Why Taxing Services Is Bad for California

With last fall’s election of former Assembly Speaker Robert Hertzberg to the State Senate, and the introduction of his Senate Bill 8, there is renewed interest in “tax reform” at the California Legislature and specifically expanding the sales tax base to include services. This call for “reform” is premised on the belief that it will address “volatility” in our state’s finances.

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However, “volatility” – fluctuations in General Fund revenues – comes instead from our state’s over-reliance on income taxes (primarily stock options, capital gains and dividends) paid by the top income earners (the top 1 percent generate over 40 percent of PIT revenue). Taxing services will not bring stability to the state’s overall revenue streams.

Moreover, a tax on services is a direct tax on labor. California already has the second highest unemployment rate in the nation according to the U.S. Department of Labor in December. Taxing services that are proposed by SB8 will tax services that rise and fall with the economy, but exempt services that are less impacted by the general economy (i.e., medical care and education).

Taxing services has been considered by the state Legislature on multiple occasions, most recently in two different bills in 2012. Those measures were the subject of intense lobbying in the State Capitol.  Assembly Bill 2540, proposed by Assemblyman Mike Gatto, D-Glendale, would have taxed specific services that the author believed would be used only by top income earners in the state.

On the other hand, AB1963, by former Assemblywoman Alyson Huber, D-El Dorado Hills, initially took a broader approach, but ultimately made it through the Legislature to simply have the Legislative Analyst study the taxation of services in this state.  However, Governor Brown vetoed that study bill. No measures were considered during the past two years.

In general, extending the sales tax to services in California could take several forms, such as taxing all services or a select number of them, and possibly lowering the rate for all purchases, although Senator Hertzberg does not contemplate that approach in SB8. Instead, he intends to generate $10 billion annually in new taxes and primarily spend these new tax revenues on education.

Current California law, contained in the Sales and Use Tax Law that is administered by the State Board of Equalization, imposes a tax on retailers measured by the gross receipts from the sale of tangible personal property sold at retail in this state, or on the storage, use or other consumption in this state of tangible personal property purchased from a retailer for storage, use or other consumption in this state.

The fundamental argument of those advocating for a tax on services is that California’s economy has changed dramatically from one based upon manufacturing products to one based on providing services.  As such, they argue the sales/use tax does not generate sufficient revenues because it is not taxing services, which account for a large majority of the state’s economic activity. Because of this, proponents argue, our state’s tax system has not “kept up with the times.”  Some even call the lack of a tax on services to be “unfair and unjust.”

However, taxing services would be bad for California’s business climate and would unnecessarily increase state tax revenues despite the fact that we have one of the highest personal income and corporate income tax rates in the nation. To make matters worse, our base sales/use tax rate is the highest in the nation.

California currently imposes a tax on a few services (e.g., printing and fabrication). In fact, only a handful of states tax more than 10 services. Only four states tax all services (Hawaii, New Mexico, South Dakota and West Virginia), and those are not major competitor states to California. Hawaii is the only state that taxes all professional services, with New Mexico and South Dakota taxing a number of professional services.

Several states imposed taxes on services, only to repeal them shortly thereafter (Florida and Michigan).  Maryland and Massachusetts actually repealed their services tax legislation before it went into effect. It is also important to note the entire tax structure of those states.  For example, Delaware taxes 142 listed services. However, Delaware is one of five states that does not impose a sales/use tax on tangible property.  Washington State taxes 152 listed services. However, Washington is one of four states with no personal income or corporate taxes.

We believe there are numerous shortcomings to taxing services in this state. As the state Board of Equalization has pointed out, as well as the Legislative Analyst, there are a number of policy considerations to take into account in considering whether to tax services in California.  Key among the issues raised is the administrative feasibility of such a proposal.  It will be difficult for both business owners and the state BOE to properly identify and track the information required. For example, there are thousands of businesses in this state that are not registered with the BOE because they do not currently have sales/use tax collection and reporting obligations to the state.

Moreover, the BOE notes that taxing services may create “perverse incentives.” The BOE explains that taxing a specific service might encourage consumers to purchase the service from out-of-state providers, thereby creating a competitive disadvantage for California businesses. The more expensive the service, the more in taxes that would be paid which, in turn, will create a stronger incentive to move the business out-of-state.

Furthermore, the BOE and LAO note the general call for avoiding the taxation of services used primarily by businesses. They contend that most economists and tax experts agree that states should avoid expanding the sales tax to cover services used primarily by businesses because any sales tax paid by a business will be factored into the prices it charges for goods and services, which would also potentially be subject to tax, thereby creating “a tax on a tax” scheme.

In addition, California’s existing sales tax law is inherently regressive because lower-income individuals typically spend a larger percentage of their earnings on taxable goods. By expanding the sales tax base to include services, the state’s sales tax will become more regressive as many of the services to be taxed will be paid for by lower-income citizens.

Moreover, a tax on services would harm those companies that have to contract for services, but not affect those that can provide the same services in-house. Small businesses, which most often contract for support services, would be forced to pay sales taxes. As a result, the tax burden would fall more on small and mid-sized businesses.

Finally, this taxing services proposal has to be put in the context of all the other major costs of doing business in this state. Employers in California are already facing significant increased costs of doing business due to increased personal income and sales taxes under Proposition 30, higher workers’ compensation rates, higher minimum wage, reduced federal unemployment insurance credit, higher energy costs, and increased costs due to the implementation of the Affordable Care Act. California has the highest personal income tax rate, highest state sales tax rate, highest corporate taxes in the western U.S., and the second highest gas tax in the nation.

Chris Micheli is a Principal with the government relations firm of Aprea & Micheli Inc.