Tax reform, part 2: Sales tax expansion would hit broad array of services

Editor’s note: This is the second in a series about the Vermont Blue Ribbon Tax Structure Commission Report. In this story we analyze the commission’s sales tax proposal; tomorrow we examine its recommendations for income and Internet tax reforms (Parts 3 and 4). On Feb. 14 we will report on tax expenditures (Part 5), and on Feb. 15, we will look at reform ideas that didn’t make the final cut (Part 6).

“Tax reform Part 1: Where policy meets politics” was an overview of the political context for the commission’s recommendations.

Kristi Martin of Barre receives a tattoo from Aartistic Inc. artist Amanda Lopez on Saturday. Under the proposed tax reforms, Lopez's services such as accounting, landscaping, and custom meat slaughtering could be taxed as well. Photo by Josh Larkin.

Let’s face it; no one likes taxes. The word gives most people hives. And so when lawmakers, administration officials and independent commissions suggest changes to the existing system, business interests go into panic mode. Often, politicians aren’t far behind — for good reason.

Tax hikes are very difficult to pass — never mind proposals for new levies on income, goods, services, extraction of natural resources and the like.

Even when changes do become law, a tail wind stirred by special interests can turn the political weathervane fairly quickly.

Last session, for example, under pressure from business groups, including the Vermont Chamber of Commerce, Gov. Peter Shumlin, who was then the Senate President Pro Tem, and House Speaker Shap Smith, both Democrats, rolled back increases in estate and capital gains taxes in an agreement with Republican Gov. Jim Douglas. Shumlin and Smith reasoned that the increase in capital gains taxes hurt small businesses and could make wealthy Vermonters think twice about maintaining a residence here. House GOP leaders claimed the Democrats, after weeks of pressure, cried “uncle.”

Changes to the tax code are unpopular because they create winners and losers. The capital gains rollback, for example, is projected to save well-to-do residents about $11 million in capital gains taxes, and about $2 million in estate taxes in fiscal year 2012. The money has to be made up somewhere in the state’s budget — through cuts to services, shifts between funds or other tax increases (unlikely, as the Democratic leadership has taken a no-tax-increase pledge).

The Vermont Blue Ribbon Tax Structure Commission proposal to lower income and sales tax rates also creates winners and losers. The sales tax rate would drop from 6 percent to 4.5 percent. That reduction is only possible, however, if the Legislature and the governor back the commission’s proposal to expand the tax to certain goods and services that were previously exempt.

While the income tax side of the equation has generated some opposition, it’s the sales tax expansion, not surprisingly, that has been the focus of controversy. The losers would be Vermont businesses that would have to charge sales taxes on goods and services, namely apparel merchants and shoe stores (they were exempted from the sales tax in 1999) and 132 service purveyors, from lawn mowing companies to general contractors, tattoo artists, lawyers and dog groomers. (Thirty-two services are already taxed.)

Shumlin and Senate President Pro Tem John Campbell, D-Windsor, have said they’ll oppose the expansion of the tax.  As residents of towns close to the New Hampshire border, both are sensitive to the Granite State’s lack of a sales tax.

Tom Torti, executive director of the Lake Champlain Regional Chamber of Commerce, described the service tax as “a sea change in how we do business.” The report, he said, “acknowledges we’re in a service economy rather than a goods economy.”

Torti gives the Democratic leadership — Shumlin, Smith and Campbell — credit for moving the Tax Commission reforms forward. “What we want to see from legislative leaders is, do they have courage to tackle difficult issues regardless of the outcome?  It’s more than heartening (that they have),” Torti said.

“It’s going to take enormous political courage to do anything with this because there are so many winners and losers,” Torti adds. “Change is difficult if you’re used to the status quo, and going to something as radical as this will shake up all the dice.”

In general, winners under the commission’s plan would be most income tax filers (their rates would go down under the plan — taxpayers in the top tax bracket would benefit slightly more), and retailers who sell certain goods. Under the services tax, food, prescription drugs and medical services would be exempted. Business-to-business transactions are not included in that proposal, either; the tax would be applied only to services and goods purchased by individuals or consumers.

The commission’s recommendations are revenue neutral, that is, they don’t raise or lower taxes. The three-member panel’s obligation was not to worry about what was politically feasible (that’s the Legislature’s responsibility), but to determine whether the existing tax structure was working — or not — and to consider changes outside the context of the existing system. They mulled over assessing taxes on the removal of natural resources from the state (such as water for bottling); they looked at taxing health care benefits; they weighed the pros and cons of eliminating the sales tax. All of these ideas, however, were rejected.

