Taxing services shouldn’t be all or nothing

A centerpiece of Gov. Mary Fallin’s FY 2018 Executive Budget is her proposal to expand the sales tax base on services. As she explained in her State of the State address:

“As the economy in the United States has shifted from a manufacturing-based economy to a services-based economy, the way we impose taxes and collect revenue no longer reflects the current economy, but an outdated system that has not changed much since its inception.”

The Governor’s proposal, which is set out in detail in this spreadsheet, would expand the sales tax to all 164 services that are currently untaxed in Oklahoma. Based on current taxable sales, the sales tax expansion is projected to generate $940 million in new revenue in FY 2018, of which $840 million would be available for appropriation. Under the Governor’s budget plan, this additional revenue, along with increases in the cigarette tax and motor fuel taxes, would be enough to make up the state’s budget shortfall and allow for the elimination of the sales tax on groceries and the corporate income tax.  The tax would raise an additional $648 million for cities and $121 million for counties.

The Governor’s rationale for expanding the sales tax base to more services — that it is essential to maintaining the long-run adequacy of the sales tax in an economy that is increasingly service-based — has considerable merit. Oklahoma currently taxes 32 services, according to a 2007 survey by the Federation of Tax Administrators, far less than the average state, which taxes 55.  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.

As we argued in a 2011 issue brief on modernizing the sales tax and in a blog post last year, 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 and an increasing structural budget deficit. In addition, taxing services would establish a more level playing field for businesses and make the overall tax system more stable.

However, there are important policy objections to the Governor’s broad-ranging proposal to expand the sales tax to include all services. One significant concern is the inclusion of services consumed primarily  by businesses. Economists and tax specialists from across the ideological spectrum caution against taxing business 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 on business inputs are passed on to consumers in the form of higher costs. Taxing business purchases risks 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. It also creates an advantage for large businesses, that can hire their own in-house accountants, lawyers, graphic designers, data processors, and other services and avoid paying the sales tax, compared to small businesses and non-profits that must contract out for these services and would be taxed on all their purchases.

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

Taxing all services also raises tax fairness issues. Many 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, Oklahoma now excludes residential utilities, such as electricity, gas and water, which would become taxed under the Governor’s plan. 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.

There are other concerns with the Governor’s proposal besides the question of which services to tax. Expanding the sales tax is intended to allow the state to eliminate the corporate income tax while also meeting budget obligations. But the projected revenue loss from eliminating the corporate income tax in FY 2018 — $140 million — is based on lower revenues during an economic downtown. That’s only a fraction of the revenue typically generated by the corporate income tax, which accounted for more than four times that amount — $585 million — in 2013. Meanwhile, the revenue projections for taxing services assume that the new tax would be applied to 100 percent of current taxable sales. This doesn’t allow for compliance issues and tax avoidance strategies by both businesses and consumers. The point is that if we are looking for our tax system to be more stable and viable over the long-term, throwing out  the corporate income tax and relying heavily on taxation of services is a risky way to proceed.

Even though the Governor’s far-reaching plan to tax services is unlikely to gain any traction with the Legislature, the basic idea shouldn’t be wholly rejected. Looking at which services are taxed by most of our neighbors, as proposed by a bill last session, seems a reasonable way to start. Rather than being an all-or-nothing proposition, we need careful thought about which services are the right ones to tax.