State Lawmakers Face Uphill Battles as They Seek to Tax More Services

As Maryland lawmakers look for ways to come up with billions of dollars in additional public school funding, they are wading into a controversial debate over whether to expand the state’s sales tax so it covers a wider range of services—including those provided by professionals like lawyers, accountants, architects and engineers.

Expanding the sales tax to services that are part of people’s daily lives, such as parking, pool cleaning and pet boarding, is an idea that has come up recently in other states as well. 

In Utah, lawmakers moved to tax more services as part of a larger tax package that they passed last year, but later repealed amid public opposition. And a bill now pending in Nebraska proposes taxing services more broadly, while lowering the sales tax rate to keep revenues in line with current law.

There are good reasons why a state might consider reworking its tax code in this way. Taxing more services in combination with reducing the sales tax rate or making other policy changes can lead to a fairer tax system for lower income households. It can also help states adapt to changes in consumer spending habits.  

But imposing the new taxes can be an uphill battle, often drawing stiff pushback from businesses groups and powerful industries who fight for exemptions or the status quo.

“Analysts left, right and center all can agree on a broader sales tax base,” said Richard Auxier, a researcher at the Urban-Brookings Tax Policy Center. Taxing services to broaden the base “is good tax policy,” he said, but it is also “incredibly politically challenging.”

Auxier warned that a pitfall for lawmakers is pledging to cut tax rates without a firm grasp of how far taxes can realistically be expanded. “You either can blow up your reform effort, or you can blow up your budget, if you promise and do all the easy stuff first and then sit down to actually figure out what you’re going to apply this to,” he said.

Del. Eric Luedtke, a Democrat and House Majority Leader, is the lead sponsor of the Maryland bill, which calls for dropping the state’s general sales tax rate from 6 cents to 5 cents per dollar, in addition to expanding the tax.

“It's difficult to undertake serious tax reform without some motivating factor,” Luedtke told Route Fifty last week. “In this case, the motivating factor is we need to fund schools.”

Maryland lawmakers in 2016 created a special commission that examined the state’s public education system. The panel found that the state’s schools were performing at a “mediocre level” when it comes to student learning. It also identified gaps in achievement based on factors like race and income and found teacher shortages, especially in topics like math and science.

Last year, the commission put forward a plan for improving the state’s schools. It proposes phased-in state and local spending increases over the next decade that would eventually come to total about $3.8 billion annually—or roughly 30% above projected spending levels by 2030.

Luedtke emphasized that his bill is not the only revenue proposal on the table in Annapolis as the legislature weighs options for raising school funding. “It just happens to be the one that’s gotten the most headlines,” he said.

Maryland’s sales and use tax currently is the state’s second largest source of general fund revenue. It is slated to generate about $5 billion annually in fiscal years 2020 and 2021. 

A fiscal note released on Friday for Luedtke’s bill shows that its net effect would be to boost state revenues by about $871 million in fiscal 2021. After that revenue gains would rise steadily from $2.2 billion to $2.8 billion from fiscal 2022 to 2025.

At least six other Democratic legislators have signed on as co-sponsors to the bill, which is teed up for a committee hearing on Monday. But the legislation has drawn strong opposition from Republican governor Larry Hogan and some in the business community. 

Hogan has derided the bill as the largest tax hike ever proposed in Maryland’s history and claims that, if enacted, it would “destroy” the state’s economy. 

“It is a tax on working families,” he said. “It’s not ever going to happen while I’m governor.”

Luedtke shrugged off the criticism. “The governor got elected on an anti-tax platform,” he said. “I always expected that he would oppose the bill."

Beyond the push to come up with the school funding, Luedtke highlighted what he described as “a larger conversation that's happening in a lot of states about the sales tax being degraded over time by the shift from goods to services.”

“The fundamental economic question is: why are we putting our goods-based businesses at a competitive disadvantage?” he added. “The governor is railing about how we would tax funeral services. But you pay taxes on a coffin. You just don't pay taxes for the mortuary services.”