What people forget is, when you increase costs for the construction business, that expense hurts everyone. That cost is passed along to consumers — that’s the nature of the economy.”
~ Joe Singara,
Homebuilders and Remodelers Association of Vermont

In the end, they proposed broadening the income tax base by taxing Vermonters’ adjusted gross income rather than taxable income (the amount residents claim after itemized deductions). They also suggested lowering the sales tax rate from 6 percent to 4.5 percent, while expanding it to include the broad array of services. The proposal also suggests that a number of tax loopholes or “expenditures” should be closed, and lawmakers should continue a decade-long effort to tax Internet retail sales, which has been impeded by federal rules.

The commission emphasized to lawmakers that their recommendation should be looked at holistically, not as a series of separate changes. That’s in part because aspects of the proposal are interdependent. For example, their proposal to lower income tax rates, falls short by about $25 million in inflation-adjusted dollars, according to the Vermont Joint Fiscal Office. The proposed expansion of the sales tax would make up much  of that difference.

Here’s a partial listing of services that could be taxed under that proposal: custom hay baling, horse boarding, landscaping, typesetting, carpentry, painting, water well drilling, taxi and courier services, mini-storage, marina services, water use, heating fuel, trash removal, insurance services, real estate sales, debt counseling, diaper services, fishing and hunting guide services, drycleaning, advertising, shoe repair, debt collection, lobbying, janitorial services, security services, window cleaning, data processing, parking, auto repairs, admission to events and custom meat slaughtering.

A shift in consumption

The commission came to the conclusion that the sales tax must be expanded because Vermonters’ spending habits have changed. Growth in retail sales is in purchases online — more than from brick-and-mortar stores.

Meanwhile, the amount of money residents spend on services has increased dramatically. Because these trends have become more amplified over a 40-year period, the commission determined the state’s sales tax revenues are no longer sustainable.

In 1969, when Vermont passed a sales tax, which was applied almost exclusively to goods, about half of consumer spending was on services. In 2007, about 66 percent of consumer spending in Vermont was on services, and about 33 percent of consumption was for goods, according to the report issued by the commission last month. That trend is expected to continue.

Consequently, revenues from the sales tax are falling. The state, according to the commission report and outside economists, has a balanced revenue portfolio compared with other states. Income taxes raise $590 million annually and property taxes $619 million, while sales taxes bring in roughly $335 million a year.

Vermont currently taxes about 32 out of a possible 164 services. Compared with other states, we fall in the middle. Twenty-three states impose a sales tax on more services than we do. Of that group, only six charge a sales tax on 100 or more services, and only three approach the 160 mark — Hawaii, New Mexico and Washington state. In the region, our neighbors to the south and west, Connecticut and New York, are the only states that tax a substantially higher number of services.

The economists interviewed for this series say Vermont’s situation is part of a national trend, and they recommend that all states consider broadening sales taxes to more services.

All paths of taxation in Vermont, however, seem to reach the same dead end — the banks of the Connecticut River. Our neighbor to the east — New Hampshire — doesn’t charge sales or income taxes and derives most of its revenues from the property tax, fees and a 5 percent tax on interest and dividends. For four decades, Vermont retailers have bemoaned the Granite State effect: They say Vermonters go out of their way to buy goods in New Hampshire to avoid paying sales taxes. Consequently, the retail sector over the border has grown at Vermont’s expense.

Vermont businesses have seen a significant migration of sales to New Hampshire, according to the study “The Unintended Consequences of Public Policy Choices: The Connecticut River Valley Economy as a Case Study” by University of Vermont economics professor Art Woolf. Over the course of 40 years, per capita sales in New Hampshire have tripled — at the expense of retail traffic in Vermont, according to Woolf.

If the tax is expanded, critics say, certain services, especially those that are “portable,” like accounting, will suffer, too. Even the lower 4.5 percent tax, business leaders say, will drive Vermonters across the river for haircuts, car repairs, legal advice and architectural services.

Proponents of the sales tax say Vermont has avoided the traffic congestion, unsightly development and the proliferation of big box stores that has plagued the New Hampshire side of the border.

Recent reports show that tax-free New Hampshire might not be the economic Shangri-La it’s purported to be. Our Granite State neighbors are facing a $200 million to $800 million deficit, and a recent report from the New Hampshire Fiscal Policy Institute, a liberal think tank, recommends that the state rethink its ultra-conservative tax policies.

