Expanding the retail sales and use tax to services, as some lawmakers have proposed, would make it even more regressive. The California Budget Project (which recently changed its name to the California Budget & Policy Center) concluded its analysis of a service tax by saying, Absent a reduction in the state s sales tax rate or other efforts to minimize the regressive impact of taxing services, extension of the tax would increase the share of taxes paid by low- to middle-income Californians, who already pay the largest share of their income toward taxes, relative to high-income households. (California Budget Project, Should California Extend the Sales Tax to Services? 2011.) To put this into perspective, a tax on repair and maintenance services, for example, would raise the cost for working families who need to fix their appliances, cars and

9 homes by 7.5 to 10 percent, while having no effect on those who can afford to buy new appliances, cars, homes, etc. Basically, such a tax would harm those who use these services the most, and who likely are least able to afford them. This tax imbalance also would apply to public agencies in disadvantaged communities. A service tax would disproportionately hit older public facilities and infrastructure located in lower-income areas that are in greater need of repair and renovation. There would be much less impact on newer buildings and infrastructure in developing neighborhoods. A 7.5 percent tax on a facilities renovation project could mean a $1,075,000 bond on the ballot instead of a $1 million bond measure. In lower-income communities, a 7.5 percent difference in a parcel tax could mean the difference between passage or failure of the ballot measure. If the funding measure is not approved, the facility will fall into further disrepair, and maintenance costs will be even higher down the line. If the tax is approved, taxpayers will pay more not only for the repair itself, but also for the debt service on an additional $75,000, which totals more than $113,000 (including $38,800 in interest costs) over a 30-year period at the current 3 percent interest rate. As different proposals to expand the retail sales and use tax to services have been introduced in California, there have been no apparent solutions to the myriad problems and challenges associated with the tax, as discussed in our prior commentaries. What is more apparent is that a service tax would run counter to sound tax policy principles relative to tax equity, worsen California s already regressive sales tax, and disproportionately hurt those families and communities that are least able to afford it. April 10,

10 April 17, 2015 CALTAX COMMENTARY: Consumers Wallets Would Take a Big Hit From New Tax on Services By CalTax Fiscal Policy Director Therese Twomey Expanding the retail sales and use tax to all services that currently are non-taxable would cost California families and businesses close to $123 billion a year, according to the State Board of Equalization, which is responsible for administering the sales and use tax. Yes, that s B for billion, and that s based on the average statewide tax rate of 8.42 percent, not the 10 percent tax rate that is actually charged in several of the state s larger counties. What is your share of the $123 billion in new taxes? To get a better idea of just how much a sales tax on services would cost, some of my colleagues and I decided to keep track of all of our service expenses in March, and tally them up. Our self-reported data is not meant to be an economic model, but serves as a hypothetical example for a four-member, two-member or single-member household with similar expenses. Of course, some households may have more of one type of expense, and less of another. The table below shows what we spent for various types of services for the month of March, and the amounts relative to each category. We also differentiated between households of different sizes. As you can see from the table, based on the average statewide tax rate of 8.42 percent, a family of four could pay approximately $270 a month, or $3,230 a year, in higher taxes if the retail sales tax were expanded to services. A two-member household with no dependents could pay almost $318 a year ($26 monthly), and a single-member working individual could pay $2,043 a year in additional taxes, or the equivalent of $170 a month. Your monthly expenses undoubtedly are different for example, a friend who recently went through a divorce just about fainted when he considered the prospect of having to pay an additional 8.42 percent for all of the legal services so plug in your own numbers to the table on the next page to see how much of a bite a sales tax on services would have on you and your family s budget.

