New Economy Stumping State Sales Tax Systems

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By Jennifer McLoughlin

It’s inevitable that states will need to modernize their sales tax systems, a leading tax analyst says.

“If sales tax is going to continue to be an important revenue source for states, and all signs are that it needs to be and will continue to be, it needs to keep up with the economy,” Joe Henchman, Tax Foundation vice president of state and legal projects, told Bloomberg BNA. “And, eventually it’s going to be so out of sync with our service-based economy, that every state is going to have to do it.”

In a Feb. 10 report, the Tax Foundation detailed deficiencies with states’ sales tax structures and proposed repairs, including broadening the sales tax base to incorporate services, eliminating exemptions for select consumer goods and carving out business-to-business transactions from the base.

States are increasingly scrutinizing systems that are remnants of an economy dominated by transactions of tangible goods—and out of sync with an economy increasingly centered on intangibles and services. However, politics, public pressure and uncertainty over the revenue impact can stifle efforts to reshape sales tax regimes.

Marketplace Metamorphosis

While historically a steady stream of revenue for states, sales tax yields have taken a hit as the modern marketplace has shifted away from local, goods-based sales to more interstate, services-based transactions.

Joe W. Garrett Jr., Alabama’s deputy co-commissioner of revenue, told Bloomberg BNA that a Department of Revenue presentation before a legislative committee highlighted a 50-year decline in the state’s sales tax revenue. Whereas sales tax revenue was once twice the size of income tax revenue, income taxes now outpace sales taxes by 50 percent—where the state once captured $2 in sales tax revenue for every $1 of income tax revenue, it now generates $3 of income tax for every $2 of sales tax.

“Legislatively, the rates are the same,” Garrett said. “And, legislatively, no fundamental changes to the base. But the big change to the base that has come has been changes through the economy” and a movement away from traditional tangible personal property (TPP) to intangibles and services.

Sweeping in Services

According to the Tax Foundation’s report, “services now represent approximately two-thirds of consumption, and largely go untaxed by state sales taxes.” Hawaii, New Mexico and South Dakota are general exceptions, with systems that sweep in services.

Moving wholesale from a sales tax structure that carves out services to a system that captures services would likely be an uphill battle in states. Rather, the transition may be a crisis-triggered response or incremental expansion.

“You could have a state that’s in such a dire situation that it’s the least bad alternative, and it overcomes the individual opposition you have from all the represented industries,” Henchman said, noting that the Illinois governor has discussed broadening the sales tax base, which may be a better alternative to raising already high property or business taxes.

On the other hand, as part of its 2014 tax overhaul efforts, the District of Columbia expanded its sales tax to gym and yoga studio memberships. The move created some controversy, but as Henchman explained, the measure passed with proponents advocating that it wasn’t an industry-specific penalty but a correction of a historical accident allowing an exemption.

However, wholesale adoption of a sales tax structure that captures services may be possible—particularly if taxpayers don’t feel targeted and detect some benefit in return.

“Either the whole rate is reduced,” Henchman said, “or we significantly reduce this other tax. Or we’re able to pay for this thing that everybody wants. If people can view this as a benefit being worth the cost, people can be non-parochial and be willing to give up their little deduction. It’s really hard to do, of course.”

State-Specific Strategies

“The proper solution is to broaden the sales tax base to include services, and use the revenue from that base broadening to lower the sales tax rate, or the rates of other more economically-damaging taxes,” according to the Tax Foundation’s report.

As with all revenue strategies, the ultimate approach will be state-specific.

The District of Columbia’s tax overhaul package utilized the sales tax expansion in part to increase the standard deduction on the income tax, lower the income tax rate on middle-income earners and lower the business tax rate, Henchman said.

“If you have a large package and you don’t want every single piece of it to be rate reducing, this is a way to generate additional revenue, reduce sales tax inequity, and make sure your sales tax grows better with the economy going forward,” he said.

However, the District of Columbia’s approach may not work for others.

For example, Henchman noted that Nebraska is mulling a proposal to expand the sales tax over 12 services, with the trade-off of funneling some revenue to reduce the individual income tax rate.

Leave Income Tax Rates Alone

However, not all state choices on trade-offs may be welcomed.

Michael Mazerov, with the Center on Budget and Policy Priorities, told Bloomberg BNA that base broadening to reduce the sales tax rate is a positive change—but using the revenue from a broader sales tax base to offset reductions in personal and corporate income tax rates presents risks. This plays into the overall trend of cutting personal and corporate income taxes, “which inevitably forces greater reliance on sales taxes, and we think that’s a bad thing.”

“It worsens the overall distribution of state and local taxes, and it creates a real problem in terms of this sustainability of the revenue structure,” said Mazerov, a senior fellow with the center’s State Fiscal Project. “Because when a situation where more and more income is going to the wealthiest share of the population at the same time that you’re reducing the income taxes at the top, it means that the revenues are not going to keep up over time with the cost of providing services.”

