How the sales tax is failing Washington's schools

Taxing services could deliver us from our education woes.
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Taxing services could deliver us from our education woes.

As the Legislature continues its search for revenues to fund basic education, it might consider extending the sales tax to currently exempt services. Numerous personal and professional services are exempt from taxation simply because they have never been included in the tax base.

The Revenue Act of 1935 ignored services in part because the economy at that time largely involved the production and sale of tangible goods. Since then, some services have been added to the sales tax base. Most recently, the 2013 legislature added telephone services: cell phones, home land lines and coin-operated phones.

The number of services currently taxed is larger than one might guess, but is less than those that are either implicitly or explicitly exempt. A 2007 survey of state taxation of services by the Federation of Tax Administrators found that Washington state taxed 78 services at the full state rate (6.5 percent) while 97 were not in the tax base and thus were untaxed. Another 8 services were exempted.

The FTA data indicates that Washington, in fact, taxes more services than most states. But numerous inconsistencies are apparent. Auto storage is taxed while fur storage is exempt. You pay a sales tax at a tanning parlor, but not at a massage parlor. Hiring a fishing guide is taxed, but a golf instructor is not. If you pay someone to install a sign on your business you will be taxed. But not if you advertise on a billboard. Video rentals are currently subject to retail sales tax, but movie theater tickets are exempt.

The Department of Revenue provides a listing of services subject to the retail sales tax in four categories: construction, recreation, personal, and miscellaneous. Data provided by the Department to the author indicates that services in fiscal year 2013 generated $1.2 billion, or about 15 percent of all sales tax collections.

The department’s 2012 tax exemption study estimates that the state could collect $3.76 billion in the current biennium (2013-2015) if the implicit exemptions were repealed.

The shift of the American economy from tangible personal goods to services was identified more than 50 years ago. In 1968 economist Victor Fuchs observed that half of American jobs were in services.

Since then, the growth of the service sector has been inexorable. The federal Bureau of Labor Statistics, which tracks consumer spending, summed up the shift over the 30 years from 1982 to 2012 in an article earlier this year:

 There has been an increase in the total quantity of services at the expense of commodities — a shift primarily due to an increase in the quantity of shelter, in particular owner-occupied shelter. There has also been a considerable increase in the quantity of 'other services' (a residual category not including shelter, transportation services, medical care services, and energy services)…

Services now account for almost two-thirds of Americans' out-of-pocket spending. In states, including Washington, that are highly dependent on the sales taxation of consumer goods, this has had a profound effect on tax revenues.

The state’s Economic and Revenue Forecasting Council tracks taxable sales relative to state personal income, and forecasts that the measure will continue on a downward slide in Washington at least through 2019. (See chart below.)

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Source: Washington State Economic and Revenue Forecast, June 2014, page 52.

The reasons for the decline in sales tax revenue include several factors in addition to spending on untaxed services: the growth of untaxed online sales, the increase in income inequality and, rather counter-intuitively, the reduced price of many consumer goods.

Online sales continue to grow as a percent of all sales. The Department of Revenue estimates that the state would gain almost $500 million in the next biennium (2015-17) if Congress passes the Marketplace Fairness Act, which would require all online sellers to collect sales tax even when the seller has no physical nexus in the state.

Income disparities contribute since low to middle income households spend a larger percent of their income on necessities than do higher income households. And, as a Standard and Poor’s report recently indicated, there are now fewer medium income households after adjustments for inflation. Affluent households are experiencing growing incomes, but they tend to spend more on untaxed services and they save more.

The import of inexpensive goods from China has also contributed to the shift. It has allowed consumers to spend less on tangible personal goods and more on basic services such as rent and medical care.

The slide is also reflected in Washington's ranking on the tax collection versus personal income index. In 2011, the state fell to 35th as measured by state and local tax collections per $1000 of personal income. If Washington had been at the U.S. average of $108 instead of $99, it would have collected an additional $1.6 billion in 2011.

All services should be candidates for taxation.

For Washington state legislators, a starting point is to investigate previous attempts, both successful and failed, to tax services. The DoR exemption report indicates that successful efforts were mounted in several sessions starting in 1939 and it’s possible that legislation was introduced, but not adopted, in other years as well.

An historical study might uncover why some services were considered for taxation while others were not. A cursory look by this author did not turn up reasons for the services that were added to the tax base in 1993 (landscape maintenance, professional sport events, guided tours and a number of personal services, including physical fitness and tattoos).

The added services were part of a larger tax measure that passed on party line votes in both houses. But it’s not clear that the services that were added contributed more to the partisan debate than did other aspects of the bill.

There will be a need for a process that provides an opportunity for stakeholders to comment both for and against continuation of these tax breaks. And both the Joint Legislative Audit Committee and the Citizen Commission for the Performance Measurement of Tax Preferences should review the exemptions retained.

Service taxation has been an issue in discussions regarding the taxation of the state’s businesses. The Washington State Tax Structure Study Committee, the last group to investigate the state’s tax structure in detail, pointed out in its 2002 report that the taxation of services can lead to the pyramiding of the B&O tax. In other words, taxing a professional service such as engineering design that is necessary for the production of a product can cause a tax to be paid on an earlier tax.

The committee recommended that such pyramiding be eliminated by changing from a tax on gross sales to a value added tax (VAT). Short of that, it recommended that taxing services should be incremental.

There are probably other reasons for a careful approach to services taxation. Services such as legal advice are purchased by governments, so taxing it would simply move revenue from one government pocket to another. Then there is the question of tax regressivity and fairness. Perhaps some services in the medical category should remain exempt since they contribute to the public good, as does the exemption of prescription medicine from the sales tax.

Taxing personal and professional services will not be an easy exercise, nor will it greatly improve the state’s tax structure. But it will shore up the eroding sales tax base and contribute needed revenues for education. Legislators will have to determine whether it meets the Supreme Court’s McCleary mandate for tax sources that are “regular and dependable”.


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About the Authors & Contributors

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Dick Nelson

Dick Nelson is a former Washington State legislator. He currently contributes to the public debate on state and local fiscal issues through research and commentary. As when he was in the legislature, he prefers the Democratic Party.