Tax Pyramiding 101

Below is a partial transcript from January 22's Late Debate with Jack and Ben, hour 2 with economist Dr. John Spry, who explains the fuzzy thinking in the Governor's budget proposal.  As usual, this is edited for clarify and brevity.

Jack Tomczak: John Spry, Late Debate Senior Economist, Economics Professor at the University of St. Thomas is here to discuss Governor Dayton’s budget and tax proposal that he unleashed on the unsuspecting citizens of Minnesota today.

John Spry: [It’s full of] terrible policy ideas.

Tomczak: There seems to be a reduction in some taxes and a broadening of the base, which is what you and Mitt Romney had been been saying that needs to be done.

Spry: And DFL Senator Ann Rest from New Hope.  However, he’s raising the sales tax rate, because he has a tax pyramiding scheme.  So we need to talk about the power of tax pyramiding to hurt the Minnesota economy.  It’s a very bad idea that every economist I know of [dislikes.]  I tried on Twitter to find an economist who took the other side and I couldn’t find any.  Tax pyramiding is where you pay a tax on a tax on a tax on a tax, like the different levels of a pyramid.  So when you get to the end, even though the rate may only be 5.5 percent, if the tax has been paid three times, you could wind up paying a 15 percent sales tax.

Tomczak: Give me a real world example.  Name a product or a service and name the levels of the pyramid that we would be paying tax on.

Spry: Let’s talk about grocery store bread.  [To open] a new grocery store you have to pay architectural services.   You have to pay legal services.  These are business to business services and these will now have sales tax under the Governor’s proposal.  So, the grocer is paying sales tax to the architect and then to the lawyer.  And then the grocer wants to figure out how this internet thing works, so rather than using an in-house expert on advertising and new media, a consultant is hired.  And then all these taxes get baked into the cost of a loaf of bread.  Even though you don’t see the sales tax on your receipt, under Governor Dayton’s proposal, there will be sales tax on food in your grocery store. 

This is a huge mistake. This is a well known thing among economists, that when you do a sales tax you just want it to be one time so people know what they’re paying.  You see it on your register receipt.  But what Governor Dayton’s doing I would call hidden.  It’s putting in layer after layer after layer like a cake for a wedding.  And by the time you’re done, even though any individual layer of the cake is only 5.5 percent, the pyramid could end up [much higher] depending on what you buy.  Even Governor Dayton’s Revenue Commissioner Myron Frans today (01/22/2013) admitted that we would have lower wages and some combination of higher prices.  This goes against what every economist that has studied good tax policy says we should do.

Benjamin Kruse: The Governor was bragging that he was lowering the rate, by 20 percent for everyone but then broaden what gets taxed.  You’re saying the price of everything is going to go up but it’s not going to get flagged as tax because it’s hidden behind paperwork.

Spry: I think in general we should be open and transparent.  I think paying for government is a good thing if government’s doing something that has popular support, creates value, and is a constitutionally permitted function of government.  And I want to do it in a visible way.  Unfortunately, the Governor says he really doesn’t know what his tax proposal would do for sure.  There’s probably a 12 sales tax on some things, 8 percent on others.  When you think about it, almost every business needs an accountant.  They’re going to be in a building designed by an architect.  They may need information technology consulting.  Our economy grows and the pie is as big as possible when businesses are run for common sense reasons, not to avoid this unwise tax policy.

Let’s say a small company uses an architectural firm or a CPA firm, those services are taxable.  But if a big company has an in-house architect, and an in-house tax department, that is not taxed.  That puts small businesses at an unfair disadvantage that actually hurts things for everybody.   A big business is going to see a huge tax advantage in getting bigger, by getting rid of its small business consultants.

***

Later, John Spry mentioned that Florida had tried this in the late 1980's, repealing it just six months later.  Here's a brief summary from the Universtity of Georgia Law Review:

The storm of controversy surrounding Florida's sales tax on services did not subside with its enactment and implementation. Indeed, it intensified. Spearheaded by national advertisers and advertising media, taxpayers launched a vigorous and well-financed campaign to repeal the tax. Some of the nation's largest advertisers—including Coca-Cola, General Foods, Kraft, Lever Brothers, and Procter & Gamble—canceled or reduced their advertising in Florida to protest the tax. Media trade associations, including the Magazine Publishers Association and the Television Bureau of Advertising, were among the business groups that expressed their displeasure with Florida's tax by canceling at least 60 conventions they had booked in the state. Advertisers and the media were joined by lawyers, realtors, and homebuilders in assailing the tax. United under the acronym STOP (Sales Taxes Oppressing People), tax protesters poured Lipton's Instant Tea into Florida's harbors to rekindle memories of a tax protest some two centuries earlier.

