Tax hikes may reach services - state taxes on service industries

Nation's Business, April, 1988 by Joan C. Szabo

Strapped for cash and looking for new revenue sources to help balance their budgets, many state governments are slashing expenditures, raising tax rates and trying to attach the burgeoning service sector to their sales-tax base.

For some states, Florida has become an example of the goal of a tax on services-if not a lesson in how to achieve it. Florida recently passed one of the most far-reaching service taxes ever levied by a state, and then repealed it after business complained that it was driving up costs. The Florida controversy renewed the longstanding debate over whether a tax on services is economically productive.

Service taxes, say business experts, are especially troublesome because they drive up the cost of doing business and reduce competition in the marketplace, especially for smaller companies.

"With a service tax, states create an incentive for business to perform certain services in-house, instead of contracting out for them," says William Myers, director of legislation and research for the American Legislative Exchange Council, a business-funded organization of conservative state legislators. But small firms are not able to hire full-time attorneys, accountants and other service providers, so they end up paying more for services.

A service levy also is criticized for its "pyramiding" effect, in which the tax may be paid more than once during the process that leads to the final product. This also drives up prices and reduces sales, critics contend.

But with the fiscal outlook for states so uncertain, the virtually untapped service levy is expected to remain an appealing option.

"While most states are better off now than during the recession of the early 1980s, their fiscal conditions are not as strong as in the late 1970s," says Corina L. Eckl, staff associate with the National Conference of State Legislatures. The group represents state legislatures at the federal level and conducts research on their behalf.

"The likelihood of state fiscal conditions worsening has increased, as many states are faced with sluggish economies and federal aid cuts," she says.

The degree of fiscal weakness varies by region. Southwestern and Rocky Mountain energy states, for example, have been hit hard by the decline in world oil prices. Levies from oil and gas production have declined to a trickle. These levies are known as "severance taxes," a reference to the severing of resources from the ground. Preliminary figures from the U.S. Commerce Department's Census Bureau indicate that fiscal 1987 state severance-tax collections were down 36 percent from the previous year.

Also feeling the budgetary pinch are states in the Plains and Midwest. Their troubles are tied to poor performance in the agricultural sector. New England and Middle Atlantic states report economic strength, however.

In the hunt for new revenue, 33 states raised tax levels in 1987, while only six lowered them, says Karen Benker, research director of the National Association of State Budget Officers (NASBO). Some states, including Idaho, Indiana and North Carolina, raised corporate income taxes, while others, such as Hawaii, lowered them.

Changes in the federal tax system broadened the tax base, resulting in a revenue gain of as much as $7 billion for the 35 states whose income-tax rates are tied to federally calculated adjusted gross income.

About 80 percent of this revenue gain "windfall," has been returned to taxpayers by a number of states. But that did not occur with the corporate income tax. "A considerably larger proportion of states retained the windfall from the corporate income tax than for the personal income tax," says Steven Gold, director of fiscal studies for the National Conference of State Legislatures.

To address budgetary shortfalls, many states also cut spending. Before fiscal 1987 ended, 24 states were under pressure to trim their budgets to avoid deficits. In Oklahoma, for example, transportation was trimmed by 39.5 percent, and funding for elementary and secondary education was reduced 10.2 percent.

Most states have balanced-budget requirements, though the strength of the requirements varies. In some states the governor must submit a balanced budget, in others the legislature must enact a balanced budget, and in others the carryover of a deficit into the next fiscal year is prohibited.

Despite such budget requirements, Alaska, Louisiana and Texas ended 1987 with budget deficits, and Alaska, Louisiana and West Virginia expect deficits in fiscal 1988, according to NASBO, In West Virginia, Gov. Arch Moore has proposed a major tax increase totaling up to $100 million.

In addition, California, Colorado, Connecticut, Idaho, Missouri, New Mexico and North Dakota are concerned about maintaining balanced budgets this year.

As states hunt for new revenue, a tax on services gains more appeal. Services constitute one of the fastest-growing sectors of the economy and could raise substantial revenue for states. In Florida, for example, taxing services was expected to raise $800 million in the fiscal year ending this June 30, and $1.2 billion in the next year.