Curing the Structural Defect in State Tax Systems: Expanding the Tax Base to Include Services - Timothy R. Hurley

• Citation: Vol. 61 No. 2
• Publication year: 2010

Curing the Structural Defect in State Tax Systems: Expanding the Tax Base to Include Servicesby Timothy R. Hurley^*

I. Introduction

"The state retail sales tax in America can be likened to an illegitimate child that was not wanted but that came anyway."¹ At least that is how one economist has described the sales tax. He went on to state, "Being unwanted is not really unusual and it is certainly no bar to normal growth. It is even possible for the illegitimate to gain respectability."² Apparently, the salex tax has gained respectability.³ Less than eighty years ago, there was no such tax in the United States.⁴ In 1932 Mississippi introduced what is the modern-day sales tax.⁵ Since then, forty-four states have enacted some version of a retail sales tax with Vermont the last in 1969.⁶ Today, there are five states without a sales tax: Alaska, Delaware, Montana, New Hampshire, and Oregon.⁷

Economists measure the respectability of the sales tax not only by its explosive growth, but also by the amount ofrevenue it contributes to the states.⁸ In 2008 states collected $240.4 billion in general sales tax, which was less than the $279.1 billion states collected in personal income tax.⁹ If selective sales taxes are included, however, the total sales tax is $357.3 billion, far exceeding the personal income tax.¹⁰ Beyond that, from the states' perspective, it is a relatively easy tax to administer because vendors collect the tax from consumers and then remit the funds directly to the state.

The sales tax, however, is not without its issues and nuances. For example, in New York, consumers pay the sales tax "on the purchase of baseball tickets, Prell shampoo, non-sterilized cotton' [sic] and hot nuts, but not on the purchase of Broadway tickets, Head & Shoulders shampoo, sterilized cotton, or cold nuts (until recently, large marshmal-lows were taxable whereas small marshmallows were exempt)."¹¹ Probably one ofthe most peculiar characteristics ofthe sales tax is that states, for the most part, exclude services from the sales tax.¹² For example, states generally charge sales tax for the purchase of a lawnmower but not a lawn service. Likewise, they charge sales tax for laundry detergent and movies purchased at a store but not laundry services and Pay-Per-View movies watched at home.

When enacting the sales tax, states excluded services from taxation largely because, in those times, goods dominated the economy.¹³ Times have changed. Services now dominate the economy,¹⁴ but states still do not tax services to a wide extent.¹⁵ This structural defect in state taxing systems causes a substantial gap between needed revenue and actual revenue. This Article explores the sales tax, its history, and its structural defect. The Article advocates expanding the tax base to include services to cure the structural defects in state taxing systems.

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II. Sales Tax

A. In General

In 2008 states collected $240.4 billion in sales tax, not quite the $279.1 billion states raised from the state personal income tax.¹⁶ The margin between these revenue producers, $38.7 billion, is considerable and has been growing in recent years. For example, in 2007 state sales tax yielded $238.0 billion while the personal income tax yielded $265.7 billion—a difference of $27.7 billion.¹⁷ Likewise, there was a considerable difference in 2006 when the state sales tax provided $229.6 billion while the personal income tax provided $293.1 billion—a difference of $63.5 billion.¹⁸ This, however, has not always been the case. In fact, 1998 was the first year in the last half-century when the state personal income tax exceeded the state sales tax.¹⁹ In 1997, for example, the sales tax yielded $147.4 billion while the personal income tax yielded $145.0 billion.²⁰ The sales tax regained its status as the largest source of state tax in 2003 and 2004 but has not held that position since that time.²¹

Table 1 presents the sales tax yield by state for 2008. On average states realized about 30.8% of their tax revenue from the sales tax.²² Their reliance, however, varied. States without a personal income tax rely heavily on the sales tax;²³ including Washington (63.2%), Florida (60.0%), Tennessee (59.2%), South Dakota (55.4%), Nevada (50.3%), and

Texas (48.5%).²⁴ Wyoming, however, has no personal income tax and raised only 34.3% of its tax revenue from its sales tax, but Mississippi, a state that has a personal income tax, raised 47.4% from its sales tax.²⁵

Generally, "[s]tates in the Northeast rely less on the sales tax than do those in the West."²⁶ For example, compare New York (17.3%), Massachusetts (18.8%), and Vermont (13.3%) with Arizona (46.9%), Idaho (36.9%), and New Mexico (34.4%).²⁷ One commentator notes that

[t]here is no ideal mix of taxes that could, or should, be prescribed to states; the mix in any given state is a product of peculiarities of the state's economy, choices in the design of particular taxes to be broad or narrow, and the history of politics of each state.²⁸