11 Service Type Home (landscaping, pool cleaning, house cleaning, pest control, etc.) Dependent care (child care, after-school care, elderly care, etc.) Professional services (tax preparation, legal, delivery, etc.) Personal (haircut, manicure, dry cleaning, gym membership, etc.) Repairs (car, appliances, flooring, etc.) Phone and television (home and cell phone service, cable or satellite TV, etc.) Entertainment (movies, golf, restaurant tips, etc.) Total Amount Spent on Services Additional Tax Per Month* Four-member (Two adults and two children) Household Two-member (Two adults aged with no dependents) Single-member (One adult, professional occupation) $ $210 $ $279 $78 $1,200 $274 $69 $144 $ $486 $125 $440 $180 $42 $28 $3,197 $314 $2,022 $ $26.44 $ Additional Tax Per Year* $3, $ $2, *Using the average statewide tax rate of 8.42 percent. You While the $123 billion tax increase already is bad enough, it does not take into account lost opportunity costs or other economic factors, such as higher prices for products and everyday goods. Additionally, what is the cost to California families if employers are forced to make job cuts? How much more of a drain will this be on the state s already bankrupt unemployment insurance fund? Will this force more families into public assistance programs like Medi-Cal? How will we pay for this (and other state programs) if businesses relocate or downsize, and fewer companies and workers are paying income taxes? And, how do you measure the lost opportunity costs when employers choose to expand in other states? These and many other implications need to be carefully examined. We need to be concerned not just about the checks we would have to write to pay for the tax, but also the jobs, revenue and economic opportunities that will be lost. April 17,

12 The Challenge of Taxing Services Tax & Fiscal Facts March 2015 At Issue Every few years, there are renewed discussions of imposing a sales tax on services in California, often proposed in the name of modernizing the economy, closing California s budget gap, or stabilizing cyclical fluctuations in tax revenue. This year, the discussion is precipitated by talk of tax reform and options to increase revenue due to the approaching sunset of Proposition 30 s temporary sales and use and personal income tax increases. The California Tax Foundation was established by the California Taxpayers Association in 1980 as a 501(c)3 not-for-profit organization to promote sound tax policy through objective, thought-provoking research K Street, Suite 1250 Sacramento, CA (916)

13 The Challenge of Taxing Services Tax preparation and advice Attorney services for divorce proceedings, child custody and criminal cases Veterinary services and pet grooming Car rentals and storage unit rentals Home alarm/security service Tips at restaurants And many more Under most proposals to impose a service tax, services used by businesses would be taxed if they are out-sourced and not provided in-house. Some examples: While medical services most likely would be exempt from a sales tax on services, some health-related costs could be subject to tax. What services could be subject to tax? Currently, California individuals and businesses pay taxes on the purchase or use of various tangible goods, but do not pay taxes on services. Past legislative proposals have varied in the specific services that would be subject to tax; however, most would tax everyday services including: Grooming (haircuts, manicures, spa services) Child care and babysitting Dental cleanings, fillings and braces Home phone and cell phone service Cable and satellite television Music lessons, dance lessons and golf instruction Admission tickets to movies, sporting events and amusement parks Access to golf facilities and ski resorts Shipping and delivery of packages Installation services for flooring, windows and appliances Repair and maintenance of cars, homes and appliances Lawn and pool maintenance and cleaning Accounting and payroll Legal and attorney services Research and development Architectural design and construction Product design and engineering Consulting Manufacturing Advertising Procurement, transportation and shipping/ delivery Equipment installation Repair and maintenance Telecommunications and cellular service Security And many more Would a sales tax on services modernize the tax system and promote economic growth? Proponents of a sales tax on services often seek to raise tax revenue and modernize the economy, because, in their opinion, there has been a shift from the consumption of goods to a consumption of services. There are several reasons why this premise is flawed, and why a sales tax on services would prove harmful to the state s long-term economy. First, while the economy in general has moved from manufacturing to service industries from an employment perspective, from a taxable consumption perspective, there is simply no 2

