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SALES TAX ON SERVICES:

A MlCH‘GAN PERSPECTIVE

By Joanne K. Bump

Submitted as a Masters Thesus
Mlchlgan Stale UniveISIly

Depl. ol Agncullural Economics
Novembet,1990

 

 

SALES TAX ON SERVICES:
A MICHIGAN PERSPECTIVE

By

Joanne K Bump

A THESIS

Submitted to
Michigan State University
in partial fulfillment of the requirements
for the degree of

MASTER OF SCIENCE

Department of Agricultural Economics

1990

ABSTRACT

SALES TAX ON SERVICES:
A MICHIGAN PERSPECTIVE

By

Joanne K. Bump

The growth of Michigan’s sales tax revenue is procyclical and inadequate as it
declined during recessions and it fell beneath gains in personal income. The states non-
taxed service industry revealed a more stable growth pattern compared with the cyclical
manufacturing sector. As Michigan policy makers face the challenge of maintaining
collections they could avert a future tax rate increase with the broad based taxation of
services, raising up to $950 million. While there is no economic justification for
exempting services, their taxation tends to improve equity and efficiency. Florida’s
service tax repeal created uncertainty over the feasibility of taxing services. However,
the controversy may be explained by a tax shift from multi-state firms with economies of
scale to in-state taxpayers. The intangible nature of services and high transaction costs

complicated tax administration and consequently weaken public acceptance.

Copyright by
JOANNE KAY BUMP
1990

ACKNOWLEDGEMENTS

The investigation and analysis of the Michigan sales tax on service
exemption would not have been possible without the professional and personal support
of many people.

I am indebted to Dr. Lynn Harvey, who served as my academic and
research supervisor, and provided encouragement throughout the investigation. His
insightful discussions of the research findings served to improve the report’s focus and
organization. Professors Colletta Moser and Paul Menchik provided valuable guidance
as committee members. I am grateful to Dr. Moser for recruiting me into the graduate
program, and for encouraging me to fully develop the issues uncovered by the study. Dr.
Menchik’s class room perspectives on public ﬁnance serviced to spark my interest in
analyzing the taxation of services and to enhance the theoretical analysis.

I wish to thank Pat Neumann for her technical support in word
processing. Her time, patience, thought and tireless effort in assembling the tables and
graphics greatly enhanced the report’s presentation.

I would like to thank my employers, Jim Verdier and Douglas Drake from
the Department of Management and Budget, for providing me with the ﬂexibility to
work part-time while writing this paper. The experience acquired by analyzing state tax

issues for the department has given me a more developed perspective for tax evaluation.

Therefore, I am grateful to those public service colleagues who have enhanced my
knowledge of the Michigan economy and tax policies over the years.

Finally, I wish to express my appreciation to my family and friends. My
parents, Gerald and Gertrude Bump, instilled the value of being actively involved in
government. My father’s pursuit of taxation issues and my mother’s desire for leaving
the community a better place then how she found it, stimulated my interest in developing
public finance alternatives. My Aunt Elsie Vance provided me with an invaluable role
model and an appreciation for the written word. While growing up, I was inspired by
her work as an educator at a time before women pursued careers. My brother, Kenneth
Bump, and friends, Ella Jean Buss, Mary Pollock, Cecilia Morris, and Lois Dean,
provided constant personal support. With their encouragement, I was able to make a

greater contribution than would have otherwise been possible.

iv

TABLE OF CONTENTS

LIST OF TABLES ................................................. ix
LIST OF FIGURES ................................................ xi
CHAPTER 1 - Introduction ........................................... 1
1.1 Statement of the Problem ............................... 1
1.2 State Revenue Growth .................................. 1
1.3 Tax Expenditures ...................................... 6
1.4 Sales Tax Expansion ................................... 7
1.5 Service Exemption ..................................... 8
1.6 Deﬁnition of Goods and Services .......................... 8
1.7 Political Feasibility of Taxing Services ...................... 9
1.8 An Institutional Framework ............................. 10
1.9 Research Objectives ................................... 11
1.10 Summary ........................................... 12
CHAPTER 2 - The Structure of the Michigan Sales and Use Taxes ............ 14
2.1 The Community Choice Model .......................... 14
2.2 Michigan’s Structural Provisions ......................... 14
2.3 Legislative Act and Tax Base ........................... 16
2.4 Michigan’s Constitutional Sales Tax Rate .................. 17
2.5 Estimated Cost of Exemptions ........................... 18
2.6 Distribution by Fund Source ............................ 18
2.7 Michigan Sales Tax Effort and Capacity ................... 20
2.8 Interstate Comparison of Rates and Exemptions ............. 21
2.9 When Goods and Services are Joint ....................... 23
2.10 Use Tax Deﬁned ..................................... 25
2.11 Characteristic of Services ............................... 26
2.12 Apportionment of the Business Taxes in Michigan ........... 26
2.13 Constitutional Amendment to Limit Revenue Growth ......... 28
2.14 Flexibility ........................................... 29
2.15 Summary ........................................... 30
CHAPTER 3 - Equity and Efficiency of Taxing Michigan Services ............. 31
3.1 Introduction ......................................... 3 1
3.2 Equity Defined ...................................... 31
3.3 Horizontal Equity .................................... 32

Page

3.4 Vertical Equity ...................................... 34
3.5 Distributional Characteristics of a Good ................... 35
3.6 Michigan’s Equity Rating ............................... 39
3.7 Michigan’s Food and Drug Exemption ..................... 41
3.8 Tax Incidence ....................................... 41
3.9 Efﬁciency ........................................... 43
3.10 Efﬁciency and Rights .................................. 44
3.11 Deadweight Loss ..................................... 44
3.12 Inverse Elasticity Rule ................................. 45
3.13 Consumption Taxes and Exemptions ...................... 46
3.14 Comprehensiveness of the Sales Tax Base .................. 46
3.15 Gross Receipts and Value Added Taxes ................... 47
3.16 Summary ........................................... 48
CHAPTER 4 - Michigan’s Sales Tax Revenue Adequacy and Stability .......... 50
4.1 Introduction ......................................... 50
4.2 Michigan Sales Tax Collections .......................... 50
4.3 Real Sales Tax Collections .............................. 53
4.4 Stable Revenue Base Deﬁned ........................... 53
4.5 Adequate Revenue Base Deﬁned ........................ 57
4.6 Data Sources ........................................ 58
4.7 Shift Toward Service Sectors ............................ 60
4.8 Growth of Services .................................... 60
4.9 Ratio of Services to Manufacturing ....................... 63
4.10 Summary ........................................... 63
CHAPTER 5 - Impact of the Michigan Sales Tax on Services ................. 66
5.1 Introduction ......................................... 66
5.2 Services Deﬁned ..................................... 66
5.3 Service Industry Composition ........................... 67
5.4 Revenue Estimates ................................... 69
5.5 Sales to Income Ratio ................................. 70
5.6 Health Services ...................................... 75
5.6.1 Medical Inﬂation ..................................... 76
5.6.2 Health Beneﬁts by Income .............................. 78
5.6.3 Health Service Expenditures ............................ 78
5.6.4 Taxing Medical Services ................................ 80
5.6.5 Medical Service Exemption vs. Credit ..................... 82
5.7 Business and Professional Services ........................ 83
5.7.1 Taxing Business Services ............................... 86
5.7.2 Business Inputs Deﬁned ............................... 86
5.7.3 Marginal Rate of Substitution ........................... 87
5.7.4 Vertical Integration ................................... 87
5.7.5 Sales Tax on Business Inputs ............................ 87
5.7.6 Michigan’s Industrial Processing Exemption ................ 88
5.7.7 Interstate Comparison of Business Input Exemptions ......... 88

vi

Page

5.7.8 Resale Exemption Guidelines ........................... 89
5.7.9 Cost of Resale Exemption .............................. 90
5.8 Personal Services ..................................... 91
5.9 Legal Services ....................................... 93
5.10 Amusement and Recreation Services ...................... 95
5.11 Auto and Miscellaneous Repair Services ................... 96
5.12 Selected Education and Social Services ................... 100
5.13 Hotel and Motel Services .............................. 101
5.14 Policy Alternatives ................................... 105
5.15 Broad Based vs. Incremental Taxation ................... 105
5.16 Tax All Services ..................................... 108
5.17 Tax Most Services ................................... 110
5.17.1 A Low Income Credit ................................ 110
5.17.2 Relief Provision Criteria .............................. 112
5.17.3 Comparison of Low Income Sales Tax Credits .............. 113
5.17.4 Summary of Taxing Services with Adjustments ............. 115
5.18 Tax Services and Lower the Rate ........................ 115
5.19 Exempt Services and Raise the Rate ..................... 118
5.20 Summary .......................................... 1 19
CHAPTER 6 - The Florida Experiment: An Institutional Analysis ........... 122
6.1 Introduction ........................................ 122
6.2 Predicting Policy Outcomes ............................ 123
6.3 Situation, Structure and Performance .................... 124
6.4 Florida’s Revenue Shortfall ............................ 125
6.5 Heavy Reliance on Sales Tax ........................... 125
6.6 Low Visibility ....................................... 126
6.7 Tax Shifts .......................................... 126
6.8 Sunset Strategy ..................................... 127
6.9 Tax Implementation .................................. 128
6.10 Consumer Taxation .................................. 128
6.11 Business Taxation ................................... 129
6.12 Taxation of Out-of-State Firms ......................... 129
6.13 Apportionment ..................................... 130
6.14 Delivery of Non-geographic Services ..................... 131
6.15 Economies of Scale .................................. 132
6.16 Sense of Community ................................. 134
6.17 Tax Shift to Consumers ............................... 135
6.18 Summary .......................................... 136
CHAPTER 7 - Summary, Conclusions and Future Research Needs ........... 139
7.1 Problem Statement .................................. 139
7.2 Sales Tax Structure .................................. 140
7.3 Equity and Efficiency ................................. 141
7.4 Revenue Adequacy and Stability ........................ 141
7.5 Policy Options ...................................... 142

vii

Page
7.6 Florida’s Experience ................................. 144
7.7 Continuity vs. Change ................................ 146
7.8 Future Research Needs ............................... 147
APPENDICES
A. ................................................. 148
B. ................................................. 149
C. ................................................. 150
D. ................................................. 15 1
E. ................................................. 155
F. ................................................. 156
G. ................................................. 160
H. ................................................. 162
I. ................................................. 166
BIBLIOGRAPHY ................................................. 174

viii

LIST OF TABLES

Page

Table 1.1 Michigan Revenue Growth, 1978-1988 ...................... 2
Table 2.1 Michigan Sales and Use Tax Expenditures .................. 19
Table 3.1 Selected Service Expenditures as a Percent of Income ......... 36
Table 3.2 Potential Tax Base: Michigan Sales and Use ............... 47
Table 4.1 Sales and Use Tax Revenue by Category ................... 51
Table 4.2 Sales an Use Tax Revenue by Category, Annual Percent

Change ............................................ 52
Table 4.3 Sales and Use Tax Revenue by Category, Income Elasticity

by Component ....................................... 56
Table 4.4 Michigan Gross State Product, 1963-1986 .................. 61
Table 5.1 Sales Tax on Services, Revenue Estimates .................. 69
Table 5.2 Michigan’s Economy Ranks Larger Than New Mexico

and South Dakota .................................... 72
Table 5.3 Comparison of New Mexico and South Dakota Service Tax Base

as a Percent of Personal Income with Michigan’s Taxable

Service Base ........................................ 73
Table 5.4 Medical Services, Consumer Expenditure Survey, 1984—86 ...... 79
Table 5.5 Comparison of Taxable Services for Selected States

with Broad Based Structures ........................... 106
Table 5.6 Comparison of Sales Tax Policy Alternatives ............... 121
APPENDICES
A R.T.S. Tax Capacity Indices, 1975-86 ............................ 148

EQ’TJI'HUOU!

R.T.S. Tax Effort Indices, 1975-86 .............................. 149
General Sales and Gross Receipts Taxes, 1986 ..................... 150
Major Features of State Sales Taxes, October 1989 ................. 151
State General Sales Tax Rates ................................. 155
Interstate Comparisons of Services Taxation, 1985 .................. 156
Summary of State’s Taxation of Service Items ..................... 160

Table 1: Michigan Gross State Product, 1963-1986, All

Industries, Real Dollars GSP in Millions ......................... 162
Table 2: Michigan Gross State Product, 1963-1986

Annual Percent Change of Real Dollars .......................... 164
Census of Services Service Industries, 1987 ....................... 166

Figure 1.1

Figure 1.2

Figure 2.1

Figure 2.2

Figure 2.3
Figure 2.4

Figure 3.1

Figure 3.2

Figure 3.3

Figure 3.4

Figure 3.5

Figure 3.6

Figure 3.7

Figure 4.1

LIST OF FIGURES

Page

Michigan Inﬂation Adjusted Revenue Declines with

Recession ............................................ 3
Michigan’s Total Revenue Capacity and Effort ............... 5
Michigan Sales Tax Collections by Business Category,

FY 1989 ............................................ 16
Michigan Use Tax Collections by Business Category,

FY 1989 ............................................ 17
Distribution of Michigan Sales Tax by Fund Source ........... 21
Michigan Sales Tax Use Falls Below Potential, 1986 .......... 22
Medical Service Expenditures as 3 Percent of Income,

1984 ............................................... 37
Personal Service Expenditures as 3 Percent of Income,

1984 ............................................... 37
Transportation Service Expenditures as a Percent of

Income, 1984 ........................................ 38
Legal and Other Professional Service Expenditures as a

Percent of Income, 1984 ............................... 38
Repair Service Expenditures as a Percent of Income,

1984 ............................................... 40
Entertainment Service Expenditures as a Percent of

Income 1984 ........................................ 40
Michigan Sales and Use Tax Exemptions Comprise Large Portion

of Tax Base, Fiscal 1988 ................................ 48
Growth of Michigan Sales Tax .......................... 54

Figure 4.2
Figure 4.3
Figure 4.4
Figure 4.5
Figure 4.6

Figure 4.7

Figure 4.8

Figure 4.9
Figure 5.1
Figure 5.2
Figure 5.3
Figure 5.4
Figure 5.5
Figure 5.6
Figure 5.7
Figure 5.8
Figure 5.9
Figure 5.10
Figure 5.11
Figure 5.12
Figure 5.13
Figure 5.14

Figure 5.15

Page

Growth in Michigan Sales Tax Adjusted for Inﬂation ......... 54
Michigan Sales Tax, Growth in Real vs. Nominal Dollars ...... 55
Sales Tax Income Elasticity ............................. 55
Michigan’s Economy Shifts, 1963-1986 ..................... 61
Growth of Services vs. Manufacturing, 1963-1986 ............. 62
Selected Major Service Industries, Long Term

Growth, 1963-1986 .................................... 62
Selected Small Service Industries, Long Term

Growth, 1963-1986 .................................... 64
Ratio of Services to Manufacturing, 1963-1986 .............. 64
Service Industries Composition .......................... 68
Growth of MI Health Services ........................... 75
Health Service Industry Composition ...................... 76
Financing of Health Services ............................ 77
Growth of MI Business Services ......................... 84
Business Service Industry Composition .................... 84
Growth of Professional Services .......................... 85
Misc. Professional Industry Composition ................... 85
Growth of MI Personal Services ......................... 92
Personal Services Composition .......................... 92
Growth of Legal Services ............................... 94
Growth of Amusement and Recreation Services ............. 97
Growth of Motion Picture Services ....................... 97
Amusement Industry Composition ........................ 98
Growth of Auto Repair Services ......................... 98

Figure 5.16
Figure 5.17
Figure 5.18
Figure 5.19
Figure 5.20
Figure 5.21
Figure 5.22
Figure 5.23
Figure 5.24
Figure 5.25
Figure 5.26
Figure 5.27

Figure 5.28

Page

Auto Repair Service Composition ........................ 99
Growth of Misc. Repair Services ......................... 99
Misc Repair Industry Composition ...................... 100
Growth of Social Services ............................. 102
Social Service Industry Composition ..................... 102
Growth of Education Services .......................... 103
Selected Education Industry Composition ................. 103
Growth of Hotel Services .............................. 104
Hotel Industry Composition ............................ 104
Tax All Services ..................................... 109
Tax Most Services ................................... 111
Tax Services and Lower Rate ........................... 117
Raise Tax Rate ..................................... 120

CHAPTER 1

Introduction

1.1 Statement of the Problem

Michigan policy-makers are presently being challenged by the ever growing
demand for public services, but with less real resources to ﬁnance them. Several policy
changes may be made to provide additional revenue to Michigan state government such
as enacting new taxes or reducing tax expenditures. This policy analysis will examine the
option of repealing the sales tax on services exemption and the impact it would have on
the current tax structure as measured by equity, efﬁciency, revenue adequacy and
stability. An institutional framework will be applied to predict the consequences of

taxing business and individuals in the political economy.

1.2 State Revenue Growth

The growth of Michigan’s state revenue collections has slowed over the past
decade. The federal government has reduced federal aid sent to the state and at the
same time increased the number of federally-mandated programs. From 1981 to 1990,
federal grants-in-aid to Michigan have decreased by over $1 billion (Michigan Executive
Budget Fiscal 1990-91, 1990). In addition, state revenue collections have not kept up
with the growth of expenditures. As illustrated in Table 1.1, from 1978-1988 Michigan’s

real revenue growth has increased by only $225 million. This was measured by the

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3

annual change in Michigan state government’s major operating funds including the
Michigan General Fund - General Purpose, School Aid and Lottery collections (Ofﬁce of

Revenue and Tax, 1989). See Figure 1.1.

Inflation Adjusted In Millions

Revenue up $225 mulllon
from '78 to '88 :1

$8,000

 

$7,500

$7.000 \\
$6,500 \ //
$6,000

w

$5,500 ' j 1 g 1 1 1 i 1
1978 1980 1982 1984 1986 1988

 

 

 

 

 

 

 

 

 

Source: Data from Ofﬁce of Revenue and Tax Analysis, Michigan Department of Management and Budget
and Michigan Department of Treasury.

Note: Michigan revenue is defined as the General Fund - General Purpose Fund plus School aid and Lottery
which reﬂect the state government operating sources.

Figure 1.1. Michigan’s Inﬂation Adjusted Revenue Declines with Recession

Since the revenue base reﬂects Michigan’s economic activity some portion of the
low revenue growth may be attributed to the state’s declining manufacturing sector,
particularly in the dominant motor vehicle industry. World-wide competition has shifted
auto production and the associated employment away from the traditional domestic auto-
makers located in Michigan. The traditional U. S. domestic auto-makers production fell
from 100 percent of total domestic production in 1978 to 86.5 percent in 1989 (Drake,

1989). Similarly, employment in the U. S. motor vehicle industry has fallen from the

4
pre-recession peak of 1,004.9 thousand in 1978 to 841.5 thousand in 1987, a drop of 16.3

percent (W 1988).

To facilitate a comparative ﬁscal analysis, the Advisory Commission on
Intergovernmental Relations (ACIR, 1989) provides an index of state ﬁscal capacity and
effort. Fiscal capacity is deﬁned as ”the dollar amount of revenue that each state and its
local government would raise if they applied a nationally uniform set of tax rates to a
commonly used set of tax bases.” (ACIR, 1989, p.2.). Examples of the taxes included in
the representative tax base are personal income, corporate income, sales or gross
receipts, motor fuel, beer and wine, tabacco, insurance, vehicle registration, vehicle
operating licenses, property taxes, estate and gift taxes, etc. Fiscal capacity reﬂects a
state’s potential revenue base while effort measures the actual tax burden levied on the
base. Fiscal effort is determined by dividing the states actual revenue collections per
capita by its capacity per capita times 100. It provides a relative indicator of the states
utilization of its potential revenue base relative to other states. ACIR provides ﬁscal
capacity and effort for the sales tax as well as for total state taxes. The U. S. average is
equal to an index value of 100. From 1975 to 1986, Michigan’s tax capacity index
declined from 101 to 96 while its effort has followed an upward trend from 106 to 118.
This is illustrated in Figure 1.2 and Appendix Tables A and B. As Michigan’s tax
capacity declined beginning in the recession years, taxpayers were required to make a
greater tax effort to maintain revenues. The state’s tax capacity has improved from the
recessionary low index level of 90 in 1983. However, as Michigan moved well into an
expansionary period in 1986, the state’s tax capacity remained 8 index points below the
prerecessionary peak of 104 index points in 1979. Thus, the state’s potential revenue

base has not recovered from the last economic downturn.

0 lndlces of 100 : U.S. Avg.

 

 

130 ’* _______ x

120 ''''' aﬁ’ ‘*.,, .............

 

 

’11 U “y‘—
100 \

90 \l.

80

 

 

 

 

I 1

70 L I I l L L
1975 1977 1979 1980 1981 1982 1983 1984 1985 1986

 

 

 

— Tax Capacity ‘*" Tax Effort

Source: Data from Advisory Commission on Intergovernmental Relations, 1989.

Figure 1.2. Michigan’s Total Revenue Capacity and Effort

Given low revenue growth rates, state policy makers are examining alternatives
for ﬁnancing state government which also improve the tax structure. Policy alternatives
such as implementing new taxes or increasing tax rates are less viable options because of
the public sentiment voiced in the last decade by tax revolt movements. Several states
are attempting to increase revenues by altering their tax structure through the closing of
selected tax expenditures which result in revenue losses. A tax expenditure is revenue
foregone due to exemptions, exclusions or deductions from the tax base, credits applied

to tax liability or preferential tax rates.

13 Tax Expenditures

The broadest deﬁnition of tax expenditures includes all tax exclusions,
exemptions, deductions, credits or preferential rates, while more narrow definitions
include only those tax provisions which substitute for direct expenditures. The objective
of a tax expenditure is to either to provide a tax incentive to promote certain behavior
the taxpayer would not make without the tax provision or to reduce the tax burden for
specific groups of taxpayers.

Tax expenditures allocate government resources for selected programs which
accomplish performance objectives similar to direct spending programs but at lower
administrative costs. Lawmakers may choose between the two types of funding
mechanisms based on the performance desired for a particular type of good or service.
Even though the dollar amounts of tax expenditures are comparable in size to direct
budget outlays, tax expenditures are not reviewed as closely and often lack political
exposure. Direct expenditures for one program are weighed against competing needs for
other programs because lawmakers must match direct expenditures with total revenue to
balance the budget. This type of institutional budget censtraint has not been made
explicit for tax expenditures. Structural mechanisms to control the growth of tax
expenditures have not been developed and implemented. Without these structural limits,
the performance of the tax structure to provide an adequate level of ﬁnancing for the
state budget is depressed by the growth of lost revenues.

The enlargement of the tax expenditure budget is an example of a social trap.
This is a situation in which policy makers get started in one direction that they later ﬁnd
unpleasant (Platt, 1973). Interest groups are given a back door appropriation by
lowering their taxes through tax expenditures. As the cost of these provisions rises there

is no painless way to retreat from providing them. After tax expenditures are enacted

7

into law policy-makers are reluctant to eliminate tax expenditures, like sales tax on
services, due to pressure from special interest groups. It is in the lawmakers short-run
interest to accommodate a special interest groups with a tax preference, but the
associated revenue loss eventually requires them to increase taxes at which point it
becomes a social trap. Since this link between the provision of a tax preference and the
need for increased revenues at a later time is not well established or immediate,
lawmakers may not realize the long run consequences of their actions.

To illustrate the cost of tax expenditure, states like Michigan have taken the first
step to develop a tax expenditure budget to catalog and estimate the revenue foregone.
In ﬁscal 1978-88, the State of Michigan estimated that Michigan’s state and local tax
expenditure budget exceeded 39 billion dollars. After cataloging and estimating the
magnitude of the revenue loss, the next step is to evaluate the effectiveness of tax
expenditures. However, most states have not undertaken this project because evaluating
these provisions is difficult when tax expenditures are hidden in the tax code and records

of those beneﬁting from the expenditure are not always available or readily identifiable.

1.4 Sales Tax Expansion

This paper will discuss the sales tax on services exemption, one of the tax
expenditures recently under consideration for change by several states. Proposals to
expand the sales tax are prevalent due, in part, to the public acceptance of the tax.
According to a survey of changing public attitudes on government and taxes conducted
by the Advisory Commission on Intergovernmental Relations (1988), the sales tax is a
popular tax. When asked “what was the better way to increase taxes for state

government," 57 percent of the respondents indicated they preferred the sales tax.

8

The popularity of expanding the sales tax has risen because much of the revenue
potential from state property and income taxes has already been captured. The sales tax
ranks as the second largest state revenue source nation-wide. In Michigan, sales and use
tax base comprised 32.6 percent of total general fund - general purpose state revenue in
ﬁscal year 1988.

1.5 Service Exemption

The rational for a services exemption falls under the broad deﬁnition discussed
above which is to reduce the tax burden for speciﬁc taxpayers or groups of taxpayers.
The primary reason for the service exemption is that the service sector was a smaller
proportion of the economy when the Michigan sales tax was enacted in 1933. According
to John Due, the objective of a sales tax is to distribute the costs of government services
in relation to consumer spending with the assumption that taxes are shifted forward by
the ﬁrms from which the tax is collected to consumers. Consumers gain satisfaction
from services just as they do from goods. Thus, there is no economic distinction between

goods and services that justiﬁes not taxing services, (Due, 1983).

1.6 Definition of Goods and Services

In recent years a common theme in describing the U. 8. economy is that
consumers are shifting their consumption from one dominated by goods to one with a
more equal share of services. “Goods are essentially tangible objects which consumers
eon purchase for their own or some other party’s use. Services are essentially intangible
objects, normally actions performed for the beneﬁt of consumers, which consumers may
buy.“ (Passero, undated). A more technical deﬁnition between goods and services is

provided by the Bureau of Labor Statistic’s division between the private economy goods

9

producing and service producing industries. The service producing industries include
transportation and public utilities, wholesale trade, retail trade, ﬁnance, insurance and
real estate and services. The goods producing industries include mining, construction,
and manufacturing. The discussion of this paper will focus on the service industry within

the broader service producing economy.

1.7 Political Feasibility of Taxing Services

In 1987, Florida broadened the sales tax base to include services but the
legislation was repealed within 6 months after considerable political controversy. Several
states considered legislation to tax services during the 1987 legislative sessions but after
the Florida experiment failed, state legislative activity waned due to insufﬁcient support.
State policy makers, cautious not to repeat Florida’s performance, have set up tax reform
committees to study the issue. Policy makers may consider taxing services after
reviewing studies which point out the merits of the tax based on public ﬁnance criteria.
However, these recommendations have met with resistance as many policy makers are
proceeding with caution, claiming that taxing services is not politically feasible and citing
Florida’s tax repeal as evidence. While some authors conclude that taxing services is too
politically sensitive to merit consideration, others argue that policy makers are likely to
renew their interest in taxing services as memories of Florida’s tax repeal fade and the
demand for ﬁnancing state programs intensiﬁes without adequate revenue growth. Thus,
the crux of the policy discussion is focused on whether taxing services is politically

feasible.

10
1.8 An Institutional Framework

This paper will draw from an institutional approach for analyzing the situation,
structure and performance of the Michigan Sales tax structure. The paper will expand
on the public ﬁnance theories to include an institutional framework to address issues like
political feasibility. The model uses an industrial organization input-output model to
describe the performance of a particular market or sector of the economy as a function
of the behavior of the participants within the market structure. The input-output model
as adapted by Shaffer and Scth (1972), coined the ”Community Economics Model",
includes a political economy component and public choice theory for non-market
decisions. The consequences of an institutional structure are applied within a given
situation of interdependence. The structure of rights gives order to this interdependence
and creates opportunity sets for the participants. Performance is the ﬂow of
consequences, results or outputs from a particular activity, program or organization.

The Florida experiment raised several issues which states like Michigan need to
consider when taxing services. These issues will be analyzed using institutional concepts.
Questions to review include: the impact of ﬁrms and individuals on state tax policies as
they attempt to shift the tax burden to others; the impact of politicians as they attempt
to maximize votes; and the impact of bureaucrats as they maximize security, as outlined
by Bartlett (1973). The consequences of alternative methods used by interest groups to
inﬂuence decisions as outlined by I-Iirschman (1970) through exit, loyalty and voice.
How inﬂuencing policy makers through the subsidization of transaction and information
costs is impacted by the distribution of wealth as outlined by Coase. How interest
groups may respond to change in property rights by challenging the tax through the legal
system as discussed by Samuels (1982). How Michigan may adjust the tax structure to

accommodate the situational characteristic of services which are intangible and makes

11

tax nexus difﬁcult to determine. How political boundaries and sense of community

impact the use tax levied on services purchased out-of-state but used in-state.

1.9 Research Objectives

The investigation into the Michigan sales tax exemption addresses the following

research objectives:

1.

Analyze sales tax on services from an institutional framework with the community
choice model and the Situation, Structure and Performance Paradigm.

Review the Michigan sales tax structure to determine its strengths and
weaknesses based on the traditional public ﬁnance criteria for a good tax
structure. This analysis addresses the issues of equity, efﬁciency, revenue stability
and adequacy. In addition, a simple tax structure eases administration and public
acceptance. A balanced proportion of collections derived from more than one
source prevents over relying on any single tax which could exaggerate the impact
from the negative characteristics found in any tax. By creating a broadly based
tax structure, the positive characteristics of one tax may offset the negative -
aspects of other taxes for a more well rounded outcome (Kleine and Shannon,
1985).

Compare Michigan’s state tax capacity and effort with that of other states.
Identify and analyze what other states have chosen to include or exclude services
from their tax base.

Analyze the service sector in Michigan using Gross State Product and Census
Data. Determine the extent to which the Michigan economy has shifted away
from a goods producing economy toward a service economy and the impact on

the sales tax base.

12

6. Estimate the revenue from taxing services assuming alternative exemptions in the
tax base.

7. Identify and develop policy alternatives for providing a Michigan sales tax on
services.

8. Determine what Michigan can learn from Florida’s tax repeal by applying the

community choice model.

1.10 Summary

The challenge of balancing the state budget requires policy makers to examine tax
policy alternatives which maintain collections. The growth of Michigan’s state revenue
collections has slowed over the past decade. The federal government has reduced
federal aid sent to the state and at the same time increased the number of federally-
mandated programs. From 1978 to 1988, state revenue as measured by collections from
the General F und-General Purpose, School Aid and Lottery, grew only $225 million on
an inﬂationary adjusted basis, up 3 percent. This low growth rate is due, in part, to
declines in the manufacturing sector, particularly the auto industry. Thus, the demand
for public services continues to grow, while the real resources available to ﬁnance them
are rising at a depressed rate. Consequently, as Michigan losses its tax capacity,
taxpayers are required to make a greater tax effort to maintain revenues.

