JUNEAU: The Problems With Taxing Business Services

The Council on State Taxation (COST) just released a study, “What’s Wrong with Taxing Business Services? Adverse Effects from Existing and Proposed Sales Taxation of Business Investment and Services,” that is very timely considering the Jindal administration’s tax swap proposal which would impose a new tax on most business services in Louisiana. The study was not undertaken strictly with Louisiana in mind. Its findings, however, are very relevant to the deliberations that will soon begin in our Legislature.

One of the major problems with taxing business services is the economic distortion it causes through the phenomenon of “pyramiding,” which is the imposition of a sales tax on business inputs in various stages of the process leading up to the final sale of a product or service to the end consumer. With pyramiding, the effective sales tax rate can be significantly higher than the statutory rate since it is imposed in an often hidden fashion throughout the process – which greatly diminishes transparency. One of the reasons that most states offer numerous exemptions to the sales tax is due to the pyramiding problem of taxing business inputs. Imposing sales taxes on services would exponentially compound the pyramiding problem.

The COST study notes that taxing business inputs can be a definite disadvantage from an economic development standpoint. According to COST, “A sales tax on business inputs imposes a particular burden on in-state businesses selling in regional or national markets, since they are less likely to pass the costs on to out-of-state consumers….” Currently most states, including Louisiana, do not tax business-to-business services due to the complexity and lack of transparency brought about by pyramiding. If Louisiana does impose a 6.25 percent sales tax on business-to-business services, the COST study similarly predicts the following impacts:

  • A much higher percentage of the state sales tax collections would be borne by businesses –on top of the large majority of the property taxes paid in the state that already burden businesses. This would be a deterrent to job creation and retention.
  • Larger companies would look strongly at providing more services in-house to avoid a high sales tax compounded by pyramiding. Smaller businesses providing the services would suffer from that reaction.
  • Companies limited by marketing conditions from passing through the sales tax costs, particularly in out-of-state markets, would have a strong incentive to reduce investment and employment in Louisiana.
  • Pyramiding makes it impossible to accurately determine who bears the burden of a sales tax on business services and how the burden varies among consumers. That makes it difficult to design policies that effectively offset the sales tax burden on households. It also creates problems for an accurate determination of the amount of revenue the tax would yield.

Other states have experimented with taxing business services and, as the COST study notes, often found it a bad experiment. “Several states that have adopted major sales tax changes that extended the sales tax to business purchases of inputs have subsequently, and often quickly, voted to repeal the extensions.” According to the study, in 2011, Louisiana had the third highest amount of business inputs taxed among the 50 states, nearly 55 percent. The Jindal tax swap plan would likely rank us as number one—a ranking we can do without.

It is interesting to note that one of the three authors of the COST study done by Ernest and Young LLP is Robert Cline, National Director of State and Local Tax Policy Economics for the firm. Mr. Cline is running numbers for the Louisiana Department of Revenue and the Louisiana Department of Economic Development; he isn’t to my knowledge in charge of plan design for them. He might want to give those departments a copy of his COST study so they can see how flawed the huge tax on business services they are proposing would be from an economic development and business competitiveness standpoint.

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