There are, however, some certainties among the state sales taxes. For example, states receive large amounts of revenue from sales taxes that have relatively low statutory rates, enjoy a relatively low administrative burden because the collection and remittance by vendors is simple, and face little public objection.²⁹

Table 1: Sales Tax Yield by State for 2008³⁰

Tax Revenue from Sales Tax (in Thousands of Dollars)	Percentage of Total Tax Revenue
Alabama	$2,285,892	25.2%
Alaska	-	0%
Arizona	$6,428,114	46.9%
Arkansas	$2,809,063	37.3%
California	$31,922,464	27.2%
Colorado	$2,310,000	24.0%
Connecticut	$3,181,584	23.8%
Delaware	-	0%
Florida	$21,510,000	60.0%
Georgia	$5,800,377	31.9%
Hawaii	$2,619,823	50.9%
Idaho	$1,347,588	36.9%
Illinois	$7,940,859	24.9%
Indiana	$5,742,660	38.5%
Iowa	$1,840,164	26.7%
Kansas	$2,262,560	31.6%
Kentucky	$2,876,016	28.6%
Louisiana	$3,455,256	31.4%
Maine	$1,071,462	29.1%
Maryland	$3,752,956	22.6%
Massachusetts	$4,105,168	18.8%
Michigan	$8,227,624	33.2%
Minnesota	$4,543,608	24.8%
Mississippi	$3,136,932	47.4%
Missouri	$3,223,710	29.4%
Montana	-	0.0%
Nebraska	$1,532,225	36.7%
Nevada	$3,076,348	50.3%
New Hampshire	-	0.0%
New Jersey	$8,909,547	29.1%
New Mexico	$1,952,200	34.4%
New York	$11,314,200	17.3%
North Carolina	$5,262,411	23.1%
North Dakota	$529,448	22.9%
Ohio	$7,859,452	29.8%
Oklahoma	$2,095,548	24.7%
Oregon	-	0.0%
Pennsylvania	$8,866,224	27.6%
Rhode Island	$847,627	30.7%
South Carolina	$3,052,255	36.1%
South Dakota	$731,834	55.4%
Tennessee	$6,830,496	59.2%
Texas	$21,667,860	48.5%
Utah	$1,961,850	33.0%
Vermont	$338,352	13.3%
Virginia	$3,663,192	19.9%
Washington	$11,341,240	63.2%
West Virginia	$1,107,533	22.7%
Wisconsin	$4,270,187	28.3%
Wyoming	$743,624	34.3%

B. Fundamentals of the Sales Tax

The retail sales tax varies from state to state in its statutory scheme and its terminology.³¹ The various sales tax statutes, however, have a similar theme. States generally design the sales tax to be a uniform tax that applies to a wide range of personal consumption expenditures.³² In addition, the sales tax should shift to the ultimate consumer and apply to the amount actually paid by that consumer.³³ This shift underscores the sales tax's underlying philosophy of "distribut[ing] shares of the costs of government according to consumption expendi-ture."³⁴

Professor John Due describes these rationales as follows:

If a sales tax is to be a truly general consumption tax, it should apply to all expenditures for personal consumption purposes but not to any transactions involving use in business activity. Exclusion of any personal consumption purchases favors those persons with disproportionate expenditures on these goods, leads to economic distortions by shifting purchases and production from taxed to untaxed goods, reduces revenue at given rates, and, as is well-known, complicates compliance and administration. Inclusion of purchases for production purposes is contrary to the philosophy of the tax, results in haphazard and uncertain distribution of the tax burden, affects choice of production processes, and, from a state's standpoint, may adversely affect economic development.³⁵

Inherent in Professor Due's description of the sales tax is the concept that not all sales should trigger a tax.³⁶ Under the sales tax, the focus on consumption means that states should exempt from the sales tax any purchases by a business, even the prosperous ones.³⁷ Nevertheless, an empirical study by Professor Raymond Ring indicated that the average state's sales tax comprised 59% sales to households and 41% sales to businesses.³⁸

The structures of all retail sales tax statutes at a minimum apply to tangible personal property, unless specifically exempted.³⁹ The usual practice ofthe sales tax statute is to sweep all sales into the "retail sales net" and then to exclude specific transactions.⁴⁰ Most sales tax statutes, therefore, define a retail sale as "a sale of tangible personal property for any purpose except for resale."⁴¹ The definition of retail sale, therefore, eliminates inventory from taxation, and inventory is a major class of sales to businesses.⁴² The statutes also define tangible personal property generally as "personal property that may be seen, weighed, measured, felt, or touched or which is in any manner perceptible to the senses."⁴³

Probably the most important definition that a retail sales tax statute provides is that of a sale. The occurrence of a sale is the only transaction that triggers the tax.⁴⁴ States typically use a similar definition of...