Proposals to expand the sales tax are prevalent as it ranks as the second largest
state tax nation-wide. The Michigan sales and use tax base comprised 32.6 percent of
total general fund - general purpose state revenue in ﬁscal year 1988. In addition, the
sales tax is a popular tax which would reduce the political resistance to expanding its use.
The public acceptance of a tax depends on the degree of backing for the government

program its ﬁnances. A taxpayer constituency has been developed for the programs that

13

the sales tax ﬁnances. For example, Michigan policy makers have previously identiﬁed
education as needing ﬁnance reform to ensure collections. Since 60 percent the sales tax
is distributed to the school aid fund for education there is popular justification for
extending its use.

This paper will discuss the sales tax on services exemption, one of the tax
expenditures recently under consideration for change by several states. According to
John Due (1983), the objective of a sales tax is to distribute the costs of government
services in relation to consumer spending. Consumers gain satisfaction from services just
as they do from goods. Thus, there is no economic justification for the exemption of
services which would warrant its continuation. Nonetheless, once tax expenditures like
the sales tax on services are enacted into law, policy makers are reluctant to eliminate
them due to pressure from special interest groups. It is in the lawmakers short-run
interest to accommodate a special interest groups with a tax preference, but the
associated revenue loss eventually requires them to increase taxes. Since the connection
between the provision of a tax preference and the need for increased revenues at a later
time is not well established or immediate, lawmakers may not realize the long run
consequences of their actions.

After the Florida service tax repeal some authors have concluded that taxing
services is too politically sensitive to merit consideration. However, others argue that
states are likely to renew their interest in taxing services as memories of Florida’s tax
repeal fade and the demand for ﬁnancing state programs intensiﬁes without adequate
revenue growth. Thus, the policy discussion has expanded beyond the economic impacts

of the tax and is focused on whether taxing services is politically feasible.

CHAPTERZ

The Structure of the Michigan Sales and Use Taxes

2.1 The Community Choice Model

The Situation, Structure and Performance Paradigm is a framework for analyzing
community problems and policies developed by Schmid (1985). The model assumes that
people are interdependent and share scare resources. Because of this interdependence
there are conﬂicts and possibilities for mutually beneﬁcial joint action. Joint action may
result in high transaction costs to attain joint beneﬁts. The ability to act collectively to
manage conﬂict and produce joint beneﬁts results from human choice. A sense of
community is required to be interdependent and act collectively.

A community economics analysis provides a framework for predicting and
explaining the consequences of the policy decisions. The model is concerned with the
establishment of rights and obligations within a community and collective acquisition
through taxation and purchase of good and services for community consumption. The
analysis begins with the identiﬁcation of one type of situational variable, the
characteristic of a good or service. The characteristic of a good will combine with the

structural alternative applied to determine a particular performance.

2.2 Michigan’s Structural Provisions
Structural examples include establishing rights and obligations for members using

resources and methods of collective taxation. The structure establishes the opportunity

14

15

set and incentives and disincentives which result in behavior by community members.
The paper will discuss the structural variables which deﬁne the existing sales and use tax
structure including the legal basis for taxing sales, the sales tax rate and its constitutional
limit, the base, exemptions and distribution by fund source. Michigan’s sales tax will be
compared to other states to determine the relative degree to which these factors impact
Michigan in similar and different ways. The sales tax effort and capacity will be
measured against the national average to illustrate its under utilization and the taxes
ability to sustain expansion. Next, the paper will discuss Michigan’s recent legislation to
tax computer software which illustrates the distinction between that portion of an item
which is a taxable good and a non-taxable service. The paper will discuss the use tax
and the potential for developing structural provisions to apportion services delivered out-
of-state but used in state. The intangible characteristic of the service transaction makes
delivery of the good difﬁth to determine. Michigan could adjust its structural
provisions from apportioning the Single Business Tax to apportion the use tax on
business services. Finally, the impact of increasing state revenue will be analyzed given
the limit on total state revenue growth through the Headlee Amendment.

The structure of Michigan’s sales tax impacts its effectiveness. Chapters three
and four will analyze the strengths and weaknesses resulting from these sales tax policies
based on the traditional public ﬁnance criteria for a good tax structure. This analysis
addresses the issues of equity, efficiency, revenue stability and adequacy. In addition, a
structure which is simple cases administration and public acceptance. The state may
desire a balance in the proportion of collections derived from a single revenue source
because over relying on a tax will exaggerate the impact from the negative characteristics

present in any tax. By creating a broadly based tax structure, the positive characteristics

16

of one tax may offset the negative aspects of other taxes for a more well rounded

outcome (Kleine and Shannon, 1985).

2.3 Legislative Act and Tax Base

The sales tax was enacted in 1933 (PA. 167) and levied on the gross proceeds
from retail sales of tangible personal property for use or consumption. The initial rate
was set at 3 percent but was raised to 4 percent by Michigan voters as a result of a
constitutional amendment in 1960.

The Michigan use tax is a companion to the sales tax and was enacted in 1937
and levied on the use, storage, and consumption of certain tangible or material personal
property and services such as intra-state telephone, telegraph and other leased wire

communications, used cars sold by individuals, hotel and motels. Figures 2.1 and 2.2

Gen Mdse
5.7%

Auto
25.6%
Bldg Mtls
6.9%
MISC Retail
Furniture 107%

4.7%

 

Non— Retail
25.4%

Source: Data from Ofﬁce of Revenue and Tax Analysis, Michigan Department of Management and Budget,
Fiscal 1990-91 Executive Buget Document

Figure 2.1. Michigan Sales Tax Collections by Business Category, FY 1989

17

Machinery
3.6

  
    

Auto
Telephone
22.7

Blng Const
6'3 Hotels
4.6

MISC. Bus Serv
5.9
MISC. Retail
4.5

Other
32.5

Source: Data from Ofﬁce of Revenue and Tax analysis, Michigan Department of Management and Budget,
EM 1990-91 Executive Budget Documgt.

Figure 22. Michigan Use Tax Collections by Business Category, FY 1989

illustrate the distribution of sales and use tax base by the object of taxation for fiscal year

1989.

2.4 Michigan’s Constitutional Sales Tax Rate

In 1960, the maximum sales tax rate was ﬁxed by the Michigan Constitution at 4
percent. PA. 1 and RA. 2 of the second session of 1960, set the four percent tax rate
for both the sales and use tax. The higher rate of 4 percent became effective January 1,
1961. A Constitutional limit was not placed on the use tax, but the Michigan Supreme
Court held in 1959 that if the use tax rate was higher than the sales tax rate, the
difference could not be applied to the items subject to the sales tax (Brazer and Blume,
1982). The constitutional limit on the sales tax rate of 4 percent has provided a

disincentive to raise the rate because to do so would require a signiﬁcant amount of

18

political support for altering the state Constitution, and thus, Michigan’s tax rate has

remained constant.

2.5 Estimated Cost of Exemptions

Michigan provides several exemptions to the sales and use tax base and therefore
it is not a pure consumption tax which would include all transactions. According to
Blume (1982), nearly 82 percent of Michigan’s sales tax base is received from households
and 18 percent is levied on business. In addition to the $2.48 billion in revenue collected
from the sales tax in fiscal 1988, another $1.9 billion of sales tax revenue was foregone
due to exemptions. Beyond the exemption for services, the largest exemptions are for
food and industrial processing. Table 2.1 identiﬁes the exemptions and revenue
foregone. Chapter 5 will discuss the estimated revenue loss from services in greater

detail.

2.6 Distribution by Fund Source.

The Michigan sales tax revenue is distributed by statute, section 205.75 of PA.
167 of 1933 as amended, as follows: 60 percent to the School Aid Fund, 15 percent to
cities, villages and townships and 25 percent to the General Fund. The Comprehensive
Transportation Fund receives 27.9 percent from the general fund’s portion of the auto
related sales tax as set in statute. The use tax differs from the sales tax in that is
distributed 100 percent to the general fund, according to section 205.111 of PA. 94 of
1937 as amended. Thus, most of the sales tax revenues goes to education and local

government. See ﬁgure 2.3.

Table 2.1

19

Michigan Sales and Use Tax Expenditures

 

 

 

 

Tax Expenditure (in thousands) FY 87 FY 88

Air and Water pollutlion $ 1,399 5 1,483
Bad Debts 6,996 7,416
Churches 4,,601 4,919
Collection Fee 18,656 19,679
Commercial Domestic Aircraft n.a. n.a.
Commercial Vessels 1,936 2,052
Communication and Telephone Exemption 8,745 9,270
Computer Software 5,830 1,545
Damaged Beer n.a. n.a.
Donated Property 65 69
Driver Training 1,924 2,039
Enterprise Zone 0 0
Food 397,755 422,680
Food for Students 2,950 3,127
Government or Red Cross 2,950 3,127
Gratuity and Tips 1,796 1,904
Horticultural and Agricultural Products 37,067 39,291
Hospital and Nursing Homes 2,950 3,127
Industrial Processing 260,018 284,099
Inmate Purchases 123 130
Interstate Sales 42,000 44,520
Isolated Sales n.a. n.a.
Military Post-Exchange Sales 2,682 2,843
Military Vehicle Sales (Non-resident) 770 816
Military Vehicle Sales (Resident Out-ofState) 38 40
Newspaper, Periodicals and Films 19,880 21,073
Non-proﬁt Ambulance and Fire Service 65 69
Non-proﬁt Hospital or Housing Construction 2,693 2,855
Non-proﬁt Organizations 22,189 23,520
Non-resident Property n.a. n.a.
Ophthalmic and Orthopedic Products 10,377 11,000
Prescription Drugs 15,730 16,647
Radio and TV 1,411 1,527
Sales of Business n.a. n.a.
Sale of Water 2,180 2,311
Services 949,140 1,006,088
Small Out-of-State Purchases 1,274 1,350
Telephone Services 3,475 3,684
Textbooks Sold by Schools 1,411 1,496
Vehicle and Aircraft Transfer 5,351 5,672
Vehicles Purchased for Use in Another State n.a. n.a.
Vending Machines 13 14
$1,951,482

The State of Michigan estimated revenue foregone for services differs from the updated 1987 estimate
shown in Chapter 5 of this report because the Executive Budget estimates are based on the 1982
Census of Services adjusted upward for inflation from 1982 to 1988.

 

20

The distribution of government programs beneﬁting from the tax collections is a
significant factor because public acceptance of tax changes is stronger when taxpayers are
able to link the tax increase with a speciﬁc government program (Bradford, Case and
Ebel, 1989). Even when the link to a government program is apparent, public support

will vary depending on the taxpayers degree of utility for the program.

2.7 Michigan Sales Tax Effort and Capacity

Chapter one reviewed the ACIR index for tax effort and capacity for Michigan’s
total revenue. This section will discuss the same measures applied to the sales tax
instead.

Michigan policy makers may evaluate the performance of the Michigan sales tax
structure by comparing to that of other states. To facilitate an interstate comparative
ﬁscal analysis, the Advisory Commission on Intergovernmental Relations (ACIR, 1989)
provides an index of state ﬁscal capacity and effort. Fiscal capacity is deﬁned as "the
dollar amount of revenue that each state and its local government would raise if they
applied a nationally uniform set of tax rates to a commonly used set of tax bases."
(ACIR, 1989, p.2.). Fiscal capacity reﬂects a state’s potential revenue base while effort
measures the actual tax burden levied on the base. Fiscal effort is determined by
dividing the states actual revenue collections per capita by its capacity per capita times
100. It provides a relative indicator of the states utilization of its potential revenue base
relative to other states. ACIR provides ﬁscal capacity and effort for the sales tax as well
as for total state taxes as illustrated in Appendix Tables A and B.

In 1986, Michigan’s sales tax per capita capacity index was recorded at 97.8,

ranking 23 in the nation. Michigan’s sales tax effort was 79.9, ranking 36 in nation.

20

The distribution of government programs beneﬁting from the tax collections is a
signiﬁcant factor because public acceptance of tax changes is stronger when taxpayers are
able to link the tax increase with a speciﬁc government program (Bradford, Case and
Ebel, 1989). Even when the link to a government program is apparent, public support

will vary depending on the taxpayers degree of utility for the program.

2.7 Michigan Sales Tax Effort and Capacity

Chapter one reviewed the ACIR index for tax effort and capacity for Michigan’s
total revenue. This section will discuss the same measures applied to the sales tax
instead.

Michigan policy makers may evaluate the performance of the Michigan sales tax
structure by comparing to that of other states. To facilitate an interstate comparative
ﬁscal analysis, the Advisory Commission on Intergovernmental Relations (ACIR, 1989)
provides an index of state ﬁscal capacity and effort. Fiscal capacity is deﬁned as “the
dollar amount of revenue that each state and its local government would raise if they
applied a nationally uniform set of tax rates to a commonly used set of tax bases."
(ACIR, 1989, p.2.). Fiscal capacity reﬂects a state’s potential revenue base while effort
measures the actual tax burden levied on the base. Fiscal effort is determined by
dividing the states actual revenue collections per capita by its capacity per capita times
100. It provides a relative indicator of the states utilization of its potential revenue base
relative to other states. ACIR provides ﬁscal capacity and effort for the sales tax as well
as for total state taxes as illustrated in Appendix Tables A and B.

In 1986, Michigan’s sales tax per capita capacity index was recorded at 97.8,

ranking 23 in the nation. Michigan’s sales tax effort was 79.9, ranking 36 in nation.

21

School Aid

    

General Fund*

Local Govt 25%

15%
OF receives 27.9% of auto related G:

Figure 2.3. Distribution of Michigan Sales Tax by Fund Source

This illustrates that Michigan’s sales tax capacity is only slightly below average while its
tax effort is signiﬁcantly below the index. While Michigan’s sales tax effort is below
average, its total tax effort is above average. This suggests that the sales tax effort is _
under utilized relative to other state taxes. Appendix Table C provides an interstate

comparison of the sales tax index. (See Figure 2.4.)

2.8 Interstate Comparison of' Rates and Exemptions

One explanation of Michigan’s low tax effort index is that Michigan’s sales tax
rate of 4 percent is relatively low compared to other states. A total of 30 states have
state sales tax rates which are higher than Michigan’s 4 percent in 1989. In addition,
Michigan's per capita sales tax revenue was recorded at $293.82 which is below the US.

average of $375.89. (See Appendix Table C.)

22

Ml Sales Tax: Effort 2 79.3 Capacity = 97.8

is Per Capita

$400
$350
$300
$250
$200
$150
$100

$50

 

$0
Sales Tax Bases

[HID US Average Capacity Ml Capacity ﬂ Ml Revenue

Source: Data from Advisory Commission on Intergovernmental Relations, 1989.

Figure 2.4. Michigan Sales Tax Use Falls Below Potential, 1986

Exemptions provide another interstate indicator of Michigan’s sales tax base. A
count of states which grant exemptions also provided by Michigan is listed in the
Appendix Table D. Of the 45 states which levy a sales tax, 27 exempt food, 44 exempt
prescription drugs, 30 exempt custom computer programs, 25 exempt repair charges, 28
exempt installation services and 44 exempt materials for manufacturers, producers and
processors. Thus, the Michigan exemptions listed in the table are provided by most

states.

23
Of the 45 states leving a sales tax, only 3 levy a broad based tax on services,

including: New Mexico, Hawaii and South Dakota. Eight states, including Michigan, do
not as a rule tax services. The 34 states remaining levy the tax on a limited number of
services. Appendix Table F lists the degree of service taxation in each state. Appendix
Table G lists the number of states which tax the service item.

In 1987, legislative proposals to tax services were prevalent. Minnesota extended
the sales tax to selected services not including professional services. Several states
considered taxing services but the proposals were not enacted due to insufficient support.
States included in this category were Arkansas, Illinois, Indiana, North Dakota,
Oklahoma, Washington, Iowa, Colorado, Montana, Nevada, Texas and Wisconsin. After

the Florida tax repeal, the issue became almost non existent in 1988 (Boucher, 1988).

2.9 When Goods And Services Are Joint

The Michigan tax structure has been adjusted to accommodate the situation when
goods and services are joint. The structural provisions which taxes goods and exempts
services creates an incentive for taxpayers to itemize services out of any transaction.
However, it is difﬁcult to separate out that portion of the transaction which is a good
versus a services as is illustrated by Michigan’s recent enactment of legislation to tax
computer software. The legislation was introduced in response to Macabees Mutual Life
Insurance Co. v State Department of Treasury, 1983. This case held that the software
adapted to the needs of a speciﬁc user was exempt from the use tax because the ”focus
of the instant transaction is on the personalized service of the software vendors an
intangibles transaction.” The court said that customized software should be separated

from canned software (Schrager, 1984). The legislation separated that part of the

24

software which was a tangible and taxable good from the intangible non taxable service.
House bills 4608 and 4612 were introduced in May 1987 by Representative Mary C.
Brown. House bill 4608 amended the Sales Tax Act to specify the type of computer
software was subject to the state sales tax. House Bill 4612 similarly amended the use
tax. The tax would be levied on computer software for sale to the public and software
modiﬁed or adapted to the buyers needs only if it was available on an ”as-is" basis. The
tax would not apply to software designed for the exclusive use of the purchaser and for
any technical support required to adapt or modify the software to the purchaser needs
(House Legislative Analysis, 1987).

These bills separated that portion of the software which is considered a tangible
taxable goods from that portion of the good which is not taxable as an intangible service.
The bills focused on the taxation of canned, pre-written and off the shelf software.
These forms of software would be taxed but the customized software would not. If the
canned software is mixed with the customized software in one package, only the canned
portion is taxable. The legislation illustrates the administrative and legislative difficulty
of taxing tangible goods and not taxing intangible services when the goods and services
are mixed into one product. In most state court decisions on software, the courts have
reasoned that the true value of the transaction was in the service provided and that the
purchase of tangible personal property, in a disk for example, was incidental to the
transaction. The mixing of goods and services is an increasing occurrence in the new

technological age.

2.10 Use Tax Deﬁned

To tax in-state sales, states like Michigan have found it necessary to levy a use
tax on goods purchased out-of-state but used or consumed in the taxing state.
Consumers may not be aware of the distinction between the sales versus the use tax
because the tax rate is the same and it is levied on a similar base. One difference is that
the good is purchased out of the taxing state. For example, a Michigan resident buying a
car in Ohio but using the car in Michigan would pay a Michigan use tax on the purchase
price of the vehicle rather than a sales tax because it is an out-of—state purchase used or
consumed in Michigan. The Michigan resident pays the tax to only one state as
reciprocity laws prevent double taxation. The purpose of the use tax is to create a level
playing ﬁeld. Without it, consumers have an incentive to buy from out-of-state ﬁrms to
avoid the tax. States have found that creating a level playing ﬁeld requires that the tax
liability of the purchaser must be the same regardless of the sellers location. Thus, the
use tax is a long standing compliment to most state sales taxes.

Michigan can learn from the taxation issues identiﬁed by the Florida tax repeal
experience as much of the controversy focused on the use tax of business services which
were non-geographically speciﬁc to the state. Multi-state ﬁrms doing business in Florida
lobbied against the tax as will be discussed in Chapter 6. While some argue that it would
be simpler not to levy the use tax on out-of-state services and the courts do not require
it, the trade-off is the lack of equity for in-state businesses. Michigan currently does not
apportion the use tax for out-of-state firms because the state of use is more easily
determined when the item of purchase is a concrete good. When a state taxes an

intangible service, however, it may be necessary to make adjustments to the tax structure.

26
2.11 Characteristic of Services

The nature of services as intangibles complicates its taxation compared with the
tangible characteristics of goods. The long standing situs rule in most states is that use
or consumption occurs at the point where the seller or his agent delivers the goods. The
point of delivery is more easily manipulated for service ﬁrms which have greater mobility
to move to other states because they require less investment in physical plant and
inventory than do the manufacturing of goods. For example, services require less
interstate transportation costs as a telephone call or envelope may be used to deliver the
tangible result of work from a consultant. Thus, due to these characteristics of the
service transaction, the ﬁrm may more easily move out of state without disrupting service

to the customer (Francis, 1988).

2.12 Apportionment of the Business Taxes in Michigan

Michigan does not apportion its use tax on goods. However, it does have
experience in apportioning business taxation for multi-state ﬁrms. An example of how
Michigan has structured an apportionment formula is illustrated in the Michigan Single
Business Tax (SBT), the states tax on business activity. SBT tax liability for out-of-state
ﬁrms is apportioned by the three-factor formula, weighing payroll, property and sales
equally.

The three factor apportionment formula has long been accepted as a fair way to
apportion business income and therefore, a likely approach for policy makers to extend
to the taxation of services. Some form of apportionment is used by most state business
income tax structures. Of the 45 states which levy a business income tax not including

Michigan, 26 have a simple average of the three factors of property, payroll and sales, 7

27
states weight property and payroll by 25% each and sales 50% and 12 states have some

other combination of apportioning these factors (ACIR, 1990).

Michigan’s apportionment formula was recently challenged in the Michigan
Supreme Court. In 1988, Trinova Corporation, an Ohio-based firm whose business
activity in Michigan involved $103 million in sales with a small sales ofﬁce, argued for a
refund using an alternative method of apportioning under section 69 of the Single
Business Tax. Using this apportionment method, the ﬁrm would have had no Michigan
tax liability. The ﬁrm asserted that, ”there is no justiﬁcation for apportionment when the
geographic locus of a tax base can be identiﬁed with precision. Thus, there is no warrant
for apportioning an ad valorem tax. The SBT, in adopting a formulary apportionment
approach, wrongly assumes that the value added by the taxpayer’s business activities
cannot be speciﬁcally attributed to the states in which it conducts those activities, and, in
so assuming, has in this case produced ”a grossly distorted result." (Petition For a Writ,
1989, p.18) The Michigan Supreme Court held that apportionment relief under section
69 of the Michigan Single Business Tax may be obtained if the ﬁrms "business activity
attributed to the state is out of all appropriate proportion of the taxpayer’s intrastate
business activity or has led to a grossly distorted result.” The purpose of the
apportionment provision is to ensure that each state taxes only its fair share of the
interstate transaction. Trinova Corporation failed to show that the statutory
apportionment provision was out of all proportion to the businesses activity in Michigan
(Haggerty, 1988, p.1-2). The outcome of the case is uncertain as it was appealed to the
U. S. Supreme Court.

This court case challenged the Michigan three factor formula was for

apportioning the tax liability of a multi-state corporation. It illustrates that firms are

28

likely to resist apportionment as a procedure for evaluating tax liability when the actual
state of business activity may be determined in another way. In the case of intangible

services, however, apportionment may be required.

2.13 Constitutional Amendment to Limit Revenue Growth

Other features of the Michigan tax structure such as the constitutional
amendment to limit state revenue growth could impact the states policy on taxing
services. In a 1978 general election, Michigan voters said “yes" to a Constitutional
amendment, often referred to as the Headlee Amendment, restricting the growth in state
revenue. Section 30 of the amendment ensured state spending on behalf of local
governments, section 29 concerned state requirements of local governments and section
31 focused on local property tax millage reductions. Section 26 regarded the limitation
placed on the collection of state revenue. The enactment of the Headlee amendment
added complexity and raised additional tax policy issues for the legislature when
considering tax structure reforms. Policy makers need to evaluate how the addition of _
services to the tax base will impact the total growth of state revenue. The grth of
total state revenue can not exceed the speciﬁed percentage of total state personal income
as outlined by section 26.

The legislature enacted P. A. 504 of 1988 to implement this restriction which
required an official calculation of the ﬁscal 1979 base year state revenue limitation. This
calculation determined that total state revenue for ﬁscal year 1979 equaled 9.49 percent
of the applicable personal income for calendar year 1977. The section 26 revenue limit
is based on personal income as reported in August of the year following the year being

measured. The limit is tied to a ﬁxed percentage which is not a ﬁxed dollar amount.

29

The dollar amount changes as the personal income data for the state changes. Since
there is a lag between the calendar year being measured and the ﬁscal year being
limited, it is possible that a strong ﬁscal year following an economic downturn will result
in state collections exceeding the limit.

Policy makers became aware of the sensitivity of the calculation after periods of
economic downturn in 1985 as Michigan came close to exceeding the revenue limit. The
state remained below the revenue restriction by only an estimated $6.1 million. This
gave the state a very close margin of error given that this dollar amount is a relatively
small portion of state’s total revenues which exceed $15 billion. The cyclical nature of
this limitation amendment is evident in estimates of the amount under the limit. These
estimates range from $1,757.4 million in ﬁscal 1990 to $6.1 million in fiscal year 1985
(Drake, 1989).

The tax limitation amendment could impact the alternatives available to state
policy makers for taxing services. During periods of steady upward growth the added
revenue from taxing services while adding to total revenue would probably not place
collections beyond the limit. However, as the state moves out of a year of economic
downturn, the added revenue will likely exceed the limit. The constitutional amendment
to limit total state government revenue growth provides policy makers with an incentive
to stabilize revenue growth over the business cycle. This incentive is likely to increase

the use of counter cyclical tax structures.

2.14 Flexibility
Tax policy makers could build ﬂexibility into the tax structure with an adjustment

mechanism which takes this revenue constraint into account. While state revenues are

30

capped, there is ﬂexibility in the choice of taxes levied. One alternative would be to
expand the base and use the additional revenue gained to lower the rate. The state
would gain from increased efficiency and revenue stability resulting from a broader base.
Secondly, the state could provide a low income tax credit and adjust the percentage
applied for the credit depending on estimates for revenue exceeding the limit. One
disadvantage of type of provision is that it is counter cyclical as consumers would receive
an added boost to income after the recessionary period. Nonetheless, if the credit is
targeted to low income individuals, this group is most likely to be the last taxpayers

beneﬁting from the recovery.

2.15 Summary

The following chapter has illustrated how the present tax structure levied on the
tangible goods results in a tax capacity and effort. According to the Advisory
Commission on Intergovernmental Relations, Michigan’s sales tax capacity is just below
the average state capacity while the sales tax effort is signiﬁcantly below that of other
states. Michigan’s tax rate is relatively low when compared to other state tax rates,
resulting in less tax effort and less revenue but more efﬁciency. Michigan could improve
its tax eﬂ'ort and capacity by taxing services. To do so would require adjustments to the
tax structure which take into account the intangible nature of services such as developing
an apportionment formula for the use tax. In addition, policy makers would need to
address how to build ﬂexibility into the structure to comply with the Headlee
Amendment. One way is to provide a low income credit which could be adjusted as the

business cycle changes.

CHAPTER 3

The Equity and Efficiency of Taxing Michigan Services

3.1 Introduction

The design of a good tax system may be rated using traditional principles of
taxation such as equity, efficiency, simplicity and revenue adequacy and stability. This
chapter will review how taxing services would impact the equity and efﬁciency
characteristics of the sales tax structure. Michigan’s sales tax equity rating will be
reported since the impact that taxing services depends on the progressiveness of the
present sales tax base. Michigan’s effort to improve equity by providing exemptions for
food and drugs will be reviewed. The distributional characteristics of services by income
class will be evaluated to assess how taxing services may impact the progressiveness of
the sales tax structure. Factors impacting tax incidence, or who pays the tax, will be
examined. The report will discuss the impact of taxation on efﬁciency and Michigan’s

sales tax will be compared to other consumption tax alternatives.

3.2 Equity Deﬁned

According to Thurow (1973), every time taxes are levied or public expenditures
are incurred, decisions about economic equity are being made. In market economies,
individual preferences determine market demands for goods and services and as a
consequence determine the market distribution of income. However, individual

preferences are weighted by economic resources before they are communicated to the

31

32

market. A basic responsibility of government in a market economy is to create an
equitable distribution of income and wealth if it has not been produced by the market.
Thus, greater equity is ensured by evaluating the equity impact of proposed changes to
the tax structure.

Equity may be defined in various ways. It may be seen from the perspective of
satisﬁed needs. Wants may not be satisﬁed but needs can be. In a relative sense, equity
may be interpreted using historical and cultural trends as a basis of comparison.
Alternatively, equity has been thought of as the common good indicating that society
should provide the basic goods and services like health, education and welfare. As
equity may be deﬁned from several perspectives, each interpretation involves a value
judgement on the part of policy makers. Thus, equity is not an economic criteria but a

principle of justice, according to Boadway and Wildasin (1984).

3.3 Horizontal Equity

Fairness issues within public ﬁnance are evaluated using horizontal and vertical
equity. It is concerned with how the burden of output reduction in the private sector is
distributed within society given various tax structures. A tax is horizontally equitable if
two persons with equal welfare before the tax is imposed, have equal welfare after the
tax is levied. The horizonal equity of the sales tax structure which taxes goods and
exempts services could be improved. If individual A’s utility equals individual B’s utility
before the tax, but A has a higher preference for services and a lower taste for goods
compared to B, then after the tax, A’s utility would not equal B’s utility. Taxing services
would increase the equality of welfare for those with a utility or preference for goods

versus services. For example, a consumer purchasing a lawn mower pays a sales tax on

33

the machine while a consumer purchasing a lawn care service is favored because they
pay no tax.

Horizontal equity also addresses the trade-off between the taxed good and the
exemption on leisure. A sales tax on goods will discriminate against the person with a
strong preference for commodities as opposed to leisure. Since leisure is not taxed its
use it being encouraged relative to consumption of goods x and y. The best tax, as one
that most discourages leisure, was formalized by Corlett and Hague (1953-4). While no
tax is levied directly on leisure, the tax which discourages the use of leisure creates less
distortion. Leisure may be deﬁned as the total number of hours available minus labor.
Since the number of hours is ﬁxed, as labor increases leisure will decrease. A rise in
labor represents an decrease in utility and a decrease in leisure. Consumers may
substitute leisure for commodities and thus we may interpret leisure like other goods.
Given two commodities, x and y, and leisure, z, the best tax would increase the tax rate
on the good which is a complement to leisure, creating indirect tax on recreation
(Boadway and Wildasin, 1984). Complements describe a relationship between two goods
such that if the price of one good increases, the quantity purchased of the other good
will fall (Nicholson, 1985). Examples of services which are complements to leisure are
amusement services like motion pictures, golf, bowling, and ﬁtness services. Thus, if the
price of amusements rises, due to the tax, the quantity of leisure consumed would fall.

