Expanding sales taxes is no easy choice for Illinois

    (EDITOR’s NOTE: Illinois Republican gubernatorial candidate Bruce Rauner’s announced fiscal plan would freeze property taxes but eliminate the state sales tax exemption for 32 professional and business services. He has said expanding the sales tax base would generate more than $600 million. The following piece reflects on what state governments must consider in regards to such sales tax deliberations.)

    Ever since 1921 when the state of West Virginia imposed a tax on goods sold, sales tax has been a windfall for state revenue and an additional expense or cost for consumers and businesses. Other states quickly saw the advantage of taxing goods and followed suit. By 1940, at least 30 states had a state sales tax. Today, only five states (Alaska, Delaware, Montana, New Hampshire, and Oregon) do not.
    Along with income tax, state sales tax revenue has become an important source of income for the states that collected it, helping to pay for the ever-increasing demand for government services for their residents. Today, it accounts for close to half of state tax collected nationwide.
    When the first state sales tax was enacted, personal consumption spending consisted of approximately 60 percent for merchandise or “goods” and 40 percent for “services.” Due to societal and economic factors too numerous and complex to go into here, those numbers have been steadily shifting. Currently, spending is nearly the opposite of what it once was, with only 33 percent for goods and 67 percent for services. The increase in spending for services has been matched by the increase in small businesses providing those services.
    It’s easy to see how a tax on goods alone was affecting the revenue stream for the states. To offset this revenue shortfall, some states have enacted legislative changes assessing a state sales tax on services performed in the state. As the balance of consumer spending continues to shift from goods to services, the states will see faster growth in sales tax revenue. And broadening the tax base will make sales tax revenue more stable in the long run, because declines in one area will be offset by gains in another area. Taxing both goods and services will help achieve stability of state revenue in both the short- and long-term and is popular with both political leaders and economists.
    As state lawmakers seek to expand the sales tax base, they face the major decision of which services to tax. The taxation of personal services is an issue that is best addressed comprehensively rather than piecemeal. Picking and choosing a small set of services to tax violates the neutrality principal of taxation by creating winners and losers.
    Another decision to be made is whether the tax should be applied to the consumers’ purchase of services, to businesses, or to both. If a business is charged the tax, those costs will simply be passed on to the consumer in the form of higher prices for that business’ goods and services. This increase in the base cost of that business’s goods and services will in turn be subject to sales tax of the consumer.
    Typical sales tax on goods is collected and remitted to the government only once, at the point of purchase by the end consumer. An alternative that some states have considered is a Value Added Tax (VAT). This tax is imposed on the value added to each stage of production and distribution of all goods and services. Not only does the consumer pay tax on the finished product, but the manufacturer and distributor also pay tax on the materials used to produce the item. VAT is the primary taxing method throughout Europe. Michigan is the only state that currently relies on a VAT as a significant source of revenue.
    While the states might be thrilled with their increased revenue in such scenarios, lawmakers need to tread lightly. Business owners look at all factors that will affect their bottom line, and the subject of tax rates has become more and more important. Taxes are a state-to-state issue, and businesses will do what works best for them economically, including moving to another state to operate their business.
    Until state lawmakers become less focused on the topic of raising revenue with increased and/or additional taxes, and more focused on reducing spending, increased state taxes are here to stay. The debate will go on, however, regarding how the state revenue will be generated and who will pay.
    Kenneth R. Diel is managing member of Diel & Forguson LLC.