Proposals to Expand the Sales Tax, Not as Simple as it Sounds!
Things are moving as expected in the Kentucky General Assembly. The Governor recently presented his 2010 – 2012 budget proposal last week. Legislators are now working on their own budget proposal, and there is much speculation about what their proposal will be. All budget proposals will involve tough decisions since revenue for the two-year period is expected to be somewhere between $750 million and $1.5 billion less than anticipated.
One idea floating around is the expansion of Kentucky’s sales and use tax to include various specified services. Since it is unusual for states to tax services, these proposals are controversial.
The Kentucky Society of Certified Public Accounts (KyCPA), with the support of CPAs around the state, has voiced opposition to the expansion of the Kentucky sales tax to cover previously untaxed services because, generally, they tax business-to-business transactions. In addition, several years ago, the American Institute of Certified Public Accountants (AICPA) studied this topic and reached the same conclusion:
“The AICPA generally opposes the imposition of sales and use tax on services, including professional services. This opposition is based on the unique situations that arise in the creation and delivery of services, which are not suited to the imposition of a traditional sales tax.”
A broad-based tax on services would represent a massive shift in Kentucky tax policy and, as such, requires careful study. We agree with the KyCPA’s recommendation that the Legislature allow sufficient time for input from the Department of Revenue, CPAs, businesses, chambers of commerce, researchers, academia and ordinary citizens.
It’s Not That Simple!
Proposals to expand the sales tax to include services seem rather simple and straightforward, but they are not! Applying the sales tax to services is very complicated. Here are what we believe are the key considerations, based on the KyCPA’s recent analysis:
Sales Taxes In General
Ideally, the sales tax should be structured so that it taxes all personal consumption (i.e., consumption by individuals) at the final retail stage. Consistent with this principle, sales tax should not be imposed on business inputs because they are part of the cost of a final product that will be subject to sales tax (unless, of course, the Legislature has specifically decided to exempt those products from sales tax).
But don’t individuals buy services too? Yes, but while individuals are the primary consumers of some services (dry cleaning, lawn services, limousines), most are purchased by businesses (legal, accounting, computer consulting, call centers, etc.). So, consistent with the basic principle underlying sales taxes, if business inputs are exempt from the sales tax just like raw materials and employee labor, then many business services should be as well.
Sales Tax Exemptions
For various political and economic policy reasons, many transactions that would otherwise be subject to sales tax have been exempted. Every state has exemptions for certain types of business inputs (for example, machinery, raw materials, component parts, packaging, purchases for resale, etc.) that eliminate some of the adverse effects of taxing them.
Sales tax exemptions in Kentucky law have been quantified in a report by Kentucky’s Office of the State Budget Director. According to the 2008-2010 report, in the state’s fiscal year (FY) ending in June 2007, the sales tax generated $2.8 billion. In FY 2008 and 2009, the sales tax generated $2.9 billion dollars in each year. Had there been no exemptions, the sales tax would have generated $2.3 billion more in FY 2008. Of that total, 67% (about $1.6 billion) was attributable to the exemptions for:
Food items
Prescription medicine, devices and physical aids
Non-profit, educational, charitable and religious institutions
Labor charges in connection with the installation of taxable property
Residential utilities
In addition, some proposals target another important and sizeable Kentucky exemption for industrial supplies that is not covered in the Budget Director’s Report and is important to manufacturing businesses in Kentucky. The elimination of the single exemption for industrial supplies would raise at least $200 million more from Kentucky’s manufacturers. This exemption is significant because of the amount of money involved, and the surrounding states generally do not impose sales tax on industrial supplies. Click here for a complete list of sales tax “Tax Expenditures” in the report.
Arguments In Favor of Eliminating Existing Sales Tax Exemptions:
- The sales tax should apply equally to all similar transactions; current law has many inconsistencies. For example, food purchased from a grocery for home consumption is exempt, yet food purchased in a restaurant and food prepared for home consumption are subject to sales tax.
- The sales tax should apply to all consumption. Thus, the tax burden would be spread evenly among taxpayers based on their consumption. After all, the sales tax is, in many situations, a voluntary tax. For example, sales tax on a TV is incurred only when you buy a TV and the more expensive the TV, the higher the tax.
- The political or economic reasons for many sales tax exemptions no longer exist.
- The state needs the money to meet its financial obligations and maintain the current level of services.
Arguments In Favor Of Retaining Existing Sales Tax Exemptions:
- Certain exempt transactions are appropriate because the sales tax is a “regressive” tax, meaning lower income individuals pay a higher percentage of their income on sales taxes than higher income individuals. Additionally, tax should not be imposed on an individual’s basic needs.