While the principle of horizontal equity is generally accepted, its difﬁcult to
implement because it requires a judgement of when two persons have equal welfare
levels. Even when individuals have the same budget constraint, income, and
consumption of goods and services, they may not be judged as equals because they differ
in their capacity to enjoy the commodities. The traditional definition of horizontal

equity as the equal treatment of those equally situation is inadequate for implementation

34

purposes because the diversity in individuals tastes makes comparisons of individual
utility ambiguous.

For completeness, horizontal equity should also take into account the relative
beneﬁts of public expenditures of different individuals. This is difﬁcult to do, however,
since the advantages of public programs to various taxpayers are not revealed in the
market price (Boadway and Wildasin, 1984). Despite the difﬁculties in making
horizontal equity operational, the consideration of horizontal equity as a criteria for

evaluating a tax policy alternative will improve economic justice.

3.4 Vertical Equity

Vertical equity is concerned with how the tax system treats persons of differing
welfare levels. To evaluate vertical equity the entire tax structure is included in the
review because the progressiveness of one tax may somewhat offset the regressiveness of
other taxes. The degree to which the tax system is vertically equitable is determined
after making a value judgment about the appropriate way to treat people at different
utility levels. For example, it is a value judgement to ﬁnd that a rise in the price of a
necessity good will reduce social welfare more than a rise in the price of a luxury good
(Boadway and Wildasin, 1984).

Conventional wisdom ﬁnds the burden of the present state sales tax is mildly
regressive (Fox and Murray, 1988). They cite the Tax Foundation (1970), Pechman and
Okner (1974), Musgrave and Musgrave (1980), and Phares (1987). However, Davies
(1969), argued that the focus on income and consumption within a single year overstates
the regressiveness of the sales tax. Households may experience a temporary fall or rise
in income but maintain the former consumption level more in keeping with their

expected permanent income. While a person’s consumption patterns may be based on

35

permanent income rather than current income levels, taxes must be paid from current

income (Bohm and Craig, 1987).

3.5 Distributional Characteristics of a Good

Research suggests that while the average propensity to consume taxable goods
declines as income increases, the average propensity to consume potentially taxable
services may increase depending on the service. Vertical equity would be enhanced by
including selected services in the sales tax base. Different commodities will be consumed
in different proportions by various income or utility groups. One can compare the
relative effects on social welfare of price changes in various commodities by the use of
F eldstein’s "Distribution Characteristic of a Good” which is the weighted average of
marginal social utilities of income of all persons in the economy weighted by the
proportion of total output of the commodity. Equity implications of raising the price of
a good requires knowledge of (1) the proportions in which different income groups
consume the good; and (2) a value judgement made about the marginal social utility of
incomes of various persons (Boadway and Wildasin, 1984). The ﬁrst part of this
question has been researched by Bohm and Craig (1987). They calculated the average
propensity to consume services out of current period income by income class using the
1984 Consumer Expenditure Survey.

The Bohm and Craig analysis reveals that for all services combined, regressivity is
conﬁned largely to those earning less than $30,000 after which the tax is roughly
proportional through $60,000 (See Table 3.1.). In particular, the taxation of medical
services, and personal services would be regressive across most income classes as
illustrated in Figures 3.1 and 3.2. For example, other activities, transportation and

professional services, shown in Figures 3.3 and 3.4, exhibit a regressive pattern only in .

8: a .82 .65: .3x ..o> .52 .852 2:. .8... 3 3:82 a. :8: :Eu :5 Ego: . ”83::

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36

 

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8.: 8.: 8.: 8.: 8.: 8.: 8.: 8.: 8.: 8.: 8.: 8.: ::.: 850
8.: 8.: 8.: 8.: 8.: 8.: 8.: 8.: 8.: 8.: 8.: 3.: 8.: 38523.
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8.: 8.: 8.: 8.: 8.: 8.: 8.: 8.: 2.: 2.: 2.: 3.: 8.2 885.822
8.: 8.: 8.: 8.: 8.: 8.: 8.: 8.: 8.: 8.: 8.: 8.: 8.: 850
8.: 8.: 8.: 8.: 8.: 8.: 8.: 8.: 8.: 8.: 8.: 3.: :5 3:3

acommmoucﬂ

3.: 8.: 3.: 3.: 3.: 3.: 3.: 3.: 2.: 3n: :0: 8.: 8.5 8:28:32 8:8. u

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“Connemara“:

8: :m: we: 3.: 3.: «a: 3.: 2.: 3.: 3.: 3.: 2w: 8.: a: mean: :0
8.: 8.: 8.: 8.: 8.: 8.: 8.: 8.: 8.: 8.: 8.: 8.: 3.: 850
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8.: 8.: 8.: 8.: 8.: 8.: 8.: 8.: 8.: 8.: 8.: 2.: 8.: :63

8.43%

2.: 2.: 2.: 2.: 2.: 2.: 2.: 2.: 2.: 2.: 3.: an: 8.: 33.3
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3.: 3: an: :8 8.: :8 8.: 8.: 8.: 2.: 8.: 8.: 3.: .8088

qua—rang
8.: 8.: 8.: 8.: 8.: 8.: 8.: 8.: 2.: 2.: 2.: 2.: 22 3288:
8.: 8.: 8.: 8.: 8.: 8.: 8.: 8.: 8.: 8.: 8.: 2.: 8.: .8685
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3.: 8.: 8.: 8.: 8.: 8.: 8.: 8.: 2.: 2.: 3.: an: :3 3...:ch 83.685

g
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3.: 2.: 3.: 2.: 3.: 8.: 2.: 2.: 2.: 2.: 2.: 8i: :3 is: 3303982

mopaow van-mama

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.0885 Eugen— : a: men-58:25— oatom 3.8—om

ﬁn 035—.

37

Service Expendrlures as a % of Income
5.5%

4.5%

3.5%

2.5%

1.5%

0.5%

 

5 10 15 20 25 30 35 40 45 50 55 60
Income Class rn Thousands of $

-9- Doctors & Nurses -+- Hosprtals

Source: Data from Bohm and Craig, 1987 and US. Consumer Expenditure Survey, 1984.

Figure 3.1. Medical Service Expenditures as a Percent of Income, 1984

Service Expenditures as a % of Income

 

 

 

3.5%

 

 

3%

 

 

2.5%
2% \
1.5% \
1% \
0.5% '
0% 4W 4% ﬂ H—Q—ﬁ!
5 10 15 20 25 30 35 40 45 50 55 60
Income Class in Thousands of S

 

 

 

 

 

+ Personal

Source: Data from Bohm and Craig 1987 and US. Consumer Expenditure Survey, 1984.

Figure 3.2. Personal Service Expenditures as a Percent of Income, 1984

38

Service Expenditures as a % of Income

 

 

2.5%
2%

\
I. \
0.5%\\

0%

 

 

 

 

__.Ik

4.. ___l
I I I L J -

v I

 

 

5 10 15 20 25 30 35 40 45 50 SS 60
Income Class in Thousands of S

'9- Local Transportation -0- Non Local Transport

Source: Data from Bohm and Craig 1987 and US. Consumer Expenditure Survey, 1984

Figure 3.3. Transportation Service Expenditures as a Percent of Income, 1984

Servrce Expenditures as a % ol Income

 

 

 

 

 

 

 

 

 

 

O
< @3
1.5%
.9. @
05%K\
0% 1 W

 

5 I0 15 20 25 30 35 40 45 50 55 60
Income Class in Thousands ol 5

-9- Legal + Other Protessronal

Source: Data from Bohm and Craig 1987 and US. Consumer Expenditure Survey, 1984

Figure 3.4. Legal and Other Professional Service Expenditures as a
Percent of Income, 1984

39

the lowest income classes, but would yield a proportional burden in the higher income
classes (Fox and Murray, 1988). Figures 3.5 and 3.6 indicate the regressive pattern of
repair and entertainment services. Since regressivity is focused at the lowest income
levels, tax equity could be improved with a low income credit. Further research is

needed on the equity impacts for Michigan based on more current information.

3.6 Michigan’s Equity Rating

The marginal equity implications of taxing services in Michigan depends on the
progressiveness of the existing base. The Michigan sales and excise tax burden,
measured by the share of income for families of four in 1987, is below the U. S. average
for every income quintile. While Michigan’s sales tax structure is more equitable than
the average state, it is still regressive. Families earning an average of $8,633 pay 2.5
percent of their income in sales taxes while higher income families with earnings
averaging $66,164 pay 1.4 percent of income. States with the least regressive tax systems
exempt selected necessities like food for home consumption or prescription drugs and / or

provide low income sales tax credits on the state income tax (Nickels and Dimes 1988).

 

States tended to levy more progressive income taxes in the late 1970’s and early
1980’s. According to Case and Ebel (1989), policy makers are favoring more regressive
state taxes based on a comparison of data from the Advisory Commission for
Intergovernmental Relations data from 1978 through 1987. States had experienced rapid
growth in the use of the personal income tax during the 1970’s and early 1980’s.
However, by the mid 1980’s state reliance on personal income taxes and property taxes
leveled off, and reliance on the remaining sales taxes increased. Michigan’s effort to
improve sales tax equity has been primarily provided through a food and prescription

drug exemption.

40

Service Expenditures as a 96 of Income

 

 

3.5%<
3%
2.5% \
2%
I: \\
1% \\

0.5%

 

 

 

 

A
V

0% l i l
5 10 15 20 25 30 35 40 45 50 55 60

Income Class in Thousands of 5

 

 

+Auto Repair +Other Repair

Source: Data from Bohm and Craig, 1987 and US. Consumer Expenditure Survey, 1984.

Figure 3.5. Repair Service Expenditures as a Percent of Income, 1984

Servrce Expenditures as a % ol Income

4
3.5% m

3%

2.5% \
2% \
1.5% \
1% \

0.5%\
0%44t'4tl1'1'

5 I0 15 20 25 30 35 40 45 50 55 60
Income Class In Thousands ol 5

 

 

 

 

 

 

 

 

 

 

+ Entertainment

Source: Data from Bohm and Craig 1987 and US. Consumer Expenditure Survey, 1984.

Figure 3.6. Entertainment Service Expenditures as a Percent of Income, 1984

41
3.7 Michigan’s Food and Drug Exemption

Michigan adds progressivity to the tax by exempting food for home consumption
with an estimated revenue loss of $423 million and a prescription drug exemption,
costing $17 million (Em 1 1987-88 Michigan Tax. Expenditure Appendix, 1989). Nearly
two-thirds of the 45 states that tax sales exempt food purchased for home consumption.
Almost all states provide an exemption for prescription drugs and utilities. The
disadvantage of providing relief for the poor through an exemption is that much of the
benefits go to non-poor households (Gold, 1990). Tax credits may be targeted at those
in poverty or near poverty. The disadvantage is that the benefits may not reach those

for which it was intended because of their lack of knowledge of the credit.

3.8 Tax Incidence

There are alternative ways to measure tax incidence for state sales taxes. Tax
incidence is a branch of public finance which evaluates the segment of the economy
which bears the ultimate burden of taxation. The agent bearing the tax incidence may
differ from the agent paying the tax, as defined by statute, because market
responses to the tax may result in a shift in tax incidence to someone other than the
initial agent. Since many markets may be impacted at the same time tax incidence is
diffith to determine (Nicholson, 1985).

According to Pechman (1985), in a competitive model, the sales tax is borne by
consumers in proportion to their total expenditures since the tax does not change the
relative prices and thus alter consumption. Nonetheless, some analysts are skeptical of
traditional incidence theory because markets are not perfectly competitive, labor and
capital may not be mobile and taxation may affect savings and work effort. Since firms

are not perfectly competitive or perfectly monopolistic they do not necessarily follow

42

proﬁt maximizing policies. Businesses may set prices to cover costs plus a mark up for
profits. Firms may target a rate of return on invested capital and shift the tax forward to
consumers or backward to workers or some portion of both. The leading firm in an
industry may raise prices to recover the tax providing an umbrella to less efficient
producers. Whether or not the firm is able to pass the tax on to individuals through
higher prices depends on the competitive characteristics of the market and pricing
structures and the price elasticity of the service. The price elasticity of demand for a
service is the percentage change in the quantity of the service demanded in response to a
1 percent change in the price of the service. Houthakker and Taylor (1970), researched
the price elasticity of demand for some service industries which will be further discussed
in Chapter 5.

In a competitive market, if the demand for a service is price elastic, rising prices
from taxation will more than proportionately reduce demand and the firm will absorb a
portion of the tax through reduced business volume. If the demand is inelastic, a price
increase will result in a proportionately smaller decline in quantity demanded and the
ﬁrm will more easily add the full tax to prevailing prices. In addition, if the ﬁrm
operates in a national market with a less price ﬂexibility due to a national pricing
structure, shifting the tax to individuals may be more difficult. Future research is needed
on the price elasticity of demand for service industries and the characteristics of their
markets and pricing structures to estimate tax incidence.

In addition, the measurement of sales tax incidence based on current
consumption from current income assumes that the tax is shifted entirely forward to the
consumer in the form of higher prices (Bohm and Craig, 1987). However, a portion of
the tax will not be shifted to in-state consumers. According to Coopers and Lybrand, an

accounting firm, who studied the financial records of service businesses in Florida, and

43

found that about two-thirds of business service purchases are believed to be made by
multi-state businesses who would find if difﬁcult to pass on the tax to in-state consumers
because of their national pricing structures. In addition, Browning (1979), argues that a
sales tax is borne by the owners of inputs in the form of lower input prices as the tax
lessens aggregate demand. Furthermore, the tax is less regressive because low income
households may be eligible to receive transfer payments which are indexed to inﬂation

and therefore their income rises with prices increases (Bohm and Craig, 1987).

3.9 Efﬁciency

Administrative and economic efficiencies are other important criteria used to
judge tax structure changes. Further research is needed on the administrative efficiency
aspects of taxing services. Economic efﬁciency describes a situation in which there is an
optimal allocation of resources. That is, when resources are allocated so that no activity
can be increased without reducing another activity (Nicolson, 1985). Economic efficiency
is derived from the pareto optimality where no one can be made better off without at
the same time making at least one other person worse off. A change in resource
allocation constitutes a pareto improvement if at least one person is made better off as a
result of the change and no one is worse off. Most changes in the economy can not be
judged according to the pareto principle because it requires value judgments about
interpersonal welfare comparisons. In general, government prevents the attainment of
pareto optimality through the market mechanism when it imposes taxes that provide a

distortion through changes in prices and income.

3.10 Efficiency and Rights

Efficiency defines trades within the market as a private and voluntary choice
within a certain legal structure. However, the impact of altering the law to tax services is
the speciﬁc situation to be determined by policy evaluation. The speciﬁcation of law or
rights will govern the outcome of efficiency analysis or who is in the position to make
choices in the market. Judgements about who receives the rights and who does not, tend
to reinforce the existing distribution of wealth as to the party most valuable. Solutions of
the optimal tax are without meaning unless adequately defined. There are efficient
adjustments to any legal change and thus efficiency can not be judged without first
deciding the purpose of the activity and this requires a value judgement. Therefore,
efficiency can be used as an evaluation tool only after rights are granted which is a

distributional principle (Samuels, 1982).

3.11 Deadweight Loss

Efficiency may be evaluated within a certain rights structure. The most efﬁcient
taxes minimize these distortions in welfare called deadweight losses (Boadway and
Wildasin, 1984). Raising revenue with a sales tax on good X will increase its price
relative to an untaxed service Y. The imposition of a tax on good X creates a wedge
between the higher price paid by demanders and the lower price received by supplies.

As the price paid by consumers increases due to a sales tax, less overall quantity
is demanded and a deadweight loss is imposed on good X. The deadweight burden is a
measurement of the loss to the economy resulting from the implementation of a tax
which distorts. It is the excess of the income that would have to be given to a consumer

to restore them to their pretax situation (Diamond and McFadden, 1974).

45

Whether the tax imposed is an ad valorem tax or a specific tax makes a
difference in how ﬁrms adjust either the quality or quantity of the service produced.
Both types of taxes increase prices by the same amount but the supplier response is
different. Since the sales tax is an ad valorem tax, or a percentage tax on the dollar
value of sales, firms have an incentive to reduce quality because the tax is based on the
value of sales. For a specific tax, levied on the quantity sold, the situation would be
reversed as producers would tend to reduce quantity. Thus, the price may rise by less
than the tax increase as producers make adjustments in the quality or quantity of sales

(Nicholson, 1985).

3.12 Inverse Elasticity Rule

The inverse elasticity rule governs which tax is most effective from an efficiency
perspective. This rule states that the rate at which taxes should be levied on
commodities depends on the characteristics of the price elasticity of demand. The
optimal tax is inversely proportional to the price elasticity of demand. Services
characterized with inelastic demands should have the highest tax rates because they
impose the least deadweight loss (Boadway and Wildasin, 1984). If the extreme case,
when the demand is perfectly inelastic, the tax is fully paid by the consumer. If demand
is infinitely elastic, the tax is completely paid by the ﬁrm.

The inverse elasticity rule highlights the trade off between equity and efﬁciency.
The optimal set of taxes, from an efficiency perspective, minimizes the relative
deadweight losses incurred from taxing commodities. However, this conﬂicts with the
equity criteria because the most efﬁcient taxes are levied on necessities which comprise a

large portion of the low income groups budget. Thus, a tax structure with fair

46

distribution of the burden of output reduction in the private sector among various

members of society may not be the most eﬁ‘icient tax.

3.13 Consumption Taxes and Exemptions

The taxation of all goods and services creates less distortion between taxed and
untaxed goods from an efﬁciency view point. A sales tax will distort relative prices and
create an excess burden when some goods are not taxed. Nonetheless, no state levies a
pure sales tax because excluding all business sales would narrow the tax base to such an
extent that states would need to raise the tax rate. While a sales tax on all consumption
would have no effect on relative prices of consumption goods, it would affect the trade
off between leisure and consumption as leisure is not taxed. In addition, it would
complicate the sales tax administration as deﬁnitions would be needed to differentiate
between consumer and business items. Some business services may be exempt to reduce
multiple taxation of business inputs. This will be discussed in Chapter 5 on business
services. Simplicity of tax administration necessitates that these deﬁnitions be clear
enough for third party collection agents to apply the tax at the check out counter. Thus,

state sales tax structures differ from the a pure sales tax.

3.14 Comprehensiveness of the Sales Tax Base

Administrative and political decisions have been made regarding exemptions in
order to deﬁne the consumption basis of the sales tax. According to Musgrave and
Musgrave (1984) these exemptions have narrowed the tax base to an estimated 37
percent of consumption (Fox and Murray, 1988). Michigan’s sales and use tax
exemptions are estimated at $1.9 billion compared with sales and use tax collection of

$2.8 billion for ﬁscal 1988 as shown in Table 3.2. The large portion of the sales and use

47

 

 

 

Table 3.2
Potential Tax Base: Michigan Sales and Use Taxes
(Dollars in Thousands)

Percent
Revenue or Exemption FY 88 of Total
Sales Revenue 3 2,449,794 50.9
Use Revenue 416,062 8.6
Services 1,006,000 20.9
Food 422,680 8.8
Prescription Drugs 16,647 0.3
Industrial Process 284,099 5.9
Other Exemptions 222,056 4.6
Total 3 4,817,338 100.0

 

Source: Data from M 1990-21 ﬁxative Eugget and ax

The State of Michigan estimated revenue foregone for services differs from the updated 1987 estimate

Note:

11 ' Fiscal 1987-88.

shown in Chapter 5 of this report because the WM estimate is based on the

1982 Census of Services adjusted upward for inﬂation.

tax base which is exempt is illustrated in Figure 3.7. The major exemptions include

services, food and prescription drugs and industrial processing. From the $4.8 billion

potential sales and use tax base recorded, 59 percent is taxed. Thus, the Michigan’s sales

and use tax base is less comprehensive than a broad based consumption tax.

3.15 Gross Receipts and Value Added Taxes

Alternative forms of consumption taxes could be levied by states at different

stages of production. The retail sales tax is different from a gross receipts tax in that the

sales tax is levied on ﬁnal sales while the gross receipts tax is applied to all sales. A

value added tax is conceptually equivalent to a similarly comprehensive pure retail sales

tax. The value of the good is equal to the sum of the value added at each stage in the

production process. However, most state’s retail sales tax applies to more than the

48

Sales Tax Revenue
50.9%

Other Exemption
4.6%

   

Use Tax Revenue
8.8% Industrial Process
5.9%

Services
20.9%

Source: Data from Fiscal 1990-91 Executive Bu et and Fiscal 1987-88 Tax Expenditure Appendix.

 

Figure 3.7. Michigan Sales and Use Tax Exemption Comprise Large
Portion of Tax Base, Fiscal 1988

finished good because goods are purchased by business. The advantage of the value
added tax over the retail sales tax is that business items are taxed only once providing

less distortion over production and consumption decisions. The advantage of the sales
tax is its simplicity and familiarity to US. business. In addition, to the extent that the tax
falls on owners of capital, the sales tax is less regressive (Francis, 1988). Thus, the retail
sales tax, gross receipts tax or the value added tax are various forms of consumption

taxes which could be levied and provide different a different impact when taxing services.

3.16 Summary
The sales tax has gained popularity and acceptance as a viable alternative for
raising revenue. In general, states are moving away from progressive taxation structures

and toward more regressive alternatives like the sales tax. One disadvantage is that most

49

authors agree that state sales tax structures are mildly regressive. The tax equity on low
income taxpayers could be improved by oﬁ’ering exemptions or credits. Horizontal
equity addresses the trade-off between the taxed good and the exemption on leisure. A
sales tax on goods will discriminate against the person with a strong preference for
commodities as opposed to leisure. As a proxy for taxing leisure, the state could tax its
complements. Examples of services which are complements to leisure are amusement
services like motion pictures, golf, bowling, and ﬁtness services.

Within a speciﬁed rights structure, the efﬁciency beneﬁt from broadening the
sales tax base is that there is less distortion and substitution between taxed and non-
taxed goods. Reviewing the efficiency of the present sales tax structure provides a basis
for comparison required to determine the impact of adding services. The most efﬁcient
taxes are those that minimize the distortion from changes in prices and income resulting
from the tax. A pure consumption tax would not effect relative prices because all items
would be taxed except leisure. However, no state levies a pure consumption tax due to
the exemptions and credits applied with the tax. States could choose to tax consumption
with alternatives to the retail sales tax such as the gross receipts tax or a value added tax.
These taxes would result in different efﬁciency impacts with the value added tax creating
the least amount of distortion on business items. Nonetheless, most states continue to
levy a retail sales tax because of its familiarity, consumer acceptance and administrative
simplicity. As will be discussed in Chapter 5, states could gain efﬁciency by expanding
the base to services and lowering the tax rate on a revenue neutral bases. Chapter 5 will
also discuss the new legislative proposals considered by states which have tended to tax
services on an incremental basis rather than the broad based approach and thus these tax

structures are less likely to improve efficiency.

CHAPTER 4

The Michigan Sales Tax Base:
Revenue Adequacy and Stability

4.1 Introduction

Chapter four will analyze the revenue stability and adequacy of the Michigan
sales tax base. Issues to be addressed concern whether the sales and use taxes will
provide sufﬁcient and adequate revenue for public programs. The cyclical nature of
sales tax collections will be reviewed to illustrate how limiting the taxation to the goods
producing sector has contributed to the instability of collections. A review of the service

sector, during this same period, illustrates its more stable or growth orientated history.

4.2 Michigan Sales Tax Collections

The Michigan sales tax data illustrates that collections have followed a procyclical
pattern. Table 4.1 of sales and use revenue by category is measured in nominal
collections by ﬁscal year. The cyclical nature is illustrated in the recessions of the early
1980’s. According to Peterson (1984), the business cycle fell from a peak in January
1980 to the trough in July 1980 for a contraction of 6 months in fiscal year 1980. A 12
month expansion followed reaching another peak in July 1981. The subsequent trough
was recorded in January 1983, ending a 18 month contraction which overlapped ﬁscal
years 1981-83. Sales tax collections, as measured by the annual percent change, fell

during the business contraction as shown in Table 4.2. The growth of nominal sales tax

50

51

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53

collections slowed to 1 percent in 1980, followed by a slight upturn in 1981 of 4.7 percent

and then declined -0.4 percent in 1982. Use tax collections followed a similar trend.

4.3 Real Sales Tax Collections

Sales tax collections are compared on a nominal and real basis to illustrate the
impact of inﬂation on collections. Figure 4.1 shows the change in nominal dollars
collected from 1978 to 1988. Michigan sales tax collections actually declined by over $6
million in ﬁscal 1982. Figure 4.2 indicates the change in physical trends, measured by
inﬂation adjusted sales tax collections. Real collections fell in 1979, slightly preceding
the recessionary period and continued to decline until 1983. Figure 4.3 summarizes the
comparison of the annual change of sales tax collections on a nominal and real basis

from 1978 to 1988.

4.4 Stable Revenue Base Defined

A revenue source is defined as stable when the growth rate of revenues is
constant over the business cycle. This occurs when the short run income elasticities of
revenue collections rise in recessions and fall 'in expansions. See figure 4.4. Fox and
Murray (1988) found the sales tax to be relatively unstable as elasticities were very
procyclical across the business cycle.

Short run income elasticities of Michigan sales tax collections are presented in
Table 4.3. These year to year measures of the annual percent change in sales tax over
the annual percent change in personal income fell in the early 1980’s recessions and rose
in expansionary years. A review of the sales tax elasticities by category reveals that the
components falling behind the growth of personal income and contributing most to the

decline from 1980-82 include building materials, autos and furniture. Auto sales tend to

54

ANNUAL CHAMSE IN MILLIONS OF S

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

250
200
150 '— ""4
100 ~
50 .. ..... ,.... .... P.
0 152% all
-504':1:1.L 1 4.1%
1978 1980 1982 1984 1986 1988
FISCAL YEAR COLLECTIONS IN NOvIINAL S
Source: ic ' ' e u t various years and Departments of Management and Budget and Treasury.
Figure 4.1. Growth of Michigan Sales Tax
0 ANNUAL CHANGE IN MILLIONS OF REAL $
100 ~
0 mm m nnm
-100
-200
_300 J] 1 IL 1 l 1 11 l g l 1
1978 1980 1982 1984 1986 1988
FISCAL YEAR SALES TAX COLLECTIONS
Source: W various years and Departments of Management and Budget and Treasury.

Figure 4.2. Growth in Michigan Sales Tax Adjusted for Inflation

55

ANNUAL CHANGE IN MILLIONS OF $

 

I

 

2,500

2,0001” '\ m x

1.500 A M

 

 

 

 

 

 

 

 

1,000
500
U l l l l l l l l l l
1977 1979 1981 1983 1985 1987
FISCAL SALES TAX COLLECTIONS
‘9— NOMINAL DOLLARS """ REAL DOLLARS
Source: Micmm ﬁgecug’ e Budget, various years and Departments of Management and Budget and Treasury.

Figure 4.3. Michigan Sales Tax, Growth in Real vs. Nominal Dollars

4 Income Elastlcity

 

 

 

 

O —s L
I
\

 

l l l 1 l J

 

 

 

-2 ‘ i 1 i r i 1
1977 1979 1981 1983 1985 1987 1989

-|l- Total Sales Tax + Auto Sales Tax

Source: Collections from Michigan Executive Budget, and personal income from Bureau of Economic Analysis.

Figure 4.4 Sales Tax Income Elasticity

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56

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57

dampen during recessions as consumers tend to delay the purchase of large durable
goods. In addition, consumers who require financing of car sales are particularly
sensitive to interest rates which tend to rise during recessions. Further, the low growth
of furniture and building materials may be explained by fact that these goods are
complements to new housing which usually is postponed during economic downturns.
These procyclical goods, autos, furniture and building materials, comprised 37.2 percent
of the sales tax base in fiscal 1989. Thus, a large portion of Michigan’s sales tax

collections are unstable and cyclical in nature.

4.5 Adequate Revenue Base Deﬁned

An adequate tax can be defined as one where the long-run total income elasticity
of tax revenues equals the long run total income elasticity of expenditures. The total
elasticity for all a state and local expenditures financed from own sources was 1.12
between 1970 and 1984, illustrating that an adequate tax structure would be slightly
elastic. A tax is inadequate if the demand for public services has a higher total income
elasticity (Fox and Murray, 1988). Since Michigan’s Constitution requires a balanced
budget, expenditures are reduced to equal revenues and therefore an income elasticity of
expenditures would not reﬂect true expenditure growth.

Nonetheless, the principle that the income elasticity of revenue should be slightly
elastic may be applied to Michigan. Michigan’s long-run income elasticity for the sales
tax averaged 0.83 from 1977 to 1989, less than an elasticity of one. This period was
chosen because prior to 1975, Michigan taxed food and this change substantially impacts
the amount collected. The Michigan income elasticity for the use tax was 0.95. This is

more adequate but with less impact on state finances as it only representing 17.2 percent

58

of the sales tax collections in 1989. Thus, the adequacy of Michigan’s sales tax base

could be improved.

4.6 Data Sources

Tax collections are not available for services in Michigan because they are not
currently taxed. The analysis, therefore will be based on information obtained from
government agencies. To assess the magnitude of the service sector, the Census of
Service Industries data from the U. S. Department of Commerce will be utilized. The
Census of Services Industries for 1987 records gross receipts of establishments. Receipts
are the basic dollar volume measurement for service establishments of ﬁrms subject to
the Federal Income tax. In general, it includes receipts from customers or clients for
services provided, from the use of facilities and from merchandise sold in 1987 even if
payment was not received in 1987.

The economic census is a major source of facts about the structure of the
economy. Title 13 of the U. S. Code, sections 131, 191, and 224 directs the Census
Bureau to take the economic census every 5 years, covering years ending in 2 and 7.
The next economic census is scheduled to cover 1992, and thus the 1987 data (published
in 1989) is the most recent available. The Census of Services data is organized by the
newly revised standard industrial classification system (SIC). Selected reports are
included with bridge tables to link old and new classification systems for a comparison
with the 1982 data.

Data are presented for establishments in the following classifications: hotels,
rooming houses, camps and other lodging places, personal services, business services,
automotive repair, services and parking, miscellaneous repair services, motion pictures,

amusements and recreation services, health services, legal services, selected educational

59

services, social services, museums, art galleries and botanical and zoological gardens,
selected membership organizations, engineering, accounting, research, management and
related services. Excluded services generally have a non-profit character and include:
elementary and secondary schools, colleges, universities, professional schools and junior
colleges, labor unions and similar labor organizations, political organizations, religious
organizations and private households. Government establishments are excluded except
for government operated hospitals which were included.

