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?

Minnesota's 21st Century Tax Reform Commission Issues Final Report

The Governor's 21st Century Tax Reform Commission of Minnesota, formed in February 2008, has released its final report (2/13/09). That's an amazing time frame given the daunting task of reviewing an entire tax system, holding public hearings and reaching agreement on what is needed to modernize the system and support economic growth in the global economy.

The final report is entitled Minnesota’s Millennium: Launching a New Generation of Competitive Leadership and Economic Growth. The commission's recommendations include several bold ideas to improve the business climate in the state and better tie the state's tax system to today's ways of living and doing business. The Commission's summary report notes these broad categories of changes:

• Reduce business tax burdens
• Improve the transparency of business taxation
• Promote investments in innovation, entrepreneurship and emerging/high-tech companies
• Pay for reform while aligning the tax system with consumption

Specific recommendations include:

• repeal the corporate income tax
• exempt 20% of active business income from pass-through entities
• simplify property taxation
• improve the R&D tax credit including making it refundable
• increase the cigarette excise tax
• broaden the sales tax to include more types of personal consumption (the commission explains why, but wisely left the decision of what exactly to add, to the lawmakers)

The report also explains economic and global changes that warrant tax law changes. It also explains some tax law ideas to ignore (such as a gross receipts tax) and the rationale for the law changes recommended. It's a very good report.

What's next?

Hopefully, the legislators will hold hearings on the report. I think a public education campaign would help because some of the changes likely won't be well received, such as the repeal of the corporate income tax and the broadening of the sales tax for consumers. That may be a tough sell because most people don't appreciate that all taxes are ultimately paid by individuals. There is also a need to be sure there is no abuse, such as people incorporating to try to avoid paying income taxes. An educational campaign effort should be helpful.

I think Minnesota has made a great step forward with the commission and its bold suggestions that indicate they realize that the global economy of today warrants a tax system different from the systems most states have that assumes borders are still important and businesses don't operate globally.

California has its own Commission on the 21st Century Economy underway to make recommendations to the governor and legislature on how to improve the state's budget and tax systems. The Commission should find much helpful information in the Minnesota report. That's good because the California commission has a much shorter time frame to get its work done - about 3 months.

What do you think?

The $3,000 Capital Loss Limit - Is it Time to Raise It?

Since 1978, individuals have been able to offset their excess capital loss each year against up to $3,000 of non-capital gain income. This might be viewed as a pretty good deal in that the gain gets taxed at a lower rate (15% today) while the $3,000 loss taken against wage and interest income might be taken at up to a 35% tax benefit (the current top marginal rate).

But, today, some may think that it is time to update the 30-year old $3,000 amount. Congressman Kirk has once again introduced legislation to raise the limit to $20,000 (H.R. 884). But, the loss limitation is a complicated matter because of challenges in taxing capital gains and losses and the potential for game playing - and the fact that gains at date of death escape income taxation. Also, capital gains and losses are skewed toward higher income individuals. So, for example, despite H.R. 884 being labeled as providing middle class relief, it would provide a larger benefit for higher income individuals because they have more gains and losses. To be geared to the middle class, the larger limit would have to be restricted to individuals below a specified AGI (such as $200,000 MFJ).

I've got a short article on the capital gain limitation, pros and cons for increasing the limit and some alternatvie proposals - Is It Time to Increase the Capital Loss Limitation? The AICPA Tax Insider, 2/12/09.

And, please see a capital gains taxation idea of Professor Jonathan Kesselman, posted at this blog (1/09) - here.

New York Copycats - More States Try to Grab Remote Vendors

In April 2008, New York enacted a law that became informally known as the "Amazon tax " act. The legislation creates a presumption that sellers are soliciting business in the state and thus are required to collect tax if, per an agreement, they compensate New York residents for directly or indirectly referring potential customers. Referrals may be made through a Web site or other means. The presumption only applies to sellers with over $10,000 of sales to New York customers made via the referrals in the prior four quarters. Sellers may rebut the presumption by showing that the residents did not solicit sales in New York for them. [For more details, see Grabbing Remote Vendors (7/08).]

The result in New York is that Amazon, started collecting sales tax and Overstock terminated agreements with its New York associates. Both companies filed suit on the basis that the legislation was unconstitutional.

Decisions were issued in both cases in January 2009. The Supreme Court of New York dismissed the claims for failure to state a cause of action in that there was no way the companies could prevail to find the law unconstitutional.

