Maryland Botching Sales Tax Reform

The Maryland Senate’s tax committee has so far rejected O’Malley’s wise suggestion to expand the sales tax to health club memberships, tanning salons and massage therapists, instead choosing to tax computer service companies and landscaping companies. The Baltimore Sun has correctly excoriated the senators for political cowardice (the health club industry whined) but has not explained the proper criteria for who should and shouldn’t be taxed. Here’s what the Sun wrote about the sales tax debate:

“Lawmakers are making decisions with far more regard to the vicissitudes of politics than to good tax policy. And unless the full Senate or House makes changes, Mr. O’Malley’s goal of simultaneously eliminating the state’s structural deficit and lowering taxes for most Marylanders will no longer be possible.

No doubt the owners of computer service companies, landscapers and arcade operators are wondering how they ended up on the Senate’s hit list. Mr. O’Malley had originally targeted health clubs, tanning salons and massage therapists for an expansion of the sales tax. By not giving the new targets fair warning, the Senate certainly cut down on those pesky protests.”

Here’s how a sales tax should be designed: tax all end-user goods and services but exempt all business purchases. The reason is “tax pyramiding” — businesses who pay sales tax have to raise the prices of what they’re selling, and when the final customer pays sales tax on that, they’re paying tax on a tax. This tax pyramiding inflicts long-term damage on the economy, undertaxing vertically integrated businesses and over-taxing products that result from a long production chain.

Admittedly, the exemption decision isn’t always so black and white because some goods and services are marketed to both consumers and businesses. But the Maryland Senate fumbled some easy ones and got a couple right. Here’s how the final tally would look if good, fair tax policy were the guide:

Health club memberships, tanning salons and massage therapists are overwhelmingly consumer services, so they should be taxed. Same for arcade operators — the Senate was right to add them, even if it was rude to do so without warning. But to prevent tax pyramiding, exemptions should be extended for landscapers and computer service companies, which overwhelmingly sell to business, and for the same reason the Senate was correct to scrap O’Malley’s suggestion to tax real estate management firms.

If the Maryland legislature really wanted to hit a home run with sales tax policy, it would eliminate enough unjustified exemptions to raise the money it supposedly needs, without having to raise the sales tax rate from 5% to 6%,