The Hindu Business Line : How American states tax services

AS SERVICE tax in India has rapidly accelerated in coverage to become a major revenue source for the Centre, it would be of interest to broadly survey the coverage of the tax in the US, where it is levied at the State level. In India, it is levied at the Centre, and plans are afloat to extend it to the States.

State sales taxes in the US can be divided into three broad groups for taxation of service purchases (Due and Mikesell, 1994, Research Institute of America):

General coverage

This coverage excludes services rendered by employees to employers and a few categories, such as financial intermediation. All service purchases are taxed unless the statute specifically exempts them.

No retail sales tax fully integrates taxation of services with that of goods, but Hawaii, New Mexico, and South Dakota provide the broadest coverage, the first two from their adoption and the latter by later expansion.

Extensive taxation of services

Repair, installation, maintenance, and other services associated with tangible personal properties are taxed, along with a long list of specifically identified services (parking, landscaping, pest control, laundry and dry cleaning, as also cable television are common examples).

Medical, optical, and dental care, legal services and other professional services are seldom taxed. However, Iowa, Minnesota, and Texas provide the broadest list in terms of economic significance of the taxed services (though Minnesota misses repair and installation services).

Other States with extensive taxation are Connecticut, Florida, Kansas, Louisiana, Mississippi, New Jersey, New York, Ohio, Pennsylvania, Tennessee, Utah, Washington, West Virginia, Wisconsin, and Wyoming.

Limited or no coverage of service purchases

The tax applies to purchases of tangible personal property, and makes no concerted attempt to tax services.

A few selected services may be specifically taxed, but some States do not tax services at all. The 23 States not previously mentioned in other categories fall into this one.

A consumption expenditure tax that includes household purchases of services will have significant fiscal advantages. First, taxing services will increase the yield from any statutory tax rate.

The impact depends on what services are added and what purchases are already in the base.

Adding household purchases of repair, installation by maintenance of tangible personal property and services rendered by commercial establishments — including those for services care — can increase revenue by 10-15 per cent, much of that from services related to automobiles.

Taxation of privately provided services — babysitting, housecleaning, and so on — is not administratively feasible, and taxation of medical and dental services may create unacceptable social problems.

Furthermore, evidence suggests that the broader base will grow somewhat more rapidly because a growing percentage of household spending is on services rather than commodities.

The US national income data show that from 1985 through 1994 the service component of personal consumption spending rose at 7.4 per cent annually, compared with a rate of 5.1 per cent for the taxed. But the difference between the rates for services and goods illustrates the pattern.

Second, taxing services can reduce discrimination according to household preferences.

Without taxing services, persons with high preferences for services pay less tax than equivalently situated consumers with lower preferences for services.

The impact on regressiveness is not so clear. Evidence shows existing taxes with broad-based extension to services leave the tax regressive to income levels around $30,000, above which the tax is roughly proportional. Siegfried and Smith find that the short-lived extension of the Florida sales tax to selected services in 1987 reduced regressively.

However, whether adding services to any existing goods-oriented sales tax will reduce regressively depends on what the existing tax has exempted (and taxed) and what services are added.

Finally, limiting the tax to commodities causes difficult problems when goods and services are sold together.

Examples include computer programmes (purchase of the physical disk or the services of the optometrist), though there are also problems with repair charges that involve both materials and labour.

Taxing services does, however, present puzzles. First, firms selling services are usually small. The firms are often highly specialised, and there are few economies from large size because the labour content of the product value is considerable.

As a result, administration will be more difficult for the authorities and compliance will involve small firms with less skill and sophistication with the tax systems.

The authorities can deal with the problems by taxing directly. That is generally the approach many value added taxes (VATs) use when they exempt small businesses from collecting tax on their sales, but not from paying tax on their purchases.

This is implicitly the approach used by American States: Businesses selling services do not have tax suspended on their purchases.

Where the labour content of the final sales to the consumer is high, a considerable portion of consumption expenditure will go untaxed.

Second, many services have mixed use, being purchased by both households and businesses. For instance, attorneys work for both businesses and households.

To prevent complications, retails sales taxes characteristically exclude difficult services transitions from the base and, for good measure, the simple ones as well.

Taxing services

A tax on consumption should not treat household expenditure on goods, such as purchase of a television, differently from household expenditure on a service, such as the repair of that television. Both are consumption expenditures.

In practice, the retail sales tax more often that not reflects the pattern for such taxes established in 1930: The base is simply defined to be tax purchases legislative afterthought, often limited to transient lodgings, rental of tangible personal properties, property repairs and installation, and admissions, and not all taxes go even that far,

For instance, many taxes do not tax the servicing of items that are taxable when sold. States have been especially reluctant to tax professional services by physicians, dentists, lawyers, accountants, and casualty insurers.

It will be seen that India and the US have avoided the "thorny" problem of taxing the services of lawyers and doctors. Again the tax assessment services of tax lawyer and chartered accountants are exempt.

(The author is a Chennai-based management consultant.)

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