14 The Challenge of Taxing Services conclusive evidence that consumption of services has outpaced the consumption of goods. To the degree that taxable sales have declined as a percentage of personal income, it could be explained by several reasons: (1) greater consumption of goods that currently are exempt from taxes, such as food, prescription medicines, etc.; (2) higher consumption of various services that the Legislature likely will exempt from a sales tax, such as medical care and education; and (3) the decline in prices of goods due to lower production costs overseas. Second, taxed activities tend to grow slower than untaxed activities. If California s economic future depends on the production of high valueadded services, taxing those services merely serves to slow economic growth. A tax on labor, at a time when California s unemployment rate remains high and the state s recovery is tenuous, would be a significant setback to regaining the jobs lost during the last several years. While broadening the sales tax to services would bring some amount of new revenue to the state in the short term, it could stifle long-term economic development. For example, taxing services would lead to a migration of not only service jobs and businesses out of state, but also the jobs and businesses that either support or are end-users of those taxed services. A tax on services also would be a deterrent to business expansion or relocation in the state. All other factors being relatively equal, business expansion and relocation decisions typically are predicated on factors that maximize returns on investment and a sales tax on services would mean lost investment and employment opportunities. Migration of businesses and jobs would not only hurt workers, but also would lower corporate tax and personal income tax revenue for the state. Additionally, fewer higher-paying jobs means less homeownership, which reduces property tax values and revenue. And fewer jobs means less disposable income for purchases of goods that support the sales tax revenue base. All of these situations limit economic growth for the state over the long run. What problems are associated with taxing business-to-business sales? Economists and tax experts generally recommend against imposing a service tax on business-to-business sales, or business inputs, for a variety of reasons. First, a service tax puts in-state businesses at a competitive disadvantage, because it increases the cost to produce or provide a good or service. For some businesses, this increase may lead to higher prices, creating pricing disadvantages for California goods and potentially reducing demand. This would result in lower product sales and decreased manufacturing in the state. Other businesses may be unable to pass along the cost, because they compete in the national and international markets. These businesses would be inclined to reduce investment and employment in the state to compensate for the higher costs, resulting in fewer jobs and opportunities for economic growth. These competitive disadvantages would extend to in-state businesses that contract for services Building, construction, repair and other maintenance or repair services could be subject to a sales tax on services. 3

15 The Challenge of Taxing Services vs. those with in-house staff; between businesses of different sizes; and between private service providers vs. federal providers. For example, businesses that procure services would be subject to the tax, while competitors with in-house staff would not. Smaller businesses, which tend to outsource their accounting, repair, maintenance, payroll, etc., would be disproportionately impacted because they would pay taxes on these services, while larger competitors that employ in-house staff, and may already benefit from other economies of scale, would not. Additionally, a service tax sometimes favors federal service providers, such as the U.S. Postal Service (which would not be subject to tax under the U.S. Constitution s Supremacy Clause) over private providers like FedEx or UPS, which would be taxed. A service tax on business inputs also poses significant administrative, auditing and compliance challenges for both the state and taxpayers, because it would be difficult (especially for multi-state businesses) to determine where a service is consumed. Costs for the state to administer select services have been estimated at upward of several hundred million dollars a year, not including compliance costs for taxpayers. Finally, from an economic and tax policy perspective, a tax on services leads to tax Pet grooming and veterinary services could be subject to a sales tax on services. pyramiding taxing an input as it moves through the various stages of production, and taxing it again when purchased by a consumer. This not only reduces tax transparency, but also causes distortion, making it impossible for policymakers to determine the final effects of the tax on the consumer. What impact will a service tax have on California s businesses, families and economy? A broad-based tax on services would expose the state to numerous adverse economic consequences: Puts California businesses at a competitive disadvantage. California has the highest state sales tax rate in the nation, and the highest top personal income tax rate compared to other states. 1 A sales tax on services would make it even harder for California companies to compete, on several levels. For example, California service industries would have a significant pricing disadvantage compared to services provided in other states. Not only would this reduce demand for California-based services, it also would make it more costly for California companies that use taxable services to produce or provide goods and services. California products/services would be more expensive and, all other factors being equivalent, would have less demand than their out-of-state counterparts. A tax on services would threaten many of California s key industries, including high-tech, manufacturing, and the financial sector. Reduces jobs and investment in the state. Lower demand for a product or service often forces businesses to cut operational costs through layoffs and reduced investments. Other businesses may be forced to move their operations to lowercost states to remain competitive. Both scenarios reduce opportunities for job and economic growth in California. 4

