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?

How sales tax exemptions can waste one's time

Recent litigation in Missouri over whether converting frozen dough into baked goods is "processing," such that the electricity used is exempt from sales tax, shows the time and money that can be wasted with pointless rules.  The solution is to not have businesses pay sales tax - instead, only have it paid by the final consumer (the same was a VAT works).  Please see my summary of the case and issues in this SalesTaxSupport.com post.

Minnesota Storage Tax Problems

I've several times about the problem of states broadening their sales tax to pick up goods or services consumed by businesses. States should not do this as it exacerbates the pyramiding problem and it makes the tax more complex. A recent example of moving down the wrong path of base broadening is Minnesota. This state starts taxing some storage fees starting April 1, 2014.

For more, please see my January 24, 2014 tax policy post at SalesTaxSupport.com.

Any base broadening should only cover consumption of individuals (non-businesses).

Boundless Sales Tax Exemptions

I noticed that a law enacted recently in Utah created their 75th sales tax exemption.  That is quite a lot of exemptions. Not to pick on Utah though because most states likely have that many or more. Exemptions usually mean the need for detailed guidance on what exactly that exemption is. Utah's 75th one is for fuel cells, which they have defined in another statute and use that same definition for the exemption (which is better than creating a new definition).

I have a post at SalesTaxSupport.com with more about the exemption and policy considerations for exemptions. I also note that it was not clear why the exemption was added. I was unable to find anything from the sponsor or in the legislative record (another common problem with exemptions - there should be a reason given for why something that was subject to sales tax should no longer be subject to sales tax).

A reader offered the possible explanation that eBay planned to build a fuel cell powered data center in Utah (BloombergBusinessWeek, "EBay's Bet on Fuel Cells Will Influence Data Centers," by Adam Lesser, 10/31/12). Not sure if the timing of that with the new exemption that started April 1, 2013 is right, but it seems likely that to further encourage use of fuel cells that reduce emissions and air pollution, the sales tax exemption was added.

As I often note in my posts, sales tax should not apply to business purchases in order to avoid pyramiding of the tax. But, since this policy is not followed by the states (and is difficult to flat out implement since about 1/3 of sales tax revenues comes from business purchases), lawmakers occasionally expand the list of sales tax exemptions, as was just done in Utah, to address isolated, perceived needs.

Please check out the post for further policy discussion on sales tax exemptions.

What do you think?  Should exemptions have stated reasons for them included in the legislative proposal? Should they be forbidden? Should states just work toward exempting all business purchases?

Minnesota Governor's Tax Plan

 

http://www.salestaxsupport.com/

I have a post at SalesTaxSupport.com on Governor Dayton's tax reform plan that includes broadening the sales tax base and lowering the rate. While that is a great way to modernize the tax system, he needs to avoid expanding the base for business purchases.  For more, please take a look - here.

What do you think?

Debt Free America Act

Congressman Fattah (D-PA) has once again introduced the Debt Free America Act (H.R. 1125) (in the 111th Congress, it was H.R. 4646). This proposal calls for a 1% fee (really a tax) on "every specified transaction." That is any transaction where payment is made by cash, check, credit card, or transfer of stock or other financial instrument. A "transaction" is any retail or wholesale sale, purchase of intermediate goods, and financial and intangible transactions.

There would be a credit for low income individuals based on their adjusted gross income. The individual income tax including the AMT would be repealed after 2021 (the credit would end then as well). The stated goals are to promote economic prosperity and eliminate the debt (as well as interest on it). The text of H.R. 1125 notes that the fee is different from a sales tax and a VAT. The proposal also calls for an 18-member task force to study and make recommendations to address the country's fiscal imbalance.

Congressman Fattah's office asked me for comments on the proposal back in January 2010, which I provided. It doesn't appear that any were incorporated - oh well. I applauded his effort to reduce the debt which I noted doesn't really seem to get much attention; instead, we just keep hearing about tax cuts and more deductions and credits.

Below are the comments I provided in February 2010 on the proposed transaction fee. I believe it needs reform to improve transparency, equity and efficiency. One glaring problem is to repeal the individual income tax but keep the corporate income tax and have businesses pay the transaction fee along with individuals - often on the same transactions (there is a pyramiding problem in the proposal). The text of my earlier comments:

1. Fee versus tax: A fee is generally viewed as something paid for particular services to be received. On the other hand, a tax is something charged that is not tied to services received, but is used to generally fund government operations. Given the use of the transaction fee, it should be called a tax.

