Time to Tax Services, Not Just Sales

It's no secret that sales taxes are a regressive way to raise revenues. And the heavy reliance on such taxes across the country explains why state tax systems tend to clobber the poor while asking little of the rich.

But here's something that most people don't know: Even sales taxes themselves are designed unfairly, taxing the sale of products but not the sale of services. If you go to Walmart and buy a flat panel TV, you'll pay sales taxes on top of the price. But if you go to a dentist to get your teeth whitened, you won't pay any tax on that service.

Sales taxes were first imposed in most states during the 1930s through the 1950s in an era when the modern service economy did not yet exist. It's fair to say that most policymakers back then never imagined that Americans would spend so much money on stuff like cosmetic surgery, pool maintenance, massages, lawyers, landscaping, pet grooming, life coaching, and on and on.

California is a great example. Sixty years ago, its sales taxes covered much of what was happening in that state's economy, providing Sacramento with 60 percent of all state revenues. Today it raises just 25 percent of revenues, and that shortfall helps explain California's budget woes.

As a bipartisan group, the Think Long Commitee for California, pointed out in a 2011 report:

California’s $2-trillion economy is no longer dominated by manufacturing and agriculture, but is primarily composed of services and information activities. Yet, California’s tax code is so outdated that nearly $1 trillion – that is, roughly half – of the state’s economic output is not taxed.

While we tax the sale of a donut eaten in a coffee shop, we don’t, for example, tax the sale of legal, consulting, accounting or architectural services. In essence, those who produce goods such as donuts or machinery are subsidizing those who produce services and information.

Oh, and guess who's buying that donut versus getting a new wing designed for their home?

Apply similar math across other states, and you start to understand the recurrent fiscal crises faced by governors over the past two decades. You also understand why, in some states, low-income residents literally face twice the tax rate as the affluent. As a report by the Institute on Taxation and Economic Policy found earlier this year:

The average overall effective state and local tax rates by income group nationwide are 11.1 percent for the bottom 20 percent, 9.4 percent for the middle 20 percent and 5.6 percent for the top 1 percent.

In some states, the poor pay four times the rate. Again, the problem is not just over-reliance on sales taxes by states. It's the narrow and archaic way those taxes are structured.

One good solution might be to drastically lower sales taxes and raise revenue primarily through more progressive income tax systems. One problem with this, though, is that revenue from income taxes tends to be quite volatile, with the earning of affluent tending to fluctuate the most -- particularly earnings from capital gains. The appeal of sales taxes is that they are more stable, so there is a strong case for retaining such taxes in the revenue mix, as long as they can be made more progressive.

The Think Long Committee has proposed a broader sales tax in California that would include all services, save for those for education or health.

How much money overall could states raise if taxes on services became a standard feature of sales taxes? The Center for Budget and Policy Priorities estimated potential revenues of $87 billion in 2009 report.

That's real money, and it could be used to reverse the steep cuts to higher education made by states in recent years.

This sounds like a good deal: Tax the architects, but make it easier for kids to become architects.