Consider these two scenarios: A family spends Saturday afternoon at the local shopping center, buying a new washing machine, summer sandals, children’s books and dog food. With every purchase, the state takes its cut, courtesy of California’s 7.25 percent sales tax.
Then consider a mid-sized advertising firm across town. It contracts with an accountant, a software developer, a lawyer and a cleaning service. Every time the company pays for these services, the state of California collects absolutely nothing.
But what if the state started getting a piece of that action?
Some state lawmakers are pushing that idea: Create a new business services tax they say would allow the state to cut California’s high sales tax to consumers and pull the state’s antiquated tax code into the 21st century.
A proposed bill would add a 3 percent tax to business services, and use the proceeds to lower by 2 percent the sales tax consumers pay at the cash register. In other words, it would be revenue neutral.
Still, that effort by Van Nuys Democratic Sen. Robert Hertzberg is a long shot for now. His bill has support from some of the state’s largest public employee unions—but more than 100 businesses and other groups oppose it. They label it a “job killer” that would trigger negative reverberations throughout California’s economy.
If California does eventually tax business services, some lawmakers next want to levy a service tax on consumers’ purchases too—car repairs, eye exams, massages, lawn services, yoga classes, haircutters and hundreds more.
The state’s tax code was created in the 1930s. Over time, people have started spending more of their income on nontaxable services than taxable goods.
Services now account for almost 80 percent of the economy, yet the state gets most of its funds from personal income and sales taxes.
Many experts argue that California needs to reduce its dependence on personal income revenue, which can decline dramatically in economic downturns or if the wealthy decide to leave. During the 2008 recession, for example, the state’s budget shrunk by 23 percent as income tax revenue plummeted—a downturn that led to state worker furloughs and massive state budget cuts.
Nonetheless efforts to rejigger the state tax code have long failed to gain traction.
But with major federal tax changes taking effect, state legislators are starting to discuss how to make the California tax system more fair and stable, reducing inequities in the system and volatility in state finances.
Hertzberg said he hopes it will jumpstart interest in state tax reform, saying federal changes have “provided an opportunity to start creating incremental change.”
He describes his Senate Bill 993 as a “modest, phased-in approach that begins to shift and expand our tax base, and it gives relief to middle and low-income taxpayers hurt most by the federal tax law.” He also contends it could raise $14 billion in its first year—and make out-of-state companies doing business in California contribute to the economy when people make use of their services within California.
An architect working in Los Angeles but building in China would not have to pay the service tax, for instance, because the service is received outside the state. In contrast, a legal consultation from a New York lawyer to a California client would be a taxable activity here.
But business groups here are unswayed.
The California Chamber of Commerce issued a statement contending that the bill would force companies to “increase prices, reduce expenses—or perhaps relocate—to accommodate this new burden. If adopted, any other state in the country will have a more business friendly tax environment than California and lower prices for the services covered. California does not need another disincentive for businesses to stay in California, locate in California, or grow in California.”
While most states tax some business and personal services, California is one of a handful of states without any service taxes.
Two states have a broad sales tax on services like the one Hertzberg proposes: Hawaii has a 4 percent tax on legal and accounting services, and New Mexico has a 5 percent tax on major businesses hiring accountants. South Dakota and West Virginia tax more than 100 services, and several states, including Colorado and Nevada, tax fewer than 20 services, according to Accountex Network.
The untapped potential for California is huge. Taxing all currently nontaxable services could generate an estimated $122.6 billion, according to a legislative analysis.
Seven years ago lawmakers sent Gov. Jerry Brown a measure to merely study the financial impact of using a broad sales tax on services to cut personal income and sales taxes—and even so, he vetoed it.
Earlier this month, Brown unveiled a nearly $9 billion surplus in a state budget that’s just shy of $200 billion. Brown has said his office is working on frameworks for a change in the tax system, but he does not see the political will to make it happen. Asked about Hertzberg’s idea for a service tax, he responded:
“It will take the business community. It will take a wide spectrum of California leaders to be able to move from where we are to where many people think we ought to go.”
Instead of taking a vote on Hertzberg’s bill after its initial hearing, the Senate Governance and Finance Committee instead opted to organize panels for and against the idea at a second hearing on the bill June 13.
“What I’m committed to is to be able to go deeper into that and bring all voices to the table,” said the committee’s chairman, Healdsburg Democrat Mike McGuire. “This is one we’re going to be talking about for quite some time,” McGuire said.