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Opinion: Columnists

Manhattan Moment: Service taxation: A winning issue for Republicans

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Opinion,Columnists,Taxes,Manhattan Moment

Traditionally understood, "tax reform" means closing loopholes to finance an across-the-board cut to tax rates. At the federal level, such revenue-neutral reform now looks unlikely. Though Republicans still support the concept, Democrats have become increasingly firm in their conviction that the purpose of closing tax loopholes is to generate revenues and raise taxes on high earners.

Prospects are brighter at the state level, where Republicans hold complete control of 25 state governments. Indeed, several Republican governors have recently proposed major tax changes. But with the exception of Louisiana's Bobby Jindal, these governors have neglected to address one of the greatest weaknesses of current state tax codes: namely, their tendency to exempt most services (as opposed to goods) from sales taxes.

Broadening the sales tax to include more services would create fairer, more efficient and more modern state tax codes. It would also finance massive cuts to tax rates. More Republicans should follow Jindal's lead and make service taxation central to their tax-reform plans.

The sales tax is a major funding source for state governments, providing the mean state with about a third of its total revenues. But, over the years, it has become unreliable, as sales tax bases have gradually eroded. This development has been driven by three factors: the rise of generally untaxed online commerce, states granting exemptions for basic necessities such as food and clothing and increased consumer spending, proportionally, on services as opposed to goods. As a recent Tax Foundation report noted, state sales taxes were designed in the 1930s, when sales of "tangible personal property" constituted about two-thirds of the economy. This figure has since dropped to only one-third.

Taxing online commerce is fundamentally a federal issue, and removing exemptions for food and clothing is politically impossible. Thus, if states want to reverse erosion in their sales tax bases, they must tax more services -- from the small-bore, such as barbers, cleaners and auto repair shops, to the highly lucrative, such as finance and insurance -- even lobbying is generally sales-tax-exempt.

Tax-base erosion leads to greater inefficiency in tax systems because it forces lawmakers to raise tax rates to compensate for a narrower base. Indiana University's John Mikesell has calculated that, between 1970 and 2010, the mean state sales tax base narrowed from 55 percent of personal income to 37 percent. During the same period, the mean sales tax rate rose from 3.5 percent to 5.5 percent. Exempting services creates a tax code unfairly biased in favor of service-industry businesses over those that traffic in goods. As Alan Viard at the American Enterprise Institute has written, distinguishing between goods and services can lead to wasteful litigation, because the distinction is unclear in some cases -- such as computer software.

Like goods, all services should be presumed to be subject to the sales tax, absent special legislative provision. Only Hawaii, South Dakota and New Mexico currently take this approach. All other states' systems are designed such that legislators must make a special effort to tax any particular service -- with predictable results. According to the Federation of Tax Administrators' most recent survey of trends in state service taxation, half of all states tax less than 40 of 168 services included in the survey; 44 tax no professional services.

Done right, service taxation is no revenue grab and is perfectly complementary with Republican governors' ambitions to cut income taxes. As President Reagan understood, the broader the tax base, the lower rates can go.

Since the 2012 elections, Jindal has been arguing that Republicans must fight back against being tagged as the "stupid party." Service taxation is a smart idea: It enjoys wide-ranging support among tax policy experts and has been consistently recommended by special state commissions on tax reform. Pursuing service taxation would allow Republicans to seize the high ground in tax policy debates and refashion themselves as the party committed to improving tax codes -- by eliminating distortions, unfairness and inefficiency, and by adapting codes to the service-based 21st-century economy.

Stephen D. Eide is a senior fellow at the Manhattan Institute's Center for State and Local Leadership.

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