2. Base: Transactions to be taxed include retail and wholesale sales, purchases of intermediate goods and financial and intangible transactions. Why not also include services and rent? It seems that payment of a mortgage is a financial transaction, so would be taxed (and the purchase of the home also would have been taxed). It seems that rent should also be taxed as equivalent to a mortgage payment or purchase of an asset. Since it sounds like the goal is to apply the tax to any transaction, it would be inequitable and economically distortive to only apply the tax to transactions involving property and financial transactions and not also services and rents.

3. Digital: Given the varied ways some goods can be transferred today, it would be helpful to clarify that goods refers to both tangible and digital goods.

4. Double taxation: The definition of transactions seems quite broad such that the same funds could be taxed multiple times to the same individual. For example, assume an individual receives a paycheck of $300 and cashes it at a check cashing store. That sounds like a financial transaction upon which the proposed tax applies. When the individual spends the net proceeds at the store, a tax is imposed again. If this is not intended, the definition of transaction should be clarified. If this is the intent, employees might request that they be paid in cash rather than a check (assuming that avoids a transaction tax, and if it does, that seems too easy of a way to avoid the tax).

5. Pyramiding: A problem with most sales taxes as well as gross receipts taxes is that when businesses pay them, all or a portion of that tax is added to the sales price upon which the buyer also pays the tax. This results in a tax on a tax or "pyramiding." The amount of pyramiding can vary from industry to industry and company to company depending on the amount of vertical integration in the company and the complexities of the manufacturing and distribution chains. Because the transaction tax is paid by everyone with no refund to businesses, the tax will pyramid and that should be avoided. One way to avoid that is to only have the transaction tax apply to the final non-business consumer. This is how a credit invoice VAT operates.

6. Tax gap: While the rate is likely to be low because the base is so broad, there is likely to be efforts by some taxpayers to find ways to avoid or evade the tax. Appropriate compliance and penalty provisions are needed to help reduce this reality.

7. Bartering: While application of the tax to bartering transactions is to be studied and a report issued after implementation of the tax, this is likely too late. Under the income tax, bartering transactions are usually subject to tax and people figure out how to value the bartered services. Thus, there seems to be no reason not to stress that the tax applies to bartering transactions from the start.

8. EITC: The EITC is a significant social welfare program administered through the tax law. Its repeal will represent a tax increase for many working individuals who today pay little or no federal income tax, but who would be subject to the transaction tax as well as payroll taxes. Also, since the transaction tax is a regressive tax (while the income tax is progressive), some relief should be provided to low income taxpayers who will likely be burdened by the new tax. In addition, while both the transaction tax and income tax are in place, the proposed §25E credit will not be the equivalent of the EITC even if it is refundable. Consideration could be given to providing payroll tax relief to individuals currently subject to the EITC.

9. AMT repeal: While the AMT for individuals is repealed, there is no mention of whether it is also repealed for estates and trusts. Also, the minimum tax credit (MTC) of §53 appears to remain. Even when (if) the income tax is phased out, something specific should be said about MTCs that some individuals are carrying forward to use against future regular tax liability. The MTC carries forward forever and because it represents a prepayment of regular tax, individuals will expect that they can use it someday. Either it should be terminated or allowed to be used against the transaction tax (although perhaps not able to offset 100% of it in any year). Either way, it should be clear what happens to the MTC carryfoward.

10. Individual versus corporate income tax: Repealing only the individual income tax while apparently maintaining an income tax on corporations, estates and trusts can cause some problems. For example, the tax law will play too large of a role in business form. Small businesses, in particular, will be inclined to avoid the corporate form (unless S corporation status is retained and available to them). Also, individuals will still indirectly pay income tax because the corporate tax is ultimately paid by individuals – employees, investors and customers.

11. Study: Additional items to include in the study along with the EITC, AMT, child tax credit and mortgage interest deduction, include the impact on charitable contributions, fringe benefits and retirement savings planning. The study might also include whether any tax relief should be provided for spending attributable to certain casualty losses.

