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Tuesday, February 24, 2009

Stuck in the 20th Century - California's New and Very High Sales Tax Rate

Part of the plan to balance California's budget involves temporarily increasing the state sales tax rate from 6.25% to 7.25% starting April 1, 2009 (changed by ABX3 3). The new rate is really 8.25% because of the longstanding 1% local rate imposed statewide. And many local jurisdictions have district sales taxes that make the rate even higher. In San Jose, the new sales tax rate will be 9.25%. The highest rate will be Southgate where it will soon become 10.25%!

These are really high tax rates! California now has the highest sales tax rate (moving up from a tie for 8th place; see FTA comparisons). This is not a good contest to win!

Yes, California needed to balance a budget that had a $40 billion shortfall. The sales tax increase was not the place to get the money though although it probably seemed like an easy place. This high tax rate will mostly hurt:
  • Low income individuals - The sales tax is regressive; that is, it represents a greater percentage of the income of a low income individual relative to a higher income individual
  • Businesses - Unlike many states, California does not offer any sales tax exemption to businesses for the purchase of manufacturing or R&D equipment. We were not a business friendly state before the sales tax increase and we remain an unfriendly place. This sales tax increase makes it even more unlikely that businesses will want to expand in or relocate to California. That will hurt our economy now and going forward.

A much better way to go for a sales tax change would be to broaden the tax base and lower the rate. There are many reasons for this change including equity. Today, many of the consumption items not subject to the California sales tax are mostly consumed by high income individuals. This includes personal services (such as a trainer), health club dues, digital downloads (higher income individuals are more likely to have access to broadband than other individuals have), and tickets to entertainment and sporting events. Why exempt consumption of high income individuals and instead tax the consumption of lower income individuals?

For more on this topic, please see my paper - here. On 2/12, I had the opportunity to share that paper and some brief testimony with the Governor's Commission on the 21st Century Economy. There was a lot of testimony about why we can't expand the sales tax to apply to more types of services we consume. Many of these arguments just don't make sense. Thus, they translate to an argument that we just cannot improve our tax system if it means that some businesses will have to start collecting sales tax. I doubt sellers of tangible personal property who have always collected sales tax would be too sympathetic. I'll note four of the arguments made and their shortcomings:

  1. A tax on services failed years ago in Florida. Well, why did it fail? It was taxing services used by businesses which should NOT be done. That leads to pyramiding, and creates challenges of figuring out where the tax should be imposed when the services likely involved more than one state. Let's stop letting this argument be raised and instead help policymakers to understand why sales tax should not be imposed on businesses. A broadening of the sales tax base to include more services should focus on personal services (beauty salons, personal trainers, animal care, etc.)
  2. It will hurt small businesses because large businesses won't want to use their services if they are taxed because the large business can instead hire an employee to provide the services and no sales tax would be owed. Well, there are two strong counterarguments to this one: (i) we should not collect sales tax from businesses (see (1) above). (ii) for decades, small businesses that sell goods have also run the risk that large businesses will just decide to produce the goods in-house to avoid sales tax (although they may have to pay tax on the raw materials). Why all of the sympathy towards service providers and none to sellers of taxable tangible personal property?
  3. Consumers will just go out of state to get the services to avoid the sales tax. Again, base broadening should be to personal services, not those consumed by businesses. People are not going to go out of state to get a hair cut or their pet groomed.
  4. It's too complicated to collect sales tax and file the forms. Well, sellers of tangible personal property have been managing to collect and remit for decades. Also, there are simplification techniques that should be implemented for all small businesses. The federal model of how most emplyers of household employees handle their employment tax payments is a great example (it is done right on the income tax form and just once per year). Small businesses should be allowed to include the sales tax on their income tax form and quarterly estimated income tax payments, for example. Also, the state should create a refundable credit to help businesses that become subject to collection to cover their start up costs (new software, training, etc.).

Hopefully the commissioners will take a careful look at how out of date our sales tax is and make the changes that will bring it into the 21st century ways of living and doing business - where we have converted some tangible goods to digital ones and where we consume more personal services and entertainment than we did in the 1930s (likely due to 2-earner families and greater disposable income). AND - let's lower the rate to make the California sales tax a more equitable tax. Eventually, let's work towards eliminating pyramiding (a good start would be to exempt R&D equipment from the sales tax).

What do you think?

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