By Andrew Crutchfield, Special Projects Analyst, California Common Sense
The sales tax is intended to be a tax on consumption. While California collects sales tax when a book is purchased, it collects no sales tax when someone receives a haircut. So why is one form of consumption taxed, while the other is not?
California taxes most goods, but doesn’t tax most services. This dates back to the 1930s, when most states implemented sales taxes. Then, people mainly consumed goods, so the sales tax targeted the consumption of goods. States deemed that taxing services generated an administrative burden that was not worth the limited additional revenue.
Today however, Californians mainly consume services. As the goods’ share of consumption decreases, the state increases the sales tax rate to generate the same amount of revenue.
In 1982, household consumption of services exceeded consumption of goods for the first time. Since then, services have only continued to grow as a portion of household consumption. If it taxed all feasible services, California could raise an additional $13.2 billion.
I recently spoke with Professor Annette Nellen, Director of San Jose State University’s Tax Program. She argues that taxing services would end the erosion of the sales tax base that is driving up sales tax rates statewide. By broadening the tax base, taxing services would also help to reduce revenue volatility (fluctuations). Less revenue volatility would improve the state’s business climate and budgeting projections.
Nellen stated that given wide opposition to it, simply applying the sales tax to services is not politically viable in California. Both consumers and service providers would oppose the change. And service providers would pass the tax on to consumers, resulting in higher prices and lower sales.
According to Nellen, the state can overcome opposition to broadening the sales tax by pairing it with an overall sales tax reduction. Once the sales tax base is broadened to included services, a lower overall sales tax rate can generate the same amount of revenue or more. She argues that consumers dissatisfied with the new tax on services will welcome the reduction on the sales tax on goods.
Another measure that would make expanding the sales tax to services more politically palatable: exempting from the sales tax goods and services that are business inputs. Inputs are resources that a business uses to produce its own goods and services, which it later sales to consumers. When a business pays sales tax on those inputs, double taxation (or “pyramiding”) occurs because the consumer also pays sales tax again when purchasing from the business. Tax pyramiding hides from the consumers how much tax they are actually paying on their purchases.
Nellen said that businesses would be far more likely to support a new tax on services if it was included an exemption from sales tax for business inputs. She added that exempting business inputs from the sales tax would have the added benefit of improving the business climate by reducing the costs of doing business in the state. The state collects approximately 20% of current sales tax revenue on the purchase of business inputs, suggesting that the new exemption would offset some of the increased revenue associated with a new service tax.
Recently, several states attempted to extend their sales tax to services with varying degrees of success. In 2007, to stop a government shutdown, Michigan passed legislation levying a 6% tax on services. However, the new tax on services was so unpopular with the public that the State Legislature repealed it before it ever took effect. The measure contained neither a substantial reduction in the overall sales tax rate nor gradual implementation.
In 2007, Maryland proposed extending the sales tax to “luxury” services, including massage therapy, landscaping, tanning, and computer services. These industries lobbied against the tax, ultimately securing its repeal altogether.
Nellen argues that provided that the state implements it carefully, applying the sales tax to services in California is feasible. Careful implementation would call for gradually phasing in the broader tax. For instance, businesses that sell both goods and services are already equipped to collect taxes on the goods they sell, so they would transition first. After a training and education period, the tax could phase in for businesses that sell only services. To offset the administrative costs of initially collecting this new tax, Nellen suggests a temporary tax credit for service businesses.
So it is feasible, but would Californians – currently facing rising sales taxes – ever be receptive to the change? If Prof. Nellen is correct, lowering that overall sales tax may be the key.