Figures from the U.S. Bureau of Labor Statistics show that in 1960, commodities, including goods like food, clothing and appliances, made up about 63% of the nation’s consumer spending, while services totaled about 36%. By 2012, those figures had roughly flipped.

This dynamic has continued in more recent years. 

U.S. Bureau of Economic Analysis statistics for the final quarter of 2019 show that services comprised about 70% of the total dollar value of goods and services purchased by, or on the behalf of, the nation’s residents. These figures also show that about half of the money spent on services was linked to either housing, utilities, or health care.

“Consumption is always changing,” said Auxier, with the Tax Policy Center.

He noted that some of the change has to do with technology. "It was simple when we went from 8-tracks to tapes to CDs because those were all tangible goods, those were all going to be taxed,” Auxier said. “Streaming music services, that's something different.”

Most states, including Maryland, tax services to some degree. Hawaii, New Mexico, South Dakota, and West Virginia have some of the nation’s broader taxes on services. Other states, meanwhile, have moved to ban taxes on services in recent years.

Information the Federation of Tax Administrators collected from 42 states for 2017 shows that utility services and hotels and lodging are some of the most commonly taxed. At that time only seven states taxed “professional services,” like those provided by doctors and lawyers. 

Maryland currently taxes services like office and industrial building cleaning, special order printing, certain commercial laundries, credit reporting, armored cars and private detectives.

Luedtke’s bill proposes a blanket tax for all services except for those that would be specifically exempted. It currently includes exemptions for services involving education, healthcare, social services, religious organizations and nonprofits groups.

Dozens of business lines would become subject to the sales tax under the current version of the bill, according to the fiscal note. 

Some of the newly taxed services would include data and information technology work, licensing of software rights, interior design, the sale of online advertising space, personal training, sightseeing tours, swimming pool cleaning, pest extermination and snow removal.

Luedtke expressed an openness to discussing exemptions, particularly for consumer services that people at all income levels use, such as haircuts.

Depending on policy makers’ goals, there are ways that broadening a state sales tax to include more services could make for a more equitable tax code. 

Expanding the tax, while also lowering the rate, might mean that people pay more for luxury services like a personal trainer at their gym. But, on the other hand, someone buying basic necessities like shoes for their kids would pay less tax on that purchase.  

Auxier said it is generally the case that higher earners buy more services than people with lower incomes. Still, depending on how a sales tax plan is structured it could apply to plenty of services that many people rely on. 

For example, Luedtke’s bill as written would cover services like car repairs.

Benjamin Orr, executive director of the left-leaning Maryland Center on Economic Policy, said that the group is still evaluating the legislation. “Broadening the sales tax base to certain services could definitely be a component of a well-designed package,” Orr said. 

But he emphasized that he would want there to be protections for low-income residents.

Sales taxes are generally considered to be a regressive form of taxation—they consume a larger share of income for lower earners, than for higher earners making the same purchases.

Orr described Maryland’s tax code overall as regressive—“absolutely upside down,” he said—even though it includes some features that make it less so, like a sales tax exemption for most groceries and a graduated income tax.

Expanding Maryland’s earned income tax credit, which can reduce or eliminate the state and local income taxes on low to moderate income households, was one policy change that Orr suggested could soften the blow to those earners if the sales tax is broadened.

The Maryland Center on Economic Policy has proposed its own blueprint for raising additional state revenues for schools. 

Applying the sales tax to more services is one part of that plan. But it also calls for a range of other changes, like closing what the group describes as corporate tax loopholes, getting rid of certain economic development subsidies, restructuring the state’s income tax, and decreasing the threshold for applying the estate tax to $1 million from over $5 million.

Notably, Luedtke’s bill at this point does not include an exemption for business-to-business services, which might include things like payroll, consulting, marketing or equipment repairs. 

Including business-to-business services in sales tax proposals like the one in Maryland can result in what is sometimes called “tax pyramiding,” where tax costs stack up in the course of companies completing transactions with one another and then get passed to consumers. 

Asked about this issue, Luedtke’s office said the bill was written to be very broad at first to start conversations about how it can best be implemented. 

