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Tax experts, economists say Dayton’s business sales tax is a bad idea

Tax policy wonks strongly object to taxing business-to-business services for multiple reasons, chief among them that it results in “tax pyramiding.”

Most tax policy experts would endorse — at least in concept — DFL Gov. Mark Dayton’s proposal to expand Minnesota’s sales tax to clothing and consumer services, and lower the tax rate from 6.875 percent to 5.5 percent.

Broadening the sales tax base would modernize the tax code to reflect our service-oriented economy, stabilize the sales tax as a source of revenue and reduce the inequities that result from the current law — taxing products, but not services that fulfill similar needs.

“Generally speaking, the broader the tax base and the lower the rate, the better off you are,” says Mark Haveman, executive director of the Minnesota Center for Fiscal Excellence (formerly the Minnesota Taxpayers Association).

But Haveman and other tax policy wonks strongly question the wisdom of Dayton’s plan to extend the sales tax to business-to-business services, including accounting, advertising, architecture, computer, design, employment, engineering, legal, management consulting and business support services.

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“It is very rare when all economists agree,” says John Spry, a professor of business economics at the University of St. Thomas and an expert on state tax policy. “But I am still trying to find an economist who studies this area who thinks taxing business-to-business services is a good idea.”

Not surprisingly, leaders of the business community have strongly opposed the proposal, saying it would make Minnesota products and services less competitive and drive jobs out of the state.

“The business-to-business tax doesn’t make sense for economic reasons, for fairness reasons or for practical reasons,” says Bill Blazar, senior vice president of the Minnesota Chamber of Commerce. “There’s nothing progressive about it.”

Proposal ‘clarified’

Late last week, top aides to the governor attempted to “clarify” the proposal, saying it never was intended to apply to services performed by Minnesota firms that are “delivered to another state.” This had gone unmentioned by Dayton’s revenue commissioner, Myron Frans, during nearly four hours of testimony before the House and Senate tax committees.

Source: Research Department of the Minnesota House of Representatives

Frans told lawmakers that the governor was proposing to extend the sales tax to business-to-business services, as well as consumer services, as a matter of fairness. “If I as a consumer am paying taxes on legal and accounting services, why shouldn’t businesses do the same?” he asked.

The commissioner also dismissed concerns that the proposal would cost Minnesota jobs.  “Gov. Dayton often says, ‘We’ve been hearing for 30 years that businesses are going to leave.’ Well, Minnesota is here. We have a thriving business economy. We’ve got great businesses. We have not seen evidence that [business] flight occurs when these kinds of changes are made.”

Dayton also seized upon the proposal because it is a lucrative source of new revenue. It appears that about three-fourths of the $2 billion in new revenue from the sales tax expansion is generated by the tax on business-to-business services, based on administration budget documents. The Revenue Department did not respond to a request for the specific revenue estimates and other information.

Economists and tax policy experts object to the idea of taxing business-to-business services for multiple reasons, chief among them that it results in “tax pyramiding.”

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Laura Kalambokidis
Laura Kalambokidis

“If there’s a product or service that has multiple stages of production, when taxes are applied in stages, then you are applying a tax on top of a tax,” explains Laura Kalambokidis, a University of Minnesota economics professor and tax expert.

Kalambokidis says the classic example is “the baker who buys the flour, pays a tax on it, and then sells the bread to the consumer. Then you apply the tax on the sale to the consumer, so it ‘pyramids.’ It’s building so that you have 5.5 percent or whatever on the inputs. That then gets baked into the price of the good. The more stages of production, the more time it happens if every input is taxed.”

As a result, critics say, such proposals unfairly tax some products and services more than others by imposing varying levels of taxes on business inputs as well as the general sales tax on the final product.

A related problem is that the tax is not transparent to the taxpayer, one of the key principles of sound tax policy espoused by groups such as the Tax Foundation, nonpartisan tax research group based in Washington, D.C.

“It’s a bad tax — it’s a hidden tax,” says Arthur Rolnick, an economist and former senior vice president of research for the Federal Reserve Bank of Minneapolis. “It’s going to end up distorting business decisions.”

Tax, not business, decisions

Both Spry and Kalambokidis echoed these criticisms, saying the tax could result in businesses making decisions for purely tax reasons and not sound business reasons.

“A business that uses a lot of legal services and usually purchases those services outside of their own firm might just decide they will hire lawyers and bring that in-house,” says Kalambokidis. “They might be making that decision because of the tax consequences, and not because that is the best choice for their business. That is one of the inefficiencies that could arise.”

The business-to-business tax could be particularly hard on small businesses, which may have no option other than to contract for accounting, legal, payroll and other services.

The state also could have problems administering and enforcing the tax, particularly when it comes to collecting it on the purchase of services by Minnesota businesses from firms located out of state. In cases where the supplier of the service does not have a Minnesota presence, the Minnesota buyer would be required to report the transaction and pay a “use” tax equal to the state sales tax.

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Large Minnesota businesses with offices in other states could respond by relocating certain functions to other states or contracting for services out of offices located elsewhere.

Spry envisions the Revenue Department “sending use tax auditors into businesses in Minnesota and saying, ‘We’d like to see all of your legal bills or engineering bills or services bills.’ How successful they will be in collecting the use tax is kind of hard to say.” 

He also suspects the state would need “a whole series of court cases” to delineate how the tax would be applied. “It boggles the mind.”

Finally, studies suggest that the business-to-business sales tax would fall most heavily on lower income residents, making the state’s tax system more regressive. That’s the opposite of the goal being pursued by the governor, who is proposing to raise income taxes on the top 2 percent of wage earners and make the tax system more progressive.

Incidence of 2008 taxes imposed on businesses, by population decile

rate of business tax paid per income decile
Source: Minnesota Center for Fiscal Excellence
Studies suggest that the business-to-business sales tax would make the state’s tax system more regressive.

Every two years, Revenue Department researchers conduct what they call a “tax  incidence study,” showing how the burden of all state and local taxes is distributed among all income groups. The study includes business taxes passed along by businesses and indirectly paid by consumers.

The most recent study, completed in 2011 for taxes paid in 2008, found that Minnesota’s three major taxes — income, sales and property — were increasing progressive from the second decile until the top decile of taxpayers, where the tax burden dipped from 8.3 percent of income to 7.8 percent of income. (A new incidence study is expected to be released in March.)

However, if you look just at business taxes paid by individual taxpayers, the story is just the opposite. The burden falls from 15.3 percent for the lowest decile of wage earners to just 1.8 percent for the top decile.

“Business taxes are the primary reason for regressivity in Minnesota’s tax system,” Haveman says. If Dayton’s business-to-business sales tax is approved, he says, future incidence studies “very likely again will suggest that the wealthy are not paying their ‘fair share’” — even after the income tax increase on the top 2 percent.