The Two Hardest (But Most Important) Sales Tax Reforms

August 02, 2012

Ernst and Young recently released a report on state and local business taxes, and one of the charts in it is fairly illustrative of a pattern we’ve noticed a lot in the sales tax reform debate: one of the hardest (but most important things) to change about the sales tax base is to remove sales taxes on business inputs.

Business inputs (products that businesses buy so that they can make other things) should be exempt from sales taxes. This is not because businesses deserve special treatment, but because taxing business inputs results in “tax pyramiding,” the problem where one tax applied many times on a supply chain results in a high effective tax rate at the end of the supply chain. Taxation of business inputs results in the unequal (or non-neutral) treatment of industries or companies that have many capital inputs and disincentivizes improving machinery and investing in labor-saving devices.

That said, I think the Ernst and Young report (without trying—the report wasn’t really about sales taxes) gave me a better idea of why the taxation of business inputs is so politically difficult to remove from sales tax codes. The revenue from those taxes represents 20.1 percent of state and local business taxes! State and local governments don’t want to give up the taxes on those products because then they would likely have to raise rates.

The second hardest (and equally important) reform to make to the sales tax is to include all services in the sales tax base. Sales taxes should apply to services because failure to do so distorts the economy in favor of the service industry and at the expense of the goods industry.

Most states have a system where many services do not pay sales taxes, and those industries lobby heavily to keep their special treatment. My favorite story about this is the 2007 Maryland saga where Governor O’Malley attempted to expand the sales tax to services, but not all services, just the ones deemed “luxury” services.

After the proposal was made, lobbyists from such “luxuries” as real estate management, landscaping, tanning, massage therapy, auto repairs, and health clubs descended on Annapolis and ended up getting their services removed from the base expansion proposal. In the end, the only industry that was included in the base expansion was the computer services industry, and even they were successful in getting an exemption built back into the sales tax the next year.

Even Governor O’Malley (the originator of the plan!) was eventually on the record saying that the plan was “unfair” to single out just the computer industry to pay sales taxes.

I think there are two lessons to glean from these stories. First, reform plans should couple the reform of removing sales taxes on business inputs with the reform of expanding the sales tax to services. That mitigates the large revenue loss that occurs by just doing the former.

Second, sales tax reform is all about “going for the gusto.” The Maryland story shows us that picking out a few services seems “unfair” to the public. But even better, including all services would allow for the rate to be brought down substantially in the interest of making the reform revenue neutral. These seem like changes you could rally taxpayers around.

Here’s our most recent ranking of state and local sales taxes (just released this week).

Follow Scott Drenkard on Twitter @ScottDrenkard.

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