Obstacles to Taxing Services — Are They Insurmountable?

Attempts to apply sales tax to services continued to fail in 2007. What’s the problem with taxing services?

February 28, 2008
by Annette Nellen, CPA/Esq.

State sales tax bases have traditionally included only tangible personal property. Often services are either ignored completely in describing the tax base, or a small number of services are specifically targed as legally taxable. One reason for exclusion is historical. Tangible personal property was the main consumption item back in the 1930s when many states started imposing a sales tax. However, in the past two decades, consumption of services has become significant.

Since 1990, the Federation of Tax Administrators (FTA) has tracked the number and types of services taxed in each state. Of the 168 services tracked, Hawaii, New Mexico and South Dakota tax the greatest number (over 140 each), while most states tax less than 60 services.

To preserve or expand revenues, many states have pursued broadening their sales tax base to include more types of services. These efforts have not always been successful. States’ need to preserve their tax bases in light of changing consumption patterns, combined with their inherent need for revenue, makes it inevitable that states will continue to pursue expansion.

Below, we’ll look closer at reasons for taxing services, obstacles to doing so and possible solutions.

Famous Failures

Protests generated nationwide attention when two states attempted to expand their sales tax to services in the late 1980s. In 1987, Florida expanded its sales tax to include specified services, only to repeal it six months later. The legislature replaced the tax with a rate increase (New York Times). In 1990, Massachusetts expanded its sales tax to services only to repeal it before the effective date.
More recently, to generate needed revenue, Michigan enacted a use tax on 23 specified services including landscaping, party planning and packaging (HB 5198, October 2007 (PDF)). On the day the new tax went into effect, December 1, 2007, it was repealed and replaced with a business tax surcharge (HB 5408, December 2007).

Reasons for Including Services in the Sales Tax Base

Consumption Trends: Changes in lifestyles and technology have led to changes in consumption patterns. Busy families might hire a house cleaner, gardener and nanny. And it is not uncommon to hear of people hiring personal trainers and pet sitters.

From 1970 to 2001, consumption of tangible personal property minus groceries dropped from 39 percent of household consumption to 33 percent. From 1970 to 2001, consumption of services increased from 31 percent of household consumption to 44 percent (Mazerov, Expanding Sales Taxation of Services: Options and Issues, Center on Budget and Policy Priorities; also see Minnesota House Research).

Consumption trends also include greater consumption of digital goods. Reasons for expanding tax bases to include services also apply to digital goods, such as music and software downloads.

Tax policy and structure: Economically, there is no rationale for taxing some forms of consumption while exempting others. There is no reason to tax laundry detergent, but not dry cleaning services, or a lawn mower, but not gardening services.

Broadening the sales tax base to include more services can make the sales tax more equitable and can allow for a rate reduction (making the tax even more equitable). If needed, base broadening and a rate reduction can be combined to generate new revenues. States facing reduced sales tax collections due to a diminishing tax base might find it simpler to increase the tax rate, rather than expand the base. This approach though, ignores the underlying problem and creates others. Many services are more likely to be purchased by higher income individuals. Exempting that consumption while increasing the tax on tangible personal property makes the sales tax more regressive. Also, many states already have high sales tax rates and further increases may lead to competitive problems for businesses and greater tax evasion.

A broader base can also reduce volatility that can improve government budgeting. Base broadening can also help improve economic development decisions. For example, in some states, such as California, local governments are very dependent on sales tax revenues. Thus, they are “incentivized” to get retailers to locate within their jurisdiction rather than trying to attract businesses that offer nontaxable goods or services. A broader base enables governments to make better economic development decisions.

Issues and Analysis

Listed below are some of the reasons for the famous failures noted earlier, and suggestions for improvement.

  • Education: Predictably, adding a tax to something previously untaxed is not popular. A state should pursue education efforts to help consumers understand the sales tax and the benefits of base broadening. Once in place, taxpayers will also need information on when they owe use tax on services obtained from out-of-state.
  • Avoid pyramiding: Base broadening should be allocated to services that are not typically used by businesses so as to not worsen a state’s pyramiding problems. Pyramiding is the imposition of a tax on a tax. For example, if a business pays sales tax on its purchases, it will factor that cost into what it charges customers. When customers pay sales tax on purchases from that business, they pay a tax on a tax. Not taxing services primarily consumed by businesses should also be good for the state’s business climate. A sales tax on hair cuts won’t cause hair salons to leave the state, but a tax on information technology services may cause businesses to leave or to avoid locating in the state.
  • Legality: A state should review federal and state rulings for help in properly defining the expanded tax base. A 1987 Florida ruling provides insights on reducing the likelihood of legal challenges. Among other findings, the court noted that imposition of sales tax on legal services was permissible. Per the court, states have flexibility and discretion in selecting items to be taxed “provided that the classification is reasonable, non-arbitrary and rests on some ground of difference having a fair and substantial relation to the object of the legislation (In re Advisory Opinion to the Governor, 509 So 2d 292, 303 (FL 1987)).”

    Case law should also be reviewed to aid in drafting rules on nexus and determining the tax on services performed and/or delivered to more than one state.
  • Transition: Implement the expansion gradually. The enacting statute should specify the items added to the base with effective dates spanning a future time period. This allows more time for the tax agency to help businesses that become subject to tax collection, and for consumers to adapt to the changes.
  • Compensation: Base expansion will cause more businesses to be subject to sales tax compliance. A state should provide a refundable tax credit to alleviate start-up costs for these businesses and ideally, provide compensation for all businesses that collect sales tax.
  • Rate reduction: The base should be expanded along with a rate reduction. This helps consumers to see justification for the base broadening beyond just generating revenue. A rate reduction might also alleviate other sales tax issues, particularly in states that already have a high rate.


Tax policy and revenue needs make it inevitable that states will continue to explore sales tax base broadening to include more services, as well as digital goods. Whether states will learn from the failed attempts remains to be seen. Working to avoid the obstacles though, such as in the ways noted above, should lead to improved tax systems and a manageable change process.

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Annette Nellen, CPA, Esq., is a tax professor and Director of the MST Program at San José State University. She is also a fellow with the New America Foundation. Nellen is an active member of the tax sections of the ABA and AICPA. She is a member of the AICPA’s Individual Taxation Technical Resource Panel. She has several reports on federal and state tax reform and a blog.