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Friday, June 8, 2007

Sales Tax - What Should It Apply To?

One of the weaknesses I noted earlier for the California tax system is that its sales tax base is narrow in that not all consumption is taxed and there are many exemptions. Let me elaborate...

California's sales tax was created in 1933 with the Retail Sales Act. The tax was to be imposed on retailers for the privilege of selling tangible personal property. In 1935, the use tax was enacted to complement the sales tax to ensure that in situations where a retailer was not obligated to collect sales tax (such as because it was not located in California), the California consumer would be obligated to pay use tax at the same rate. While the sales tax is imposed upon the retailer (although they can add it onto what the buyer pays), the use tax is legally imposed upon the purchaser.

Because the California sales and use tax rules specifically apply to tangible personal property, sales and purchases of services and intangibles are exempt from the tax. However, there are exceptions. If the service is embedded in the goods or if an intangible (such as a film) can be viewed as really being tangible, they will likely be taxed. The California Revenue & Taxation Code has many rules that explain what taxable tangible personal property means. For example, a restaurant's prices may not be separated between services and food; instead, the entire restaurant bill is subject to sales tax.

In addition to items or services that are not subject to the sales and use tax rules because they are not tangible personal property, California law provides many exemptions where an item of tangible personal property will not be subject to tax. Sometimes the law is written to address a specific item, such as ice used to pack food for transportion (R&T Section 6359.7). Other times, the exemption is to benefit the seller such as because they are a charitable organization (for example, R&T Section 6360 provides that a charitable organization selling certain prisoner of war bracelets is not subject to sales tax on the items).

The list of exemptions is quite long and every year, there are legislative proposals to make it even longer. The Board of Equalization (BOE) that administers the sales and use tax has a publication that lists the exemptions and the amount of revenue that is not collected due to the exemption (Pub. 61). This publication organizes the exemptions into categories as follows:
  1. Necessities of life (including food and certain medicines)
  2. General public benefit (including certain sales to museums and certain charitable items, such as the bracelets mentioned earlier)
  3. Industry benefit (including certain sales of transportation items for interstate use, custom computer programs, certain racehorse breeding stock, and certain periodicals)
  4. Exclusions by definition (such as cash discounts, intangibles, admission charges, and lodging)
  5. Other exclusions, exemptions and credits (such as occasional sales, sales for resale, and the first $400 of tangible personal property purchased outside of the US and brought in by an individual within 30 days)

Cost of the exemptions: The BOE is not able to obtain data to measure the cost of all of the exemptions noted in Pub. 61 so "N/A" appears throughout the list. Here is a summary (data is from the BOE 2005 publication):

  1. Necessities of life $9,900 million (about 1/2 represents food)
  2. General public benefit $1.5 million
  3. Industry benefit $552.7 million
  4. Exclusions by definition $115.3 million
  5. Other exclusions, exemptions and credits N/A

While the above dollar amounts are substantial, they are not the best figures to use to determine the effect to the state of broadening the sales tax base. For example, a significant personal consumption item missing from the above amounts are services, such as what one pays at the barber shop or to their tax preparer. Also, the amounts above include some items that may be difficult to subject to sales tax such as some items sold by individuals at a garage sale.

However, there are reasons to reconsider the sales tax base including:

  1. The sales tax rate is already high (roughly 8%, but varies from county to county). Broadening the base would enable the rate to be lowered.
  2. Some exemptions reach beyond the intent of the exemption. For example, the exemption for food includes milk and vegetables, but also a $20 block of cheese purchased at a gourmet grocery store. Assuming the food exemption is to benefit purchases that are necessities of life, it is too broad. Another option is to tax all food but then provide relief to low-income individuals through other means such as a refundable income tax credit.
  3. All exemptions should be reviewed periodically to see if the original reason for their creation is still valid.
  4. As consumers have increased their consumption of services and intangibles (such as digital downloads) and decreased their consumption of tangible personal property, the sales tax base needs to be reconsidered. Many states tax far more services than California does and several are broadening their base to include digital items (particularly where they are substitutes for tangible items such as music).
  5. The sales tax base is pyramiding in that businesses pay sales tax on tangible personal property they buy unless it is for resale or otherwise exempt. Any tax they pay will get included in the cost of the tangible property they sell to consumers so there will be a tax on a tax. It would be more appropriate to not tax businesses so pyramiding would be avoided.

Also, tax laws are complicated whenever something is exempted or subject to a special rule. Exceptions require special definitions which are not always easy to write or enforce. For example, some of you may recall years ago when California started taxing snack food but then found it was very difficult to define a snack (the tax was later repealed). A tax base with few exceptions not only allows for a lower rate, it can also improve compliance and administration, and lead people to view the tax as more fair (because everyone is paying the tax on their purchases).

For more information on this topic and ways to broaden the base, please see my report #2a at:

References cited above:

Pub. 61

Comparison chart of services taxed by different states

1 comment:

Nina Athena said...

Sometimes, owning a business or not, we still need to manage our income, especially when it comes to taxes and that’s the hardest part. Hiring a tax professional will be a good step to start when you have to deal with small business tax but it is also effective whether your purpose is to manage personal income or manage a business. Thank you for sharing your thoughts! Would love to see more updates from you.