- Most people would agree that taxable products should be subject to tax only one time – when the product is purchased for consumption by the final consumer. For this reason, a retailer’s purchase of inventory is exempt from sales tax because it is purchased for resale, not consumption. Otherwise there would be a tax on a tax – the pyramiding of taxes, so to speak. For example, raw materials purchased by a manufacturer and supplies purchased by a farmer are exempt from tax because they will become part of a potentially taxable product. Many exemptions are consistent with the theoretical basis that sales tax is a tax on items purchased by the final consumer. So business inputs are appropriately exempt, thereby, avoiding double taxation and the pyramiding of tax.
- Exemptions are important economic incentives that tend to attract new business or protect important Kentucky industries. This is part of the reason for exemptions from which the equine industry benefits.
Arguments In Favor of Not Taxing Services:
- Businesses purchase the largest amount of most services. Imposing the tax on business consumption causes a pyramiding of the tax; that is, tax is paid on an item or service that has already been taxed at an earlier stage of production. Pyramiding is not only inconsistent with the notion that a retail sales tax should be a single-stage levy on final consumption, but most importantly, it means that the total tax on any one product or service will be dependent on the number of times tax has been paid on inputs at earlier stages of production.
- Most states do not tax the services that are targeted in many proposals. This would cause a negative impact on Kentucky’s economic development efforts because Kentucky businesses and residents would be at a 6% competitive disadvantage for services that could be provided in any location. These include call centers; computer repair activities; and advertising, legal, accounting and consulting services. This would encourage jobs to shift outside Kentucky, especially to bordering states, which is important because a large percentage of Kentucky’s residents and businesses are in border communities.
- Independent service providers would immediately be at a 6% disadvantage compared to businesses that obtain the same service from employees. For this reason, business expansion would be impeded, business employment opportunities would be reduced and small businesses would be disadvantaged.
- Compliance and enforcement. On the surface, proposals to expand the sales tax to include services can appear to be simple and straightforward, but, closer examination uncovers many complicated issues and questions.
For example, some services can be created in, delivered from and used in multiple states. Does Kentucky have jurisdiction to tax out-of-state service providers? Which services does Kentucky have the jurisdiction to tax? What about other states? Will Kentucky tax services (1) created in Kentucky regardless of whether the beneficiary of the service is in Kentucky or (2) only services for which there is a benefit from the services in Kentucky, regardless of where they were created? Can it? Also, the provision of services often requires sub-service providers. What about an exemption for sales of services for resale?
Numerous administrative complexities are also involved with the taxation of services. The Department of Revenue will need to educate potential new service provider taxpayers about their new tax obligations. Service providers will need time to register with the Department and acquire the capability to comply with their new tax obligations.
There are also policy complexities. Which current exemptions will apply to services? What about services consumed in the manufacture of tangible personal property? Shouldn’t these be exempt like materials incorporated into finished products? What about definitions of taxable services? How will service providers know that their services are now subject to tax?
- Economy of Collection. The costs to collect a tax should be kept to a minimum for both taxpayers (compliance costs) and the government (administrative costs).
Does Kentucky’s Tax Policy Affect Behavior?
When considering changes in Kentucky’s tax laws, perhaps the aspect that is the most difficult to evaluate is how changes in tax policy affect personal and business behavior. Undoubtedly, higher taxes do affect individual and business decisions, including not only where goods and services are purchased but also where individuals and businesses reside. Fortunately for us all, individuals and businesses have many choices.
Action needed?
At this point, we believe that expanding the sales tax, eliminating exemptions and comprehensive tax reform are not seriously being considered for implementation in this session of Kentucky’s General Assembly, but we are still skeptical. You never know what might happen as the session winds down in March, and the pressure to balance the budget increases.
In addition, most people believe that these proposals will be discussed in the future, perhaps after the November elections or in the 2011 meeting of the General Assembly.
If there are proposals that seem to have political viability, we will send an alert so you can make your opinions known.
If you are one of those odd people who really like digging into the details, we would be glad to provide copies of the following:
“Position Paper Opposing Sales and Use Tax on Services”, American Institute of Certified Public Accountants, February 6, 2004.
“Tax Expenditures Analysis, Fiscal Years 2008 – 2010”, Commonwealth of Kentucky, Office of State Budget Director.
“Sales Tax on Business Inputs, Existing Tax Distortions and the Consequences of Extending the Sales Tax to Business Services”, Council on State Taxation, January 25, 2005.
“Report to the Sub-Committee on Tax Policy Issues to the Committee on Appropriations and Revenue”, Kentucky General Assembly, William F. Fox, Professor of Economics and Director of the Center for Business and Economic Research, the University of Tennessee. This report is sometimes referred to as “The Fox Report”.
Updated through February 18, 2010