Taxing (or Not Taxing) Services is Wrong Focus - How to Improve Sales Tax

The sales tax, used by almost all states, is a consumption tax. Generally, consumption is what the final consumer does.  For example, a company manufactures paper, a greeting card company purchases some of that paper to make greeting cards and sells them to the final consumer or to a distributor who sells them to the final consumer. As the paper or cards move through this supply chain, a sales tax exemption for items purchased for resale prevents sales tax from being charged. The final consumer is the only one who pays sales tax when the card is purchased (reaches the end of the supply chain).

Supply chains and tax systems are not always this "simple" though because not everything a business buys is directly for resale.  A recent case in Kansas found that electricity purchased by Southwestern Bell Telephone, Co. LLC (No. 120,167 (2020)) to help in the delivery of telecommunications services was exempt from sales tax because it was used in this production. A lot of time and effort though went into the determination of whether Southwestern Bell owed sales tax.

A simpler approach is possible and is really part of a proper sales tax system. This approach is that businesses should not pay sales tax on any of their purchases; only the final consumer should pay sales tax.

The Kansas case is just one of many decided every year in addition to ones settled on audit and dealt with by sellers in determining if they should be charging sales tax to a customer. This is a lot of wasted time given that the sales tax should be just on the final consumer. This required element of a sales tax avoids "pyramiding" in the system which occurs when a business pays sales tax and factors that into the price it charges customers leading to tax charged on tax.

There are annual discussions in many state legislatures and by taxpayers and industry associations about not imposing sales tax on services. I think the better focus is on changing the law to tax a broad base of consumption (including services except perhaps for some medical services) and only charging the tax to the final consumer.

This is how a value-added tax (VAT) works. In a pure VAT system (one without lots of exemptions or special rates), everyone pays VAT on all purchases. If that buyer is a business, they get their VAT back. This helps ensure collection by collecting the tax throughout the supply chain. It also prevents the need for a seller to accept an exemption certification from a business buyer and then be liable for the sales tax if it turns out the certificate is invalid.

Will this system work? In theory. In reality, states rely on sales tax paid by businesses so it is hard to replace. But I think a gradual shift to broaden the base, such as to include digital goods that are equivalent of taxable tangible goods (such as iTunes and digital books), entertainment, and personal services will help. Also, not including business purchases in the expansion of the sales tax base. AND, it is important to lower the rate so this is not a tax increase but a tax system improvement effort to make it function better today and in the future. It will also avoid the eroding sales tax base that affects many states today, such as technology allows us to buy non-taxable digital versions of what was previously a taxable tangible purchase (books is a good example).

So, let's eliminate time spent arguing for sales tax exemptions for businesses and expanding tax bases to include more services and instead pursue:

• Prohibiting any sales tax base expansion from applying to items purchased by business (so as not to make the existing pyramiding problem worse).
• Expanding the sales tax base to cover all final consumption with very few exemptions, while lowering the rate. 

What do you think?

California Prop 55 - Kicking the can down the road

California always has budget problems. In 2012, temporary tax increases were voted in to raise both the state sales tax rate and the top personal income tax rate. These put California at the top among state for high tax rates. These provisions expire soon, but budget problems remain. So, Prop 55 on the November 2016 ballot calls for extending the income tax rate increase.

Per the "findings" in Prop 55:

"Unless we act now to temporarily extend the current income tax rates on the wealthiest Californians, our public schools will soon face another devastating round of cuts due to lost revenue of billions of dollars a year. Public school funding was cut to the bone during the recession. Our schools and colleges are just starting to recover, and we should be trying to protect education funding instead of gutting it all over again. We can let the temporary sales tax increase expire to help working families, but this is not the time to be giving the wealthiest people in California a tax cut that they don’t need and that our schools can’t afford."

The continuing increased rates kick in on taxable income over $250,000.  Prop 55 would result in 9.3% not being the top personal income tax rate. Instead, brackets about $250,000 would include 10.3%, 11.3% and 12.3%.  With the longstanding mental health tax, the rate on income over $1 million would continue to be 13.3% through 2031. Yes, 2031!  That's a bit hard to picture.

How many people in California have income in this range? Using IRS zip code data for 2014, here are percentage for a few selected California zip codes based on $200,000 or more of AGI (after itemized deductions, fewer would have taxable income over $200,000 and the IRS doesn't report for taxable income over $250,000):

Fresno 93728           < 1%
Sacramento  95816    5%
San Jose 95125        19%
Torrance  90503         8%

This is not representative of course, but it is safe to say that less than 5% of California individual filers have to deal with the top rates.  And for the top temporary rate of 12.3% on taxable income over $500,000, less than 1% are affected.  Of course though, many in this range have a few million of annual income which is why the increased rates at the top can bring in millions of dollars.

