Tax Analysts Blog

Don't Be Fooled -- Services Should Be Subject to Sales Tax

Posted on Sep 23, 2015

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.

Read Comments (10)

edmund dantesSep 22, 2015

Interesting that this proposal is in California, which is already notorious for
the odd exemptions in its sales tax on goods. Definitional problems are what
undermine a sales tax on services. Everyone knows what goods are, not everyone
will agree on what a service is.

I paid my monthly health care insurance premium. Sales tax? What service did
I consume?

I went to the doctor for a checkup, which cost $300. I had a $50 co-pay, my
health insurance picked up the rest. Sales tax applies to which figure, my
out-of-pocket or the value of the doctor's compensation? What if his "list
price" for a checkup is higher than the negotiated fee with the insurance
company? Highest price prevails?

I had a $100,000 operation. Sales tax? What if it was covered by insurance?
Does the state send me a sales tax bill?

I paid my property taxes. Sales tax? Yes, if you life in CT as I do, and have
leased business property. I don't see what the service was.

Professional fees are, in general, fully subject to income tax. To impose a
sales tax on those same fees feels like double taxation to most people. Sure,
the professionals use their influence to resist the tax, but their arguments
are persuasive because sales taxes on professional fees seems like government
overreach, naked greed. Plus, most people are poorer than the professionals
who serve them. They tend to think, "Why am I being hit with a sales tax, why
not tax the rich doctor or lawyer if the state needs more cash?"

Resisting sales taxes on professional fees may be less cowardice and more smart

edmund dantesSep 23, 2015

I agree with AMTbuff completely.

Also wanted to mention, sales taxes usually don't apply to "essentials" such as
food. What "essential" services would have to be exempted from the sales tax?
Certainly medical services, no one wants to consume those until they are truly

In terms of taxpayer psychology, I can avoid paying sales tax on a new car
purchase by delaying my purchase or switching to public transit or buying a
used car. If I decide to buy the new car, I can plan my purchase for a time
when I have enough cash to cover the tax. I have some control.

Not so with medical services, this will usually be an urgent and profoundly
unpleasant and unplanned moment in my life. Why is this good time for the state
to put its hand out? Because I'm defenseless?

david brunoriSep 23, 2015

AMT and Edmund, I usually agree with you guys. But in this case, not so much.
That service providers are subject to income tax is besides the point. The
sales tax is supposed to fall on the buyer -- not the provider. We are not
penalizing anyone except the poor consumer. Ideally, I would tax services and
radically lower the rates on all consumption. Edmund, you are right about the
politics though.

AMTbuffSep 23, 2015

David, do you agree with my point that a sales tax on services would result in
a heavier total tax burden on services than products? Products have input costs
which are not taxed, whereas the input costs for services, including what the
employee spends on education, commuting, and even survival, are heavily taxed.

Economists seem to agree, and then forget, that most employee expenses should
be deductible when measuring true economic income. This becomes more important
when comparing taxation of goods to that of services.

If we are proposing to tax services just like goods, then let's be consistent:
Depreciate education expenses in full, allow deduction of commuting, image
enhancement expenses and a pro-rata share of living expenses (hours worked as a
fraction of waking hours). Once that is done, go ahead and apply sales tax to

By the way, what is the rationale for not charging an employer sales tax when
the employer purchases the services of an employee?

david brunoriSep 23, 2015

AMT, the tax burden on service providers is in my opinion irrelevant. The issue
is not that service providers get screwed by other taxes. The issue is whether
we should tax some consumption and not others.
The tax is paid by the consumer. That being said, I agree that employee
expenses should be deductible! But that is an income tax thing.

AMTbuffSep 24, 2015

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

The toaster is not already being taxed on an amount approximating your purchase
price. The service provider is. That's the crucial difference.

Taxing services would penalize them relative to products, because products are
taxed at lower corporate rates and on only the relatively small portion of the
price that is profit.

vivian darkbloomSep 24, 2015

"Products have input costs
which are not taxed, whereas the input costs for services, including what the
employee spends on education, commuting, and even survival, are heavily taxed."

Not sure I'm following this. The same issue is faced for the "input costs" of
an *employee* working for a manufacturer as for a service provider. Not even a
VAT system is going to solve that "problem", even if it is a problem, and I'm
not sure that it is. All the input costs of a manufactured product are subject
to sales tax at the point and time of sale to the consumer. David correctly
notes that the consumer incurs the charge in either case.

edmund dantesSep 25, 2015

"That service providers are subject to income tax is besides the point."

Have to disagree with you on that. On a theoretical level, I understand what
you are saying. As an academic matter you are correct. But on a practical
level, back in the real world, few ordinary taxpayers will concur. They tend
to think that "consumption" means that something will be consumed. You know,
like food. When I get a haircut, in the ordinary sense of the word nothing is
consumed, I just leave with less hair. The transaction is fully taxed when the
barber pays an income tax, there's no need for the transaction to be taxed a
second time with a sales tax. Unless you are greedy.

In contrast, with the purchase of tangible goods no one thinks that the income
tax is applied to sale. Everyone already knows that the income tax will only
apply to the profit, if any.

For highly taxed California to adopt a $120 billion tax increase would be,
well, surprising. I suppose they need the money for all those $100k pensions
they give to state workers.

david brunoriSep 25, 2015

Edmund, Its more than an academic argument. There is no economic difference in
me spending ten dollars on a book, a lamb chop, or a haircut. I am consuming
all of them. And if you tax consumption all should be taxed.

In your example the barber is paying income tax. But I don't care because we
are taxing the barber's customer with the sales tax.

That being said, I still almost always agree with you.

vivian darkbloomSep 25, 2015

"In contrast, with the purchase of tangible goods no one thinks that the income
tax is applied to sale. Everyone already knows that the income tax will only
apply to the profit, if any."

Edmund, but the amount a consumer pays for services is not the amount subject
to income tax, either. Service providers have input costs, too. The barber
must pay for his supplies, rent, insurance, etc. The amount you pay for your
haircut is not the amount of "profit" subject to income tax. Other service
providers have much higher overhead than a barber.

I think you are also overlooking the fact that with respect to tangible goods,
quite a bit more is subject to income tax than the profit of the retailer.
Every person in the supply chain, from raw materials on downstream, normally
has "profit" and these are subject to income tax.

I must be missing something in your (and AMT"s argument).

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