Better Served: States are encouraged to broaden sales tax base

Should states be looking at broadening their sales tax bases to cover more currently untaxed services? That is the argument made in a recent paper by Michael Mazerov of  the Center on Budget and Policy Priorities:

Most states could improve their sales taxes and their tax systems in general with some expansion of the tax base to include services. Levying sales taxes on services makes state tax systems fairer, more stable, more economically neutral, and easier to administer. Moreover, because state sales taxes are a major source of funding for schools, universities, health care, public safety, and other functions of state and local government, adding services to state sales tax bases can help states maintain their support for those functions, for instance during an economic downturn when state revenues are declining.

Oklahoma exempts more services from the sales tax than most states; according to a 2007 survey by the Federation of Tax Administrators, Oklahoma currently charges sales tax on just 32 of 168 potentially taxable services. On  average, states tax 57 services, but only 4 states – Hawaii, New Mexico, West Virginia, and South Dakota – tax services comprehensively.  Among the services that are frequently taxed in other states but remain exempt in Oklahoma are residential utilities, repair labor,  service contracts, and cable television.

Mazerov calculates that applying the state sales tax at its current rate of 4.5 percent to what he terms all “feasibly-taxable” services could generate $792 million in new revenues in Oklahoma.  He excludes from those calculations services that are consumed exclusively or primarily by businesses rather than households, such as advertising and legal services, as well as housing, health care, education and certain others. (Most economists favor excluding services consumed primarily by businesses to avoid the risk of “tax pyramiding”, in which inputs are taxed on several occasions and become a hidden tax within the final cost of business).

Broadening the sales tax base to include services is an idea that could generate bipartisan support. Liberals like the idea because it addresses the ongoing erosion of the tax base as the economy shifts from goods to services, threatening funding for public services.  At the same time, since taxing services makes the tax system more economically neutral, conservatives are likely to be open to the idea – so long as broadening the tax base is coupled with a lowering of tax rates.

Of course, this is not to imagine that broadening the sales tax base will be universally popular – sectors that are currently untaxed are likely to push back hard against any attempt to be brought under the taxation umbrella. When a 2002 Task Force set up by Governor Keating offered a revenue-neutral tax reform proposal that involved broadening the sales tax in exchange for cuts to income tax rates, the report was treated as DOA by the Legislature.

Politics aside, as Mazerov acknowledges, there are significant economic, administrative, and legal issues that must be addressed in expanding the sales taxation of services. However,  the non-taxation of services, combined with a multiplying array of tax exemptions and preferential tax treatment, is placing the full cost of funding government services on a shrinking economic base. Policymakers must start to get serious about modernizing Oklahoma’s tax system before that base gets too narrow to support the services we depend on.