Latest State Revenue-Raising Wrinkle: Taxing Services

What do getting a tattoo, having the dog groomed and docking a boat have in common? Depending on which state you live in, the bills for all these services may have an added state tax.

At least 17 states are considering tax increases as lawmakers try to come up with budgets for fiscal 2005, which begins July 1 in all but four states. Hiking the tobacco tax is, by far, states' most common revenue raising proposal, but the idea of taxing services is on the table in a handful of states.

For example:

  • In Arkansas, in a special session that ended earlier this year, lawmakers expanded the sales tax to towing, solid waste disposal, dry cleaning, body piercing and tattoo shops, air conditioning unit installation, pest control, boat storage and pet grooming. Gov. Mike Huckabee (R) allowed the tax package to become law without his signature. 
  • In Florida, a group of former state policy makers is collecting signatures to put on the November ballot a measure that would require the Legislature to review all sales tax exemptions and determine whether the sales tax should continue to exclude services. 
  • Iowa Gov. Tom Vilsack (D) proposed taxing more services, including engineering, surveying, accounting and consulting services, but the state lawmakers adjourned in April without voting on his proposal. 
  • Kentucky Gov. Ernie Fletcher (R) dropped his original proposal to expand the sales tax to certain services because of opposition from lawmakers. Lawmakers there continue to debate both the budget and governor's tax overhaul package. 
  • New York Gov. George Pataki (R) wants to put a new tax on home security systems, sporting events and amusement parks to help balance the 2005 state budget. 
  • In Texas, the committee in charge of coming up with a new way to fund public schools included expanding the sales tax to services as an option for the Legislature to consider. In addition, Texas Gov. Rick Perry (R) wants to slap patrons of establishments where there is topless dancing with a $5 admission tax.

Last year, Ohio Gov. Bob Taft (R) won approval of a tax reform package that expands his state's sales tax to include storage facilities, satellite broadcasting, dry cleaning and laundry, vehicle towing and snow removal.

Other states that acted last year include Connecticut, which expanded the sales tax to health club services and to newspapers and magazines, and Nebraska, which agreed to start taxing construction services, recreational vehicle parks and private investigation services.

In Alabama, however, voters last year, rejected a sweeping $1.2 billion tax package from Republican Gov. Bob Riley that included taxes on entertainment and labor services.

"In the current environment, [taxing services] has certainly cropped up as something that states are very serious about. It's a big issue for a lot of states," said Sujit M. CanagaRetna, a tax and budget expert at the Council of State Governments. States face shortfalls of at least $35 billion this year, after having collectively closed budget gaps of $250 billion over the past three years.

One reason states are looking at taxing services is to bolster flagging tax bases. Sales taxes account for about 25 percent of the general revenue in the 45 states that have a sales tax. (Alaska, Delaware, Montana, New Hampshire and Oregon are the five states without a sales tax.)

The problem for states is that the U.S. economy has shifted from producing goods, like cars and appliances, which most states have taxed since the 1930s, to producing services, which most states do not tax.

"There is going to have to be some movement to the taxation of services. People will keep chipping away it, but it probably won't be a sea-change overnight," said Harley Duncan, executive director of the Federation of Tax Administrators, a Washington, D.C., group that represents all 50 state tax agencies.

Only three states Hawaii, New Mexico and South Dakota tax most of the 164 services that the Federation of Tax Administrators has identified as possibilities for taxation. (The list ranges from tuxedo rentals to photocopying to video rentals.) A majority of states tax less than one-third of the services FTA listed, according to the study updated in 2002.

Nationwide, states collectively lose an estimated $57 billion a year from not taxing services that households buy, whether it's adding a porch to the house or having the car repaired, according to Michael Mazerov of the Center on Budget and Policy Priorities, a Washington, D.C., group that studies budget policies that affect the poor.

The figure does not include taxing services that businesses buy, such as payroll processing and advertising. "I think it's inevitable that states will have to do this [expand the sales tax to services]," Mazerov said.

Changes in the way people shop further erode states' sales tax bases. That is why state lawmakers are pressing the U.S. Congress for the OK to slap a state sales tax on online purchases, which most consumers now consider to be tax-free.

Voters' anti-tax sentiment is forcing states to move slowly on the issue of expanding taxes to services. "It's a bad idea," said Paul Prososki of the Americans for Tax Reform, an anti-tax group.

Prososki said such a move would add another layer of paperwork for small businesses not equipped to comply with a new tax, harming the business and economic growth. He said such measures often pass because larger businesses "cut a deal" with lawmakers to get their operations exempted from the tax, leaving smaller businesses holding the bag.

Robert Tannenwald, assistant vice president and economist for the Federal Reserve of Boston who has written about state tax systems, said states need to explore both the pros and cons before they decide to expand the sales tax to services. "Rarely is there a win-win situation in tax policy. ... There are always costs and benefits."