I call this kicking the can down the road because instead of improving our tax system, we are applying a band-aid.  Here are a few things that would be better:

• Lower individual tax rates and broaden the base by eliminating or cutting back on exclusions, deductions and credits. This also makes the system more equitable, transparent and simple.
• Broaden the sales tax base and lower the rate. The California sales tax is still based on the 1930's economy when the tax was created. We just tax consumption in the form of tangible personal property and do not tax digital items, personal services, entertainment or utilities. Thus, the sales tax base continues to shrink as items, such as books and music, move from taxable tangible form to non-taxable digital form. This is crazy.  Also, some of the items we don't tax are ones that higher income taxpayer spend more money on such as food, utilities for their large homes, entertainment and personal services.
• The state wants to reduce greenhouse gas emissions. Governor Brown just signed SB 32 and AB 197 calling for further reductions. A carbon tax or increased gasoline excise tax would help reduce emissions and generate revenue.
• "Splitting the roll" on real property taxes to tax business property at a higher rate and/or modify the valuation approach. Prop 13 rates and valuation limits have inequitable effects among businesses that are not as relevant for businesses

What do you think?

Also see my California Tax Reform website.

The New Marketplace and Relevance to Tax

A year ago, eBay announced its acquisition of Milo which provides online information on prices and availability in local stores. This should aid in the merger of online and in-store shopping and use of mobile applications. It potentially brings about a new meaning of “marketplace.” With the acquisition, Mark Carges, CTO and senior VP, global products, eBay Marketplaces stated: “Since eBay is an online marketplace and doesn’t compete with brick-and-mortar stores, adding local store inventory to the eBay marketplace is a natural extension of what we’ve been doing for 15 years – bringing buyers and sellers together to access the largest selection available anywhere.” (12/2/10 press release)

Here is a recent article from Internet Retailer, "Updated Milo app enables mobile checkout and in-store pick up" by Kevin Woodward, 12/6/11 on the use of Milo for shopping ease.

On 12/6/11, Amazon issued a call for people to help it get price information. A press release of 12/6/11 is entitled - "Is That Deal Really A Deal? Use the Price Check by Amazon App to Make Sure." It calls upon consumers to download the free "Price Check" app for the iPhone and Android and use it to check prices against what Amazon and its sales partners offer. There are four ways a consumer can input a price into the app for verification: (1) scan the product's bar code, (2) take a picture of the item for a photo match, (3) speak the name of the product into your device, or (4) type in the product name.

This all seems to get Amazon more data for helping to set its prices - and to help make sales. For example, you are in a physical store and want to see if you can get a better price at Amazon. So you use the price check app. Being connected to the Internet, you can also, of course, order the product from Amazon right then. So you get to see and touch what a store is trying to sell you, but if you find a better price at Amazon, you can purchase it right then - you, of course, won't get to take it home with you. The first two lines of the press release offer encouragement for consumers (with the right technology) to help Amazon (and help yourself at the same time):
"As an added incentive, on December 10^thAmazon is giving customers using Price Check an additional 5% discount (up to $5) off the Amazon price on up to three qualifying items in toys, electronics, sporting goods, music and DVDs."
"Shoppers can also start submitting in-store prices with the Price Check app, ensuring they are really getting a deal and allowing all Amazon customers to get the lowest prices year-round."

I think a lot of shopping will become one of checking prices (which if you are already on your computer, we have been doing for sometime) and seeing who can get it to you cheapest. Perhaps in-store shopping will just be when we want it right away. And given that we are more prone to wanting instant gratification, will keep brick-and-mortar stores in business. I think such stores though may need to find ways to bundle goods and services. For example, buy the equipment here and we'll show you how to use it or we will come to your home and set it up.

Tax relevance:

• Borders become less relevant as consumers buying online may not even know where the product or service originated. But states are moving to market sourcing for goods and services so sellers do need to know the location of the buyer. Mobile and stationary electronics will likely need to have a location default in them unless states do want to source a sale, for example, to Illinois because the California buyer was at the Chicago airport waiting to board a plane. That seems too difficult to track and audit.
• Build the sales tax assessment and collection feature into the selling websites - states need to create a "sales tax app." It will collect the sales tax at the same time the buyer clicks to buy the item with the same funding source (Paypal or credit card, for example). This should become the standard for sales tax collection. Sourcing will have to be worked out, but technology should also be able to handle that. If purchasing on your mobile device, it knows where you are and can default to pay the state's sales tax for the jurisdiction you are in AND if your state's sales tax rate is higher, it can charge the difference to your state's tax authority (unless it is a meal consumed on the premises).

