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Taxing Services: A Step In The Right Direction


EDITOR'S NOTE: This post was co-authored by Christopher Thornberg

Much noise has been made over the years about California’s unfriendly tax environment. But an ongoing mantra at Beacon Economics is that California is not so much a ‘high’ tax state as a ‘dumb’ tax state. In other words, it is the structure of revenues that creates the problem, not simply the quantity being collected. This is important because it suggests that if we make certain logical changes to the structure of taxes in the state, it could simultaneously make California more business friendly while helping to cure the long-term deficit issues we still face – despite the current ‘balanced’ budget.

What constitutes a ‘smart’ revenue system? We would start with three basic principals:

  • Non-Distortionary: Taxes should be focused in places where they have a minimum possible impact on the functioning of markets. From this perspective the rule of thumb is small taxes on wide bases. It also means that taxes should be easy to collect.
  • Fairness: By this we mean that taxes should, in general, be progressively structured. But it also means that the tax burden is spread equally across individuals with roughly similar means.
  • Predictability: Governments need to plan ahead, and having steady revenue sources are a huge help in such a planning process. It also helps to limit the pain that is felt in years when the economy slows or contracts.

California fails miserably on all three of these tests.

Proposition 13, which has been in place since 1979, is hugely regressive and unfair – and forces the state to be highly reliant on very progressive income taxes. This, in turn, creates massive booms and busts in revenues on a year-to-year basis because of an over-reliance on taxes collected on capital gains. And sales taxes are lumped primarily on a small and shrinking portion on the spending base—goods—while the growing role of services in our world is completely ignored. Yet, with all of the talk about fiscal reform in the state legislature over the past few years, almost nothing has been done to deal with these core issues. Indeed when Governor Jerry Brown decided to close the deficit, he simply went to the well and raised sales and income taxes.

There is a glimmer of hope, however, as it looks like things may finally be about to change: A bill has emerged that will bring a little more sense to the state’s ungainly tax system. It’s a bill that will bridge a step toward reaching the important and increasingly necessary goal of smaller taxes on a broader base. In December, State Senator Bob Hertzberg introduced SB 8, the ‘Upward Mobility Act’, which would implement a sales tax on services for the first time. This is a huge move and something to support. Consider these basic advantages:

  • Senator Hertzberg’s bill moves the state along the path towards stable year-to-year tax revenue. Economic cycles don’t impact service purchases as much as they do capital gains. This implies that overall state revenues would be more stable.
  • Spending on services is a growing share of consumption for households. This implies that state revenues will keep up with growth in the economy.
  • The proposed tax on services is not a regressive tax, as some may believe. Quite the opposite, there is much to suggest that higher income households spend a larger share of their income on services than lower income households.
  • Service sales taxes are less distortionary inasmuch as is it difficult to buy a haircut or tax service from someone out of the state or country in order to avoid paying the sales tax.

There are other logical points in Senator Hertzberg’s bill. For example just as sales taxes are not collected on food or other basic necessities, health care and education services would also be exempt from the service sales tax. Lower-income residents would get some of their sales tax payments back as well, because the bill calls for $2 billion in funding from the tax each year to go toward refunds through the Earned Income Tax Credit. And in order to make sure that the bureaucracy charged with collecting service sales taxes does not impact micro-businesses, the bill exempts businesses that earn less than $100,000 in gross sales.

How much money are we talking? The bill suggests revenues as high as $10 billion per year, or more. Those monies would go a long way towards covering the loss of revenues from the end of Prop 30 and keep the state’s public K-12 education system sufficiently funded. It would also be logical to combine the service sales tax with further cuts to income taxes or a cut in the sales tax rate for goods. And ultimately this new tax vehicle will give local governments more ability to raise funds as needed.

Of course, we expect a furious backlash to begin anytime now. Every service sector is going to come up with their own logic as to why they should be exempted. Business climate advocates will howl about fleeing businesses and rich families. And, truly, it must be acknowledged that the state needs expenditure reform as much as it needs revenue reform—too much money is going to perks for special interests (of which the public unions are front and center) rather than to the basic needs of the citizens of California.

But the logic behind a sales tax on services makes good sense. And maybe, hopefully, this year, traction and political pandering in the state legislature won’t hold back meaningful tax reform.

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