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Should services be taxed like goods?

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It’s obvious that changes in how and what we spend money on these days affect the economy at large. But those shifts also affect government budgets for everything from parks to prisons to schools.  

A new report out this week from the California Legislative Analyst’s Office (the non-partisan budget wonks who crunch numbers for the state) looks at the way changes in our spending habits are shrinking sales tax revenue in California. It’s findings track an important shift for California and the rest of the country. 

Way back in the 1930s, sales taxes got popular as a way to raise emergency revenue for states. And the way sales taxes were designed reflected the economic realities of the times.  “They generally only taxed goods,” says Joe Henchman, a public policy analyst at the Tax Foundation in Washington, D.C. “Because in the Great Depression that’s what our economy was — it was a goods based economy.”

Nowadays, however, we spend less on goods, and more on services — everything from health care to rent to education to going to the nail salon.  And yet, in all but three states (New Mexico, Hawaii and South Dakota), services are not taxed under the sales tax.

“That’s why states have had to raise the rate over the last 30 or 40 years every so often, in order to keep raising the same amount of revenue,” says Henchman. 

In a modern economy, a sales tax that excludes taxing services has pitfalls in terms of efficiency and equity, argues Tracy Gordon, an economist at the Brookings Institution. She uses the example of a lawn that needs mowing.

“If you pay a kid to mow your lawn, you don’t pay taxes on that,” she says (because that would be considered a service). But “if you buy a lawn mower at the store, then you do” pay taxes. “Higher income people tend to do the former, lower income tend to do the latter, but it’s really the same type of consumption, and of course the state misses out on the revenue,” Gordon says.

The new report from California shows that the state sales tax there — which, at 7.5 percent is the highest in the nation — is bringing in a shrinking portion of the state’s revenue. In 2012, sales tax provided 22 percent of general-fund revenue, versus 36 percent in 1979. 

Many economists, on the right and the left say a tax on services would help fill in the gaps.  Politicians aren’t so sure.  Raising income taxes has proved easier.

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