The center likewise doesn’t support capturing all services within the sales tax base, such as health-care purchases that are largely non-discretionary. But, as articulated in a 2009 report, the center has advocated for states to levy taxes on household services to raise revenue and improve tax policy.

“I would encourage states that are facing budget gaps to seriously look at broadening their base to services to raise some of the revenue to close the gap,” Mazerov said. “And all I would urge along with that is that they use some of the revenues from the base broadening to offset the impact on low income households by either enacting targeted credits to offset sales taxes, as some states have done, or at the very least, use some of the incremental revenue to increase or put in place earned income tax credits at the state level that would have the same effect of offsetting the higher taxes on low income households.”

Slow Transition

Ultimately, the path to a broader tax base is often mired in politics and public resistance.

Mazerov explained that since his 2009 report, only a handful of states have broadened the base to any notable degree, such as New Jersey and Minnesota. Maine and Maryland took steps toward broadening but then reversed course. And North Carolina channeled revenue from base broadening to offset losses from deep cuts and reductions in the top rates of personal and corporate income taxes—which the center doesn’t support.

“Experts have been talking about the need for states to broaden their sales tax to services for 30 to 40 years, and the fact that it hasn’t happened is indicative of how politically difficult it is to do,” Mazerov said.

Service providers have long enjoyed a pricing advantage over retailers that peddle goods, and they fight fiercely to maintain that advantage, Mazerov added.

Favoring Select Services

Forces beyond politics may also play a role in the resistance to capturing services in the sales tax base.

In Alabama, for example, Garrett said that the efforts at sales tax expansion haven’t centered on traditional personal services, such as health care and education. And while these services have surged in the new economy, lawmakers may hesitate to target what could be considered “favored services.”

“There is this movement to a protected class of services,” Garrett said. “And it’s not just protected because of some non-substantive political reason. I think there are substantive reasons why health care and education are favored. Not to mention that the government pays most of the money behind education and health care, so in some ways, you end up with the government taxing itself.”

Targeting Digital Transactions

Officials in Alabama, like those in many states, are engaged in discussions over digital taxation—and recovering revenue from digital transactions that replaced traditional transactions once taxable, such as movie rentals and book sales. However, lawmakers also harbor reservations with folding these new economy transactions into the tax base.

“The politics are difficult because most politicians are starting from a position saying, I don’t want to increase taxes,” Garrett said. “But by maintaining the status quo, they are actually decreasing taxes. And, I think that’s a difficult message for them to one, digest, and then two, for them to try to take back to the public.”

Resistance may also arise out of challenges over identifying the tangible counterparts to the digital transactions and determining whether a transaction should be subject to tax at all. Garrett noted that streaming services have replaced a taxable transaction of renting movies, but in some ways also replaced television that is traditionally free or untaxed. Likewise, Spotify is replacing CD sales, but may also be replacing radio.

“So you have these new product or service categories that are replacing both TPP transactions that used to be taxed, and things that were services and outside the tax base,” Garrett said. “So, it really makes it difficult to use the past as a guide, as to how to treat them going forward.”

One Piece of Problem

In the meantime, litigation is pending over Alabama’s economic nexus regulation, Administrative Rule 810-6-2-.90.03, which requires remote retailers with more than $250,000 of in-state annual sales to collect and remit sales tax. The administrative measure was designed, in part, to fuel a challenge to the U.S. Supreme Court’s 1992 rule in Quill Corp. v. North Dakota, 504 U.S. 298-forbidding states from imposing sales tax collection obligations on remote retailers without a physical presence in-state.

Reaching for revenue from out-of-state vendors does address part of Alabama’s eroding tax base. But Garrett said the larger part of the problem, and the more difficult one to address, is the swapping of TPP transactions for new economy transactions of services or intangibles.

The Quill restraint, in some ways, is easier to address because it boils down to collecting tax that’s already due, Garrett said. However, taxation of digital goods and services raises questions about whether the transaction should be subject to tax—for lawmakers, it’s a difficult vote to tax a transaction that hasn’t been taxed, even if it’s replacing a product or service that was historically taxed.

And, just like the federal limitations in Quill, the modern economy is also subject to comparable constraints. For example, revenue from Alabama’s mobile telecommunications services tax, which covers cellphones, has fallen over several years. An increasing portion of cellphone bills is attributed to internet access, which states can’t tax under federal law.

“So, again, there is something that used to be taxable that is being replaced by a slightly different product or service, and here we bump up against federal restrictions that don’t allow us to tax that,” Garrett said.

To contact the reporter on this story: Jennifer McLoughlin in Washington at

To contact the editor responsible for this story: Ryan C. Tuck at

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The Tax Foundation report is at

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