Eventually, sellers will not need to deal with sales and use tax because:

• All sales would be run through the "app" so the tax is collected and remitted to the appropriate state at the same time the goods or services are purchased. Auditors would just need to verify that the technology is working.
• Sales tax bases should be broadened for many reasons (such as equity and simplicity) but would also make it easier for the app to work - full amount charged to consumer is subject to sales tax.
• States should move to exempting purchases by businesses (to eliminate pyramiding of the tax). So another verification for the app would be the type of buyer - consumer or business. But, some buyers have dual roles. So, a VAT would be better. Everyone is charged sales tax and if you are a business, you keep records to apply for a sales tax refund. But, technology should be capable of even avoiding this paperwork by a dual check - let the buyer and seller both have to enter whether the purchase is for business or consumption.

Other ideas? What do you think?

Taxing Food - Good or Bad Idea?

This past week New Mexico Governor Bill Richardson vetoed legislation that would have imposed sales tax on food (Durango Herald News, 3/25/10). His rationale was the burden such a tax places on low and middle-class taxpayers. Per his March 24 press release:

"“I am not willing to put this burden on working families in the form of an unfair tax on food. I agree with those who call this a cruel tax,” Governor Richardson said. “It is especially cruel during the worst financial crisis New Mexico has ever experienced."

The legislature had proposed reinstatement of the food tax to help cover budget deficits. Per the Durango Herald, other tax increases were enacted.

Is a sales tax on food a bad idea? Is a food exemption needed to help low and middle-income taxpayers?

No! The reality is that higher income taxpayers spend more on food so they get the bulk of the tax relief. Also, many states tax some kinds of food such as snacks or soda or take-out food. Tax laws become complicated in crafting narrow exceptions to rules. It would be better from an equity and simplicity standpoint to tax food AND provide a refundable income tax credit to low-income individuals. Or perhaps a sliding scale credit.

Some data from the US Census Bureau for 2008 indicates the following spending patterns for consumers with income before taxes below $70,000 and at $150,000 or higher:

Income below taxes less than $70,000:
Food at home $3,033
Food away from home $1,784


Income of $150,000 and higher:
Food at home $5,940
Food away from home $7,071

So, assuming a sales tax rate of 5%, a consumer with under $70,000 of income saves about $152 annually by exempting food at home. In contrast, a consumer earning $150,000 or more before taxes saves almost $300 per year. It would be better to tax the food and give the low income taxpayer a $150 refundable income tax credit. If a state also exempts food away from home, the tax break for high income taxpayers is even bigger.

Drawbacks? Yes, there are some. the big one is that a sales tax exemption is immediate while the income tax refund for a low income taxpayer won't come until they file their income tax return. If the low-income taxpayer is already receiving some type of payments from the state, it is possible that the tax credit could be distributed more regularly through that system.

Another alternative, lower the overall tax rate and broaden the base. That reduces the cost of other items purchased by low-income consumers while capturing more of the consumption of high income taxpayers. New Mexico already has a broad-based sales tax though.

But, bottom line - elected state officials should stop giving big tax breaks to high income taxpayers with the excuse that they are helping low-income taxpayers. There are other ways to help low-income taxpayers.

For more information - click here.

What do you think?

Complexity of Simplified Sales Tax

I finally just had a moment to read the background materials for a 1/20/2010 SSUTA meeting that dealt with vendor compensation for collecting state sales and use taxes. Some of the discussion questions are interesting in that I think they raise the issue of whether the SSUTA has made sales tax compliance simple enough such that Congress should allow adopting states to make remote vendors collect.

Here are a few of these discussion questions that, I think, raise additional issues beyond vendor compensation approaches.

1. "How do you determine who is a volunteer seller and who is a nexus seller initially and going forward?" I think this implies that it is not always clear when a seller has nexus in the state. And generally, that is true.
2. "Should additional compensation be required in states with more complex tax structures? What complexity factors should be considered?" Why would an adopting state's tax structure be more complex than others? If this is the case, then wouldn't it still impede interstate commerce to make a remote vendor have to collect from customers in the states with the more complex tax structures? If yes, Congress should not allow adopting states to require remote vendors to collect tax. I think this question might mean that additional simplifications are needed, such as one rate per state.

What do you think?