The Census report presents data for the U. S. as a whole, each state, each
consolidated and primary metropolitan statistical area and each county. All data in the
report originated from either census questionnaires or administrative records of other
Federal agencies. Summary statistics include data on number of establishments, receipts,
annual payroll, first quarter payroll, paid employees for pay period including March 12,
and unincorporated businesses or operations separated by individual proprietorships and
partnerships.

Another source of data on services in the Michigan economy is the gross state
product (GSP). The gross state product is the state version of the U. S. Gross National
Product prepared by the Bureau of Economic Analysis, (BEA). Estimates are prepared
for 61 industries and is composed of four components including compensation of
employees, proprietors’ income, indirect business tax and non-tax liability and other
charges. GSP data is provided by component and by industry for each state.

The advantages of the GSP data compared with the Census data is that it is
available on an annual basis while the census data is only collected every 5 years. Since
GSP data is estimated annually it provides an opportunity to review the change in
services during expansion and recession periods. In addition, GSP data provides a basis

for direct comparison of the value of good and services. For example, large durable

60

goods like cars have a higher value than a small services like lawn care. An alternative
indicator like employment illustrates the growth rate of services but not the magnitude of
the dollar base.

BEA provides estimates of GSP in both current and constant dollars. Current
dollar GSP estimates reﬂect the trends in the command over resources associated with
production. The analysis is this paper is based on the constant dollar GSP estimates
which reﬂect the physical trends in the volume of production. Constant dollar GSP

estimates are now based on national price deﬂators by industry.

4.7 Shift Toward Service Sectors

Michigan’s economy is in the process of equalizing consumption between goods
and services. GSP data in Table 4.4 and Figure 4.5 illustrates that the manufacturing
sector of Michigan’s economy has declined from 36.6 percent in 1963 to 34.7 percent in
1986. At the same time, the private service producing sectors including transportation,
communications and utilities, wholesale trade, retail trade, finance, insurance and real
estate services have shifted from 42.4 percent to 50.8 percent. The years of 1963 and
1986 were compared because they span a long run time period and are the beginning
and ending years for which GSP data are available. In addition, they are similar points
in the business cycle, following the trough by two to three years. This comparison
reﬂects the long term change in Michigan’s economy rather than the cyclical changes

which usually occur over the business cycle.

4.8 Growth of Services
The GSP line graph in Figure 4.6 illustrates the stability of the service industry,

narrowly defined, compared to the cyclical manufacturing sectors. The stability of the

61

Table 4.4

Michigan Gross State Product, 1963 and 1986
(Real Dollars in Millions)

% of 73W
Dollars Total Dollars Total
1963 1963 1986 1986

 

Total 83,796 100.0% 136,433 100.0%
Manufacturing 30,638 36.6% 47,408 34.7%
Transportation, Comm., and Util 5,261 6.3% 9,465 6.9%
Wholesale Trade 4,245 5.1% 9,093 6.7%
Retail Trade 7,489 8.9% 12,598 9.2%
Finance, Insur., and Real Est. 10,293 12.3% 19,432 14.2%
Services 8,236 9.8% 18,782 13.8%
Other 17,633 21.0% 19,655 14.4%

 

Source: Gross State Product data from US. Department of Commerce, Bureau of Economic Analysis, 1988.

Percent of Total Ml GSP
40%

35%
30%
25%
20%
15%
10%

5%

 

0%

ManuIact Transport Wholesale Retail Finance Services
Selected Sectors

@1953 -1935

Source: Gross State Product data from US. Department of Commerce, Bureau of Economic Analysis, 1988.

Figure 4.5. Michigan’s Economy Shifts, 1963-1986

 

62

 

0 REAL Ml GSP IN MILLIONS OF S

 

50

4. K. /\ /"\ r
V

 

V \/

 

 

 

 

 

 

30
20 -
1U‘M:W
ailiilllilllilllililill
1963 1957 1971 1975 1979 1983

—°— Manulaclurlng + Services
Source: Michigan Gross State Product, Bureau of Economic Analysis, 1988.

Figure 4.6. Growth of Services vs. Manufacturing, 1963-1986

REAL GSP IN MILLIONS

 

W.

5
Fieaalt::‘////“’r"
S

 

 

 

 

Busmess

 
 
 

 

 

 

 

 

 

 

2 ...............................................
, rofess 10 na I
1W‘ -- A 7.
O J l J J 4' 1 L J. l : L l J _l : l 44 1 : 1%
1983 1968 1973 1978 1983
YEARS
Health + Busmess —><-- Professorial

 

Source: Michigan Gross State Product, Bureau of Economic Analysis, 1988.

Figure 4.7. Selected Major Service Industries, Long Term Growth, 1963-1986

63

service sector may be explained by the growth of the three largest industries with GSP of
over a billion real dollars in 1986. The fairly steady upward trend of dominant health,
business and professional services from 1963 to 1986 is shown in Figure 4.7. The growth

of the smaller service industries is shown in Figure 4.8 which includes auto service,

amusement, educational, legal and social services.

4.9 Ratio of Services to Manufacturing

Another measure of the change in the Michigan economy, measuring the more
stabile growth of services compared to manufacturing is the ratio of services to
manufacturing. Figure 4.9 illustrates that this ratio has risen from 26.9 percent in 1964
to 39.6 percent in 1986. In addition, the ratio peaked at 48.4 percent in 1982 as the level

of manufacturing fell during the recession years.

4.10 Summary

Michigan’s sales tax collection data illustrates that revenues have followed a
procyclical pattern as measured by the low rates of growth during the recessions of the
early 1980’s. A revenue source is defined as stable when the growth rate of revenues is
constant over the business cycle. This occurs when the short run income elasticities of
revenue collections rise in recessions and fall in expansions. Fox and Campbell (1988)
found the sales tax to be relatively unstable as elasticities were very procyclical across the
business cycle.

Michigan’s economy is in the process of equalizing consumption between goods
and services as the manufacturing sector of Michigan’s economy has declined from 36.6

percent in 1963 to 34.7 percent in 1986. At the same time, the private service producing

Ml Real GSP in Thousands of $

 

1,200

1,000

,1»

800“- "\

 

 

 

 

 

0' l l l l % l l l l % I l l l : l l I l : l l
1963 1968 1973 1978 1983
Years
—’- amusements + personal + auto repalr
'9- mlsc. repa1r + educational + somal serv1ces

Source: Michigan Gross State Product, Bureau of Economic Analysis, 1988.

Figure 4.8. Selected Small Service Industries, Long Term Growth, 1963-1986

Serwces as a Percent of Manufacturmg

 

0.5

0.4 *- (~

0.2-

[ML

 

 

O l l l l 1 4 l l l l l l l I I l l l l 1

l i 1 TI l
1963 1957 1971 1975 1979 1983
Real Ml Gross State Product In Mill of s

Source: Michigan Gross State Product, Bureau of Economic Analysis, 1988.

 

Figure 4.9. Ratio of Services to Manufacturing, 1963-1986

65

sectors including transportation, communications and utilities, wholesale trade, retail
trade, finance, insurance and real estate services have shifted from 42.4 percent to 50.8
percent. GSP data illustrates the stability of the service industry, narrowly defined,
compared to the cyclical manufacturing sectors. Thus, adding services to the tax base
may increase the stability and adequacy of sales tax revenues over the business cycle.
Some authors assert that the growth spurt experienced by the service sector may
not continue as these sectors mature. Future research is needed to forecast the grth
of services. While the future growth of services may not contribute as much to tax
revenue as they could have if taxed in the past, they are likely to produce a more stable

collection base.

 

CHAPTER 5

Impact of the Michigan Sales Tax on Services

5.1 Introduction

The following chapter will address the impact of levying a sales tax on services on
selected industries. The purpose is to evaluate the issues surfaced in specific service
sectors and to provide the reader with a better understanding of the industries
composing the service sector tax base. The narrative will outline the composition of the

service industries, revenue estimates, grth trends and policy alternatives.

5.2 Services Defined

Services are intangible objects which consumers buy that usually result in actions
performed for the benefit of the purchaser. According to the Bureau of Labor Statistic’s
items may be separated into the private economy goods producing and service producing
industries. The private service producing industries include: transportation and public
utilities, wholesale trade, retail trade, ﬁnance, insurance and real estate and services.
The private goods producing industries include mining, construction, and manufacturing.
This chapter will limit the analysis to narrowly deﬁned service industry within the service
producing economy.

The intangible nature of services complicates the administration of the tax

compared to the tangible characteristics of goods. When taxing services, most states

66

67

apply the long standing situs rule that use or consumption occurs at the point where the
seller or his agent delivers the goods. The point of delivery for service items is easily
manipulated to another state because service firms have greater mobility as they require
less investment in physical plant and inventory than do those ﬁrms manufacturing goods.
Delivery of services requires less interstate transportation costs as a telephone call or
envelop may be used for delivery.

Services may be categorized into site specific and non-geographic specific services
for taxation purposes. The administration of a service tax is simplified if the service is
performed for use at a specific site such as landscaping services which may be attributed
to a certain location. In this case, the state of use is more easily determined. Non-
geographic specific services require the tax collector to determine the state of use,
perhaps through an apportionment formula. Firms cost of compliance rises when
intangible services with some site specific characteristics are mixed with non-geographic
specific services or when an item is composed of both goods and services but the cost of
the service is not itemized. The intangible nature of services makes administering the

tax difﬁcult because transactions are not easily separated.

5.3 Service Industry Composition
To evaluate the impact of taxing services, the Census of Service Industries data
from the U. S. Department of Commerce will be used as a proxy for the Michigan sales
tax base. Figure 5.1 illustrates the composition of the service sectors based on the 1987
Michigan Census of Services which records the gross receipts of establishments.
Categories of service establishments listed in the Census of Services include: 1)
hotels, rooming houses, camps and other lodging places, 2) personal services, 3) business

services, 4) automotive repair, services and parking, 5) miscellaneous repair services, 6)

68

motion pictures, amusements and recreation services, 7) health services, 8) legal services,
9) selected educational services, 10) social services, museums, art galleries and botanical
and zoological gardens, selected membership organizations, and 10) engineering,

accounting, research, management and related services. Services which are excluded

HOTEL
LEGAL 3.7%

  

 

.«\
AMUSEMENT "\

 

 

 

 

 

 

5 1% OTHER
MISC REPAIR 119%
3.3%
PROFESSIONAL BUSINESS
15.7% M‘ 0
___ .346

PERSONAL
4 .796

Source: Michigan Census of Services, 1987.

Figure 5.1 Service Industries Composition

have a non-proﬁt characteristic. Government establishments are excluded except for
government operated hospitals which were included. The list of categories in the
Michigan Gross State Product data is nearly the same as in the Census of Services but
with less industry detail. One difference is that professional services are listed in the
GSP rather than engineering, accounting and research. In addition, GSP data includes a
separate category for motion pictures which is listed as a subdivision of amusements and
recreation in the Census data. GSP also includes a separate category for household

services.

69

5.4 Revenue Estimates

Sales tax on services revenue estimates are shown in Table 5.1 and were based on
the Michigan Census of Services for 1987. The industries are listed in descending order
by size of establishments. A revenue estimate with further breakdowns by four digit SIC
code is provided in the Appendix Table I. These estimates assume that all services
receipts could be taxed and thus they may be viewed as the maximum amount of revenue
to be raised from in state activity. Additional revenue would be gained from a use tax
on items purchased out-of-state but used by Michigan residents and firms. More precise
revenue estimates would require further research and policy decisions on use tax
revenues, exempt sales, presently taxable activity, compliance problems, apportionment

activity of in-state and out-of-state firms and consumers, sales to affiliated groups and

Table 5.1

Sales Tax on Services, Revenue Estimates

 

 

Estimated

Establish- Receipts Revenue“
ments (Millions (Millions

Kind of Service Business (No.) of S) of $)
Health Services 15,382 6,219.9 248.8
Business Services 7,846 5,576.2 223.1
Engineering, Accounting, Research, 6,300 3,748.3 149.9
Automotive Repair, & Parking 5,357 1,840.7 73.6
Legal Services 4,326 1,769.9 70.8
Amusement and Recreation 3,436 1,447.3 57.9
Personal Services 6,338 1,127.0 45.1
Hotels, Rooming Houses, & Camps 1,434 893.7 35.7
Miscellaneous Repair Service 2,240 788.6 31.5
Social Services 1,578 219.2 8.8
Selected Educational Services 260 127.1 5.1
Other Services 870 101.9 4.1
Total 55,367 $23,859.8 $954.4

 

" Receipts times the 4% tax rate.

Source: Data from 1987 M1 Census of M'm, 1989.

 

70

behavioral responses to the tax increase such as vertical integration by firms and
reduction in quantity demanded by individuals.

Before Florida taxed services, the state commissioned a Coopers and Lybrand
study of 20,000 firms to assess the impact of the tax. Gathering information to more
precisely estimate the revenue from the tax is a significant task (Rockwood, 1987).

The Census of Services classifies firms according to their primary activity. For
example, if a manufacturing firm provides services, the firms gross receipts are classified
as manufacturing not services. According to the Census of Service Industries, receipts
do not include service receipts of manufactures, wholesalers, retail establishments or
other businesses whose primary activity is something other than services. These receipts,
however, do include receipts other than from services rendered like the sale of
merchandise to individuals or other businesses by establishments primarily engaged in
performing services which are classified as service industries. For more precise
estimates, further research is required to determine the portion of service firms receipts
that is already included in the tax base as tangible goods. Another limitation of the
Census of Service data is that it does not include establishments with less than five '
employees on the payroll and therefore some repair and professional services are not
included. Despite the limitations of establishment data, estimates based on the Census

of Service data provide a useful indication of the magnitude of the service tax base.

5.5 Sales to Income Ratio

Another method for estimating revenue and gaining some insight is to review the
collections of states which already tax services. This approach is outlined by Payne,
Lathen and Bain (1990) and relies on determining the percentage of taxable sales to

personal income from New Mexico and South Dakota, two of the three states with a

71

broad based tax on services. Both states are included to illustrate the contrast in state
tax structures and consumption patterns to provide a broader base of comparison and a
more generalized projection. This percentage is then applied to Michigan’s personal
income to estimate the amount of revenue Michigan would raise assuming Michigan
consumed services at the same rate of personal income and Michigan adopted the same
tax base and exemptions as the other states.

The limitation of this approach is that Michigan’s economy may not be similar to
that of New Mexico or South Dakota. State differences may exist in consumers behavior
due to the weather, geography, cultural practices, family size, urban to rural mix,
administrative practices, tax collection enforcement effort, legal interpretation and the
proportion of the economy represented by major industries like the auto sector. Table
5.2 illustrates the differences between Michigan and the states of New Mexico and South
Dakota in terms of state size. This comparison illustrates that Michigan is a significantly
larger state based on personal income data. New Mexico and South Dakota record
personal income of only 12.6 percent and 6.3 percent of Michigan’s personal income
level, indicating that these states have smaller economies. In addition, a review of per
capita income levels indicates that Michigan’s per capita personal income is over 18
percent higher than South Dakota’s and over 29 percent higher than New Mexico’s.
Since consumption of services tends to rise with income, Michigan residents may
consume a higher proportion of services than these states.

The other limitation of this approach is that there are only 3 states which levy a
broad based service tax including New Mexico, South Dakota and Hawaii. Idaho’s
taxation of services is primarily levied on personal services. Although Idaho is
sometimes included in a comparison, it is more appropriately classiﬁed in the middle

between a narrow and broad base of taxation. Florida no longer taxes services, and

72
Table 5.2

Michigan’s Economy Ranks Larger Than New Mexico and South Dakota

 

 

1987 1987 Per Capita

Personal Income Percent Personal Income
State Region (Millions of S) of MI (Dollars)
Michigan Great Lakes 141,618 ----- 15,393
New Mexico Southwest 17,812 12.6% 11,875
South Dakota Plains 8,900 6.3% 12,550

 

Source: Personal income from Survey of gum; Busing, August, 1988.

therefore revenue collection data is available for only a few months. Given the limited
number of states which tax services the sample is small

The advantage of this method is that it does provide additional information by
type of service. Table 5.3 illustrates the revenue Michigan could collect using New
Mexico or South Dakota’s consumption of services as a percent of personal income and
tax base definitions. The analysis indicates that personal services, auto repair services
and legal service revenues may provide more revenue and that business services, medical
services and engineering and architecture may provide less revenue than shown above.

Personal services are taxed uniformly by both New Mexico and South Dakota as
neither provides personal service exemptions. Further research on the amount of
services provided by firms primarily classified as goods producing may uncover a larger
revenue base.

Auto repair services are recorded by both New Mexico and South Dakota as 1.8
percent of personal income. The estimate for Michigan is net of repair services provided
by new car dealers as this service is not reported by the Census of Service Survey

because new car dealers are classified primarily as goods producing firms.

Business services illustrate the range of possibilities for taxation as New Mexico’s

consumption is 3.5 percent of personal income, nearly triple the 1.2 percent recorded by

73

South Dakota. New Mexico may have a larger industrial base with less exemptions

Table 5.3

Comparison of New Mexico and South Dakota Service Tax Base
as a Percent of Personal Income with Michigan’s Taxable Service Base

 

 

Taxable Sales Difference in
as a Percent of Michigan Estimated Tax Base
Personal Revenue Based on Sales from
Income as Percent of Income Michigan
Services NM SD NM SD MI NM SD
(%) (%) (Millions of 3) (Millions of 3)
Personal 1.0 1.0 56.3 56.3 45.1 -11 -1 1
Auto Repair 1.8 1.8 101.4 101.4 73.6 -28 -28
Business 3.5 1.2 197.2 67.6 223.1 26 155
Motion Pictures 0.2 0.2 11.3 11.3 19.2 8 8
Amusement &

Recreation 0.5 0.5 28.2 28.2 38.7 1 1 11
Medical 2.8 NA. 157.7 N.A. 248.8 91 NA.
Legal 1.3 0.7 73.2 39.4 70.8 —3 31
Engineering,

Architecture 1.2 NA. 67.6 NA. 149.9 82 NA.

 

 

 

 

Source: For New Mexico and South Dakota Taxable Sales as percent of income from Payne, Lathen
and Bain, 1990. For 1987 Michigan personal income of $140,847 million, from US.
Department of Commerce, Bureau of Economic Analysis.

Note:

The revenue estimate for amusements and recreation of $57.9 million includes motion picture

receipts. To match the categories of New Madco and South Dakota taxable sales, the total
amusement and recreation revenue estimate of $57.9 was subdivided into a motion picture
estimate of $19.2 and a amusement and recreation net of motion pictures of $38.7 million.

compared to South Dakota. This range of taxable sales as a percent of personal income

illustrates that Michigan’s revenue would depend on the level of business exemptions and

business service consumption in the state.

74

Medical services are taxed heavily by New Mexico, including tax collection from
services paid by Medicare and Medicaid. Michigan’s gross receipts from medical
services comprised 4.4 percent of personal income, suggesting that Michigan residents
consume a higher proportion of medical services than New Mexico’s residents. This
percentage is similar to the proportion based on the 1982 Census of Services where
Michigan’s health services comprised 4 percent of personal income. One difference
between the 1982 and 1987 Census of Services data is that the 1987 survey includes
hospitals. This adds an additional $242 million to the $6,220 million of health care
services. Health services comprised 4.2 percent of Michigan’s personal income in 1987
when hospitals were removed from the health service total, making the data comparable.
Michigan residents may consume a higher proportion than New Mexico residents
because Michigan’s health services are financed to a greater extent by the auto industry,
a dominant employer in the state providing above average health insurance beneﬁts.

Legal services are taxed broadly by both New Mexico and South Dakota. South
Dakota only exempts legal services for schools, governmental agencies and social service
agencies. The difference in taxable sales as a percent of income may be attributed to
New Mexico’s larger business tax base.

Engineering and architectural service are exempt in South Dakota but taxed in
New Mexico which accounts of the difference in taxable sales. Michigan’s gross receipts
are significantly larger than New Mexico’s, recorded at 2.7 percent of personal income in
1987, compared to 1.2 percent of income in New Mexico. The greater industrial base in
Michigan could account for this difference.

In summary, the analysis of taxable sales to state personal income in New Mexico

and South Dakota illustrates that consumption patterns and tax structures vary between

 

75

the service taxing states. Despite the limitation, the comparisions provide a useful

indication of the potential range of revenue estimates for taxing services in Michigan.

5.6 Health Services

Medical Services is the largest and fastest growing service industry and is shown
in Figure 5.2. Given its signiﬁcant proportion of the total, the health service industry will
be discussed more fully than the smaller service sectors. The revenue lost by not taxing
medical services is $248 million. Medical services comprise 26 percent of total services,
as measured by Michigan Census of Services gross receipts and over 9.5 percent of the

Michigan sales tax base levied primarily on goods. Michigan health care services, as

ANNUAL PERCENT CHANSE

 

 

 

 

 

 

 

10%
I .
5% . ...... . ............
I
I
0%
_S%jllll4jlllLLLlllliJTIIIIIII
1954 1969 1954 1979 1994

versus
Source: Real MI GSP.

Figure 5.2: Growth of MI Health Services

76
measured by Michigan gross state product adjusted for inﬂation, have grown fairly
steadily since 1963 with the exception of a few recession years in the early 1980’s. Figure
5.3 illustrates the composition of the medical industry gross receipts from the 1987

Michigan Census of Services.

DOCTORS OF MEDICINE
1%

   
  

 

FOSPITALS iii§l==:=iillI--. “/4; HOMIE‘IgARE
3.9% ﬂﬂﬂueunnn ,
\\\.‘
OSTEOPATHY \\\§\.;z _‘_'.I.. / NURSING HOME
5 o \s, ‘ =I|III / 9.7%
LABORATORIES . ' _II"OTHER
5% = 3

DENTIST
17.2%
Source: MI Census of Services, 1987.

Figure 5.3: Health Service Industry Composition

5.6.1 Medical Inﬂation

Medical cost inﬂation for both goods and services is a long established fact in the
US. Over the past 20 years, U. S. health care expenditures grew at a 12.7 percent
compound annual rate. National data on health expenditures from the Health Care
Financing Administration indicates that medical spending began to accelerate after
slowing in the 1980-85 period. The US. Department of Commerce projects that medical
costs will rise in the range of 11-13 percent annual rate during the 1990-93 period.
Demographic trends, technology and the labor-intensive nature of the sector contribute
to the hyperinﬂation. However, structural factors are the primary reasons for the high

cost. For example, direct patient payments pay for only a small portion of health care

77

INSURNVCE
3I2%3

   

FEDERAL
287%;

' ; RATI NT
STATE & LCOAL 253%

Source: Health Care Finance Administration.

Figure 5.4. Financing of Health Services

spending. Nearly three fourths of the bill is paid by health insurance and government.
Of the $469.6 billion spent on national health care in 1987, the source of financing is
distributed as follows: 25.8 percent directly from the patient, 31.2 percent from health
insurance, 28.7 percent from the federal government, 11.8 percent from state and local
government and 2.5 percent from other. (See Figure 5.4.) Since third parties such as
insurance and government pay for a majority of the cost, consumers may be less
interested in cost containment. The free market competition which could force down
prices is not present. In addition, the fee for service cost structure provides an incentive
for health care providers to expand services. Further, as the baby boomers age, more
consumers will move into the population group using a greater share of health care
services. The average American spends nearly 85% of their total medical costs for life
over the last two years of life. The Bureau of the Census estimates that the over 65 and
above 75 year old age groups will increase by 23 percent and 35 percent during 1985-

2000. (Standard and Poors Industry Survey, 1989).

78
5.6.2 Health Benefits by Income

While health care is provided to those on public assistance and middle and upper
income groups, the working poor without health care insurance would be most in need of
tax relief for medical services. Congress expanded health care benefits for the 33 million
Americans relying on medicare with the passage of the Medicare Catastrophic Coverage
Act of 1988. The US. is the only industrialized country in the West without a
comprehensive national health care system and thus 37 million Americans are presently
without health care coverage. Lower middle class consumers, earning more than the
medicaid eligibility requirements but lacking employer provided health care insurance,

comprise the largest segment of the medically uninsured (Ibid., 1989).

5.6.3 Health Service Expenditures

Medical Service costs are paid by insurance, government or directly by the
consumer. Medical service expenditures recorded in the Consumer Expenditure Survey
are the out-of-pocket medical expenditures which are not covered by insurance plans.
This data is available by region from the Consumer Expenditure Survey from 1984 to
1986. Medical Service expenditures are published for the average before tax income in
the U. S. and for the Midwest, the smallest regional breakdown which includes Michigan.
This data provided in Table 5.4 indicates that medical services comprise approximately 2
percent of the average income before taxes in both the U. S. and the Midwest. In
addition, consumers spend between 2 and 3 percent more on other health care such as
health insurance, drugs and medical supplies. Categories of individuals who may pay
more than the average 2 percent of income on medical services include the poor, the

medically uninsured and the older consumer.

79
Table 5.4

Medical Services, Consumer Expenditure Survey, 1984-86

 

% of Income

 

Before Tax
ITEM US. Midwest US. Midwest
1984
Average Income Before Tax $ 23,464 $ 22,354
Medical Services 454 414 1.9% 1.9%
Other Health Care 595 582 2.5% 2.6%
1985
Average Income Before Tax 5 25,127 $ 24,120
Medical Services 496 508 2.0% 2.1%
Other Health Care 613 634 2.4% 2.6%
1986
Average Income Before Tax $ 25,460 $ 23,316
Medical Services 502 413 2.0% 1.8%
Other Health Care 632 665 2.7% 2.9%

 

 

Source: Data from Consumer Expenditure Survey for l984~86, US. Department of Labor, Bureau of
Labor Statistics, Bulletin 2333, 1989, p. 36, 74 and 114. Calculation of percent by author.

Note: Other health care includes health insurance, drugs and medical supplies.

Bohm and Craig (1987, p.30) have determined the percentage of consumer
income allocated to medical service expenditures based on the 1984 Consumer
Expenditure Survey. While health care services comprise a small percentage of income
at every income level, those at higher income levels spend a much smaller portion of
their income on medical expenses. For example, those consumers with income of $5,000
pay 5.06 percent on doctors and nurses and 1.21 percent on hospitals. This percentage
drops signiﬁcantly at the next highest income of $10,000 to 0.7 percent on doctors and
nurses and 0.19 on hospitals. In contrast, at incomes above $60,000 expenditures drop to
0.21 percent for doctors and nurses and 0.04 to hospitals.

A listing of service

expenditures as a percent of income is provided in Chapter Three, Table 3.2.

80

Health care consumption is concentrated in the older age groups. According to a
Bureau of Labor Statistics study, households allocate a larger portion of total
consumption to health care as they age because older people are more susceptible to
disabilities and illnesses. Total health care service spending as a percent of consumption
rises with the age of the reference person from 5.5 percent in the 55-64 age group, to 8.2
percent in the 65-74 age group to 11.2 percent for those over 75 years old (Passero,
undated).

Expenditures on health care are over four times larger for services than goods.
Thus, taxing medical services as compared to medical goods would have a greater impact

on costs as they are a higher portion of the health care bill.

5.6.4 Taxing Medical Services

Of the three states that levy a broad based sales tax on services, including Hawaii,
New Mexico and South Dakota, New Mexico is the only state which taxes health services
(Boucher, 1988). However, a low income credit is provided by New Mexico to offset the
negative equity impact.

Several issues need to be addressed when policy makers evaluate whether to tax
medical services or continue the exemption. Policy makers in favor of taxing medical
services argue that including them will improve the stability and adequacy of the tax
base. In addition, specific medical services like cosmetic surgery, face lifts and some
elective surgery may be classified as a luxury service. The taxation of that portion of
health care which comprises luxury services would contribute to the progressiveness of
the tax base. One policy option is to repeal the exemption for medical services which
are not necessities such as selected cosmetic surgery or elective procedures. Further

research is needed to classify medical services into necessity vs luxury categories.

81

The rational for not taxing medical services is that health care is a necessity and
taxing it would be regressive. In addition, because a significant portion of medical
services are paid by health insurance plans a tax on medical services could drive up the
already high health insurance rates paid primarily by employers.

A large portion of medical services are paid by insurance, as discussed previously.
Without specific legislation, health insurance companies could elect not to pay the tax.
In this case, the tax could shift to either the health care provider or the patient.
Alternatively, the health insurance companies could pay the tax in the interim time until
their contracts are renegotiated with employers. Further research is required to
determine the degree to which the tax would be paid by insurers, providers or
consumers.

Incidence theory discussed in Chapter 3 suggests that who pays the tax is
inﬂuenced by the market structure and the price elasticity of demand for the service.
Medical services categorized as necessities are more inelastic. Based on a study by
Houthakker and Taylor, (1970) the relative price elasticities for physicians and dentists
were not significant but were estimated at -0.27 for other medical professionals. Given
this inelastic service, the tax incidence falls on the consumer or insurer rather than on
the ﬁrm or worker through reduced demand. That is, a price increase resulting from the
tax has a less than proportionate decrease in quantity demanded. Thus, the tax would
not result in a significant reduction in the demand for health care services.

The structure of the health care industry is characterized by monopoly power.
Since health care is in short supply, the industry is less competitive. With monopoly
power, health care providers have more control over the pricing structure. The market
area for health care is the immediate surrounding area. An increase in price resulting

from the tax is not likely to result in providers losing business to a non taxing state

82

located near by. Due to the local market, monopoly pricing and the inelastic nature of

the service a tax on health care would have less adverse impact on the industry.

5.6.5 Medical Services Exemption vs. Credit

Low income tax relief for medical services may be provided through either an
exemption or credit. However, the policy impact would differ depending on which tax
provision was used. Exempt services are not taxed at the check out counter and provide
a tax subsidy on the entire amount purchased. The consumer would be required to file a
tax form in order to receive a credit. A credit may either reduce the entire tax liability
or only a portion of the tax liability. A refundable credit provides tax relief even when
no tax liability is owed. The disadvantage of an exemption compared to a credit is that it
provides a sizable tax subsidy to non-poor households, increasing the provision’s cost.
The advantage of providing a medical services credit over an exemption is that by
targeting the tax subsidy to low income and working poor households less revenue is lost.
The disadvantage of the credit over the exemption is that some low income households,
lacking knowledge of the credit, will not apply for the reduced tax liability. In addition,
credits increase the cost of administration and may complicate the income tax form
compared to exemptions.

