We know the story very well. Most services aren't subject to sales tax in most states. From a tax policy perspective, that's no good. The sales tax should fall on all final consumption -- preferably at a very low rate. So everything we buy should be subject to tax. There are several reasons for this. First, there is no economic or tax policy reason to tax the purchase of a toaster oven but exempt the purchase of a haircut or accounting service. They're both consumption. Second, exempting services narrows the base and results in higher taxes on everything else. Third, exempting services creates a government-led incentive to spend money on services over things that are taxable. But the tax laws shouldn't be used to mess with markets in that manner. Fourth, taxing services would make the system less regressive; rich people buy more services than poor people. Finally, the exemption in a service-dominated economy is very expensive.
Professional services have been exempt forever purely for political reasons. Lawyers, doctors, accountants, real estate agents, and bankers all wield power in the state capitols. In addition to lobbying and giving politicians money, they have the resources to master public opinion. Lawyers argue that taxing their services will undermine the Constitution. Real estate agents argue that taxation will destroy the American dream of homeownership. An undertaker once told me I was evil for suggesting that his services be taxed: "What kind of person wants to tax grieving relatives?" Every attempt to tax professional services in the past 20 years has failed.
So we're left with trying to tax nonprofessional services. States have had some success taxing haircuts, body piercings, lawn care, etc. That is understandable. After all, tattoo artists don't have a strong presence in the halls of the legislature. But taxing nonprofessional services has been challenging. Many are cash businesses. And the government needs a lot of resources to ensure compliance. Appliance and car repair tends to work because people use credit for those purchases.
In any event, there is no question that taxing services is good tax policy. California Sen. Bob Hertzberg knows this. The Democrat is one of the few political leaders in the country focused on the issue. He plans to reintroduce a bill in January 2016. A bill earlier this year didn't go anywhere because most politicians are like Custard the cowardly dragon on this issue.
Hertzberg's bill would be fairly comprehensive, capturing most services. Assuming no rate decrease, the bill would raise $10 billion a year. There were a few problems with Hertzberg's original proposal. It would have taxed business purchases of services. That is a different bad idea. Generally, business purchases should be exempt from tax. Hertzberg also failed to propose lowering the sales tax rate, which he should have done. No matter what, Hertzberg is in for a fight.
This is an excerpt of an article that first appeared in State Tax Notes.
Correction, September 25, 2015: Hertzberg's proposal to tax services would raise $10 billion if the tax was set at California's current sales tax rate of 7.5 percent. The $120 billion figure originally reported comes from a California Board of Equalization study requested by Hertzberg, which said a hypothetical 8.4 percent service tax could net the state approximately $122.6 billion.