Once the tax became effective July 1, 1987, confusion over the scope of the tax and difficulties encountered by taxpayers who sought to comply with it added to the swell of public indignation. Some thought the tax covered medical services, which created understandable consternation among Florida's elderly population. Others were uncertain whether the tax applied to their services and were unclear over their collection responsibilities. Multi-state businesses claimed that it was simply impossible to comply with the rules for apportioning the sales tax base, particularly when a purchase was made by one member of an affiliated group of corporations. Responding to the public outcry against the tax (and, perhaps, to a dramatic drop in his public approval rating). Governor Martinez, whose initial support of the sales tax on services was critical to its enactment, reversed course. In late August 1987, the Governor called for a public referendum on the tax while claiming to support it personally. By mid-September he had taken a position squarely in favor of outright repeal. Two months of political wrangling followed during which the legislature met in special session on several occasions. In early October, the legislature passed a bill that would have modified the tax in a number of respects (most significantly by removing advertising services from the tax base), but the Governor vetoed the bill. On December 11, 1987, the Florida legislature enacted legislation, which was immediately signed by the Governor, raising the sales tax rate from five to six percent and repealing the sales tax on services effective January 1, 1988.78

It is too early to predict whether Florida's sales tax on services will be remembered as a brief and isolated experiment in state fiscal policy or as the harbinger of a movement toward expanding the sales tax to services. In either event, we will be feeling its aftershocks for some time to come.

Some liberals disagree, like this staff analysis from the Vermont State Legislature shows.  The author contends it was a good idea poorly executed, "snatching defeat from the jaws of victory" via numerous political blunders.  Blunder one was making advertising taxable, making the normally compliant media revolt, supporting the repeal, a blunder the Dayton Adminstration seems ready to repeat.

Comments

[Hiram]

Here is one problem. Conventional wisdom favors the broadening of the tax code, and the elimination of exemptions which distort choices. But inevitably, any change in the tax code means there will be both winners, and more importantly in terms of the politics involved, losers. And the losers don't ever see those exemptions as something that distorts choices, but as a vitally needed policy choice to which the overall rationale of broadening the tax code doesn't or shouldn't apply. It's not so much that those arguments are always wrong, so much that they can always be made. As much as we would like to argue that the tax code should be choice neutral, any change in the tax code will always have an impact on the choices we make, and is in fact always a de facto judgment on political policy judgment on the merits of those choices.

[Hiram]

I should note that rationalizations for tax reform are often in conflict. On the one hand, we want broadening, on the other hand we want to avoid confusion. On the one hand we want simplification, on the other hand we want to carve out complex exceptions such as those for business to business transactions.

[Speed Gibson]

It's simpler than that. Since businesses don't pay taxes, we as customers, employees, and investors must. If this change raises a billion dollars, that must come from our individual pockets. We'll pay $1,000 in hidden taxes for those $500 "property tax rebates."

[Hiram]

Since businesses don't pay taxes, we as customers, employees, and investors must.

Who pays taxes, where the tax burden falls, is a complicated, not a simple question. And part of the problem here is that lots of entities that do business here, whether you think of them in a shorthand term, like "corporation" or in the more complex way of thinking what a corporation is, a collection of various stakeholders, do not bear their share of the costs.

In terms of transparency or hidden costs, if that is a problem, it's fairly easily remedied. Cash registers could be programmed to provide us with an estimate of accumulated taxes paid with respect to any given item purchased. If knowing that exact figure is helpful, I am all for including it in the bill. The fact is, sales taxes are in general far more transparent than other taxes, corporate income taxes for example, and if a desire for transparency is to drive policy in that area, Gov. Dayton's proposals are consistent with that.

[Hiram]

"Reform" is a word I always view with suspicion. I think it's a value loaded term, often used as a euphemism or as a placeholder for other words that are more clarifying. "Entitlement reform", for me, is a classic example. When people use that term, what they really are talking about cuts in Social Security and various health care benefits. Those policies aren't popular, and that's why they choose to the euphemism, one that doesn't even make sense, since there is no reason to believe that genuine reform in those areas would result in any cuts at all. The situation is similar with respect to "tax reform". People don't want reformed taxes, as the kvetching about business to business sales taxes indicates, they want to pay less in taxes, and they don't mind less transparency, more complications, a narrower tax code, and any other cliche of tax reformism, if their overall tax bill can be lowered.

[Give2Attain]

Maybe this will incent people to do more work themselves. I have been convinced in the past to hire some work done since it saved me the sales tax on on the materials, which I was then able to reallocate into the worker's fee.

Of course there are at least 2 problems with this. The service personnel won't get as much work. And more weekend mechanics/builders will be injured, therefore raising our healthcare costs. (hahahaha)

I was absolutely amazed how many of Dayton's tax increase ideas are going to fall on the poor and lower middle class. Your tax pyramid is an excellent example.