Does a Service Based Economy Justify Expanding the Sales Tax Base to Services?

As Ohio and Pennsylvania currently debate their budgets for the upcoming fiscal year, governors John Kasich of Ohio and Tom Wolf of Pennsylvania have proposed, as part of their budgets, expanding the sales tax base to include most, if not all, services.  Although the philosophy behind their respective proposals may be different, proponents for the proposals have cited the shift in the basis of U.S. economy from manufacturing to service provider and the need for modernization of the system as justification for the expansion of the sales tax base.

Currently, the imposition of sales tax in most states is limited to sales of tangible personal property and to a handful of selected services unless some exemption of exclusion applies.  Taxable services are usually identified by statute or are included in a state’s definition of “sale at retail.”  There are exceptions to this model.  States such as West Virginia, in addition to imposing tax on sales of tangible personal property, also tax all services (with exception of services classified as professional or personal), however, states following the West Virginia model are currently few in number.

As governors and legislators look for ways to sell the expansion of the sales tax base to voters, they often cite the shifting U. S. economy, implying that the shifting economy is resulting in less sales tax revenue and thus, the need exist to modernize and expand the tax base. 

But is this true?  Does a service based economy result in less sales tax revenue?

While we have definitely become more of a service-driven economy, we still purchase a lot of stuff (tangible personal property).  A quick look at our closets, garages, storage lockers and offices will probably confirm that as an economy, we still purchase and consume a lot of stuff.  Considering the necessity of electronic gadgets in today’s society, it is hard to believe that we purchase less stuff today than we did yesterday.  The main difference between today and yesterday is that a lot of what we are purchasing today is manufactured in other countries and not in the United States. 

As long as consumers continue to purchase products, in most cases, sales or use tax will be due and collected.  Currently, while there are issues with sales or use tax collection regarding some remote sales made via the internet and telephone, more and more remote sellers are collecting sales and use tax.

Furthermore, data from the U. S. Census Bureau appears to indicate that overall state tax collections of selected sales and gross receipts taxes between 2008 and 2014 have more than doubled.  A service based economy does not necessarily generate less sales tax revenue than a manufacturing based economy.  Reduced sales tax revenues are usually the result of a softening economy where consumers are purchasing less and is not necessarily related a shift in the base of the economy.

Furthermore, many experts tend to overlook that service providers generally have few, if any, sales and use tax exemptions, while most states have some type of exemption or reduced tax rate for manufacturers.  States with these types of exemptions enable manufacturers to purchase machinery and equipment, raw materials and other items free from tax or at a reduced tax rate.  Most service providers pay tax on all tangible personal property they purchase and consume in the performance of their services.  Generally, there are few, if any, exemptions that apply to service providers, with the exception of a resale exemption in some limited circumstances. 

Historically, states have resisted expanding sales tax to services due to sourcing difficulties and the possibility of tax pyramiding, where taxpayers essentially pay a tax upon another tax.  The resistance, however, appears to be eroding, and some states during the previous economic downturn added more services to their tax base.

Although, currently the economy appears stable, states and legislatures are facing difficult decisions regarding the funding of various programs while at the same time addressing the issue of underfunded state and local pensions. 

While there is a need and a number of valid reasons to modernize the sales and use system, the expansion of the tax base to services is more of an attempt to generate additional tax revenue to meet the escalating cost of state and local government than it is a valid attempt to modernize the system.  

Contact us with questions regarding the Ohio and Pennsylvania budget proposals, which include taxing most, if not all, services and read about the Schneider Downs State and Local Tax team's service offerings.