Sales Taxes on Services: A Safe Bet After COVID-19?

Arguments against expanding sales tax to traditional services have proven effective in recent years, as Vertex Chief Tax Officer Michael Bernard explains.

However, some arguments for taxing services show no signs of going away. Of the three largest economic categories (manufacturing, services and agriculture), services have qualified as the largest contributor to U.S. gross domestic product (GDP) for decades. Services were responsible for an estimated 68% of GDP in 2018, and advocates of taxing services typically point to the fact that state-level taxation policies do not reflect this economic reality. This said, according to the Federation of Tax Administrators (FTA), only six states: Delaware, Hawaii, New Mexico, South Dakota, Washington and West Virginia already tax sales broadly to include services. However, in 2018, some states such as Iowa and Kentucky did expand their tax bases to also include a few services (tanning, landscaping, subscription services). Over the last decade, Connecticut added 20 services including dry cleaning and interior design, the most in the country, according to the FTA.

Proponents of taxing services also point out that increasing specific exemptions, among other measures, have contributed to narrowing the sales tax base in some jurisdictions, as sales taxes can have a greater impact on lower-earning taxpayers than high-earners (who tend to spend more on services) and that broadening the sales tax base to include services expands revenue, which is more effective during  declining economic cycles than other types of taxes (e.g., income tax increases). Still, we should also keep in mind that consumption taxes can only be raised to the point of triggering local economic inefficiency—the point where a deadweight loss occurs due to the high sales tax that can make those taxed goods (or services) considerably excessive and less appealing to shoppers, even when necessary, by reducing consumer demand to purchase certain products, less volume or both. 

Some of  these contentions are covered in a Tax Notes State article, “Sales Taxes on Services: An Uphill Battle,” that appeared in late 2019, a few weeks before the initial cases of COVID-19 struck. The author, Contributing Editor Roxanne Bland, concludes her look at the pros and cons of taxing services with what turns out to be a prophetic line: “It seems, however, that something will eventually have to be done with respect to taxing services. What that will be remains to be seen.”

Now that most states are certain to be grappling with major budget shortfalls due to the economic shock triggered by the global pandemic, previous thinking about the pros and cons of taxing traditional services could change dramatically. It is likely that more state legislators, including those who previously opposed such moves, will consider doing something about taxing services. We know as a matter of experience that in the post COVID-19 recession era, a fiscal policy solution of state and local governments will be tax base re-structuring at every level, as well public finance reforms to balance economic necessity with taxpayer equity. Only through this delicate balance can we sustain longer-term economic growth and resilience.

We’ll get a feel for those post-COVID perspective shifts once legislatures begin convening again (as scheduled or in special sessions) later this summer and fall. Given the growing need for deficit financing and some fiscal solutions (retrenchment) following massive economic stabilization and stimulus activities at the federal and state levels, tax leaders should count on legislatures putting everything on the table when it comes to tax policy changes.

In response, tax executives should start taking steps through professional and civic organizations now to exert some influence upon the ensuing process and share their corporate expertise with legislators and tax administrations. Those interactions, discussions and debates could ensure that potential tax policy changes are as carefully considered, prudently designed and well-timed as possible.