Republicans should embrace service taxation
Ohio Governor John Kasich, a Republican, recently proposed taxing 81 services that are currently exempt from Ohio’s sales tax and using the new revenues to reduce income and sales tax rates. This is a great idea, and other Republicans should follow Kasich’s example. Almost alone among Republican governors, Kasich understands that, done right, taxing services is no revenue grab, but a way to create fairer, more efficient, and more modern state tax codes and finance massive cuts to tax rates.
The tendency to exempt most services (as opposed to goods) from sales taxes is one of the greatest weaknesses of current state tax codes. Sales taxes are a major source of funding for state governments, providing, on average, about a third of all revenues. But over the years, sales-tax bases have eroded, due to the rise of online commerce, states granting exemptions for basic necessities such as food and clothing, and consumers spending a greater share of their incomes on services and less on goods. In 1935, when Ohio’s sales tax was first designed, sales of goods constituted 56.5 percent of all personal consumption in the U.S., and services only 43.5 percent. Now, two-thirds of all spending is on services and only one-third is on goods.
When tax bases erode, tax systems become more inefficient, as lawmakers are forced to raise rates to capture more revenue. The median state sales tax is now 6 percent, close to double what it was in 1970 (3.25 percent). When services are exempted from taxation, tax codes become unfairly biased in favor of businesses that sell services and against those that sell goods. As Alan Viard of the American Enterprise Institute has written, distinguishing between goods and services can lead to wasteful litigation in cases in which the distinction is not always so clear, such as computer software.
Scaling back exemptions for food and clothing is a third-rail issue, and only Congress can fully resolve the online commerce dilemma. Thus, if states want to address sales-tax-base erosion on their own, their only realistic option is to broaden the base to include more services.
In explaining his plan for “broad structural [tax] reform,” Governor Kasich contends that services should be “taxable unless specifically exempted, rather than being exempt unless explicitly made taxable,” just as goods are. But at present, only Hawaii, South Dakota, and New Mexico take this approach. According to the Federation of Tax Administrators’ most recent survey of trends in state service taxation, half of all states tax fewer than 40 of the 168 services included in the survey.
Huge revenues are at stake. Even after exempting healthcare, education, and other services “vital to well-being and opportunity,” Kasich’s plan would increase Ohio’s sales-tax base by 30 percent and generate almost $3 billion in new revenues, gross. The majority of revenues come from taxing lucrative professional services industries such as law, finance, and architecture, though small businesses such as hairstyling and dry cleaning are also targeted. Kasich would use the new revenues to lower the sales tax rate from 5.5 percent to 5 percent and to help finance a 50 percent income tax cut for small businesses and a 20 percent income tax cut for individuals.
Republicans now hold complete control of 25 state governments, and several Republican governors have recently proposed major tax reforms. But, thus far, only Kasich and Bobby Jindal of Louisiana have grasped the advantages of service taxation. (Jindal has proposed a tax reform package that includes service taxation, but has not yet released the details.) More Republicans should make service taxation central to their tax reform plans.
Not that service taxation is a lay-up, politically speaking. Many prior efforts at it have failed, due to lobbying by small business advocates and the deep-pocketed professional services industries. The challenge for Kasich, Jindal, and, hopefully, other Republican governors will be to buck the special interests and hold firm on their commitment to tax reform. Service taxation is critical to state tax reform. It enjoys broad support among tax policy experts and has been consistently recommended by special state commissions on tax reform. Pursuing service taxation would allow Republicans to seize the high ground in tax policy debates, to be known as the party committed to improving tax codes by making them fairer, more efficient, and better-suited to the service-based economy of the 21st century.
Stephen D. Eide is a senior fellow at the Manhattan Institute’s Center for State and Local Leadership. Twitter: @PubSectorInc