Economists generally oppose the taxation of business inputs, not because businesses deserve special treatment, but because taxing business inputs causes pyramiding, a problem where taxA tax is a mandatory payment or charge collected by local, state, and national governments from individuals or businesses to cover the costs of general government services, goods, and activities. es mount on top of other taxes as products are passed through the supply chain, resulting in a large tax burden on finished products. Tax pyramidingTax pyramiding occurs when the same final good or service is taxed multiple times along the production process. This yields vastly different effective tax rates depending on the length of the supply chain and disproportionately harms low-margin firms. Gross receipts taxes are a prime example of tax pyramiding in action. causes the total tax bill to be non-transparent, creates inefficient vertical integration, and benefits out-of-state production.
With that in mind, recent rulings by Indiana’s State Department of Revenue (DOR) shed some light on how Indiana views the purchases of business inputs. These rulings come against a single unnamed manufacturer that was required to pay sales and use tax after an auditA tax audit is when the Internal Revenue Service (IRS) conducts a formal investigation of financial information to verify an individual or corporation has accurately reported and paid their taxes. Selection can be at random, or due to unusual deductions or income reported on a tax return. conducted by the Indiana Department of Revenue. The statute on business input exemptions (IC § 6-2.5-5-3(b)) reads:
“Transactions involving manufacturing machinery, tools, and equipment are exempt from the state gross retail tax if the person acquiring that property acquires it for direct use in the direct production, manufacture, fabrication, assembly, extraction, mining, processing, refining, or finishing of other tangible personal property.”
Their audit resulted in the following peculiar rulings:
- Conveying raw material is not production. The manufacturing firm used a conveyer system to move recycled aluminum from storage into a machine that removes water and oil, called a chip dryer. The DOR decided that the purchase of the conveyer was taxable because while the conveyer may be a “necessary part” of the manufacturing process, they were not “machinery that has an immediate effect on the manufactured product.” The DOR decided that the conveyor was there to just “to transport a raw material during pre-production.” “Transporting […] is a pre-production activity,” and so is not exempt.
- Safety goggles are so stylish they should be taxed. The DOR determined that the uniforms and safety goggles purchased by the manufacturer were taxable under Indiana code. 45 IAC 2.2-5-8(c) example F does allow the exemption of “safety clothing or equipment which is required to allow a worker to participate in the production process without injury…” However, the DOR decided that while the manufacturer required its employees to use the safety equipment, the manufacturer could not prove that they prevented injury. Therefore, the DOR concluded that the uniforms and safety glasses “were for the comfort or convenience” of the employees.
- Depending on where you drive the forklift, it might get taxed. The DOR conducted an onsite investigation and provided “detailed information about the number of forklifts and how each of the forklifts was used.” After examining where and for what purpose they were driven, the DOR concluded that “the forklift purchases qualified for a twenty-three percent exemption.” The manufacturer was required to pay 77% of the use tax on the forklifts.
- One man’s trash is another man’s tax. The DOR ruled that slag boxes, a box, “used to accumulate and store molten waste and allow it to cool,” is taxable. They ruled that disposing waste material into slag boxes, is a post-production activity, not part of the production process. By law, “equipment that is used to actually extract the waste from the production process” is exempt, but equipment that is used to “collect, transport, store, or otherwise process the waste after its extraction” is taxable.
Of course, regardless of whether a piece of capital is used in “pre or post-manufacturing”, it is a business input, and so should be exempt from sales taxes to prevent pyramiding. Unfortunately, Indiana is by no means alone in this borderline arbitrary treatment of business inputs or even a notable offender in this regard. Research from 1999 estimated that, at the time, 41 percent of sales tax revenues nationally were on business inputs. In Hawaii, 70 percent of the sales taxA sales tax is levied on retail sales of goods and services and, ideally, should apply to all final consumption with few exemptions. Many governments exempt goods like groceries; base broadening, such as including groceries, could keep rates lower. A sales tax should exempt business-to-business transactions which, when taxed, cause tax pyramiding. fell on business inputs.
The rulings in Indiana illustrate two basic problems. First, there is little leniency for inputs used in the pre- and post-production process even though DOR will even deem these inputs “necessary” for the actual production process. This can create considerable complexity wherein 77 percent of a forklift purchase is taxable and 23 percent is exempt. This also causes significant tax pyramiding (noted above) which creates distortions in business decisions and organization.
Second, while there are exemptions for compliance with existing health and environmental regulations which require the use of certain devices during the production process, there is a costly tax disincentive, from the businesses’ perspective, to regard safety or the environment either in the pre- or post-production process. Thus in some cases the state may mandate the use of health or safety equipment but then tax their purchase; an exceedingly counter-productive way to meet health and safety objectives.
You can read the Indiana DOR’s Letters of Findings here. To discover what business inputs your state taxes, see Table 16 of our State Business Climate Index by clicking here. For more on tax pyramiding from the Tax Foundation, click here.
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