Certified ServiceAs part of her effort to close the state’s budget shortfall and avoid devastating cuts, Gov. Mary Fallin has proposed $910.5 million in additional revenues in her FY 2017 Executive Budget. The largest revenue item involves changes to the sales tax, which she labels “sales tax modernization.” In her State of the State speech, the Governor explained that, “Modernizing the sales tax code means keeping the same low rates and applying them in ways that better reflect today’s commerce and consumer behaviors.”

Her sales tax proposals involve four components: applying the sales tax to selected services; eliminating some sales tax exemptions; applying the sales tax to items delivered electronically; and improving sales tax auditing with enhanced technology. Collectively, these changes are estimated to generate $200 million in additional recurring revenues. However, the Governor’s budget offers no details as to which services should be taxed or which exemptions should be removed. She does suggest that “if structured properly,” the revenue from broadening the sales tax base could increase overall sales tax collections and allow for a lowering of the state’s sales tax rate.

This post looks more closely at issues surrounding taxing services; a follow-up post will look at the other sales tax proposals, as well as options for enhancing collections from online sales, an idea that was not explicitly part of the Governor’s proposal. (This article borrows from a 2011 OK Policy report, “Fixing the Sales Tax: Options for Reform”, which explored the ideas now being proposed by Governor Fallin. Our brief was in turn indebted to work by Michael Mazerov of the Center on Budget and Policy Priorities.)

How Oklahoma compares

Although 45 states levy a sales tax, most do not apply it to most services. States on average assess sales tax on 55 out of 168 services identified as potentially taxable by the Federation of Tax Administrators in 2007. Hawaii, New Mexico, South Dakota and West Virginia are the exceptions among states in taxing services comprehensively. Several other states, including Arkansas, Kansas, and Texas, tax a large number of services. These states widely tax utilities, admissions/amusements, and labor and repair services, but leave professional services — such as legal fees — largely untaxed.

Oklahoma currently taxes 32 of 168 services, according to the FTA’s survey. These include utility services for industrial use (e.g. electricity, natural gas and telephone, but not water), residential phone services, admissions and amusements (e.g. bowling alleys, club memberships, and video tape rentals), and leases and rentals. Among services that are frequently taxed in other states but not in Oklahoma are residential utilities, repair labor, auto services and washing, long-term automobile leases, service contracts, cable television, and overnight trailer park rentals.

The case for taxing services

Taxing_Household-ServicesThere are several strong arguments in favor of expanding the sales tax to more services:

  • Taxing services more broadly is essential to maintaining the long-run adequacy of the sales tax. The long-term shift of consumption from goods to services is highly unlikely to be halted or reversed. Without policy changes, this will mean a continuous erosion of revenue for Oklahoma’s state and local governments.
  • Taxing services would make the sales tax more economically fair and rational. Since the sales tax is intended to be a general tax on consumption, there is little reason to tax the consumption of goods but not of services, which in fact can be substitutes for one another.
  • Taxing services will likely make the overall tax system more stable. The sales tax base is dominated by purchases of big-ticket durable goods, such as cars, appliances and furniture, which often decline sharply during an economic downturn. By contrast, the purchase of services does not rise or fall as sharply over the course of a business cycle. This means sales tax revenue would fluctuate less if more services were included under sales tax.

Which services to tax?

One consideration when deciding what purchases to tax is whether they are a household necessity, especially for low-income households. For example, many states do not tax groceries to avoid increasing the cost of basic nutrition (though Oklahoma is one of the few states that does tax groceries at the full rate).

When looking at services, some currently untaxed services might be considered discretionary and are purchased primarily by more affluent consumers (for example, dry cleaning, horse boarding and investment counseling). However, expanding the sales tax might also end up covering some essential household purchases. In particular, the list of currently-untaxed household services in Oklahoma includes residential utilities, such as electricity, gas and water. The sales tax would also potentially apply to purchases such as hair cuts, car repairs and veterinary services that would affect a broad segment of the population.

Another key policy question concerns whether to tax all categories of services or to limit the tax to services that are consumed primarily by households rather than businesses. Most economists and tax specialists, from across the ideological spectrum, caution against taxing businesses’ purchases, whether goods or services, that go into the production of other goods and services. This is because of the risk of “tax pyramiding,” in which taxes are passed on to consumers in the form of higher costs. Taxing business purchases also creates the risk of making local businesses less cost-competitive compared to those based in other states and could lead a business that makes substantial purchases of taxable services to expand or shift production to states that exempt these services.

As a result of these concerns, the Center on Budget and Policy Priorities recommends that states assess services consumed primarily by households (such as hair salons, bowling and health clubs), while exempting services consumed primarily by businesses (such as advertising, payroll processing, and accounting).

How much revenue could taxing services generate?

There have been two attempts to generate estimates of the potential state revenue for Oklahoma from extending the sales tax to more services.

In his study on taxing services, Michael Mazerov calculated the potential revenue for the state of Oklahoma of expanding the sales tax to cover services that are primarily consumed by households as $792 million as of 2007. Mazerov acknowledges that this estimate is likely overstated because it assumes no taxation of existing services, though some household services are already subject to taxation in Oklahoma (see Table). In addition, adding a tax on services would lead to some shift in consumer behavior and create some new costs to ensure compliance and collection.

The second estimate was developed for a 2002 Task Force convened by Gov. Frank Keating, which recommended taxing 32 new services. This list was considerably broader than household services, as it included purchased made primarily by businesses, such as legal services, accounting, non-residential maintenance and repairs, and others. This proposal was estimated to generate an additional $821 million, an amount which would be considerably greater more than a decade later.

Unquestionably, gaining legislative support for any proposal to broaden the sales tax base to new services will be enormously difficult. Every industry that is currently exempt will fight hard to avoid being taxed, while many interest groups that grasp the need for new revenue to prevent devastating budget cuts will not easily lobby for new taxes.  A bill to broaden the sales tax to cover any service currently taxed by a neighboring state and by at least 25 states in total, SB 1484, has been introduced by Sen. Clark Jolley and has been assigned to the Senate Finance Committee. Another bill introduced by Sen. Jolley, SB 1275, creates the  Task Force for the Study of the Oklahoma Sales Tax Code with a mandate to develop recommendations that would lead to a vote of the people in 2018; it has passed out of Senate Finance and awaits floor action.