The benefit of a low income health service credit is that it is more affordable.
For example, the cost of a medical services credit for the 945,000 individuals classified as
living in poverty according to the 1980 census, using the New Mexico credit of $7.50 per
individual is $7.1 million compared to $248 million for the exemption. This illustrative
example shows that the cost of the credit would be less because the tax subsidy is not
automatically provided to non-poor households. This credit could be expanded to the

working poor and gradually phased out at higher incomes.

83

5.7 Business and Professional Services

Business services comprise the second largest service industry. The revenue loss
from exempting business services is $223 million. As shown in Figure 5.5, Michigan
business services, as measured by Michigan gross state product adjusted for inﬂation has
grown at a steady annual pace since 1964. Business services have only declined a few
times over the last 23 years and thus would add to the revenue stability of the tax base.
Figure 5.6 illustrates the composition of Business Services in Michigan.

Professional Services rank as the third largest service industry in Michigan. The
revenue estimate for these engineering, accounting and research firms is $149.9 million.
This estimate could be increased with the inclusion of a use tax on professional services
purchased out-of-state but used by Michigan ﬁrms and consumers. Figure 5.7 on the
growth of professional services, illustrates that his sector is affected by the business cycle
as the rate of growth declines during periods of downturn. Since 1963, this sector has
recorded a decline in only 5 years with the largest fall in the early 1980’s. Many of the
arguments for and against taxing business services may be applied to professional
services as they are purchased by business. Figure 5.8 indicates the composition of

professional services in Michigan.

ANNUAL PERCEAH CHANSE

 

 

 

 

 

 

 

 

 

l i 1

11111111111
1974 1979 1984

l l l l l

1E9

 

l l l l l

1 9'64

 

 

30%

25%

2096

15%

-S%

—10%

YEARS

Source: Real MI GSP.

Figure 5.5. Growth of MI Business Services

COMPUTER

25.8

 

ADVERTISING
11.5
ECTIVE
4.5

     

A

IIIIIII DET

e
O
9
I

n
It
.
s
I.
‘ .I...
qua-s
1 I
w
\\ _ \
. . v 0.000;.
0.0...
O 0 O
’35’
0....
0....
O O 0
o

O ,’

  

../

‘////

BUILDING .
5 9

PERSONNEL
13.6

                        

8.7

Source: MI Census of Services, 1987

MAIL AND REPRODUCE

Figure 5.6. Business Service Industry Composition

 

l l I

1111111111
1984

85

llLIl

 

 

l l l I I

 

 

 

 

 

Am PERCENT CHARGE

 

 

 

 

ﬁl

1974 1979

1999

 

19'54

 

—1D%
—15%

~20%

45.6%

ENENEER & ARO-IITEC.

YHRS

 

 

 

Figure 5.7. Growth of Professional Services
2196

 

Figure 5.8. Misc. Professional Service Industry Composition

Source: Real MI GSP.
Source: MI Census of Services, 1987.

86
5.7.1 Taxing Business Services

The debate over taxing business services centers on the degree to which tax
pyramiding occurs because the final purchase price includes the taxation of services taxed
at previous stages of production. In theory, a pure sales tax would not be levied on
items used as inputs into the retail service. However, in practice, an estimated 20 to 40
percent of sales taxes are paid by businesses. Some economists argue that the sales tax
should not be extended to any business services. They argue for a value added tax rather
than a retail sales tax because business inputs are taxed only once in the production
process as discussed in Chapter Three. Others argue that business services should be
taxed in a fashion which was consistent with taxation of business goods. To tax services
on a consistent basis with goods, a business service input exemption could be developed.
This exemption would require a deﬁnition of business inputs. The exemption could be
designed to be consistently applied to good and services or it could be adjusted to ease
the administration of services which have shown themselves to be difficult to administer
because of there intangible nature. A description of business input exemptions for goods

and/or services provided by other states is included as a basis of comparison.

5.7.2 Business Inputs Defined

The broad-based taxation of services sweeps into the tax base purchases of
business inputs. For example, certain services like advertising and accounting are almost
entirely consumed by business. Some authors argue that this may be undesirable
because it is inconsistent with the premise that a retail sales tax is a single-stage levy on
the ﬁnal sale of goods and services. Those favoring taxing business services argue that in
the goods sector most states tax business inputs to some degree. In addition, some

economists are concerned that the omission of this largest category of services from

87

revenue systems will result in sales tax collections which lag behind the growth of

consumption and personal income.

5.7.3 Marginal Rate of Substitution

The inclusion of business inputs results in pyramiding of the tax burden on the
ﬁnal consumer whose purchase price includes the taxation of services taxed at previous
stages of the economic process. If goods and services are taxed at multiple stages of
production, the tax rate will not be the same for all goods and interferes with choice as
consumers choose among high and low taxed goods. Producers choose among methods

of production with distortions in the marginal rate of substitution between goods.

5.7.4 Vertical Integration

The extent of tax pyramiding will depend on the degree of vertical integration
and the proportion of inputs which are taxable. The taxation of business services might
induce the business to provide those services in-house to avoid the tax. This may lead to
inefﬁciencies through distortion in resource allocation and creating a competitive
advantage for businesses that provide their own services. Production costs are affected
differently depending on the firm size and legal structure. larger ﬁrms, beneﬁting from
economies of scale, may have more incentive to integrate. Firms will vertically integrate
when the diseconomies from integration are lower than the tax cost added to the inputs

(Hellerstein, 1988).

5.7.5 Sales Tax on Business Inputs
A general commodity tax may be levied at various stages of production including

retail, wholesale or manufacturing levels (Boadway and Wildasin, 1984). Studies

88

indicate that business purchases make up a large portion of the present state sales tax
base even though every state exempts some business inputs from taxation. Fox and
Murray, (1988) estimated that between 20 to 40 percent of state sales taxes are paid on
business purchases. In Texas, 58 percent of the sales tax is levied on business purchases,
compared with 24 percent in Illinois, 14 percent in Ohio and 25 percent of the Florida
base before the service tax (Hellerstein, 1988). Thus, the objection to the service tax on
the basis that it would tax business inputs applies to the existing sales tax base.

An estimate of the proportion of business purchases taxed in Michigan is not
available and therefore further research is needed. However, an estimate of the business

input exemption on goods used directly in manufacturing is available.

5.7.6 Michigan’s Industrial Processing Exemption

Michigan provides an industrial processing exemption from the sales and use tax
for direct inputs used in agriculture and industrial processing. The industrial processing
exemption is estimated at $284 million in ﬁscal 1988, comprising over 10 percent of the
sales tax collections (Ejscal 1987-88 {Lax Expenditure Repoﬂ, 1989). Michigan could
provide a similar exemption for services. In general, states have not provided an
exemption for all business services because narrowing the tax base to only consumer
purchases would require raising the rate to maintain revenue. For Michigan, raising the
sales tax rate would be especially difficult because it would require a change to the state

Constitution and voter approval.

5.7.7 Interstate Comparison of Business Input Exemptions
A review of the sales tax exemptions provided by other states for business inputs

in the goods sector provides a basis of comparison needed to construct a similar

89

exemption for service business inputs. Many states provide exemptions for goods used
by business. Nearly all states exempt those materials used for manufacturing and
processing. States may target the exemption to materials used as an ingredient or
component part of the good. In addition, states like Texas, provide an expanded
exemption, on gas or electricity used primarily for manufacturing. Other states extend
the exemption to machinery, equipment and tools not consumed in manufacturing. The
Illinois exemption is also extended to the machine used to repair machinery as well as an
exemption on the machinery and equipment used for manufacturing. In the retail
industry, some states exempt selected packaging items. Ohio, for example, exempts
items of tangible personal property used in retailing. Thus, exemptions for business
inputs in the goods sector vary from state to state (Prann, 1988).

Although the advantages of a sales for resale exemption may be generally
accepted on a conceptual level, implementation of rules for administration of the
exemption were controversial in Florida. Florida’s debate with taxing business services
was not focused on whether business purchases were taxable. In Florida, goods received
an exemption only if they themselves were resold or incorporated physically into another
good to be resold. In general, goods purchased by a ﬁrm that were necessary for its
business were taxable. Florida’s debate centered on the resale exemption and the
deﬁnition most consistent with the existing policy for goods which was easy to
administer. The dispute concerned the administrative deﬁnition to determine when
services were purchased for internal use by a business vs. purchased on behalf of a
business customer.

5.7.8 Resale Exemption Guidelines
Jim Francis (1988), a Florida state official, outlined the three issues states need

to address when providing a sales for resale exemption. (1) The conceptual basis for the

 

90
resale exemption for goods should be clearly said and uniformly applied. (2) These

guidelines should be adjusted for application to service items. Goods and services differ
in that services are more abstract in nature and unlike the goods there is no physical
trail from the manufacturing ﬁrm to the final consumer. (3) Legislation should be
enacted giving dealers practical rules to follow for determining whether they qualify for
the resale principle. These administrative deﬁnitions are signiﬁcant as the state relies on
third parties to collect the sales tax. Since business people are not tax experts, the

exemption rules should be easy to interpret.

5.7.9 Cost of Resale Exemption

To tax Michigan services, decision makers would need to address the issues
surrounding the sale for resale exemption as much of the service tax base is comprised of
business services. Further research is required to determine the proportion of business
services which are produced for business inputs used for direct production of other goods
and services rather than for ﬁnal consumption.

In addition to the sales tax, a sale for resale exemption estimate is needed for the
use tax. Michigan could levy a use tax on out-of-state ﬁrms using Michigan services to
make the playing ﬁeld level for taxing business services. Michigan would gain revenue
from the use tax on business services but these out-of-state ﬁrms would also receive the
resale exemption. Future research is required to determine the extent that the resale
exemption would apply to out-of-state ﬁrms using Michigan services in order to estimate
the amount of services which would be taxable and the cost of the use tax resale
exemption. An estimate of the use tax sale for resale exemption requires further
research on the degree to which ﬁrms would claim the exemption depending on whether

the ﬁrm applied the allocation method for site specific purchases or used the

 

91

apportionment method for non-geographic speciﬁc purchases. The sale for resale
exemption would be more applicable to the site speciﬁc purchase because a specific item
would need to be identiﬁed for exemption. The resale exemption would be difficult to
apply with the apportionment method as previously reviewed in the discussion of the
Florida experience. An estimate of the cost of the exemption would require an extensive
survey as data on these ﬁrms is not available through the Census as the Michigan Census

of Services data is limited to Michigan service ﬁrms only.

5.8 Personal Services

The estimated revenue gain from taxing personal services is $45 million.
Personal Services are uniformly taxed by states levying a broad based service tax
including Hawaii, New Mexico, South Dakota and Florida before the tax repeal. As
shown in Figure 5.9, the grth of personal services adjusted for inﬂation is more
cyclical than the other service industries already evaluated, adding less stability and
adequacy to the revenue base. Figure 5.10 illustrates the composition of the industry
gross receipts from the 1987 Michigan Census of Services. The disadvantage of taxing
personal services is that they tend to be regressive. According to Bohm and Craig
(1987), personal services are regressive particularly at the lower income levels. At the
$5,000 and under category, personal comprise 2.64 percent of income. This percentage
drops signiﬁcantly at $10,000, the next income level, to 0.33 percent. The ratio of
personal service consumption to income continues to decline at higher income continues
to decline at higher income categories but generally levels off in the $20-30,000 range.
Beauty and barber shops comprises 22.7 percent of the total personal service industry.
One may analyze the market structure, pricing practices and price elasticity of demand

for the service in order to evaluate the tax incidence for beauty and barbershops. If the

ANNUAL PERCENT CHANSE
1 596

 

10%

 

 

5%

 

 

IIIIIIIIIIIIIIII IIIIIIIIIIIEﬂmm

 

 

0%

 

-'596 _ .....................................................................................................

 

 

_10% I l I 1 I : I I l l : l I l I II I l I I I l
1954 1969 1974 1979 1984

YEARS

 

Source: Real MI GSP.

Figure 5.9. Growth of MI Personal Services

 

 

 

 

 

 

 

 

 

 

INDUSTRIAL LAUNDRY BEAUTY AND BARBER
.9% 22.7%
FUNERAL PHOTO STUDIO
19.4% . 6.1%
x V MISC LAUNDRY
a / 13.5%
.4,
MISC
1’ 6% COIN LAUNDRY
DRYCLEANING
11.5%

Source: MI Census of Services, 1987.

Figure 5.10. Personal Services Composition

93

industry demand for the service provided is perfectly price inelastic, all of the tax will be
passed to consumers in the long run. However, the industry will absorb a portion of the
price increase if the price elasticity of demand is inelastic through a reduction in business
volume. The demand for beauty and barber shop services is generally price inelastic,
although some services are more discretionary. (Nebraska Legislative Revenue
Committee, 1986). A price increase in the four percent range is not likely to
signiﬁcantly alter public demand.

The ﬁrms ability to pass the tax burden to consumers is affected by the market.
Beauty and barber shops primarily operate within a local market and the ﬁrms they
compete with are similarly impacted by the tax. Their ability to pass on the tax could be
diminished if the higher prices from the tax adversely affected the volume of services
demanded.

The ﬁrms ability to add the full tax to the existing prices would depend on the
level of competition and on the ﬁrms pricing practices. Barber and beauty shops operate
within a competitive local market and prices reﬂect the income for labor to provide the
service. Price differences result from product differentiation based on location and
special services. These service ﬁrms purchase few services used as inputs into the final

product and thus would not be negatively affected by higher operating costs.

5.9 Legal Services

The estimated revenue gain from legal services is $70.7 million, not including
legal services provided by out-of-state firms used by Michigan residents. Figure 5.11
shows the growth of the industry since 1964 based on Michigan Gross State Product.
(Industry composition on a more detailed level is unavailable.) According to Bohm and

Craig (1987), legal services comprise a low percent of personal income and are regressive

 

94

Am PERCENT GIAMSE

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

15%
10% S
\
\
N R
A A
A A
5% - \ \ -----
A A A
A \ §
\ \ \ s
\ \ s \ \
A A A A A A
A A Al A. A A
0,, ABA A AA 9A A e
- . e . Q Eg
A A A
A A
N
A
-59, A
_1mjlllllllHlIllllllllLLllJ
1964 1969 1974 1979 1984

was
Source: Real MI GSP.

Figure 5.11. Growth of Legal Services

at the lower income levels. Legal services comprise 1.7 percent of income at the $5,000
which falls to 0.09 percent of income at the $15,000 income group. This low percentage
of personal consumption may reﬂect that, in part, legal services are consumed by
business as a cost of operating and then consumed by individuals indirectly. In addition,
evaluating an individuals consumption of legal services based on averages may be
misleading because legal services are not usually a reoccurring, everyday purchase.
However, these services may be a large portion of an annual income in the year of use.

Law ﬁrms may operate beyond the local market and their pricing structures
consider more than price competition. If the legal service operated in a local market,

the tax could be fully passed on to the consumer given that the firms had a ﬂexible

95

pricing structure. The relative price elasticity of demand for legal services was recorded
at ~0.37 (Hauthakker and Taylor, 1970). Given that the service is characterized as
inelastic, the tax incidence falls on the consumer through higher prices not on the firm or
workers through a reduction in quantity of the service demanded.

If the ﬁrm is competing with businesses in other states, the ability to pass on the
tax would be affected by whether the tax was assessed based on the location of the ﬁrm
or the location of the client. Since the tax is usually assessed based on the location of
the client, in state and out-of-state ﬁrms would be treated the same, and this factor
would not affect the ﬁrms ability to pass on the tax.

Price competition is the only kind of competition which limits the firm from
passing on the tax. However, law ﬁrms compete based on factors other than price. In
the case of a contingency fee, where the charge may be determined by past practice or
law such as a percentage of the award, the firms may not be able to pass on the tax. In
summary, law ﬁrms are likely to be able to pass on the tax, although the firms ability to
pass on the tax may be limited if the fee is ﬁxed. However, this probably does not

comprise a large portion of the total revenue collected (Nebraska, 1986).

5.10 Amusement and Recreation Services

Figures 5.12 and 5.13 illustrate the growth of amusement and recreation services.
Motion pictures, the largest component of amusements, comprises 23.6 percent of the
total based on Michigan gross state product. Figure 5.14 indicates the composition of
the industry gross receipts from the 1987 Michigan Census of Services.

Arguments for taxing amusements include that they are discretionary luxury
items, the taxation of which adds to the progressiveness of the tax structure. Given that

amusements are compliments to leisure, and leisure is an untaxed item, their taxation

96

adds to the efﬁciency of the tax structure. In addition, to the extent that they are
consumed by tourist, the tax is exported. An argument against taxing some amusements
is that those provided by government may not be taxed while similar privately provided
recreation services would be taxed.

The tax incidence for amusements is impacted by the price elasticity of demand
for services. Estimates are available for selected amusements including: motion
pictures at - 0.87, theater and opera at -0.18 and other recreation services at -0.56. For
commercial sports, the relative price elasticity was not found to be signiﬁcant
(Hauthakker and Taylor, 1970). Given the inelastic nature of these selected services,

the tax incidence falls on the consumer not the ﬁrm.

5.11 Auto and Miscellaneous Repair Services

Figures 5.15 and 5.17 illustrate the growth of auto repair and miscellaneous
repair services. The auto service industry growth tends to decline during recessions as
might be expected following the procyclical pattern of the auto industry. Signiﬁcant
declines were recorded in the early 1980 recessions. Figures 5.16 and 5.18 show the
composition of these industries gross receipts from the 1987 Michigan Census of
Services. The revenue estimate from auto repair is $73 million. Further research is
required to determine what portion of the auto repair service receipts are for auto parts
which are already taxed and would reduce the estimate. In addition, as mentioned
previously, the revenue estimated does not include collections from auto dealer repairs in
not listed in the Census of Services.

Auto repair services and misc. repair services operate in a competitive local
market and demand is price inelastic. Auto repairs may be delayed but repairs will need

to be made eventually. An increase in auto repair prices could result in consumers

10%

 

5%

 

 

 

oyzoazzoyzneyzézzza

 

 

 

 

I III/III]

 

m
E
zzzaauzr

 

VIII/Illlllll .
///////////////

 

 

 

 

 

lllllllLlLlllllllLJJlll

1964 1959 1954 1959 1991
YEARS

 

Source: Real MI GSP.

Figure 5.12. Growth of Amusement and Recreation Services

Anuurexﬂnuaux
40%

35%
30%
25%
20%
15%
10%

5%

-5%
-10%
-15%
-20%
-25%
-30%
-35%
-40%
-45%

 

Source: Real MI GSP.

Figure 5.13. Growth of Motion Picture Services

98

VIDEO RENTAL

S

E

R

w S
C% 5%
'6 E
D: . N2

3

N2 .H6
0 F
H

O

M

      

       

oeooooeoeooees
o o e o e e A

ooeooeoseeooeoso

WOWOWOVOse 6

COMMERCIAL SPORTS
10.8%

RECREATION CLUBS
8.1%

Source: MI Census of Services, 1987

Figure 5.14. Amusement Industry Composition

ANNUAL PERCENT CHANGE

 

 

15%

    

 

=====_============-==!
=====_=========_
. _===.=======_

    

==—==
=L

  

 

 

1994

l l l l l l I l I
1959

I I I I I

1954

I I I I

1999

 

I 1 Al I I

 

W _....
=:.=======
==:==:=_
=_
=
L :5... =_ ._
==.._..==.=.===.=.=.=_
m a m
1

-5%

-10%

19E4

—15%

Source: Real MI GSP.

Figure 5.15. Growth of Auto Repair Services

99

GLASS PARKING

 

4.2% 2.7%
GENERAL RERAR BODY SHOP
,1 226%
‘0
3 . . _ a d
MISC REPAIR I Q]. EXHAUST
6.6% ‘75 14!! 5.6
: IV
OTHER SERVICE 5
11.1% ‘"
TRANSMISSION RENTAL AND LEASING
27% 252%

Source: MI Census of Services, 1987.

Figure 5.16. Auto Repair Industry Composition

ANNUAL PERCENT CHAIGE

 

15% .....

 

10% _ .....................................................................................................

 

 

0%

_5% ......

 

-10%

 

 

 

_15%IJIIIIIII llllilll:IL
1964 1959 1979 1984

 

i I 1
1954

YEARS
Source: Real Ml GSP.

Figure 5.17. Growth of Misc. Repair Services

100

    

ELECTRICAL
29 2%

SMALL ENGINE
2.2%

WELDING
/ 7.2%

Source: Ml Census of Services, 1987.

Figure 5.18. Misc. Repair Industry Composition

making their own repairs. According to Hauthakker and Taylor (1970), the relative price
elasticity of demand for auto repairing, greasing, washing, parking and storage and rental
was estimated at -0.40 and for radio and television repair was estimated at -0.47. The
impact of the sales tax on services would be small for these firms as most of the tax
would be passed on to the consumer given the inelastic character of the service. One
advantage the auto repair shops have is that a portion of their income results from the
sale of parts as well as services and the price increase from the tax on the parts portion

of their business volume will not change.

5.12 Selected Education and Social Services

The estimated revenue gain for social services is $8.8 million and for selected
private education services is $5.1 million. The growth of these industries is shown in
Figures 5.19 and 5.21. The composition of these industries gross receipts from the 1987

Michigan Census of Services is illustrated in Figure 5.20 and 5.22. The taxation issue for

101

social services and selected private education services is that private ﬁrms are taxed for
the same service which is provided by government on a tax exempt basis. In addition,
policy makers may desire to subsidize education and social services to encourage the
consumption of these items. New Mexico is the only state to tax selected private
education services. Day care, a privately provided social service, is taxed by New Mexico

and Hawaii.

5.13 Hotels and Motels Services

The revenue estimate for hotels and motels is $36 million. However, according
to national data, the hotel industries business is composed of the sale of food and
beverages, which may already be included in the tax base. Applying the Laventhol and
Horwath survey statistics for the U. S. lodging industry, 1989, 7.1 percent is for beverages
and 30.3 percent is for food. Guest room rentals comprise 55.2 percent and other items
comprise 17.4 percent. The taxation status of these other items requires further
research. The revenue estimate of nearly $36 million could be adjusted downward for
the inclusion of food and beverages in the industry receipts. If these national
percentages were applied to discount the gross receipts of hotels for food and beverages
which is already taxed, the estimated sales collections would fall to $23 million. To
obtain a more precise estimate of this industries sales on service in Michigan would
require an industry survey. Figure 5.23 indicates the grth of this industry since 1964
based on Michigan Gross State Product. Figure 5.24 illustrates the composition of the

industry gross receipts from the 1987 Michigan Census of Services.

ANNUAL PERCENT CHAFGE

15%

102

 

10% _ ........ WT

 

 

.I

 

E

 

_s%llll

 

l I I

 

1984

Source: Real MI GSP.

l I I
1969

I I l l l l
I

I I I
1974 1979 1994

YEARS

Figure 5.19. Growth of Social Services

 

RESIDENTIAL CARE
50.3%

Data: MI Census of Services, 1987.

Figure 5.20. Social Service Industry Composition

' OTHER
2.3%

 

 

103

ANNLIL PERCENT CHAMSE
1 5%

 

10%

 

5%

 

XXXXX'XXXXX
I

XXXX

 

 

 

 

 

 

REE E A , E En

I9 E '5

 

 

—5%

~10%

 

 

 

 

 

I I I I I

_15% i I II I :1 I L4 : I
1954 1959 1974

YEARS

 

I i I I i I
1979 1984

Source: Real MI GSP.

Figure 5.21. Growth of Education Services

BUSINESS 81 SECRETARY
17%

  
   

DATA PROCESSING
20.6%

VOCATIONAL
35%
OTHER ED.
27 4%

Source: MI Census of Services, 1987.

Figure 5.22. Selected Education Industry Composition

104

ANNUAL PERCENT CHAIGE

 

 

 

 

 

 

 

l
l

I I
' 1979 1994

1974

1
1969

 

 

15%

19% —--

5% ~--

0%

 

—1D%

I
1994

—15%

YEARS

Realhdlf3SP.

Source

Figure 5.23. Growth of Hotel Services

     

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33% i§¢¢€d§f3¥3¥§$§8¢€£§
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MI Census of Services, 1987.

Source

Figure 5.24. Hotel Industry Composition

105

One of the arguments against a sales tax on motels and hotels is that an
accommodations tax is already levied on lodging in Michigan. Those in favor of taxing
hotel services argue that more than one tax is levied on other items. In the case of

gasoline, for example, consumers pay a gas tax as well as a sales tax.

5.14 Policy Alternatives

The impact of taxing Michigan services will be analyzed for several policy options.
1) The ﬁrst policy decision is to determine whether the state would tax services
following either a broad based or incremental strategy. If selected services were taxed,
the impact would differ depending on the industry included. Assuming a broad based
strategy, the policy options include 2) taxing services with the existing rate, 3) taxing
services with exemptions for business sales for resale, medical services and a low income
credit and 4) taxing services and lowering the rate. 5) The option of raising the tax rate
on the existing base will also be examined as a bases for comparing the service tax with a
more traditional revenue raising approach. An illustrative example of the relative
magnitude of revenue which could be raised from each of these options is shown in

Figures 5.25 through 5.28.

5.15 Broad Based vs. Incremental Taxation

The two legislative approaches which have been followed for taxing services
include the broad-based approach identiﬁed with Florida, New Mexico, Hawaii and
South Dakota. Although the Florida tax is now repealed, the tax experience provides a
basis for analyzing potential issues to be applied in Michigan. Idaho is included for a
comparison of its taxation of personal services. The items taxed by these states are listed

in Table 5.5. The incremental taxation of services was followed by Missouri, Minnesota,

 

106
Table 5.5

Comparison of Taxable Services for Selected
States with Broad Based Structures

 

 

 

 

 

T = Taxable State
ITEM HI IA NM SD FL
P RSON S VICES
Beauty and Barber Shops T T T T
Non-coin Operated Laundry, Dry Cleaning T T T T T
Tanning Beds and Salons T T T T T
Auto Repair and Services T T T T T
Dog Grooming T T T T T
Photography, Photo, Developing and Enlarging T T T T T
Car Washing T T T T T
Cable TV T T T T T
Misc Repair Services T T T T T
Amusement and Recreational Services T T T T
Financial Planning T T T T T
Investment Counseling T T T T '1‘
BUSINESS SERVICES
Employment Agencies T T T T T
Collection Agencies T T T T
Consulting Mgrnt, and PR Services T T T T*
Engineering, Architectural and Surveying T T T
Advertising T T T
OTHER SERVICES
Educational Services T
Health Services T
Day Care T T
Garbage Collection and Transportation T T
Agricultural Services T
Funeral Services and Crematories T T T
Mass Transportation T T
Taxicabs T T
Travel Agents Commissions T T
Real Estate Commissions T T T T
Stock and Commodity Brokerage Services T T
Legal Services T T T T
Accounting, Auditing, and Bookkeeping Service T T T T

 

* Mgrnt. was taxable, consulting was exempt

 

Source: Karen Boucher, ”Sales Tax on Services: The New Source of State Revenues,” Journal of State
W Fall 1988, Volume 7, No. 3, pp. 284-285.

Note: States with broad based service taxes include Hawaii, New Mexico and South Dakota. The table also
includes Florida before the service tax repeal and Idaho because of its wide taxation of personal
services.

 

107
Arkansas, Nebraska, North Dakota, Texas and Kentucky (Fox and Murray, 1988) The

comprehensive approach makes the assumption that all activity is taxable. Rather than
justify each extension of the sales tax to exempt items, this strategy requires opponents
to justify each proposed exemption. In 1987, many states were considering taxing
services but after Florida’s tax repeal most states withdrew the proposals from
consideration. A review of these tax proposals illustrates that many states intended to
tax services on an incremental basis with personal services taxed the most heavily. The
reluctance of states to adopt a broad based strategy is analyzed in the Florida Chapter.
In general, the intangible nature of services made the use tax on business services
difficult to administer and public support for the tax weakened after a media campaign
was launched by advertisers against the tax.

While enacting any tax increase is difﬁcult, the incremental taxation of services
adds the transaction costs associated with justifying the taxation of each service
(Boucher, 1988). This explains, in part, why state legislation to tax services was less
than successful. Incremental taxation of services provides an opportunity for more
powerful interest groups to exert political inﬂuence to shift the tax to those with less
inﬂuence. According to Bartlett, upper income consumers have the resources to
contribute to political campaigns and lobby to inﬂuence politicians to shift the tax to
lower income consumers. Similarly, ﬁrms attempt to shift the burden to consumers
(Bartlett, 1973). This explains the pattern of incremental service taxation which favors
business services and services consumed by upper income taxpayers with exemptions.
Table 5.5 indicates the services most frequently taxed by broad based service tax states.
Many of the personal services, resulting in regressive taxation, are uniformly taxed. The
taxation of professional services which would add to the progressiveness of the tax

structure are taxed to a lesser degree.

108

The vertical equity impact of taxing services depends on which services are taxed
as discussed in Chapter Three. The sales tax could be made more progressive by taxing
selected services such as professional services of investment brokerages, architects,
lawyers, real estate agents, and accountants which weigh more heavily on high income
budgets. In contrast, lower income individuals tend to spend a higher percentage of their
income on consumption. Regressivity would not be reduced if the tax included medical
services, funeral services, beauty and barber services (Fox and Murray, 1988).

Within the broad based strategy, there are several policy options. The broadest
policy option is to tax all services with the existing rate. The next broadest proposal is to
tax services with some exemptions or credits such as the business sales for resale
exemption, medical services exemption or credit and a low income credit. Finally,

services could be taxed with some exemptions or credits and the rate could be lowered.

5.16 Tax All Services

The broadest policy option is to tax all services with no adjustments for
exemptions or credit. Politicians, following the vote maximizing behavior as outlined by
Bartlett (1973), are more likely to make adjustments for special service interest groups.
Thus, this alternative is included primarily to illustrate the maximum amount of revenue
which could be raised. Over $950 million could be added to the sales tax base from
services. This approach raises more revenue and is more efﬁcient but less equitable than

the other plans. See Figure 5.25.

