The Split Roll Property Tax May be on Ice, but Make Way for the Split Roll Sales Tax.

Loren Kaye
President of the California Foundation for Commerce and Education

Senator Bob Hertzberg last week unveiled a long-promised “modernization” of the state sales tax, but it’s mostly just an old-fashioned tax shift from shoppers to businesses.

The guts of the plan are simple: over a three-year transition period, cut the existing state sales tax rate by two percentage points (from 4.75% to 2.75%) and enact a new three percent sales tax on services purchased by businesses.

The sales tax today only applies to “tangible property,” things you can touch, except food and medicine. For the most part services, such as those provided by custodians, entertainers, consultants and data processors, are not taxed.

The new proposal would finger a wide range of new activities never before subject to an excise tax – but only if purchased by businesses. Attorneys, accountants, advertisers, agents, auditors, actuaries, asset managers – and those are only the “As.” 

To his credit, the Senator has designed the tax trade-off to be mostly revenue neutral for the first three years. After that, it’s likely the proposal will generate increasingly more revenues than the old system, since sales of services have generally grown faster than sales of tangible goods.

This is exactly what advocates mean by “modernization:” adopting tax bases that grow rapidly in place of tax bases that plod. The bottom line will be more revenues to state coffers, but the consequence to California’s business environment is troublesome.

The proposal will create winners and losers based solely on how they can manage their consumption of business service contracts. In this case, large businesses that can self-provide legal, accounting, IT, and housekeeping expenses will have a distinct advantage over small businesses that must outsource these services.

Likewise, the many thousands of small businesses that provide business services to other firms will find their costs immediately increased by three percent, and suffer the inevitable loss of customers.

To be sure, a few states do levy a sales tax on some business services. But many others, like Michigan and Florida, have repealed their short-lived efforts. Most states do not tax these services because the tax causes major economic distortions. The main distortion is from “pyramiding,” whereby a tax is imposed at multiple levels in the production of a final product, whereby the effective tax rate exceeds the actual retail sales tax rate.

After property taxes, sales taxes on business inputs are the largest category of taxes paid by business in California, amounting to nearly $20 billion in 2016. A study by the Council of State Taxation found that California business paid about 45 percent of state and local sales taxes.

Finally, this measure does not attack the main culprit of California tax risk and inequity – the supercharged top marginal income tax rates. (This is not a criticism, since those rates cannot be changed by the Legislature until 2031, at the soonest.)

If business is already paying a large portion of the sales tax, if the new tax causes distortionary economic effects, if it creates new losers among small businesses, and if there’s no call for new revenues, then why launch this new tax scheme against California’s business?

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