12. Equity: A transaction tax is regressive in that it will represent a higher percentage of the income of lower income taxpayers relative to higher income taxpayers. Unless it is clear that the proposed transaction tax will apply to deposits and investment growth, it seems that high income taxpayers will have lowered tax liabilities with the transaction tax when it entirely replaces the income tax. While it appears that if a wealthy person were buying and selling investments, the tax would apply to the purchase transactions, what if assets sit and earn interest and dividends that are not spent? Those earnings would have been subject to the income tax (at a rate greater than 1%), but do not appear to be subject to the transaction tax until there is a transaction. Data should be gathered on the distribution of the transaction tax among different income groups. It might be that the income tax should remain for individuals above a certain income level.

13. Effect on states: States tend to rely upon the Internal Revenue Code for the foundation of their income tax. Repeal of the individual income tax at the federal level may pose challenges for many states, perhaps even leading them to also adopt a transaction tax which would increase the amount of regressive taxes imposed upon individuals.

14. VAT: Why not a VAT? The U.S. is the only industrialized country that does not use a VAT. While that is not reason enough to adopt one, a VAT has some advantages over a transaction tax. These include: (1) structured as a credit invoice VAT like other countries use, it would not be a pyramiding tax; (2) the VAT is designed to minimize non-compliance; and (3) it might help the states improve their sales tax structures by converting them to a credit invoice VAT.

For more from Congressman Fattah - here.
Commentary from the Tax Foundation (7/14/11) - here.

What do you think? Is this proposal good as it is? in need of improvement? worth fixing?

Tax Pyramiding

Pyramiding in a tax system refers to the imposition of a tax on a tax. It typically happens with taxes that are imposed on goods or services, such as a sales tax. Pyramiding causes a tax to violate several principles of good tax policy, including transparency, efficiency, equity and neutrality. For example, in California, most food purchased at the grocery store is exempt from the sales tax. However, the price paid for that food includes sales tax paid by all businesses in the production and distribution chain to get that food into the store. When a business pays a tax, it is one of many costs factored into its operations that either goes into the price of what the business sells and/or reduces profits. This effect makes the sales tax fail the transparency principle in that when you buy an item (whether tax exempt or not), the true amount of sales tax included in what you pay is not obvious due to pyramiding; the sales tax paid is definitely more than what is noted on your sales receipt.

The degree of tax pyramiding varies from state to state depending on the types of sales tax exemptions they provide to businesses. For example, California exempts purchases for resale. So, when the California grocery store buys food, it doesn't pay sales tax. Yet, it has paid sales tax on all of the equipment and other tangible personal property used in the store (supplies for example). Some states have reduced pyramiding by providing sales tax exemptions for certain types of equipment purchased by businesses, such as that used in manufacturing. Typically the rationale for such exemptions is to entice businesses to locate their manufacturing operations in the state.

The remedy for tax pyramiding is to not have businesses pay sales tax. If they don't pay the tax, then it won't be factored into pricing. There are two big obstacles to fixing pyramiding though:

1. Pyramiding has been around since the beginning of the sales tax and it generates revenue for the state (likely at least 20% of the state sales tax comes from businesses). How do you replace that revenue?
2. Many people (including lawmakers) think that businesses have too many tax breaks and are not paying their fair share and would not support legislation to make all business purchases exempt from sales tax.

Despite these obstacles, there are reasons to remove pyramiding from the sales tax system and ways to deal with the obstacles. First, there are other reforms needed to the sales tax system, such as base broadening (along with rate reduction; see my Report #2a at the link below). Revenue generated from that change can cover the revenue generated from pyramiding and be a more equitable and transparent way to generate sales tax revenue. Removal of pyramiding would likely generate increased business activity in the state because the price of doing business here would drop - other tax revenues should go up from the change. Also, taxpayer education would help. Individuals need to see the hidden cost of pyramiding (which they pay; businesses pass most costs onto customers). It would be more clear to individuals how much sales tax they are paying if the sales tax shown on the sales slip is the total amount and that will only happen if pyramiding is removed from the sales tax system.
The pyramiding flaw is a U.S. one. All industrialized countries other than the U.S. use a value-added tax to tax consumption (rather than a sales tax). A VAT that does not allow for exemptions and special rates does not impose a VAT on businesses purchases.
For more information on the problems created by pyramiding, why it should be eliminated and ways to do so, see Report #2c at:
https://www.sjsu.edu/people/annette.nellen/website/TaxReform/Report2c_21stCenturyTaxation_Pyramiding.htm

What do you think?