109

TAX ALL SERVICES
TAX STRUCTURE IMPACT

 

 

Broad Based PolIcy:
Service Taxation More Revenue Adequacy
and Siabrlriy

More Eii IcIenI
Less Equitable

Revenue:
EXIstIng Base 8 2,600 mIIlIon
Tax All Services + 950
Total 1 3755-0. million

Figure 5.25. Tax All Services

1 10
5.17 Tax Most Services

The next broadest proposal is to tax services with some exemptions or credits
such as the business sales for resale exemption, medical services exemption or credit and
a low income credit. This approach raises less revenue than the broader alternative and
is less efﬁcient but more equitable and vote maximizing. The resale exemption and
medical service exemption or credit has already been discussed in this paper. The next

section will examine the low income credit.

5.17.1 A Low Income Credit

The progressivity of the Michigan sales tax could be enhanced by providing a
sales tax credit for low income taxpayers on the income tax. One policy option is to
ﬁnance the credit from expanding the base to a sales tax on services rather from than
drawing down the income tax revenue because this provision is designed to offset sales
tax liability. The disadvantage of a credit is that relief may not reach the targeted low
income taxpayers because they may not have an income tax liability to reduce. However,
voters may ﬁnd the tax credit more politically acceptable if they see a clear link between
raising revenues and their use. The use of the sales tax credit on the income tax to
provide progressivity may be too weak a correspondence (Case and Ebel, 1989)

A low income credit could be available to the poor and/or moderate income
households. Several states provide targeted credits including Idaho, Kansas, Wyoming,
Hawaii, New Mexico and Vermont. Even though these credits are available on the state
income tax they are meant to provide relief from the state sales tax. In addition, they
ease filing and administration by not requiring sales tax receipts to document a particular

households sales tax liability. These state credit structures are included to illustrate the

111

TA>< I\/OST SERVICES

TA>< STRUCTURE

 

Broad Based
Service Taxatlon
WIth Adjustments

Exrstrng Base

Tax All Servrces
BusIness Inputs
MedIcal Credri
Low Income Credrt

Total

IA/IRACT

Policy:

Cor'rpared to The ExIstIng Base
The Revenue 19 More Stabrle
and Adequate

 

Compared TO Taxrng All Servrces
The Revenue (Barn ls tower,
The Tax ls Less EiIIcIent
But More Equrtable

Revenue:
SB 2,600
+ 950
n.a.

_ 77k
— 50

$ 3,493 I\/II|IIon

* If a medical exemption is provided rather than a medical credit, the revenue loss
would be $248 million at the 4 percent tax rate.

Figure 5.26. Tax Most Services

 

112

various alternatives for determining the beneﬁciaries, refundability, the amount of the

credit and the phase-out income.

5.17.2 Relief Provision Criteria

According to Gold, there are several desirable features which may be used to

develop state relief provisions including:

1)
2)

3)

4)

5)

6)

7)

8)

9)

A reasonable cost of relief

The beneﬁts should be received by the targeted taxpayers
The tax relief should be distributed following the principles of vertical and
horizontal equity
All deserving taxpayers should receive the beneﬁts.

The range of beneﬁts for those that qualify for the beneﬁt and those that nearly
qualify for it should be reasonable. Thus, large notches should be avoided.

The tax system should create positive incentives and avoid negative effects like
discouraging work or savings.

The programs should be designed to be administered cost effectively.

The tax system should not discourage taxpayers from ﬁling for benefits because
it is too complicated. Tax provisions may be made less difficult to understand
when presented in table form.

The appropriate level of government should pay for the tax relief. These criteria
will be used to evaluate various aspects of taxing services (Gold, 1987).

Achieving all of these criteria at the same time is difficult. Improving equity

requires tradeoffs with other tax criteria like simplicity, efﬁciency, revenue adequacy and

113

stability. Some analyst argue that to attain all these goals plus vertical equity requires a

system wide approach including taxes characterized as progressive and regressive.

5.173 Comparison of Low Income Sales Tax Credits

While most state sales tax structures are regressive, several states have improved
the equity of their tax structures by including sales tax credit provisions in the state
income tax. For example, Idaho provides a credit which ranges from $15 to $60 based
on household factors. The credit is available either through the personal income tax or
by ﬁling an application when an income tax return is not required. This refundable
provision solves one of the problems usually associated with credits, that some low
income taxpayers may not collect the beneﬁt because they are not required to file a
return. Kansas offers a graduated credit for taxpayers with incomes up to $13,000.
South Dakota’s credit varies from $74 to $220 for families and from $46 to $110 for
singe taxpayers. This credit is an alternative to the property tax circuit breaker and
phases out at $7,375 and $4,625, respectively and thus is targeted to the low income
taxpayer.

Wyoming’s senior citizen and disabled persons credit is meant to offset a portion
of the sales tax, property tax and utility tax expenses. The credit is available for
qualifying taxpayers with incomes below $10,000 if single and $14,000 if married. The
credit starts at $630 if single and $723 if married. With rising income, the credit phases
out beginning with incomes of $6,000.

Hawaii provides taxpayers with incomes up to $20,000 a credit varying from $8 to

$48 per exemption based on income. New Mexico with one of the most comprehensive

114

tax bases provides a credit reaching into the middle incomes range. Taxpayers receive a
credit of up to $45 per exemption for food and $7.50 per exemption for medical and
dental expenses, or four percent of medical expenses if that is the greater amount. This
credit is phased out at adjusted gross income levels of $30,000 to $45,000 for joint
returns. Finally in Vermont, persons with incomes below $13,500 not claimed as a
dependent receive a credit that ranges with the number of personal exemptions. The
maximum credit is for a household with 10 exemptions and an income below $2,000
(Gold, 1987).

Even though providing a sales tax credit on the state income tax eases the tax
burden on the poor, the use of the credit method by states is less effective than it could
be. According to Citizens for Tax Justice (Nickel and Dimes, 1988), only New Mexico
attempts to reduce the burden of sales tax on poor families by more than half. The
credit method is less effective after federal tax reform because most poor families do not
ﬁle an income tax return. A 1984 U.S. Treasury Department study on a national sales
tax concluded that, in practice, the credit system would only offset less than half of the
sales tax burden on poor families (Nickels and 2m es, 1988).

In summary, most authors agree that state sales tax structures are mildly
regressive. States are moving away from progressive taxation structures and toward
more regressive alternatives like the sales tax. Some states offer credits to offset the tax
incidence on the low income tax payers. However, only the credit provided by New
Mexico attempts to reduce the sales tax burden on the low income taxpayer by more
than half. Nonetheless, the sales tax has gained acceptance as a viable alternative tax

structure and offering exemptions or credits would increase its progressivity.

1 15
5.17.4 Summary of Taxing Services with Adjustments

When the policy options of providing a low income credit, a resales exemption
and a medical service exemption or credit are mixed together the joint policy impact is
difﬁcult to assess. Overall, these provisions reduce the level of collections available for
state programs. From the $950 million available from taxing all services, $248 million
would be spent on a medical service exemption or $7.1 million on a medical service
credit for those in poverty. A lower income credit would cost about $50 million for those
in poverty. The cost of either the low income credit or the medical services credit would
increase if the working poor and lower middle income groups were included.
Exemptions could be provided for selected education services of $9 million and for social
services of $5 million. The revenue could be lowered by the resales exemption for which
an estimate is not available. As shown in Figure 5.26, an additional $893 million could
be raised over the existing base collections of $2,600. In conclusion, this policy
alternative would be more equitable but less efﬁcient and raise less revenue than the

proposal to tax all services.

5.18 Tax Services and Lower the Rate _

Broadening the base to include services and lowering the rate minimizes
distortion. Lower tax rates result in less price distortion and substitution between taxed
and non-taxed goods. However, the policy option of lowering the rate may be less
attractive to policy makers as Michigan already has a relatively low sales tax rate of 4
percent with 28 states levying rates above Michigan’s in 1987 (Advisory Commission on

Intergovernmental Relations, 1987).

116

Broadening the base and lowering the rate a half a percent may be more
politically acceptable because less revenue is initially raised. The advantage of this
alternative is that it could forestall raising the rate in the future as services tend to be a
more stable and adequate tax base for revenue collections. The provision of exemptions
or credits would reduce the revenue available to ﬁnance lowering the rate a full percent.
In addition, as politicians follow vote maximizing behavior outlined by Bartlett (1973)
and compromise to accommodate the interests of selected service groups, the revenue
raising potential will be diminished, leaving less revenue available for a rate reduction.
To lower the rate a full cent to 3 cents on the dollar and maintain the existing collection
level would require $650 million in added revenue. Although Michigan residents are
accustomed to a tax rate in full cent units, many states levy rates in the tenths or
hundredths place and provide a tax table for ease of calculation. The trade-off is the
administrative simplicity with a full cent tax rate vs. revenue adequacy. A tax rate with
units less than one percent complicates the tax structure. Nonetheless, other states levy
tax rates in this manner. See Appendix Table A-5 for a listing of state tax rates.

An illustrative example of the cost of taxing services with adjustments and
lowering the rate to 3.5 cents, is shown in Figure 5.27. Lowering the rate from 4 cents to
3.5 cents, would result in a decline in the existing base from $2,600 million to $2,275
million. Likewise, the total service revenue would decline from $950 million to $831
million. The cost of the exemptions and credits would also be less with a. lower rate.
The state could expand the base, lower the rate and still raise additional revenue. The
revenue raised would be lowered by the resale exemption for which an estimate is not

available. In summary, compared to the other plans, this alternative is more politically

117

TA>< SERVICES 53¢ LOWER RATE
TA>< STRUCTURE |I\/IRACT

 

Policy:
Tax l\/lost Revenue More Stabile
Services at and Adequate than
Lower Rate Existing Tax Base

Complicates Tax Rate

More Efficient

More Equity from
LOW Income Credit

Rolitical Acceptance

 

Tax Rate of 35% Revenue:
Existing Base 513 2,275
Tax Services + 834
Medical Credit* — 6

Low Income Credit — 44
Business Input n.a.
Total $ 3,056

‘ If a medical exemption is provided rather than a medical credit, the revenue loss would be
$217 million given a 35 percent sales tax rate.

Figure 5.27. Tax Services and Lower Rate

118

acceptable and efﬁcient. However, less revenue is raised and the tax rate is more
complicated. The equity of the tax structure could be improved by providing a low

income credit.

5.19 Exempt Services and Raise the Rate

Raising the rate is the typical policy adopted by states to increase revenue. Many
states have raised their tax rates in the last 15 years. West Virginia and Nevada have
increased their tax rates to the greatest extent. Only 13 states, including Michigan, have
not increased the tax rate since 1973. (Hilker, 1988).

Raising the tax rate on the existing base which exempts services has the
advantage of providing more revenue from a well established, familiar tax. This option
was more politically acceptable tax to Michigan policy makers crafting tax proposals as it
was recently included in an unsuccessful ballot proposal which raised the tax rate from 4
to 6 percent along with other tax changes. The disadvantage of this option is that it
aggravates the existing problems of regressivity, and revenue adequacy and stability. In
addition, as the goods producing tax base continues to decline, and less goods are taxed,
the incentive to substitute untaxed services for taxed goods will persist.

The disadvantage of raising the rate is that it does not produce as much revenue
per one percent increase. The revenue gain from raising the rate is somewhat less than
the collections per one percent as states raising their tax rates have experienced
(NASBO meeting, 1990). Firms and consumers respond to rate increases by altering
their consumption away from the taxed good or service through vertical integration, and

substitution of untaxed consumption for taxed consumption. Michigan’s sales tax has the

119

potential of raising up to $650 million per one percent and the use tax could raise up to

$111.7 million per one percent based on 1989 collections. See Figure 5.28.

5.20 Summary

This chapter analyzed the growth trends, revenue potential, sector composition
and tax policy issues for each industry. Over the last two decades, services have grown
steadily. The service industries with the largest revenue potential include health,
business and professional services. The broadest policy alternative is to tax all services
without exemptions or credits and results in the maximum revenue potential. The next
broadest proposal is to tax services with adjustments. To improve equity, a low income
credit and a health service exemption or credit could be provided. In addition, business
service resale exemption could be developed to reduce double taxation of intermediate
services incorporated into the ﬁnal service. Taxing services with adjustments would be
more equitable and politically acceptable but less efficient and raise less revenue. The
policy alternative of taxing services and lowering the rate was included to illustrate that a
proposal to tax services could meet the tax policy goals of efﬁciency and revenue
adequacy and stability with a smaller gain in collections.

Policy makers could avoid the issues raised when broadening the base by
increasing the tax rate. Many states have raised their tax rates in recent years and
Michigan considered a rate increase on a recent ballot proposal. Raising the tax rate is
a likely option because it results in the least amount of change. According to Schmid

(1985), there is a trade-off between continuity and change. A stable set of expectations

120

RAISE TI—IE TA>< RATE

TA>< STRUCTURE

 

Raise the Tax
Rate l Cent and
Exempt SerVices

Existing Base
Increase l Cent

Total

IIVIRACT

 

Rolicy:
Large Revenue Cain
Revenue Less

Stabile and Adequate
Less Equitable
Less Efficient
Simple 8x Familiar

Revenue:
EB 2,000
+ E350

$ 3,250 million

Figure 5.28. Raise the Tax Rate

121

is needed for long-term investments and continuity is built into our system of law.
Nonetheless, a degree of change is required to prevent stagnation. Consumers are
changing their buying patterns from one dominated by goods to a more equal mix of
goods and services but the tax structure remains stagnate and thus the state’s tax base
will continue to decline. To some extent, taxing services builds on continuity because it
is based on the familiar sales tax. The beneﬁts of expanding the sales tax to include
services may be apparent. However, with change, existing rights are called into question
and policy makers are faced with the challenge of balancing the need for change and the
desire for continuity. Table 5.6 summarizes the revenue raising potential of the policy

alternatives discussed above.

 

 

Table 5.6
Comparison of Sales Tax Policy Alternatives"
(Dollars in Millions)
Change from Change from
Existing Taxing All
Policy Alternative Revenue Tax Base Services

1 Existing tax base 2,600 0 --
2 Tax all services 3,550 950 0
3 Tax most services 3,493 893 -57
4 Raise rate one percent 3,250 650 -300

5 Tax most services &
lower rate to 3.5% 3,056 456 -494

 

* Use tax revenue not included.
Chapter 6 illustrates the policy issues which were revealed by taxing services in
Florida. These issues need to be addressed by states like Michigan prior to taxing

services.

CHAPTER 6

The Florida Experiment: An Institutional Analysis

6.1 Introduction

An analysis of the Florida tax repeal is
included in this paper on taxing Michigan
services because the Florida experiment
created uncertainty over the political and
economic impacts of the tax. As indicated by
Boucher (1988), over a dozen states considered
taxing services in 1987, but after the Florida set

back legislative action was nonexistent in 1988.

 

 

 
  
  
  

ELOR IDA'S
SALES TAX

O\I SERV I CE S

 

 

Swendson and Kozub (1988, p.225) analyzed Wisconsin’s attempt to tax services and

concluded that "The experience in Wisconsin and Florida shows that the expansion of the

sales and use tax to services is not politically acceptable."

According to Shaffer (1975), uncertainty impacts political-economic power

because when the policy impact is unpredictable, special interests have the advantage of

persuading politicians to accommodate their concerns. When the immediate benefits of

serving uniﬁed interests are deﬁnite, but the effect of tax changes are not certain,

politicians are more likely to vote for immediate and assured results rather than for

122

123

those with distant and dubious consequences. Since we live in an interdependent world,
politicians are not likely to proceed with this tax policy without a better understanding of
why the Florida tax was repealed and what Michigan can learn from the experience.

Base on an economic analysis alone, there are many advantages of taxing services
for revenue adequacy and stability and efﬁciency. The disadvantages may be remedied
with provisions like a low income credit, medical service credit or exemption, business
input exemption, etc. Florida policy makers took into consideration these traditional
criteria for improving the tax structure and attempted to resolve the policy issues before
the tax was enacted. Nonetheless, the tax met with resistance leading to its repeal. A
literature review indicates that the advertising industry was very inﬂuential in defeating
the tax and that the most controversial provision involved the use tax on out-of-state
ﬁrms. The following institutional analysis will provide additional insight into the factors

leading to the tax repeal.

6.2 Predicting Policy Outcomes

As discussed in Bartlett (1973), it is difficult to use the traditional, normative tax
policy principles to analyze tax policies. Regardless of the improvements which would
result from following the principles of equity and efficiency, votes required to retain
office will take priority. While equity and efficiency describe what "ought to be”, these
guidelines are limited in that they do not predict the outcomes of tax policy decisions.
By analyzing the motivations and behavior of interest groups who inﬂuence decisions, the
outcomes of tax policy decisions may be predicted. Florida’s experience will be used as a

case study to analyze the issues raised in states who have taxed services.

124
6.3 Situation, Structure and Performance

The following section will apply the community choice model to Florida’s
situation prior to the new tax through its repeal. This Situation, Structure and
Performance Paradigm (SSCP) is a framework for analyzing community problems and
policies developed by Schmid (1985). The model assumes that people are
interdependent and share scare resources. Because of this interdependence there are
conﬂicts and possibilities for mutually beneﬁcial joint action. Joint action may result in
high transaction costs to attain joint beneﬁts. The ability to act collectively to manage
conﬂict and produce joint beneﬁts results from human choice. A sense of community is
required to be interdependent and act collectively.

A community choice analysis begins with the situation creating interdependence
and opportunities for conﬂict and cooperation. Opportunities for person A to impact
person B depends on their preference and the characteristics of the goods and services
under study. Identiﬁcation of the situation refers to the varying characteristics of
resources, goods, and services.

The structure refers to all the predetermined social characteristics of the '
community system and its members which inﬂuence the members’ choices. Structural
examples include establishing rights and obligations for members using resources,
methods of collective taxation and purchase of goods and services and methods of
collective production of goods and services. The structure establishes the opportunity set
and incentives and disincentives for each member. The structure will result in behavior
by community members because of their opportunity sets which is called conduct.
Conduct refers to all the choices, decisions, or strategies that the members adopt within
the opportunity set established by the structure. Conduct by members will have

consequences deﬁned as performance. Performance is identiﬁed as costly or beneficial

125

depend on the preferences of individuals. The taxation issues identiﬁed by the Florida
tax repeal will be analyzed from the SSCP perspective by identifying the tax situation and

structure which results in the conduct and performance of ﬁrms and consumers.

6.4 Florida’s Revenue Shortfall

Expanding the sales tax to services was Florida’s answer to the need for
additional resources to provide public services. Florida was under continued pressure for
capital outlays for a growing population, an expensive education system and
environmental management (State Policy Bepgrts, 1987). The sales tax rate was five
percent and was levied primarily on tangible goods. The performance of the sales tax
could be improved as it was regressive, less efficient and collections were inadequate. As
a result, politicians were supportive of alternatives which raised additional revenue and

also improved the tax structure.

6.5 Heavy Reliance on Sales Tax

The state constitution prohibited an income tax which provided Florida policy
makers with an incentive to utilize the sales tax, the second largest source of state tax
collection (ACIR, 1988 and 1989). As a consequence of the income tax prohibition,
Florida relied heavily on the sales tax as it comprised 53.3 percent of total revenue
collections (Rockwood, Fresen and Francis, 1988). A good tax structure is balanced
when it minimizes over reliance on any one tax source. When more than 30 percent of a
total state tax collections are derived from the sales tax, the overall tax structure is not
balanced (Kleine and Shannon, 1985). In addition, the constitutional prohibition against
an income tax focused political consideration on a more limited number of tax

alternatives. This increased the potential for further reliance on the sales tax.

126
6.6 Low Visibility

The political support for the tax may predicted by analyzing the conduct, behavior
and motivations of consumers, ﬁrms, politicians and bureaucrats. Consumers are not
directly involved in the decision making process. Consumers delegate tax decisions to
policy makers (Bartlett, 1973) to minimize costs of collecting information.

Policy makers favored the sales tax because they perceived it to be vote
maximizing given its low visibility characteristic. Taxes reduce consumers utility from the
market by lowering disposable income and introducing distortions into the relative prices.
Taxes and public expenditures may increase or decrease a consumers utility in the
market and the consumers perspective on the utility of government policies will
determine their political response. Tax structures are less visible when the tax is an old
tax because the perceived tax burden fades with time. In addition, the visibility of the
tax is lessened when the tax is collected on each sale and consumers view the tax as part
of the price (Bartlett, 1973). Thus, when a tax is less visible, consumers perceive a

lower tax burden than may actually exist and they voice less political opposition.

6.7 Tax Shifts

Another beneﬁt to Florida consumers was that some portion of the tax burden
could be shifted to business. According to Bartlett (1973), it is in the consumers interest
to shift the burden of taxation to other taxpayers if the cost of inﬂuencing government is
less than the tax burden. The tax could be exported to residents of other states to a
greater degree than most states could beneﬁt from tax exporting because Florida is a
large tourist state with many seasonal senior citizen consumers. In addition, the tax is

regressive which shifts the tax burden away from the more inﬂuential higher income

127

groups with resources to oppose the tax. In summary, the constitutional ban on the
income tax and the perceived beneﬁts of the sales tax on services lead to the initial

support for the tax by policy makers.

6.8 Sunset Strategi

Broad based political support is usually required to increase taxes. In this case,
however, the tax could be implemented by sunsetting the tax expenditure because
services were exempt from the sales tax base. Sunsetting the exemption proved to be a
powerful strategy because it changed the typical political dynamics as it is easier to pass
a sunset bill than to repeal the exemptions. Sunsetting required less political capital
because no special interest was singled out. Because the effective date was delayed for a
year to study the tax no immediate consequences would result. To reinstate the
exemptions would require a new law and the majority of both houses and the governor’s
approval (Rockwood, Fresen and Francis, 1988). Although the statutory strategy to
sunset exemptions required less political capital, the approach failed to develop adequate
political support needed to ensure long term public acceptance for working through the
difﬁculties of implementation. Consumers and ﬁrms failed to respond and provided little
political opposition because of the delay in implementation. For example, ﬁrms delayed
developing procedures to collect the tax. As a result, ﬁrms lacked knowledge of the tax
impact after it was implemented which contributed to uncertainty. Nonetheless, the
beneﬁts of taxing services lead its adoption. Policy makers sunsetted the exemptions and

the state gained greater efficiency, revenue adequacy and stability.

128
6.9 Tax Implementation

Florida implemented the sales tax on services on July 1, 1987 with several
exemptions. Policy makers extended speciﬁc exemptions when political opposition was
suspected in the case of hair cuts and medical services (Ibid). Politicians are motivated
by the desire for less controversy and visibility concerning tax issues as voter behavior
depends on the perceived utility of the tax and expenditure. The tax which is least
visible will be the vote maximizing tax. The list of exemptions includes medical services,
governmental services, barbering services, services sold in Florida but used outside of
Florida, services sold for resale, services sold between certain related parties, occasional
or isolated sales, services rendered by an employee to his employer, financial and
investment advisory services, legal services with respect to criminal proceedings with

limits and advertising services apportioned to services provided outside of Florida.

6.10 Consumer Taxation

Some individuals articulated their preferences against the Florida proposal. As
discussed by Bartlett (1973), consumers may be expected to disapprove of taxes because
they reduce consumer utility through higher prices. Consumer inﬂuence of government
includes the least costly voting to other non-voting inﬂuence such as campaign
contributions. They will exert inﬂuence depending on the how they perceive the value of
their tax burden relative the value of government spending. They usually incur the
transaction cost of exerting non-voting inﬂuence only if the beneﬁt exceeds the cost.
Firms joined with consumers to ﬁnance a media campaign against the tax. Business
groups provided media services and through their joint action lowered the price of

inﬂuence to Florida consumers.

129

Consumers differed in the degree of utility and political support for the
government programs that the tax ﬁnanced. Taxpayers were uncertain as to how their
interests were served by the tax. For example, some senior citizens resisted the tax
because they were confused as to whether the sales tax was levied on medical services, a
signiﬁcant component of their budgets. Other consumers supported the tax which
ﬁnanced the continuation of education programs popular with government employees
and those citizens beneﬁting from the programs. Given these constituency groups,

politicians were reluctant to repeal the tax once it was enacted.

6.11 Business Taxation

Firms perceive taxes as lowering proﬁts. To maximize profits, given the
assumptions of rationality and self-interest, they will attempt to shift tax burden to
others. One way to shift the tax to consumers is in the form of higher prices. As
discussed in Chapter 5, firms in competitive local markets may be more successful in the
performance of shifting the tax forward to consumers. However, if the ﬁrm operates in
a national market with national pricing structures, shifting the tax to consumers through
higher prices is more difficult. This was the situation with multi-state ﬁrms whose

service was covered by the use tax.

6.12 Taxation of Out-of-State Firms

Much of the controversy in Florida was concerned with the criticism of the use
tax on business services. According to several authors, (Rockwood, Fresen and Francis,
1988) interstate transactions complicated the tax. The use tax is levied when a sale is
made out-of-state but the use or consumption occurs in the state and is a long standing

compliment to most state sales taxes. The purpose of the use tax is to create a level

130
playing ﬁeld. This exists only if the tax liability of the purchaser is the same regardless

of the sellers location. Without a use tax, citizens have an incentive to buy from out-of-
state ﬁrms. According to Hellerstein (1987), the issue was not one of double taxation.
Out-of-state ﬁrms taxed by Florida were not liable to pay taxes twice when they had
already paid taxes to another state.

The policy decision for states like Michigan to consider is whether to include out-
of-state services used within the state in the tax base. The issue addresses the trade-off
between simplicity and equity. It may be simpler to exempt out-of-state firms, because it
makes the tax easier to administer. However, Florida was not required by law to tax
out-of-state ﬁrms. Exempting out-of-state services is less equitable for in-state ﬁrms as it
raises their costs relative to the competing out-of-state business. To tax out-of-state
ﬁrms policy makers are faced with the challenge of adjusting the tax structure to

accommodate ﬁrms with national political power who sell an intangible service.

6.13 Apportionment

The Florida tax structure included several apportionment deﬁnitions. The
taxation of services used in Florida was levied on the full purchase price unless the
transaction had no speciﬁc geographic situs or the seller was a multi-state business and
the service was shared between states. In this case, a special apportionment formula was
used. Examples of services which are shared among states include: interstate
transportation, legal services and advertising.

The structure of the apportionment law was based on an income tax principle of
formulary apportionment. This formula assumed that non-geographic specific services
purchased by a multi-state business were used in a state in portion to its profits (Francis,

1988). The three factor apportionment formula has long been accepted as a fair way to

131

apportion business income and therefore, an understandable approach for policy makers
to extend taxation of services. Some form of apportionment is used by most state
business income tax structures. Despite the formula’s wide spread use, its application to
non-geographic speciﬁc services was not generally accepted by the Florida business
community.

Apportionment factors raised the cost of compliance for multi-state businesses.
They experienced high information costs when attempting to differentiate between
service purchases which were subject to apportionment and collected by the firm from
service purchases which were subject to allocation, and site speciﬁc to Florida. These
site speciﬁc purchases were self accrued by the purchaser not the ﬁrm. Florida gave
multi-state businesses the option of treating all purchases as apportionable. However,
this universal apportionment met with resistance because businesses would then have to
forego exemptions which were provided on selected services. The intangible nature of
services made them difficult to itemize by state and by type of service for exemption
purposes. Nonetheless, the assertion that apportionment raised the cost to business may

be a short run argument if other states also began to tax services (Francis, 1988).

6.14 Delivery of Non-geographic Services

The taxation of services became complicated when the intangible nature of
services combined with the long standing situs rule in most states that use or
consumption occurs at the point where the seller or his agent delivers the good. The
point of delivery is more easily manipulated for service ﬁrms which have greater mobility
to move to other states because they require less investment in physical plant and
inventory than do the manufacturing of goods. Services require less interstate

transportation costs as a telephone call or envelop may be used to deliver the tangible

132

result of work from a consultant. Thus, due to these characteristics of the service
transaction, the ﬁrm may more easily move out of state without disrupting service to the
customer (Francis, 1988).

The following example illustrates the complexity of taxing non-geographic specific
services. An Ohio based company could hire a Chicago based advertising agency. This
agency would contract with a New York magazine for advertising within a national
magazine. Florida could tax the national magazine based on its Florida circulation level
even if the ad was not written or published in Florida. If these out-of-state transactions
were not taxed, an incentive would be provided to not hire Florida advertisers. (S_t_at§
Poligz' Reperts, 1987). Firms have an incentive to change the state to which the service
is delivered. Hirshman’s (1970), concept of exit may be applied to ﬁrms who object to
the change in the tax structure and evade the tax in this way. Thus, the intangible nature
of services provided ﬁrms with the opportunity to more easily manipulate the state of

delivery.

6.15 Economies of Scale

Firms use other strategies to shift the tax liability to other groups such as exerting
political inﬂuence and challenging the states right to tax in court. Firms previously not
required to pay a use tax to a foreign state are likely to resist the new tax levy.
Producers may shift the tax burden to other producers by lowering their own tax liability
or by obtaining tax policies which improve the ﬁrms position in the market with tax
subsidies or tariffs on competitors goods. This type of tax shift requires direct political
activity. Firms exert inﬂuence over politicians through contributions to campaigns and

advertising. They may run public relations campaign to gain the political support of

133

consumers by stressing the prices will increase as producers pass on the tax. Not all
firms will engage in political activity. The degree of political activity is related to the size
of the ﬁrm and opportunity for gain.

Multi-state ﬁrms exhibit economies of scale which is a characteristic of a good
with decreasing cost. Human interdependence, is affected because to sell the large
number of physical units produced usually requires advertising to inﬂuence a greater
number of people to adOpt common tastes (Schmid, 1985). The ﬁrms income is
inﬂuenced by the preferences of others. The advertising industry, one of the most vocal
industries inﬂuencing the tax repeal is characterizes by economies of scale. The
advertisers market, by necessity, extends beyond state boarders. According to McCann-
Erickson, of the total advertising volume by the media, 55.6 percent operated in the
national market in 1988 (MW 1989).

There are economies of scale to producing political inﬂuence. Bartlett (1973)
predicts that ﬁrms in competitive industries participate to a lesser degree while large,
oligopolistic ﬁrms are much more active in political inﬂuence. This explains why out-of-
state ﬁrms with economies of scale were more vocal than in-state ﬁrms with local
markets. Florida advertising industry ﬁled legal challenges and launched a media
campaign against the tax. They ﬁnanced the cost of information to persuade consumers
not to support the tax.