Mike O’Halloran, Maryland state director for the National Federation of Independent Business said the group opposes the bill “based on the simple fact that this is going to make the cost of doing business go up.” The added cost, he said, will result in higher prices for customers. 

O’Halloran described taxing business-to-business services as particularly problematic. He also argued that Maryland is already an expensive place to do business and more taxes would make companies less competitive compared to those in neighboring states.

"I think the business community in Maryland will let them know when the bill is heard on Monday that this shouldn't be a proposal at all,” he said.

In Utah, lawmakers approved a tax package in December that—along with other revisions to the tax code—expanded the sales tax there to cover services like pet boarding, towing, parking lots, dating referral services, streaming media and identity theft protection.

Lawmakers considered taxing a wider variety of services as part of an earlier tax overhaul effort last year that was ultimately scrapped.

Gov. Gary Herbert, a Republican, and others have been making a case that while Utah’s income tax collections are performing well, sales tax growth has lagged, and that these two streams of revenue need to be rebalanced. The state’s constitution requires income tax revenue to go toward education spending, while sales tax dollars are more flexible.

Herbert described the measure passed last year as a good initial step towards taxing more services. But in January, he and legislative leaders decided to repeal the legislation, a move that came amid blowback over how it would have raised taxes on groceries.

The Nebraska bill would alter the state tax code so that services would be presumed taxable unless they have a specific exemption. It also calls for reducing the sales tax rate from 5.5% to 4%, and for the tax commissioner to further adjust the rate to keep revenues on par with where they would have been had the bill not gone into effect.   

"The proposal in a nutshell adapts our sales tax scheme really to the realities of our 21st century economy,” state Sen. Tom Briese, who introduced that bill, said during a recent phone interview. But the overall goal, he added, “is to reduce the sales tax rate.”

“It should appeal to fiscal conservative senators,” Briese said. “It should also appeal to the left side of the political spectrum because of its impact on the regressivity of the sales tax.”

Briese explained during a committee hearing last week that the bill’s delayed implementation date, set for mid 2021, was meant to give lawmakers time to hear from different stakeholders seeking exemptions and to establish those carve outs as they see fit.

The state senator suggested that, in his view, business-to-business transactions, health care, education and housing are all areas where it could make sense to consider exemptions.

Tiffany Friesen Milone, policy director for the OpenSky Policy Institute, which conducts research and analysis on fiscal issues in Nebraska, testified in support of the bill at last week’s hearing.

Milone said that Nebraska’s current sales tax code has created distortions, noting for example that indoor swimming pool cleaning is taxed, but outdoor pool cleaning is not. All told, she said that the state taxes just 81 services, whereas neighboring South Dakota taxes 152.

“The base has become narrowed over time by focusing only on goods,” she said. Milone did caution, however, that if services in areas like health care, housing and auto repairs were to be taxed, the burden would fall disproportionately on lower-income households.

The Platte Institute, a conservative think-tank, also supports the tax bill and the lower sales tax rate that it proposes. 

“We consider ourselves a higher tax state, in some regards,” said Nicole Fox, the group’s director of government relations. “When it comes to our sales tax, we have room to make ourselves more competitive compared to our neighbors.” 

Whether Briese’s bill will get any traction is far from clear. Nebraska’s 60-day legislative session is a little more than halfway over. And the bill does not have “priority” status, meaning even if it advances, it would likely be behind dozens of other measures lined up for debate.

In the meantime, businesses are giving the proposal a cool reception. At last week’s hearing, people representing a health club company, the state’s board of barber examiners, and a self-storage association all voiced concerns about it during testimony. 

Another objection came from a lobbyist who spoke on behalf of a wide swath of professionals, including engineers, architects, massage therapists, bankers, general contractors, insurers, veterinarians, physician assistants, trial lawyers, optometrists, and realtors.

“We really like this bill, but please take us out of it before you advance it,” Korby Gilbertson, the lobbyist said, summarizing the coalition’s message. “We’re not comfortable saying ‘trust us, you can come plead your case next year and maybe or maybe not your tax will be removed.’”