Gov. Pence’s Plan Gets it Right on Sales Tax Simplification

February 5, 2015

This post originally appeared as an op-ed on Forbes here.

Indiana has made notable strides in improving its tax climate in recent years. In 2011, the state started a phase down of its corporate tax rate from an uncompetitive 8.5 percent to what will in 2021 be the third lowest corporate rate in the country, 4.9 percent. In 2013, Governor Mike Pence and Senate Finance Committee Chair Brandt Hershman worked together on speeding up the repeal of the state’s inheritance tax and lowering the state’s already competitive individual income tax from 3.4 percent to 3.23 percent by 2017.

With rate cutting already on a glide path, this year’s legislative session is about tax simplification. But even though 85 percent of Americans say the tax code is complex, simplifying it can be hard, because you find yourself—as Governor Pence is right now—trying to make the case for fixing things like the “double-direct” test in the sales tax, or “reducing the number of modifications to federal AGI” in the individual income tax. Very few people understand these elements of the tax code, so getting legislators, taxpayers, and the media on board with these plans is hit or miss.

Let’s look at the Governor’s plan to eliminate the “double-direct” test in the sales tax, which is one of many elements to his simplification plan. Public finance experts argue that a good sales tax should be broadly applied to all final consumer transactions, butnot applied to any business-to-business transactions that occur as companies produce goods and services.

Failure to exempt these business-to-business transactions results in what’s called “tax pyramiding,” where sales taxes stack on top of each other as goods move through the production chain. Fortunately, many states (including Indiana) have statutes that exempt business purchases of equipment. You only want the sales tax to apply once at the point of consumption, so this is good policy, and states should be strengthening their business-to-business exemptions to include all sorts of business-to-business transactions, not just equipment purchases.

However, Indiana’s equipment sales tax exemption is odd because it requires that a business be able to demonstrate that the equipment was acquired for the “direct use in the direct production” of a product. This “double-direct” test is a stringent one, because unlike in criminal law, tax law puts the burden of proof on taxpayers to show that they are innocent when they get audited. The Indiana Department of Revenue finds that Indiana is the only state with a double-direct test (see page 21 here).

Pence and his team deserve credit for proposing this change, because while this is all very wonky, the bottom line is that Indiana’s current tax law is subjecting some businesses to sales taxes when they really shouldn’t be.

This long-winded explanation illustrates why tax simplification is so hard. If you read the Indianapolis Star yesterday, you might have seen the headline, “Manufacturing Tax Cut at Center of Pence Tax Plan,” and thought that the plan was some sort of manufacturer’s carve-out. It’s not, and trust me, if it was, I’d call it out. Instead, we need to think about this as right-sizing the sales tax base to exempt transactions that should never have been subject to it in the first place.

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