16 The Challenge of Taxing Services Business services, such as architectural, interior design, graphic design, printing, accounting, legal, etc., could be subject to a sales tax on services. Puts small businesses at risk, potentially drives them underground. Higher taxes on certain services could lead to a do-it-yourself approach. For example, if a tax were imposed on pool cleaning services, some taxpayers may opt to do the work themselves rather than pay the increased cost. This could put many small businesses and their employees out of work. Additionally, it could drive others to move their operations into the underground economy, putting law-abiding service businesses at an unfair disadvantage. Both of these situations would reduce tax revenue to the state s general fund. Discriminates against small businesses. Larger businesses that can afford to hire employees to do the work of an independent contractor would not pay sales taxes on services performed by these employees. Smaller businesses, however, would be forced to pay sales tax, as they must contract for these services. This results in higher costs on small businesses. Hurts working families and disadvantaged communities. Expanding the sales and use tax to services creates a more regressive tax base, because the tax requires working families and disadvantaged communities to pay a larger portion of their income than higher-income taxpayers for service-related taxes. The California Budget Project notes that extending the sales tax to services is unlikely to improve the equity of the sales tax. 2 Repair services are particularly integral to budgets of families who cannot afford to purchase a new appliance, car or home. Costly taxes would have to be paid on services to repair leaky pipes, replace a roof, or perform any other needed maintenance and repair. This runs counter to the basic policy principle that taxes should be based on an individual s ability to pay. Increases costs to government. Unlike many states, California taxes sales made to and by state and local governments. Government entities, including school districts, are huge consumers of services, and would incur cost increases of 7.5 percent to 10 percent on taxed services they purchase. Moreover, government is a huge seller of services relating to everything from education (colleges and universities) to housing (lowincome housing authorities) to medical care 5

17 The Challenge of Taxing Services Transportation and movement of goods could be subject to a sales tax on services. (public hospitals). Thus, taxing services shifts a significant portion of the sales tax burden to government, thereby increasing the cost of government for taxpayers and those who consume services sold by the government (i.e., increasing tuition on college students). Picks winners and losers. Past proposals have sought to tax some industries, while exempting others. Good public policy dictates that taxes be imposed in a manner that promotes market neutrality, and does not competitively disadvantage one industry or group of taxpayers to the benefit of another. A service tax runs counter to the principles of sound tax policy. It exacerbates competitive disadvantages among in-state businesses, puts California businesses at a competitive disadvantage relative to outof-state businesses, and sometimes tips the scale in favor of the federal government over California companies. These types of proposals create winners and losers, and benefit one industry or business to the detriment of another. Creates costly and extensive administrative problems. Imposing a sales tax on services would lead to extensive administrative problems. The State Board of Equalization (BOE) would have to identify and register myriad new businesses, many of which are unfamiliar with sales and use tax reporting and remittance requirements. The BOE potentially would have to register teenagers who provide babysitting services, mow lawns, or tutor students. The agency also would need to develop a new method for auditing service providers, which will prove difficult, because BOE staff would have to determine where a particular service was used or consumed, if doing so is even possible. For example, at what point would the service be taxed if computer software development/consulting services are contracted in one state, performed in a second state, delivered to clients in a third state, and distributed by the client to business locations in additional states? A BOE analysis of a sales tax on services proposal (AB 1963 Huber) estimated state administrative costs in the neighborhood of $847 million in the first year and more than $600 million annually thereafter. 3 Past and current legislative proposals to assess sales tax on services Over the past two decades, there have been sporadic attempts to impose sales tax on services in California. In , AB 194 (K. Murray) proposed to tax a number of specified services, including general repair of tangible personal property, installation of tangible personal property, and computer programming. In , AB 9 (Coto) proposed to impose a tax on the gross receipts derived from specialized services, as defined. Both measures failed in the policy committee. As part of the budget process, draft language proposed to enact a sales tax on a number of specific services, including veterinary care and admission to sporting events. However, the proposal never made it into a bill. More recently, two measures were introduced in proposing a sales tax on services the previously mentioned AB 1963 (Huber), and AB 2540 (Gatto). AB 1963 proposed a broad sales tax on services (with a limited number of services exempted), along with a reduction 6