The distribution of ownership makes a difference for resource allocation when
transactions costs are high, according to the Coase rule. Transaction costs are the costs
incurred in making decisions. The three kinds of transaction costs include contractual,
information and policing (Schmid, 1985). Since these costs are seldom distributed
evenly, the wealth of an interest group will determine their ability to bear these costs. If

interest groups wish to increase their income they may either use the existing rules or

134

change the rules, in which case wealth is important. The ability to ﬁnance transaction
costs was important in Florida because when the rules of the game changed, ﬁrms with
economies of scale, wielding national power could make their interests known.

Services firms characterized by economies of scale are motivated to develop
national markets and become multi-state businesses. To achieve large markets, barriers
to trade must be curtailed. Application of the Constitution’s commerce clause made
extension to national markets possible, and shifted legal rights away from local interests.
As courts struck down barriers to interstate commerce, they gave firms income much like
governments provide a tax subsidy (Schmid, 1985).

Property rights for the use tax had already been established by the courts. To
tax out-of-state services used in Florida required that the state have sufﬁcient nexus or
connection with the service. The state needed a link with the person, property or
transaction to justify the taxing power. In addition, the state must assert jurisdiction
over the seller to collect the tax. The Due Process and Commerce Clauses of the
Constitution requires that taxes to be apportioned fairly and thus, Florida had the legal
right to tax services (Hellerstein, 1987). Nonetheless, out-of-state ﬁrms challenged the

constitutionality of this right and ﬁled court cases against it.

6.16 Sense of Community

The advertising industry beneﬁtted from a national market, which included
Florida, but did not agree to the validity of Florida’s right to tax them. One explanation
of the advertising industries rejection of Florida’s jurisdictional reach may be explained,
in part, by their lack of a sense of community. According to Schmid (1985, pp.30-31), 3
community is "...defined through a common problem or the mutual advantage of joint

action... Participation in the market is not itself a legitimation of the bonds that are

135

necessary for its long run sustenance. A person can trade without agreeing to the
validity of the balance of rights brought to the trade. A sense of community, bonds,
rights and performance interact.” According to Olson’s "principle of ﬁscal equivalence"
stipulates that the boundaries of a jurisdiction to procure a public good should be drawn
so the beneﬁts and costs for the users can be internalized (Olson, 1969).

When the transaction involves a non-geographic speciﬁc service the link erodes
further as ﬁrms lack a sense of community with the taxing state. The use tax on non-
geographic speciﬁc services lacked a strong connection between taxation and how the
ﬁrm would beneﬁt from that taxation. According to Bradford, Case and Ebel, (1989),
the public is more likely to support taxation when they perceive a link between the tax
and the government program it will support. Olson’s solution of drawing boundaries to
internalize the beneﬁts and costs for taxing multi-state businesses may be difﬁcult,
particularly when the object of taxation is intangible. A structural policy alternative to
the discrepancy between the ﬁrms multi-state market and the state jurisdictional
boundary is to develop a national sales tax for national ﬁrms which would be

redistributed back to the appropriate states.

6.17 Tax Shift to Consumers

The tax was repealed effective January 1, 1988, six months after it was enacted.
Politicians attempted to vote maximize and ward off the political damage. When the tax
was regarded as a political liability, the governor and legislator backed away from
supporting it.

Florida policy makers returned to the issue of raising additional revenue for

public services. Politicians accommodated the interest of supporters of public programs

136

by ﬁnding a replacement source of revenue. However, they turned to a more politically
acceptable solution of raising the sales tax rate one percent.

The state gained revenue from the increase in the sales tax rate. However, out-
of-state service ﬁrms like advertisers were able to shift the tax burden back to
consumers. While iii-state goods producing ﬁrms and consumers paid a higher sales tax
rate, service producing businesses were no longer required to contribute to the tax base.
According to Shaffer (1975), traditional economic theory does not acknowledge that the
relationship between political and economic power is inseparable. Those with wealth will
have more incentive and capacity to sway the rules of the game. There is limited
incentive for an individual consumer to participate in the policy process but the benefit
for the concentrated interests is large because signiﬁcant gains may be won by
inﬂuencing policy makers.

Politicians in other states were affected by the tax repeal as illustrated by their
hands off attitude. Advertisers have revealed themselves to be an effective lobbying
force opposed to taxation of their industry. Access to the media lowered the industries
transaction cost for turning public opinion against the tax. The ability of any lobbying
group to shift the tax burden to others could be reduced by placing limits on the amount
of lobbying expenditures. In addition, states could provide a rigorous tax education

program explaining the impact of taxing services.

6.18 Summary

The Florida tax repeal created uncertainty over the political, and economic
impacts of the tax. Taxing services was Florida’s answer to the need for additional
resources to provide public services. Politicians were supportive of alternatives which

raised additional revenue and also improved the tax structure. The economic advantages

137

of taxing services include revenue adequacy and stability and efﬁciency. The state
constitution prohibited an income tax which provided Florida policy makers with an
incentive to utilize the sales tax. Policy makers favored the sales tax because it was vote
maximizing given its low visibility characteristic. In addition, some portion of the tax
burden could be shifted from consumers to business. The tax could be exported to
residents of other states because Florida is a large tourist state. The tax is regressive
which shifts the tax burden away from the more inﬂuential higher income groups with
resources to oppose the tax.

Sunsetting the exemptions proved to be a powerful strategy because it changed
the usual political dynamics as it is easier to pass a sunset bill than to repeal the
exemptions. Since the effective date was delayed for a year to study the tax, political
opposition was minimal as no immediate consequences would result. Florida
implemented the sales tax on services on July 1, 1987 with several exemptions.
Consumers differed in the degree of utility and political support for the government
programs that the tax ﬁnanced.

Florida’s controversy focused on the use tax of business services. Firms perceive
taxes as lowering proﬁts and will attempt to shift the tax burden to others. However,
ﬁrms operating in a national market experience difficulty in shifting the tax to consumers
through higher prices because of national pricing structures. The policy decision for
states like Michigan to consider is whether to include out-of-state services used within
the state in the tax base. The issue addresses the trade-off between simplicity and
equity. The taxation of services became complicated when the intangible nature of
services combined with the long standing situs rule in most states that use or
consumption occurs at the point where the seller or his agent delivers the goods. The

point of delivery is more easily manipulated for service ﬁrms which have greater mobility

138

to move to other states. Service ﬁrms characterized by economies of scale are motivated
to develop national markets and become multi-state businesses. Out-of-state firms
challenged the constitutionality of taxing services by ﬁling court cases against it and
exerting political inﬂuence. The degree of political activity is related to the size of the
ﬁrm and opportunity for gain as there are economies of scale to producing inﬂuence.
According to the Coase rule, the distribution of ownership does not make any difference
for resource allocation except when transactions costs are high. The advertising industry
beneﬁtted from a national market, which included Florida, but did not agree to the
validity of Florida’s right to tax them. When the transaction involves a non-geographic
speciﬁc service the link erodes further as ﬁrms lack a sense of community with the taxing
state. A policy alternative to the discrepancy between the ﬁrms multi-state market and
the state jurisdictional boundary is to develop a national sales tax for national ﬁrms
which would be redistributed back to the appropriate states.

The tax was repealed effective January 1, 1988, six months after it was
implemented. Politicians accommodated the interest of supporters of public programs by
ﬁnding a replacement source of revenue. However, they turned to a more politically
acceptable solution of raising the sales tax rate one percent. The state gained revenue
from the increase in the sales tax rate. However, out-of-state service ﬁrms like
advertisers were able to shift the tax burden back to consumers because they were no
longer required to contribute to the tax base. Policy makers in other states were affected
by the tax repeal as illustrated by their hands off attitude toward service tax proposals
which had been under consideration. The ability of any lobbying group to shift the tax
burden to others could be reduced by placing limits on the amount of lobbying
expenditures. Finally, states could reduce taxpayer uncertainty by providing a rigorous

tax education program explaining the impact of taxing services.

CHAPTER 7

Summary, Conclusions and Future Research Needs

7.1 Problem Statement

Taxing services would result in an additional $950 million in state revenues.
The challenge of balancing the state budget requires policy makers to examine tax policy
alternatives which maintain collections. From 1978 to 1988, state revenue as measured
by collections from the General Fund-General Purpose, School Aid and Lottery, grew
only $225 million on an inﬂationary adjusted bases, up 3 percent. This low growth rate is
due, in part, to declines in the manufacturing sector, particularly the auto industry.
Thus, the demand for public services continues to grow, while the real resources
available to ﬁnance them are rising at a depressed rate.

From the ﬁnancing alternatives which could be examined, including enacting new
taxes or closing tax expenditures, this paper analyzed repealing the sales tax expenditure
on services. The sales and use tax base comprises 32.6 percent of total general fund -
general purpose state revenue, in ﬁscal 1988 the second largest state tax in Michigan.
There is no economic justiﬁcation for the exemption of services which may warrant its
continuation. In addition, the sales tax is a popular tax which would reduce the political
resistance to expanding its use. A taxes public acceptance also depends on the degree of
backing for the government program its ﬁnances. Michigan policy makers have
previously identiﬁed education as needing ﬁnance reform to ensure collections. Since 60

percent the sales tax is distributed to the school aid fund for education there is popular

139

140

justiﬁcation for extending its use. The sales tax base has declined on an inﬂationary
bases during periods of economic downturn resulting in less revenue stability. In
addition, the sales tax base has eroded in response to shifting consumer purchases away
from taxable goods to non-taxable services.

The policy impact of a change in the sales tax base varies depending on the
performance of the present situation. The Michigan sales tax structure was reviewed to
determine its strengths and weaknesses based on the traditional public ﬁnance criteria
for a good tax structure. This analysis addresses the issues of equity, efficiency, revenue
stability and adequacy. In addition, a simple structure eases administration and public
acceptance. The state could balance the proportion of collections derived from any one
tax because over relying on a tax will exaggerate the impact from the negative
characteristics found in any tax. By creating a broadly based tax structure, the positive
characteristics of one tax may offset the negative aspects of other taxes for a more well
rounded outcome (Kleine and Shannon, 1985). In addition, the report evaluated service
industry growth trends, revenue estimates, sector composition and tax policy issues. An
institutional framework was applied to the Florida experience to predict the tax policy

issues Michigan may need to address prior to taxing business and individuals.

7.2 Sales Tax Structure

Since the sales tax is levied primarily on the tangible goods, Michigan’s tax
capacity and effort is limited. According to the Advisory Commission on
Intergovernmental Relations, Michigan’s sales tax capacity is just below the average
capacity while the sales tax effort is signiﬁcantly below that of other states. Michigan’s

tax rate is low relative to other states, resulting in less tax effort and less revenue but

141

more efficiency. Thus, there is suﬁ'icient latitude for Michigan to recuperate its tax

effort and capacity by taxing services.

7 3 Equity and Efficiency

According to a review of the literature, most state sales tax structures are
regressive, particularly at the lower income level. States are moving away from
progressive taxation structures and toward more regressive alternatives like the sales tax.
Some states offer credits to offset the tax burden on the low income tax payers. The
sales tax has gained acceptance as a viable alternative tax structure and offering
exemptions or credits would increase its progressivity.

Reviewing the efﬁciency of the sales tax structure provides a basis for
determining the impact of adding services. The most efﬁcient taxes are those that
minimize the distortion from changes in prices and income resulting from the tax. A
pure consumption tax would not effect the relative prices because all items would be
taxed. However, no state levies a pure consumption tax as they provide exemptions.
States could choose to tax consumption with alternatives to the retail sales tax such as
the gross receipts tax or a value added tax. These taxes would result in different
efﬁciency impacts with the value added tax creating the least amount of distortion on
business items. Nonetheless, most states continue to levy a retail sales tax because of its
familiarity and simplicity. The efﬁciency beneﬁt from broadening the sales tax base is

that there is less distortion and substitution between taxed and non-taxed goods.

7.4 Revenue Adequacy and Stability
The sales tax is less adequate and stable given that the growth of inﬂation

adjusted collections declined during recessionary periods. The growth of Michigan’s

142

sales tax collections did not keep pace with growth of its personal income. The gross
state product data was used to compare manufacturing sector and service sectors,
illustrating that services followed a steady upward growth while manufacturing followed a
procyclical pattern. Over the last two decades, services have grown steadily. The
business, professional and health services are dominate by size and offer the most
revenue gain. Their annual growth rate has followed a fairly steady path upward. Thus,

a sales tax on services would improve revenue stability and adequacy.

7.5 Policy Options

The broadest policy alternative is to tax all services without exemptions or credits,
raising up to $950 million. From an efﬁciency view point, the Michigan tax structure
could be improved with a broad based service tax. Since a broad based tax includes
business and professional services in the base, it raises the issue of whether to levy a use
tax on out-of-state ﬁrms when their services are used in Michigan. This issue was
addressed by Florida’s policy makers. The taxation of out-of-state ﬁrms may require that
an apportionment formula be developed for the use tax which takes into account the
intangible nature of services

The next broadest proposal is to tax most services. To improve equity,
adjustments could be provided such as a low income credit and a health service
exemption or credit. In addition, a business service resale exemption could be provided
to reduce double taxation of intermediate services incorporated into the ﬁnal service.
Taxing services with adjustments would be more equitable and politically acceptable but
less efficient and raise less revenue than the ﬁrst option. The revenue estimate for this

option depends on the design of the tax exemptions or credits provided.

143

The policy alternative of taxing services and lowering the rate was included to
illustrate that a proposal to tax services could meet the tax policy goals of efﬁciency and
revenue adequacy and stability without increasing taxes. Services could be taxed without
a signiﬁcant increase in collections and a lower tax rate would probably receive public
support.

The policy issue to address is the trade-off between a broader tax base and lower
tax rates or a narrower base and higher tax rates according to Dr. Ronald Fisher,
Professor of Economics at Michigan State University. In a presentation before the
Michigan House Tax Expenditure Subcommittee, Dr. Fisher discussed that the relevant
issue to evaluate when analyzing the tax structure is the distribution of revenues among
alternative types of tax sources and the composition of the tax base. That is, "What mix
of tax sources is best for our state at this time? What tax bases and rates should be
adopted for each tax to accomplish the desired mix?" The question concerns whether it
is better to levy a 4 percent rate on the sale of some consumer items and no tax on other
commodities or a 2 percent rate of most commodities including services (Fisher, 1990,

p. 2).

Policy makers could bypass the issues raised when broadening the base by
increasing the tax rate. Many states have raised their tax rates in recent years and
Michigan considered a rate increase on a recent ballot proposal. Raising the tax rate is
a likely choice because it results in the least amount of change, easing tax

implementation and public understanding.

144
7 .6 Florida’s Experience

In 1987, Florida broadened the sales tax base to include services but the
legislation was repealed within 6 months after considerable political controversy. Several
states considered legislation to tax services during the 1987 session but after the Florida
experiment failed, state legislative activity waned due to insufficient support. State policy
makers, cautious not to repeat Florida’s performance, have set up tax reform committees
to study the issue. Policy-makers may consider taxing services after reviewing studies
which point out the merits of the tax based on public ﬁnance criteria. Nonetheless, these
recommendations have met with resistance as many policy makers are proceeding with
caution, claiming that taxing services is not politically feasible and citing Florida’s tax
repeal as evidence. While some authors conclude that taxing services is too politically
sensitive to merit consideration, others argue that policy-makers are likely to renew their
interest in taxing services as memories of Florida’s tax repeal fade and the demand for
ﬁnancing state programs intensiﬁes without adequate revenue growth. Thus, the focus of
the future policy discussions revolve around whether taxing services is politically feasible.

Taxing services was Florida’s answer to the need for additional resources to
provide public services. Politicians were supportive of alternatives which raised
additional revenue and also improved the tax structure. The economic advantages of
taxing services included revenue adequacy and stability and efﬁciency. The state
constitution prohibited an income tax which provided Florida policy makers with an
incentive to utilize the sales tax. Policy makers favored the sales tax because it was vote
maximizing given its low visibility characteristic. In addition, some portion of the tax
burden could be shifted from consumers to business. Additionally, the tax could be
exported to residents of other states because Florida is a large tourist state. The tax is

regressive which shifts the tax burden away from the more inﬂuential higher income

145

groups with resources to oppose the tax. Sunsetting the exemptions proved to be a
powerful strategy because it changed the usual political dynamics as it is easier to pass a
sunset bill than to repeal the exemptions. Since the effective date was delayed for a year
to study the tax, political opposition was minimal as no immediate consequences would
occur. Florida implemented the sales tax on services on July 1, 1987 with several
exemptions. Consumers differed in the degree of utility and political support for the
government programs that the tax ﬁnanced.

Florida’s controversy highlighted the use tax levied on business services. Firms
perceive taxes as lowering proﬁts and will strive to shift the tax burden to others.
However, ﬁrms operating in a national market experience difﬁculty in passing on the tax
to consumers through higher prices because of national pricing structures. The policy
decision for states like Michigan to consider is whether to include out-of-state services
used within the state in the tax base. The issue addresses the trade-off between
simplicity and equity. The taxation of services became complicated when the intangible
nature of services combined with the long standing situs rule in most states that use or
consumption occurs at the point where the seller or his agent transfers the service. The
point of delivery is more easily manipulated for service ﬁrms which have greater mobility
to move to other states. Service ﬁrms characterized by economies of scale are motivated
to develop national markets and become multi-state businesses. Out-of-state ﬁrms
challenged the constitutionality of taxing services by ﬁling court cases against it and
exerting political inﬂuence. The degree of political activity is related to the size of the
ﬁrm and opportunity for gain as there are economies of scale to producing inﬂuence.
According to the Coase rule, the distribution of ownership does not make any difference
for resource allocation except when transactions costs are high. The advertising industry

beneﬁtted from a national market, which included Florida, but did not agree to the

146

validity of Florida’s right to tax them. When the transaction involves a non-geographic
speciﬁc service the link erodes further as ﬁrms lack a sense of community with the taxing
state. A policy alternative to the discrepancy between the ﬁrms multi-state market and
the state jurisdictional boundary is to develop a national sales tax for national ﬁrms
which would be redistributed back to the appropriate states.

The tax was repealed effective January 1, 1988, six months after it was
implemented. Politicians accommodated the interest of supporters of public programs by
ﬁnding a replacement source of revenue. However, they turned to a more politically
acceptable solution of raising the sales tax rate one percent. The state gained revenue
from the increase in the sales tax rate. However, out-of-state service firms like
advertisers were able to shift the tax burden back to consumers because they were no
longer required to contribute to the tax base. Policy makers in other states were affected
by the tax repeal as illustrated by their hands off attitude toward service tax proposals
which had been under consideration. The ability of any lobbying group to shift the tax
burden to others could be reduced by placing limits on the amount of lobbying
expenditures. Finally, states could reduce taxpayer uncertainty by providing a rigorous

tax education program explaining the impact of taxing services.

7.7 Continuity vs. Change

A proposal to tax services brings to light the trade-off between continuity and
change. A stable set of expectations is needed for long-term investments and continuity
is built into our system of law. Nonetheless, a degree of change is required to prevent
stagnation, according to Schmid, (1985). Consumers are changing their buying patterns
from one dominated by goods to a more equal mix of goods and services but the tax

structure remains stagnate and thus the state’s tax base will continue to decline. To

147

some extent, taxing services builds on continuity because it is based on the familiar sales
tax. The beneﬁts of expanding the sales tax to include services may be apparent.
However, with change, existing rights are called into question and policy makers are
faced with the challenge of balancing the need for change against the desire for

continuity.

7.8 Future Research Needs

Future research is needed as a basis for designing a marketing approach which
informs and educates the public about the beneﬁts of a new tax prior to its
implementation. Future research could focus on alternative ways of structuring
exemptions and credits which could improve equity or efficiency. The provision’s
structure will impact the cost to the state as it determines the number of qualifying
taxpayers. Advanced research is needed to design an apportionment formula which
addresses the intangible nature of services, minimizes the information cost and
maximizes public acceptance. Additional research is needed to determine the number
and size of ﬁrms operating in local or national market and to estimate the price elasticity

of demand for these service ﬁrms.

APPENDIX A

Alabama
Alaska
Arizona
Arkansas
California

Colorado
Connecticut
Delaware

DC (Washington)
Florida

(hunk

Hawaii

idaho

Illinois

Indiana

Iowa
Kansas
Kentucky
Louisiana
Maine

Maryland
Massachusetts
Michigan
Minnesota
11' . . i

Missouri
Montana
Nebraska
Nevada

New Hampshire

New Jersey
New Mexico
New York
North Carolina
North Dakota

Ohio
Oklahoma
Oregon
Pennsylvania
Rhode Island

South Carolina
South Dakota
Tennessee
Texas

Utah

Vermont
Virginia
Washington
West Virginia
Wisconsin
Wyoming

1975

101

101

103
106
145
103

109

101

1977

77
158
89
78
114

107
112

112
88

93
91
100
90
100
154

RTS Tax Capacity Indices, 1975-86
(100 = US. Average)

1979

76
217
91
77
116

110
109
110
110
I“)

81
103
91
112
98

108
109
85
104
80

99

100
173

APPENDIX A

Table 1

1980 1981
76 75
260 324
89 89
79 82
117 115
113 113
112 110
111 111
111 111
it!) 101
82 81
107 115
88 87
108 104
92 91
105 102
109 109
83 82
109 117
80 79
99 98
96 96
97 96
102 It!)
69 72
94 92
112 114
97 97
154 148
97 96
105 105
107 114
90 89
SO 80
108 124
97 94
117 127
103 99
93 90
S4 80
75 75
90 86
79 79
124 132
$6 87
a) 84
3 94
in} 99
94 90
95 9I
196 216

1982

74
312

101
93
99
71

91
110
97
151
100

1%
115
92
82
115

92
126
99
S9
81

74
S7
77
130
56

so
94
lnl
92
S7
21.) 1

Source: ACIR compilation from previous ACIR volumes on measuring ﬁscal capacity.

110 US. Advisory Commission on Intergovernmental Relations

148

1983

75
272
97
78
119

122
124
118
117
103

87
114
83
98
86

91
102
79
107
90

99
107

1984

73
250
99
75
1 19

121
124
123
120
105

1985

75
259
99
74
120

89 383

112
117
101
102

91

105
95

82

111
81

97

101

169

1986

74
177
99
73
l 18

117

a ease

aﬁaﬁa seas: 3:35

8:3

91

Eaasés aﬁaas sees

APPENDIX B

APPENDIX B

Table 1

RTS Tax Effort Indices, 1975-86
(100 = US. Average)

1975 1977 1979 1980 1981 1982

Alabama 79 79 . 86 85 9 l 87
Alaska 77 130 129 166 185 180
Arizona 108 110 115 117 106 92
Arkansas 78 78 81 86 79 81
California 119 117 95 102 100 99
Colorado 90 95 96 90 84 81
Connecticut 99 103 102 100 103 99
Dehumm: 84 80 96 89 87 84
DC (Washington) 94 118 132 131 146 145
Florida 74 73 78 74 73 72
Georgia 89 89 96 96 97 96
Hawaii 119 115 128 125 126 105
Idaho 90 89 91 88 87 85
Illinois 99 96 99 103 105 107
Indiana 92 83 84 84 89 88
Iowa 93 90 93 96 98 105
Kansas 85 89 87 88 87 88
Kenuuky 84 84 87 89 88 ' 89
Louisiana 87 79 82 78 77 81
Maine 104 100 110 111 113 107
Maryland 106 105 109 109 107 106
Massachusetts 129 133 144 135 134 119
Michigan 106 109 113 1 16 116 120
Minnesota 118 112 115 111 109 ill
Mississippi 96 94 97 97 95 92
Missouri 84 80 82 84 81 82
Montana 92 94 88 92 92 97
Nebraska 85 98 98 102 95 94
Nevada 70 62 65 60 62 63
New Hampshire 75 73 78 75 74 75
New Jersey 103 113 118 112 112 113
New Mexico 85 T7 85 83 89 83
New York 160 168 171 167 171 170
North Carolina 86 87 91 97 95 94
North Dakota 93 88 78 79 74 83
Ohio 80 78 86 87 89 94
Oklahoma 73 72 74 72 73 78
Oregon 96 92 93 93 101 95
Pennsylvania 93 94 105 104 105 106
Rhode Island 112 114 121 123 130 133
South Carolina 85 86 91 96 95 96
South Dakota 87 87 84 88 93 91
Tennessee 79 82 87 84 87 86
Texas 68 68 64 65 65 66
Utah 89 91 99 101 97 97
Vermont 108 104 1 10 104 105 103
vague 87 88 88 88 a) a)
Washington 101 94 96 94 92 93
West Virginia 85 80 82 82 83 86
Wisconsm 115 114 118 116 120 128
Wyoming 70 82 83 74 73 105

Source: ACIR compilation from previous ACIR volumes on measuring fiscal capacuy.

149

1983

87
166
91
83
92

1984

105

1(1)
115

124
95

101

1985

87
128
97
91
94

85

828

d
O

s§sss

103

101

103
125
1118

1986

86
168
99
9 l
95

83
94
8 1
143
77

89
105
90
106

103
85

101
111

APPENDIX C

 

APPENDIX C

Table 1

General Sales and Gross Receipts Taxes-1986

Capacity Per Capita Revenue Tax
Tax Per Capacity Tax Tax Per Effort
State Base' Capita Index/Rank Capacity Revenue Capita Index/Rank
Alabama $15,167 $270.57 720 I 50 31.0966 51.2668 $31256 115.5 I 11
Alaska 3.747 507.27 135.0 I 2 270.9 54.8 10266 20.2 I 47
Arizona 15,832 345.10 91.8 I 34 1,144.7 1,749.6 527.48 1528 I 2
Arkansas 9.512 289.94 77.1 I 48 687.7 777.3 327.70 113.0 I 12
California 159,400 427.15 113.6 I 12 11524.9 13.0213 48257 113.0 I 13
Colorado 19.065 421.93 1123 / 13 1.3785 1,396.7 42753 101.3 I 21
Connecticut 20.311 460.49 1225 I 6 1,4685 1.6249 50954 110.7 I 15
Delaware 3.785 43234 115.0 / 11 273.7 0.0 600 0.0 I Z
DC(Washington) 3.519 406.40 108.1 I 16 254.4 361.0 57673 141.9 I 7
Florida 70,140 434.37 115.6 I 10 5,071.2 5.0766 43483 100.1 I 22
Georgia 31.1114 367.25 97.7 I 24 2241.7 21722 35586 969 I 25
Hawaii 6.783 461.81 1229 I 5 4904 7467 703.10 1522 I 4
Idaho 3.920 28259 75.2 I 49 2834 2505 249.73 88.4 I 28
Illinois 56.727 355.01 94.4 I 29 4,1015 4.6026 39839 1122 I 14
Indiana 27,051 355.35 945 I 28 1.9558 2.1613 392.68 110.5 I 16
Iowa 12.751 323.36 860 I 42 921.9 768.6 26958 83.4 I 31
Kansas 12027 353.34 94.0 I 30 869.6 710.2 28860 81.7 I 33
Kentucky 14.964 290.21 77.2 I 47 1,131.9 8813 23639 81.5 I 34
Louisiana 19.322 310.38 826 I 44 1,397.0 2129.9 4731) 1525 I 3
Maine 6.449 397.14 105.7 I 18 466 3833 32651 822 I 32
Maryland 25.372 411.03 109.4 I 14 1,834.4 1,189.6 26655 64.8 I 42
Massachusetts 38.960 483.00 128.5 I 4 2.8169 1,721.3 295.16 61.1 I 44
Michigan 46,494 367.59 97.8 I 23 3,361.6 2.6870 293.82 79.9 I 36
Minnesota 23.883 409.77 109.0 I 15 1,726.8 1,369.9 32103 79.3 I 38
M‘ssissippi 9,474 260.94 69.4 I 51 685.0 1.0310 39278 1505 I 5
Missouri 26,760 381.93 101.6 I 19 1,9348 2.0217 399.13 104.5 I 18
Montana 3.782 333.86 88.8 I 40 2734 0.0 coo 0.0 I 2
Nebraska 7.777 351.88 93.6 I 31 5623 407.4 254.96 725 I 40
Nevada 11.925 895.29 238.2 I 1 8622 524.8 544.96 60.9 I 45
New Hampshire 7.035 495.29 131.8 I 3 5087 0.0 can 0.0 I Z
NewJersey 46.157 437.96 1165 I 9 3.3373 2.6144 343.09 78.3 I 39
New Mexico 7.059 345.07 91.8 I 35 5104 7427 50215 145.5 I 6
New York 89.226 363.11) 96.6 I 25 6.4512 8,798.3 495.07 136.4 I 10
North Carolina 29.854 340.95 907 I 38 2.1585 1.8616 29404 862 I 30
North Dakota 3.755 399.83 1064 I 17 2715 179.0 26355 65.9 I 41
Ohio 51.T79 348.19 926 I 33 3743.7 3.4982 325.35 93.4 I 27
Oklahoma 15988 349.76 93.0 I 32 1,155.9 1.0920 3.1142 945 I 26
Oregon 13.352 357.82 95.2 / 27 965.4 0.0 one 0.0 I 2
Pennsylvania 56482 343.49 91.4 I 36 4,133.8 3,241.4 272.64 79.4 I 37
Rhode Island 5.030 37297 99.2 I 20 363.6 291.4 29885 80.1 I 35
South Carolina 15.029 321.68 85.6 I 43 1.1367 1.1124 329.11 1024 I 20
South Dakota 3.293 336.30 89.5 I 39 t 2381 248.6 351.15 104.4 I 19
Tennessee 23.918 360.05 95.8 I 26 1,729.3 2431.0 50615 140.6 I 8
Texas 85591 370.96 98.7 I 22 6,188.4 5,393.7 32332 87.2 I 29
Utah 6.688 290.41 77.3 I 46 4835 679.1 40788 140.4 I 9
Vermont 3.371 450.53 119.9 I 7 243.7 98.6 18221 40.4 I 46
Virginia 29.725 371.38 98.8 I 21 2.1492 1.3702 23677 63.8 I 43
Washington 21.166 34290 91.2 / 37 1,530.4 3.4966 783.47 228.5 I 1
West Virginia 7.910 298.03 79.3 I 45 571.9 6125 319.18 107.1 I 17
Wisconsin 21.856 330.24 87.9 I 41 1580.2 1.5434 3254 97.7 I 24
Wyoming 3.156 450.11 119.7 I 8 228.2 225.0 443.78 98.6 I 23
11.8. Total 51.253321 $375.89 1000 590.617.? 390.617.? 5375 89 mm

Note: All per capita amounts are in dollars: total amounts arc in millions of dollars.
Representative Rate = 7.23%.

