Challenges of Tax Exemptions

One of several features that make tax systems complicated are the numerous exceptions that pull out from taxation something that is part of the tax base for a particular type of tax. It is probably almost impossible to find any federal, state or local tax that doesn't have some type of exception. A list of sales tax exemptions produced by the California Department of Tax and Fee Administration (CDTFA) lists 171 sales tax exemptions. All of them need a definition in the statute and often an explanation from the tax agency. This creates a lot of complexity because it is difficult to define most exemptions. For example, if a state wants to exempt food from sales tax but only healthy food, where does a "protein bar" full of sugar and not a natural item fall?

Our federal income tax law has Code sections 101 through 139I listing items of income, such as certain disaster relief payments, fringe benefits and gifts, that are income, but excluded from the measure of taxable income.

A 2023 ruling in Iowa caught my attention as an example of the complexities of defining exemptions (Sweat Iowa LLC, No. 346007, 11/14/23). Iowa imposes a 6% sales tax on "enumerated services" which includes "all commercial recreation." The term "enumerated services" signals that all potentially taxable services are not subject to sales tax. Generally, because a sales tax is imposed on personal consumption, everything that an individual purchases that is not for business use, should be subject to sales tax. If the law in any state worked that way, the rate would be lower and the tax base broader (and mostly easier to define).

For a sales tax (a tax on personal consumption), the only items that should be exempted medical services provided by a medical professional and tuition for a university or professional/job training.

In the Iowa ruling, the question was whether booking services for saunas with "science-backed technology of infrared (IR) and red light therapy(RLT) to optimize health and wellness" is "commercial recreation."

In the ruling, the Iowa Dept. of Revenue had to review the Code that defines "recreation" and then Black's Law Dictionary on the definition of "pleasure"! Because there was pleasure and promotion of physical fitness involved, the DOR found the sauna service to be taxable. It also noted that even if not recreation, it would fall under the taxable services of Turkish baths and reducing salons.

If the law instead stated that all personal consumption was taxable and only had very few exemptions, it would be a lot simpler for everyone and the rate could be lower.

And there are other reasons for a broader base, not only for sales tax, but often other taxes as well. Often the items that are left out of the base are ones where higher income individuals spend more money so they get the greater savings. This includes food which most states exempt (higher income individuals spend more on food that lower income individuals), entertainment, household services, and even a personal trainer.

A final note, of the 171 sales tax exemptions the CDTFA pub noted earlier, several only apply to businesses so should not even be part of the sales tax base and some major exemptions such as personal services and digital goods are not in the 171 because they are not part of California antiquated sales tax base of tangible personal property (been that way since 1932!).

What do you think?