18 The Challenge of Taxing Services in the personal income tax and the sales and use tax rates. AB 2540 proposed to tax specifically enumerated services. Both measures subsequently were amended to remove provisions that would enact a sales tax on services. The latest proposal, SB 8 (Hertzberg), introduced in the legislative session, seeks to impose a sales and excise tax on services at an unspecified rate, beginning on January 1 of an unspecified year. The sales tax is imposed on sellers of taxable services. The excise tax is imposed on buyers of services. Both taxes would be imposed independently of each other, and are expected by proponents to raise taxes by $10 billion a year. The measure also intends to reduce the personal income tax for low-income earners, while evaluating the current corporate tax rate along with an increase in the state s minimum wage. While the implementing language provides no exemption from either tax, legislative findings and declaratory language elsewhere in the bill intend to exclude health care services, education services, and small businesses with gross sales of less than $100,000 a year. Since neither the sales nor excise tax has a stated rate and there is no implementation date (at the time of publication of this report), the measure remains a majority-vote bill. However, if the measure is amended to actually enact/ impose a tax increase, it will require a two-thirds vote. Experience from other states Although many states tax some services, there is no apparent trend toward expanding the sales tax base to include more services. According to the Federation of Tax Administrators (FTA), other states have been reluctant to undertake a broadbased expansion of the sales tax base since several states have repealed such expansions shortly after enactment. Only two states Hawaii and New Mexico have broad-based sales taxes on services, while South Dakota and West Virginia are the only other states to tax more than 100 services. 4 Four states repealed sales taxes on services shortly after enactment: Florida. Hailed as a way to meet the expanding fiscal needs of this fast-growing state, the Florida services tax was expected to After-school programs, tutoring, restaurant tips, and automotive repair services could be subject to a sales tax on services. 7

19 The Challenge of Taxing Services bring in $1.3 billion annually. Florida enacted its services tax in July 1987 and repealed it six months later because it put in-state businesses at a competitive disadvantage with out-of-state counterparts. Massachusetts. With legislation enacted in 1990, Massachusetts attempted to tax only services provided to businesses. These included legal services, accounting, auditing, bookkeeping, engineering and architectural services. The tax would have created competitive disadvantages for service providers located within Massachusetts, but the state repealed the tax two days after it took effect. Maryland. In 2007, the Maryland Legislature enacted a computer services tax, covering web design, facilities management, custom computer programming, data center support, systems integration, installation and maintenance, computer training and data entry. According to the Maryland Computer Services Association, the tax would have been a serious blow to Maryland IT businesses, which at the time employed 68,000 people with an annual payroll of $5.2 billion. The tax was repealed in 2008, before it went into effect. Michigan. The Michigan Legislature enacted a 6 percent tax on services in October This tax was imposed on business service center services, consulting and investment advice, janitorial services, landscaping, warehousing, packaging, procurement, and personal services. Before the tax became effective, taxpayers formed a coalition to repeal it, arguing that it would hurt Michigan s economy and force jobs to leave the state. The tax was repealed just 17 hours after its effective date. Conclusion While imposing a sales tax on services would bring in some additional short-term revenue to the state, it would stifle the state s economic growth in the long term. California businesses would be put at a competitive disadvantage, because goods produced in-state would be less price-competitive compared to their out-of-state counterparts. Jobs and investment opportunities would be lost as employers seek to relocate or expand in lower-cost states. Small businesses and working families would be disproportionately affected. And costs to administer a broad-based proposal are estimated to be in the hundreds of millions of dollars a year. Endnotes 1 The Tax Foundation, State and Local Sales Tax Rates, Midyear California Budget Project, Should California Extend the Sales Tax to Services?, State Board of Equalization, Draft Staff Legislative Bill Analysis of AB 1963 (Huber), Federation of Tax Administrators, FTA Survey of Services Taxation Update, The California Tax Foundation was established by the California Taxpayers Association in 1980 as a 501(c)3 not-for-profit organization to promote sound tax policy through objective, thought-provoking research. More information about the foundation, including access to recent research, is available online at For information on ways to make a tax-deductible charitable contribution in support of the foundation, foundation@caltax.org K Street, Suite 1250 Sacramento, CA (916)