'Tax base is retail sales in millions of dollars.

2 = Zero revenue rcportcd.

Source: Price Watcrhousc

14 US. Advisory Commission on Intergovernmental Relations

150

APPENDIX D

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adsscry Commasswn on Intevgovernrncntal

APPENDIX E

APPENDIX E

Table 1

State General Sales Tax Rates

 

 

 

 

 

 

 

 

Region 8- State 10/1 I89 10/1 I88 7/1/87 7i1/86 7/1/85 7/1/84 7/1/82 7/1/80 7/1/78
U.S. Median 5.0% 5.0% 5 0% 5 0% 4.75% 4.75% 4.0% 4.0% 4.0%
New England
Connecticut 8.0 7.5 7.5 75 7.5 7.5 7.5 7.5 7.0
Maine 5.0 5.0 5.0 5 0 5.0 5.0 5.0 5.0 5.0
Massachusetts 5.0 5.0 5.0 5 0 5.0 5.0 5.0 5.0 5.0
New Hampshire No ta:
Rhode Island 6.0 6.0 6 l) 6 0 6.0 6.0 6.0 6.0 6.0
Vermont 4.0 4.0 4.0 4.0 4.0 4.0 4.0 3.0 3.0
Mideast
Delaware No tax
District of Columbia 6.0 6.0 6.0 6.0 6.0 6.0 6.0 5.0 5.0
Maryland 50 5.0 5.0 5 0 5.0 5.0 5.0 5.0 5.0
New Jersey 6.0 6.0 6.0 6 0 6.0 6.0 5.0 5.0 5.0
New York 4.0 . 4.0 4.0 4.0 4.0 4.0 4.0 4.0 4.0
Pennsylvania 6.0 6.0 6.0 6.0 6.0 6.0 6.0 6.0 6.0
Great Lakes
Illinois 50‘ 5.0 5 0 5.0 5.0 5.0 4.0 4.0 4.0
Indiana 5.0 5.0 5.0 5.0 5.0 5.0 4.0 4.0 4.0
Michigan 4.0 4.0 4.0 4.0 4.0 4.0 4.0 4.0 4.0
Ohio 5.0 5.0 5.0 5.0 5.0 5.0 5.0 4.0 4.0
Wisconsin 5.0 5.0 5 0 5.0 5.0 5.0 5.0 4.0 4.0
Plains
Iowa 4.0 4.0 4.0 4.0 4.0 4.0 3.0 3.0 3.0
Kansas 4.25 4.0 4.0 4. 3.0 3.0 3.0 3.0 3.0
Minnesota 6.0 6.0 6.0 6.0 6.0 6.0 5.0 4.0 4.0
Missouri 4.4252 4.215 4.225 4.225 4.225 4.125 3.125 3.125 3.125
Nebraska 4.0 4.0 4.0 3.5 3.5 3.5 35 3.0 3.0
North Dakota 5.0 5.5 5.5 4.0 4.0 4.0 3.0 3.0 3.0
South Dakota 4.0 4.0 5.0 4.0 4.0 4.0 4.0 5.0 4.0
Southeast
Alabama 4.0 4.0 4.0 4.0 4.0 4.0 4.0 4.0 4.0
Arkansas 4.0 4 0 4.0 4 o 4 0 4.0 3 0 3.0 3.0
Florida 6.0 6 0 5.0 5 0 5 0 5.0 5 0 4.0 4 0
Georgia 4.0 3 0 3.0 3 0 3 0 3.0 3 0 3.0 3 0
5.0 5 0 5.0 5 0 5 0 5.0 5 0 5.0 5 0
Louisiana 4.0 4 0 4.0 4 0 4 0 4.0 3 0 3.0 3 0
Mississippi 6.0 6 0 6.0 60 60 6.0 5 0 5.0 5 0
North Carolina 3.0 3 0 3.0 3.0 3.0 3.0 3 0 3.0 3 0
South Garolina 5.0 5 0 5.0 5.0 5.0 5.0 4 0 4.0 3 0
Tenne$ee 5.5 5 5 5.5 55 5.5 5.5 45 45 4 5
Virginia 3.5 3 5 3.5 3.0 3.0 3.0 3 0 3.0 3 0
West Virginia 6.0 60 5.0 5.0 5.0 5.0 5 0 3.0 3 0
Southwest
Arizona 5.0 5.0 5.0 5.0 5.0 5.0 40 4.0 4.0
New Mexico 4.75 4.75 4.75 4.75 3.75 3.75 35 3.75 3.75
Oklahoma 4.0 4.0 4.0 3.25 3.25 3.0 2.0 20 20
Texas 6.0 60 6.0 4.125 4.125 4.0 4.0 4.0 4 0
Rocky Mountain
Colorado 3.0 3.0 3.0 3.0 3.0 3.0 3.0 3.0 3.0
Idaho 5.0 5.0 5.0 5.0 4.0 4.0 3.0 3.0 3.0
Montana 4.90 la:
Utah 5.09383 5.0938 5.0938 4.5938 4.625 4.675 4.0 4.0 4.0
Wyoming 3.0 3.0 3.0 3.0 3.0 3.0 3.0 3.0 3.0
Far West
California 50‘ 4.75 4.75 4.75 4.75 4.75 4.75 4.75 4.75
Nevada 5.755 5.755 5.755 5.755 5.755 5.755 5.755 3.0 3.0
Oregon No tax
Washington 6.5 6.5 6.5 6.5 6.5 6.5 5.4 45 4.6
Alaska No tax
Hawaii“ 4.0 4.0 4.0 4.0 4.0 4.0 4.0 4.0 4.0

‘ lllinois' rate is scheduled to be 6.25% after ll l/90.

2 Missouri's rate is scheduled to be 4.425% from mil/89 to 6/30/90. unless extended by the voters.

3 Utah's rate is scheduled to decrease to 5‘72» on ill/90.

‘ California‘s rate is temporarily increased to 5% to primdc funds for earthquake relief.

5 Includes statewide state-levied local tax of 3.75% and a 2% state rate.

“Hawaii lcn'es its retail sales tax 25 part of a multirate general excise (gross receipts) tax.

Source: ACIR staff compilation from Commerce Clearing House. Sum- Tai (jimlr. October Wil‘). See 12ihle 27 for local sales tax rates.

74 Advrsory Commissron on Intergovernmental Relations

155

 

APPENDIX F

APPENDIX F

Interstate Comparison of Service Taxation, 1985l

 

 

 

Degree of Taxation Tax Structure Provisions
General Taxation of Services

Hawaii

New Mexico Excludes agricultural harvesting and warehousing non profit hospital 1
services, retirement accommodations, insurance premiums.

South Dakota Exempts health and education services; engineering, architectural,
and surveying services on projects out-side South Dakota.

Limited Taxation of Services - Narrow

Arizona Local advertising services taxed until January 1, 1986. Tax on
materials/ service combinations if value of material predominates.

Connecticut Selected business services taxed 7.5 percent; computer and data
processing credit information, collection and employment agencies,
marketing, private investigation, armored car, sign construction,
interior design, photo finishing, telephone answering,
stenographic, photocopying, certain services to realty, business
analysis, and piped in music. Also, cable television.

N. Carolina Laundry and dry cleaning

S. Carolina Laundry and dry cleaning

Limited Taxation of Services - Substantial
Arkansas Alteration, repair, etc., of motor vehicles, aircraft, farm machinery

and implements, motors, tires and batteries, boats, electrical

 

1 Tax treatment of services other than utilities, admissions, and transient accommodations.

156

Florida

Kansas

Louisiana

Mississippi

New Jersey

New York

Ohio

Pennsylvania

Tennessee

Texas

Utah

Wisconsin

157

appliances, instruments, machines, bicycles, office equipment, shoes,
tin, and sheet metal, computer equipment and hardware, and
mechanical tools and shop equipment; printing.

Repair of tangible personal property. Florida taxes cable television.

Repair of tangible personal property, laundry and dry cleaning.
Cable television, washing and waxing vehicles, and installation of
tangible personal property in Kansas.

Repair of tangible personal property.

Repair of tangible personal property, laundry and dry cleaning.
Cable television in Mississippi.

Repair of real and tangible personal property.

Maintenance, servicing, and repair of real and tangible personal
property (except laundry, dry cleaning, tailoring, services contracted
by private landowner), information services, installation, printing.

Repair and installation of tangible personal property; washing,
waxing, polishing and painting of motor vehicles; and industrial
laundry and linen services; exempts repair and remodeling of real
property and coin-operated car washes.

Repair of tangible personal property. Except wearing apparel and
shoes in Pennsylvania.

Repair and installation of tangible personal property, laundry and dry
cleaning, parking. Cable television in Tennessee. Tennessee exempts
repairs to certain machinery and equipment (natural resource
extracting, road building, and excavating and construction, and
shipping container loading) if delivered or shipped outside state after
repair.

Amusement services (amusement, recreation, entertainment); cable
television; personal services (SIC group plus massage parlors, escort
services, and Turkish baths, from group 729); motor vehicle parking
and storage; and repairing, remodeling, maintenance, and restoration
of tangible personal property (except aircraft, motor vehicles, ships,
boats or vessels other than sport fishing and other pleasure craft).

Laundry and dry cleaning; repairs, renovations, cleaning, washing, or
installing tangible personal property.

Repair of tangible personal property, laundry and dry cleaning,
photocopying, parking, cable television, landscaping and lawn
maintenance.

Wyoming

Dis. of Columbia

Iowa

Washington

W. Virginia

Alabama
California
Colorado
Georgia
Idaho

Illinois

Indiana

Kentucky

158

Repair, alteration, or improvement of tangible personal property;
geological services.

Repair, reproduction, addressing, mailing, textile renting, parking.

Limited Taxation of Services - Board

Repair of motor vehicles, garments, farm equipment, appliances and
electronics, investment counseling, bank service charges, barber and
beauty shops, carpentry, laundry and dry cleaning, photography,
equipment rentals, ﬂying service, interior decorating, warehousing of
agricultural products, printing, wrapping, packing, and packaging of
merchandise other than meat and vegetables, optional service on
warranty contracts. Employment agency services exempt. Cable
television, campgrounds, carpet and upholstery cleaning, gun and
camera repair, janitorial and building maintenance, lawn care,
landscaping, lobbying services, pet grooming, reﬂexology, security and
detective, tanning beds and salons, water conditioning and softening.

Repair and installation of real and tangible property; laundry and dry
cleaning; credit bureaus; abstractors; parking. Virtually all services
covered by the business and occupation tax.

All services exempt personal (including barber shop and beauty shop
parlors) and professional (licensed by the state). Included in the
taxed categories, for example, are bookkeeping, collection services;
private detectives.

No Taxation of Additional Services

Service Occupation Tax applies only to tangible personal property
transferred by servicement; services are exempt.

Cable television taxed. Indiana also taxes water softening and
conditioning service.

Maine
Maryland
Massachusetts
Michigan
Minnesota
Missouri
Nebraska
Nevada

North Dakota
Oklahoma
Rhode Island
Vermont

Virginia

159

Cable television taxed.

Laundry services rendered to commercial establishments are taxed.

Cable television taxed.

Cable television taxed.

Printing, parking, and advertising are taxed.

Cable television taxed.

Cable television taxed.

 

Source: Due and Mikesell, Sales Taxation, State and M Stmctuge and Administration (Baltimore: Johns
Hopkins University Press, 1983); and Commerce Clearing House, State In Review, as reported by Steve Gold,
Refomg’ State Tax Sﬁtems, National Conference of State legislatures, December, 1986, pp.220—221.

 

 

APPENDIX G

Summary of State’s Taxation of Service Items

APPENDIX G

 

 

Sales Tax Items, by SIC Code, 1987 Taxed Exempt Unspecified'
Advertising 12 17 17
Photography 36 10 -
Commercial Art & Graphic Design 37
Steno graphic Services 39
Services to Dwellings & Other

Businesses 10 0 36
Miscellaneous Equipment Rental &

Leasing 0 42
Personnel Supply Services 0 40
Computer Programming, Data

Processing, Etc. 9 8 29
Automobile Rental & Leasing 14 0 32
Automobile Parking 16 2 28
Miscellaneous Repair Services 20 6 20
Motion Picture Production,

Distribution, Theaters 4 2 40
Video Tape Rentals 4 2 40
Amusement & Recreation 28 3 15
Health 3 9 34
Legal 3 2 41
Educational 3 6 37
Social 2 3 41
Museums, Art Galleries, Etc. 2 O 44
Membership Organizations 8 3 35

160

161

Summary of State’s Taxation of Service Items (Continued)

 

 

Sales Tax Items, by SIC Code, 1987 Taxed Exempt Unspecified’
Engineering, Architectural & Surveying 2 3 41
Accounting, Auditing & Bookkeeping 2 1 43

R & D Testing 3 3 40
Management & Public Relations 2 0 44
Private Households 2 1 43
Transient Accommodations 40 6 -
TPP Maintenance, Installation &

Repair 34 12 -161.5
Processing & Printing 34 0 12
Cable TV 14 O 32
Transportation 14 4 28
Personal Services 7 5 34
Professional Services 5 37

 

* In these cases, the states’ tax laws do not specify whether these services are taxed or
exempt. They may be implicitly exempt or taxed, depending upon the way in which the
states’ laws are written. For example, stenographic services are not explicitly exempt
from taxation in New York; however, because they are not specifically classiﬁed as being
taxable,, they are implicitly exempt from sales taxation.

Source: 5.5-e . r R o .1' o. 1' - . __. i'ensat : Use Taxes A
W August, 1989, New York State Department of Taxation and
Finance, pp. A-9,A-10.

APPENDIX H

162

 

 

 

 

 

 

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APPENDIX I

APPENDIX I

TABLE 1

CENSUS OF SERVICE INDUSTRIES, 1987

 

 

No. of Receipts Multiplied
Establish- (1,000) by 4%
KIND OF BUSINESS ments Dollars Tax Rate
TOTAL 55,367 23,859,804 954,392
Hotels, rooming houses camps, & other lodging places
(except membership lodging) 1,434 893,658 35,746
Hotels and motels 1,234 864,056 34,562
Hotels 396 605,668 24,227
Hotels, 25 guestrooms or more 267 591,582 23,663
Hotels, less than 25 guestrooms 129 14,086 563
Motels, motor hotels & tourist courts 838 258,388 10,336
Motels, tourist courts 762 207,916 8,317
Motor hotels 76 50,472 2,019
Other lodging places 200 29,602 1,184
Rooming and boarding houses 28 2,801 112
Camps and recreational vehicle parks 172 26,801 1,072
Sporting and recreational amps 43 10,207 408
Recreational vehicle parks & campsites 129 16,594 664
Personal services 6,338 1,126,971 45,079
Laundry, cleaning, & garment services 1,811 453,663 18,147
Power laundries, family & commercial 67 28,069 1,123
Linen supply 63 78,942 3,158
Coin-operated laundries & drycleaning 536 69,564 2,783
Coin-operated laundries & dryclcaning 517 56,115 2,245
Coin-operated laundry machine routes 19 13,449 538
Drycleaning plants, except rug cleaning 715 131,225 5,249
Carpet and upholstery cleaning 213 26,093 1,044
Industrial launderers 55 100,690 4,028
Other laundry, cleaning & garment services 162 19,050 762
Garment pressing and agents for laundries &
drycleaners 80 4,612 184
Laundry and garment services, nec 82 14,438 578
Diaper and other laundry services nec 77 14,244 570
Diaper service 8 7,852 314
Other laundry services nec 69 6,392 256
Seamstresses and dressmaking
services 5 194 8
Photographic studios, portrait 376 68,583 2,743
Beauty and barber shops 2,619 255,319 10,213
Beauty shops 2,487 245,221 9,809
Barber shops 132 10,098 404
Shoe repair shops and shoeshine parlors 89 7,204 288
Funeral service and crematories 585 218,824 8,753
Miscellaneous personal services 858 123,408 4,936
Tax return preparation services 311 35,537 1,421
Miscellaneous personal services nec 547 87,871 3,515
Health-related personal services 197 11,690 468
Other personal services nec 350 76,181 3,047

 

166

167

Table 1 (Continued)

 

 

No. of Receipts Multiplied
Establish- (1,000) by 4%
KIND OF BUSINESS ments Dollars Tax Rate
BUSINESS SERVICES 7,846 5,576,244 223,050
Advertising 573 639,750 25,590
Advertising agencies 398 522,544 20,902
Outdoor advertising services 39 50,884 2,035
Radio, television, publishers’ advertising
representatives 78 38,491 1,540
Advertising, nec 58 27,831 1,113
Consumer credit reporting agencies, mercantile
reporting agencies, and adjustment and collection
agencies 201 107,809 4,312
Adjustment and collection services 150 59,723 2,389
Credit reporting services 51 48,086 1,923
Mercantile and reporting services 6
Consumer credit reporting services 45
Mailing, reproduction, commercial art and
photography, and stenographic services 926 488,428 19,537
Direct mail advertising services 99 118,012 4,720
Photocopying and duplicating services 138 68,261 2,730
Blueprinting and photocopying services 112 61,136 2,445
Duplicating services, except printing 26 7,125 285
Secretarial and court reporting services 217 39,699 1,588
Commercial photography, art and graphics 472 262,456 10,498
Commercial photography 126 34,227 1,369
Commercial art and graphic design 346 228,229 9,129
Commercial art 124 74,722 2,989
Graphic arts and related design 222 153,507 6,140
Services to dwellings and other buildings 1,411 330,758 13,230
Disinfecting and pest control services 140 49,270 1,971
Building cleaning and maintenance services nec 1,271 281,488 11,260
Window cleaning 41 4,540 182
Other building cleaning and maintenance
services, nec 1,230 276,948 11,078
Miscellaneous equipment rental and leasing 746 452,723 18,109
Medieal equipment rental and leasing 79 58,889 2,356
Heavy construction equipment rental and leasing 129 130,324 5,213
Leasing and rental of heavy construction
equipment without operators 74 78,754 3,150
Rental of heavy construction equipment with
operators 55 51,570 2,063
Equipment rental and leasing, ncc 538 263,510 10,540
Equipment rental 432 211,781 8,471
Equipment leasing, except ﬁnance leasing 106 51,729 2,069
Personnel supply services 780 761,549 30,462
Employment agencies 294 90,934 3,637
Help supply services 486 670,615 26,825
Temporary help supply 403 566,549 22,662
Help supply except temporary 83 104,066 4,163

 

168

 

 

Table 1 (Continued)
No. of Receipts Multiplied
Establish— (1,000) by 4%
KIND OF BUSINESS ments Dollars Tax Rate
Business services - continued
Computer programming, data processing, & other
computer related services 1,252 1,437,441 57,498
Computer programming, prepackaged software, &
integrated 668 585,294 23,412
Systems design
Computer programming services 445 383,901 15,356
Prepackaged software 80 59,942 2,398
Computer integrated systems design 143 141,451 5,658
Data processing services 309 470,628 18,825
Computer processing, information retrieval 282 445,658 17,826
Computer processing and data preparation &
processing services 272 437,926 17,517
Information retrieval services 10 7,732 309
Computer facilities management services 27 24,970 999
Computer rental and leasing, maintenance & related
services 275 381,519 15,261
Computer rental and leasing 28 129,877 5,195
Computer maintenance and repair 115 198,297 7,932
Computer related services, nec 132 53,345 2,134
Miscellaneous business services 1,957 1,357,786 54,311
Detective agencies and protective services 392 248,839 9,954
Detective, guard and armored car services 318 181,245 7,250
Detective agencies and guard services 299 164,621 6,585
Armored car systems 19 16,624 665
Security wstems services 74 67,594 2,704
News syndieates 14 10,401 416
Photo ﬁnishing laboratories 177 109,666 4,387
Photo finishing labs except mini labs 120 96,003 3,840
One hour photo ﬁnishing labs 57 13,663 547
Business services nec 1,374 988,880 39,555
Sign painting shops 69 13,523 541
Interior designing 109 27,542 1,102
Telephone answering services 106 21,889 876
Other business services 1,090 925,926 37,037
Water softening services 104
Packaging and labeling services 79 174,111 6,964
Trading stamp services 1
Miscellaneous business services nec 906 709,543 28,382

 

 

169
Table 1 (Continued)

 

 

No. of Receipts Multiplied
Establish- (1,000) by 4%
KIND OF BUSINESS ments Dollars Tax Rate
Automotive repair, services, and parking 5,357 1,840,704 73,628
Automotive rental and leasing, without drivers 379 464,200 18,568
Truck rental and leasing, without drivers 182 246,491 9,860
Truck rental, without drivers 92 60,660 2,426
Truck leasing, except ﬁnance leasing 90 185,831 7,433
Passenger car rental and leasing without drivers 170 209,460 8,378
Passenger car rental, without drivers 119 133,750 5,350
Passenger car leasing, without drivers 51 75,710 3,028
Utility trailer and recreational vehicle rental 27 8,249 330
Automobile parking 144 48,965 1,959
Parking lots 106 15,485 619
Parking structures 38 33,480 1,339
Automotive repair shops 4,004 1,123,477 44,939
Top, body, and upholstery repair shops and point shops 1,337 416,580 16,663
Top and body repair shops 1,249 390,203 15,608
Paint shops 88 26,377 1,055
General automotive repair shops 1,543 355,316 14,213
General automotive repair shops, except diesel 1,421 310,049 12,402
Diesel repair shops 122 45,267 1,811
Other automotive repair shops 1,124 351,581 14,063
Automotive exhaust mem repair shops 302 104,088 4,164
Tire retreading and repair shops 47 ' 25,548 1,022
Automotive glass replacement shops 168 76,533 3,061
Automotive transmission repair sh0ps 232 50,086 2,003
Automotive repair shops, nec 375 95,326 3,813
Radiator repair 121 32,469 1,299
Brake, front end and wheel alignment 134 38,670 1,547
Automotive electrieal and fuel system services 81 13,074 523
Carburetor repair shops 21 2,451 98
Automotive electrical repair shops 60 10,623 425
Other automotive repair shops, nec 39 11,113 445
Automotive services, except repair 830 204,062 8,162
Carwashes 458 97,338 3,894
Automotive services, except repair and carwashes 372 106,724 4,269
Lube sh0ps 95 33,665 1,347
Other automotive services, nec 277 73,059 2,922
Miscellaneous repair service 2,210 788,597 31,544
Electrical repair shops 599 230,358 9,214
Radio and television repair shops 206 56,481 2,259
Other electrical and electronic repair shops 393 173,877 6,955
Refrigeration and air conditioning service and repair shops 102 51,338 2,054
Electrical and electronic repair shops nec 291 122,539 4,902
Watch, clock and jewelry repair 55 5,514 221
Reupholster and furniture repair 219 23,706 948
Miscellaneous repair shops and related services 1,367 529,019 21,161
Welding repair 194 56,421 2,257
Armature rewinding shops 100 68,154 2,726
Repair shops and related services 1,073 404,444 16,178
Farm machinery and equipment repair shops 28 7,306 292
Lawnmower and other small engine repair 83 17,242 690
Sewer and septic tank cleaning services 105 35,401 1,416
Other repair and related services, nec 857 344,495 13,780

 

 

170

Table 1 (Continued)

 

 

No. of Receipts Multiplied
Establish- ( 1,000) by 4%
KIND OF BUSINESS ments Dollars Tax Rate
Amusement and recreation services, including motion
pictures 3,436 1,447,353 57,894
Motion picture production, distribution and services 184 341,815 13,673
Motion picture production, except for television 65 27,620 1,105
Motion picture and tape production for television 35 19,220 769
Services allied to motion picture production 53 204,508 8,180
Motion picture ﬁlm exchanges 21 84,022 3,361
Film and tape distribution for television 3
Services allied to motion picture distribution 7
Motion picture theaters 263 137,242 5,490
Motion picture theaters, except drive-in 215 130,387 5,215
Drive in motion picture theaters 48 6,855 274
Video tape rental 679 91,676 3,667
Theatrical producers (except motion picture) 128 81,608 3,264
Theatrical producers (except motion picture) bands,
orchestras 61 54,378 2,175
Producers of live theatrical productions 18 5,281 211
Producers of radio and television shows except
tape 5 2,364 95
Artists’ and entertainers’ managers or agents,
concert bureaus, booking agents 21 16,817 673
Other theatrical services 17 29,916 1,197
Bands, orchestras, actors and other entertainers 67 27,230 1,089
Dance groups and artists 2
Symphony orchestras, opera companies and
chamber music
Other music and entertainment presentations 65
Other music groups and artists 37
Other entertainers and entertainment groups 28 15,675 627
Bowling centers 431 182,283 7,291
Commercial sports and other amusement and
recreation services 1,751 612,729 24,509
Commercial sports 87 156,862 6,274
Professional sports clubs and promoters 25 50,714 2,029
Baseball clubs 2
Football clubs 1
Other professional sports clubs 7
Managers and promoters 15
Racing, including track operation 62 106,148 4,246
Auto racetrack operation 10 9,775 391
Horse racetrack operation 7 85,876 3,435
Dog racetrack operation
Racing stables and racing nec 45 10,497 420

 

171

Table 1 (Continued)

 

 

No. of Receipts mltiplied
Establish- (1,000) by 4%
KIND OF BUSINESS ments Dollars Tax Rate
Other amusement and recreation services, including 1,664 455,867 18,235
museums
Dance studios, schools and halls 121 8,955 358
Physieal fitness facilities 370 90,143 3,606
Physical ﬁtness centers, except gymnasiums and athletic 399 80,583 3,223
Membership gymnasiums and athletic clubs 20 8,146 326
Nonmembership gymnasiums and athletic clubs 11 1,414 57
Public golf courses 244 86,955 3,478
Coin-operated amusement devices 129 25,327 1,013
Amusement parks 36 22,970 919
Membership sports and recreation clubs 269 116,854 4,674
Amusement and recreation services, including museums 495 104,663 4,187
Concession operators of amusement devices and rides 22 3,799 152
Carnivals, circuses and fairs 14 8,045 322
Carnivals and circuses 13
Fairs 1
Billiard and pool establishments 14 1,874 75
Other recreation & amusements, Incl. museums 445 90,945 3,638
Museums, art galleries, and botanical and zoological 5 585 23
Museums and art galleries 4
Arboreta and botanical or zoological gardens 1
Roller skating rinks 83 17,102 684
Ice skating rinks 12 3,953 158
Other amusements and recreation services nec 345 69,305 2,772

 

172

Table 1 (Continued)

 

 

No. of Receipts Multiplied
Establish- (1,000) by 4%
KIND OF BUSINESS ments Dollars Tax Rate
Health services 15,382 6,219,908 248,796
Ofﬁce and clinics of doctors of medicine 6,300 2,875,183 115,007
Offices of doctors of medicine 6,145 2,697,211 107,888
Clinics of doctors of medicine 155 177,972 7,119
Ofﬁces and clinics of dentists 4,268 1,071,311 42,852
Ofﬁces of dentists 4,235 1,056,567 42,263
Clinics of dentists 33 14,744 590
Offices and clinics of doctors of osteOpathy 1,127 403,149 16,126
Ofﬁce and clinies of other health practitioners 2,184 445,329 17,813
Ofﬁces and clinies of chiropractors 795 111,880 4,475
Ofﬁce and clinies of optometrists 598 161,762 6,470
Ofﬁces and clinics of podiatrists and other health
practitioners 791 171,687 6,867
Ofﬁces and clinics of podiatrists 396 84,868 3,395
Ofﬁces and clinics of health practitioners nec 395 86,819 3,473
Nursing and personal are facilities 418 601,733 24,069
Skilled nursing are facilities 293 524,688 20,988
Nursing and personal are facilities except skilled
nursing are facilities 125 77,045 3,082
Intermediate are facilities 71 47,938 1,918
Nursing and personal are facilities nec 54 29,107 1,164
Hospitals , 12 242,808 9,712
General medial and surgial hospitals 2
Pachiatric hospitals 6
Specialty hospitals, except pwchiatric 4
Other halth services 1,073 580,395 23,216
Medial and dental laboratories 537 307,925 12,317
Medial laboratories 237 243,273 9,731
Dental laboratories 300 64,652 2,586
Home health are services 195 87,246 3,490
Miscellaneous health and allied services nec 341 185,224 7,409
Kidney dialysis centers 7
Specialty outpatient facilities nec 211 101,105 4,044
Health and allied services, nec 123
Legal services 4,326 1,769,856 70,794
Selected eduational services 260 127,149 5,086
Libraries
Voational schools 109 92,291 3,692
Data processing schools 24 26,167 1,047
Business and secretarial schools 32 21,584 863
Voational schools, nec 53 44,540 1,782
Correspondence schools 2
Voational schools, except correspondence and
voational high schools, nec 51
Schools and eduational services nec 151 34,858 1,394

 

173

Table 1 (Continued)

 

 

No. of Receipts Multiplied
Establish- (1,000) by 4%
KIND OF BUSINESS ments Dollars Tax Rate
Social Services 1,578 219,167 8,767
Child day are services 653 55,233 2,209
Other social services 925 163,934 6,557
Individual and family social services 196 22,441 898
Job training and voational rehabilitation services 44 26,118 1,045
Residential are 648 110,227 4,409
Social services, nee 37 5,148 206
Engineering accounting, resarch, management, and related
services 6,300 3,748,258 149,930
Engineering, architectural, and surveying services 2,073 1,710,303 68,412
Engineering services 1,402 1,407,709 56,308
Architectural services 471 252,741 10,110
Surveying services 200 49,853 1,994
Accounting, auditing, and bookkeeping services 2,187 787,110 31,484
Research, development and testing services except
noncommercial 360 476,923 19,077
Commercial physial and biologial research 122 334,520 13,381
Commercial physial research 74 292,306 11,692
Commercial medial and biologial research 48 42,214 1,689
Commercial economic, sociologial, and eduational
research 146 78,720 3,149
Testing laboratories 92 63,683 2,547
Engineering, accounting, research, management, and related
services (except noncommercial research organizations) - con
Management and public relations services 1,680 773,922 30,957
Management services 508 314,131 12,565
Management consulting services 832 298,858 11,954
Public relations services 112
Facilities support management services 2
Business consulting services, nec 226 112,160 4,486
Services, nec 870 101,939 4,078
Scientiﬁc and related consulting services 114 27,881 1,115
Other services, nec. 756 74,058 2,962

 

Source: Data from US. Department of Commerce, Bureau of the Census, Michigan Census of Services,
1987, pp. 6-10.

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