Expanding Sales Taxation of Services: Options and Issues

Public finance economists and other tax experts have been urging states for decades to include more services in the sales tax base. Levying a sales tax on services satisfies all the criteria by which state tax policy options are normally evaluated:

• Taxing services can generate substantial new sales tax revenue.
• Taxing services broadly is essential if the long-run revenue adequacy of the sales tax is to be maintained.
• Bringing services into the sales tax base may reduce the year-to-year volatility of sales tax collections.
• Expanding the sales taxation of services will make the sales tax fairer.
• Imposing the sales tax on services can improve the allocation of economic resources.
• Expanding the sales taxation of services can simplify the process of administering and complying with the sales tax.

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There are tradeoffs involved, however. For example, moving toward comprehensive taxation of services could strain the administrative capabilities of state tax departments if done too quickly, since many businesses that previously did not collect sales tax would need to be brought into the sales tax system. Thus, achieving an optimal balancing of these goals requires an understanding of all of the potential effects of expanding taxation of services and careful choices about which services to tax.

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[E]xpanding the sales taxation of services presents policymakers with numerous choices, each option having advantages, disadvantages, and inherent trade-offs. Taxing healthcare services, for example, would tap the most rapidly growing segment of the service economy, but it also would sharply increase the regressivity of the sales tax. Taxes on landscaping and housekeeping services would raise additional revenue from predominantly upper-income households, but they could be difficult to enforce because of the large number of people who provide the services on an informal basis. Expanding the sales tax to a large number of relatively narrow services could raise substantial revenue, but it also could entail integrating a large number of new merchants into the sales tax administration system in a very short period of time. Adding services to the tax base a few at a time can help ensure that the state's tax administration resources are not overwhelmed, but it tends to give a free ride for an extended period of time to newly invented services -- many of which are likely to be consumed by the most affluent segments of the population.

View Michael Mazerov's complete, comprehensive analysis on TAX.com.