The court found a high degree of probability that NY-based Amazon "associates" earning a commission when customers begin their Amazon purchase from their website are interested in generating income and thus, will encourage sales. "It is also highly probable that New York residents will more likely than not have ties to other New York residents and it is not irrational to presume that at least some of them will actively solicit business for the remote seller from within the State from others within the State." The court also noted that Amazon and Overstock could rebut such presumption.

Per the court in the Amazon case: "[the rule] does not broadly tax any and all Internet sales to New York consumers. It requires a substantial nexus between an out-of-state seller and New York through a contract to pay commissions for referrals with a New York resident along with realization of more than $10,000 of revenue from New York sales earned through the arrangement. The neutral statute simply obligates out-of-state sellers to shoulder their fair-share of the tax-collection burden when using New Yorkers to earn profit from other New Yorkers."

It is interesting that the court continues to refer to Amazon.com as an out-of-state seller despite the decision. When a vendor has an agent or representative in a state, typically, that is viewed as, in effect, making the vendor present in the state -- and subject to sales tax collection. The wording may be due to the fact that Amazon did not try to rebut the presumption.

[Links to the Amazon decision from The Public Law Library (free).]

Well, states are eager for revenues to address budget shortfalls. So far, subsequent to the 1/12/09 decisions, at least 4 states have introduced legislation mirroring what New York enacted and at least 1 state has a draft proposal. The States:

• California - ABX3 27 / status
• Connecticut - SB 806 / status (has a $5,000 threshold rather than $10,000)
• Hawaii - HB 1405 / status
• Minnesota - HF 401 / status
• North Carolina - draft

Considerations:

• What about the appeal of the Amazon and Overstock decisions?
• Is this the best way to write tax laws - create rebuttable presumptions that are so difficult to rebut that you either need to change your business practices (as Overstock did) or start collecting the sales tax (and reduce the state's worries about how to get its residents to rightfully pay the use tax they owe)?
• Will this mean that states might not be as interested in the Streamlined Sales & Use Tax Agreement? Perhaps, but the legislation won't grab online vendors who don't use the associates arrangement or who stop using it as Overstock did.
• States still need to do a better job educating their residents about the use tax and making it easy to collect (such as by having it reported on income tax returns with the option of calculating it using a table) [for more info - click here]

Hard times can lead to desperate measures. This isn't really the legislative approach to improve the operation of a sales and use tax in an Internet era. It doesn't solve all of the sales and use tax collection issues and the bills will likely lead to litigation and confusion among consumers.

What do you think?

Forgotten Tax Issues - Let's Be Sure They Are Remembered

The Congressional Budget Office projects a $1.2 trillion deficit for 2009 (8.3% of GDP)! Even before the recession, falling home prices and 9% unemployment we were looking at significant budget deficits. That makes it even tougher to think that we can easily extend any of the 2001/2003 tax cuts that expire in 2010 or permanently "patch" the AMT to keep millions of individuals who should not be subject to AMT from owing it.

Even without the greater budget problems, there was a concern over how extending the tax cuts could happen given the high cost. I think that this is why President Bush was exploring tax reform (such as with his Advisory Panel on Tax Reform) - could the tax system be changed to avoid the need to deal with extending costly tax cuts?

I think there is still a desire to see how some of the tax cuts can be made permanent as well as implement some other changes such as a lower corporate tax rate.

Congress and the Administration have a lot on their plates:

• economic stimulus
• health care reform which likely (hopefully) will include looking at ALL of the funds and incentives available today for health care including those in the tax law
• energy/environmental changes - which will also likely involve the tax law
• dealing with expiring tax cuts

This all sounds like an opportunity for major reform - which hopefully can be coordinated rather than piecemeal.

AND - there are more issues - some of which I think have been forgotten, such as:

• corporate integration (it should be considered in any reduction in the corporate tax rate and any change in the capital gain/loss rate or structure)
• depreciation - the system is outdated
• worker classification - still unresolved since 1978
• penalty system - we've added more penalties in the last 10 years (there are over 100!) - is it working (after all, we have a $345 billion annual tax gap)

And, what about the topics of simplification and return-free filing?

It is time for reform and modernization of the federal tax system. To be effective, all of the issues need to be on the table. Many of these topics have been studied for years - by the government, academics and others - let's do something with all of this information!

For more information on the four topics noted above, please see a short article of mine in the AICPA Corporate Taxation Insider for January 2009 - Remebering Forgotten Tax Issues.

What do you think?