Granholm?s Service Tax: Right Principle, Wrong Application, Wrong Target

February 8, 2007

Lawmakers have proposed many tax plans in Michigan recently. Governor Granholm’s new “Service Tax” is easily the worst.

Governor Granholm just released details on her proposed 2 percent sales tax on services to help plug the state’s budget deficit, which experts say ranges from $800 million to $1.1 billion. Her plan would raise $1.47 billion in the next fiscal year by applying the 2 percent rate to the purchase of services by individuals and businesses. Businesses are expected to bear at least half of the legal incidence, with individuals picking up the rest of the tab.

What’s most maddening about this proposal is that Granholm gets the policy foundation right, then completely botches the implementation. Consumer services should be subject to the sales tax and there is absolutely no sound reason to exempt them when consumer goods are taxable. Instead of following this logic by expanding Michigan’s current sales tax to consumer services, however, Granholm instead proposes a separate tax that applies mostly to business purchases.

In doing so she has hijacked a good policy idea in an apparent effort to make businesses pay more tax. Even liberal economists agree that businesses shouldn’t pay sales tax on their purchases since it violates almost every tax policy principle, including transparency, neutrality, and growth-promotion. Since the service tax would be levied separately from the state sales tax, her plan also will increase complexity in Michigan’s sales tax system. Applying the tax retroactively would make her plan score a perfect zero out of five on our tax policy principles.

Instead of proposing a sales tax on business services to raise revenue for the state’s deficit, Granholm should have proposed expanding the consumer sales tax base to replace revenue from the Single Business Tax (SBT), which expires next year. Instead, her SBT replacement plan would take the state from one principal business tax to three, including a gross receipts tax, which is almost as bad as her service tax idea (though others in the state have proposed a gross receipts tax as well–we cover all the replacement plans in a Special Report).

What should be a historic opportunity for tax reform in Michigan is turning into a carnival of distortionary and discredited tax proposals. While most of the carnage can be blamed on the political climate, which refuses to allow the tax burden to be “shifted” from businesses to individuals, it also creates an opportunity for a real fiscal leader to emerge. That leader should congratulate Governor Granholm for her drive to apply the sales tax to services, then insist that such a move be part of SBT replacement and not a general tax increase.

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