Homebuilders and professionals balk at tax

Chair of the House Ways and Means Committee, Janet Ancel, D-Calais. Photo by Josh Larkin.

Though an omnibus bill based on the proposal hasn’t been introduced yet (House Ways and Means, which will offer a bill at some point, is still taking testimony on the commission’s report), two lawmakers have proposed legislation based on the commission’s recommendations. Rep. Jeff Wilson, D-Manchester, introduced a bill last week that calls on the state to tax Internet purchases, and last month, Rep. Jim Masland, D-Thetford, introduced H.122, based on the commission’s recommendation to broaden the sales tax base. Both lawmakers are members of Ways and Means.

Masland, who lives on the New Hampshire border, supports the idea of a structural change to the sales tax, though he said he is keenly aware of the potential impact an expanded sales tax on consumer services could have on his constituents.

“We might as well get the discussion going outside the building,” Masland said.

That conversation has begun in earnest, and the reaction from professionals and the construction industry has been overwhelmingly negative.

I understand the logic of taxing services, but hiring an attorney to collect your child support is different than getting a tattoo.”
Bob Paolini,
Vermont Bar Association

Joe Sinagra, executive officer of the Homebuilders and Remodelers Association of Vermont, said the 4.5 percent sales tax would be applied to all aspects of the residential construction sector, including real estate services, architectural services, plumbing, heating, electrical work, general contracting, excavation, concrete work and masonry. Sinagra said the proposed sales tax would have “a huge impact” on an industry that has already been taking a significant hit in the local economy.

“Any new tax on this industry would make it even harder for the Vermont construction industry to do business,” Sinagra said. “It would have a huge effect on the rest of the population because the cost of housing would go up. What people forget is, when you increase costs for the construction business, that expense hurts everyone. That cost is passed along to consumers — that’s the nature of the economy.”

Jay Ancel, one of the founding partners of Black River Design, an architectural firm in Montpelier, said the tax could hurt architects at a time when a number of firms have already gone out of business in the down economy. “Adding a tax on services doesn’t help,” Ancel said.

Sinagra couldn’t say how much cost a sales tax would add to the construction of a home, since a carpenter might hire plumbers and electricians instead of subcontracting the work to circumvent the sales tax, but he said adding $200 to $1,000 to the cost of a $200,000 home “would price out” home buyers who are having a hard time qualifying for mortgages.

“Every dollar matters when it comes to qualifying for a bank loan,” Sinagra said.

A larger percentage of Vermont’s gross state product is tied to the housing sector, Sinagra said, than any other state except Nevada. Eight percent of our economy is related to housing. New Hampshire, by comparison, derives 5.59 percent of its gross state product from residential construction, he said.

“Housing is very important to Vermonters,” Sinagra said. “It’s easy to tax housing as a way to generate money quickly, but we also have to remember the role housing plays here.”

Lawyers see the levy on legal services for criminal defense cases as possibly unconstitutional, according to Bob Paolini,  executive director of the Vermont Bar Association. Without an exemption in that  instance, the state would impose a sales tax “on the exercise of a constitutional right.”

Paolini said the tax could lead to a heavier burden for the courts if Vermonters seeking child custody or a divorce can’t afford to pay the tax and decide to represent themselves.

“I understand the logic of taxing services, but hiring an attorney to collect your child support is different than getting a tattoo,” Paolini said.

The Vermont Society of Certified Public Accountants also looks askance at the sales tax on professional services, according to Jeff Fothergill, a former president of the association.

In testimony before Ways and Means, Fothergill said Vermont accountants have long opposed an extension of the sales tax to professional services, such as law, architecture, engineering, accounting, bookkeeping and land survey services. The society argues that a sales tax on professional services would be difficult to administer, create potential confidentiality breaches, reduce a firm’s competitiveness with out-of-state rivals and place “cash demands” on businesses that customarily extend credit to clients.

There is a danger that more individuals would drop local accountants in favor of Turbo Tax or services from New Hampshire — or India, he said.

Fothergill supports the notion of broadening the sales tax base and lowering the rate, and in testimony to House Ways and Means, he didn’t object to the commission’s proposal to tax other services.  “Our position is specific to professional services,” Fothergill said.

SOP for economists

While broadening the sales tax base wouldn’t win lawmakers many friends in the business community, economists say it’s an important step toward making the system more sustainable, though politically it’s a difficult sell.

Matt Gardner, executive director of the Institute on Taxation and Economic Policy, said, “Any tax study in the last 30 states has identified exactly this kind of recommendation for broadening the base to tax things we buy every day.”

From a policy perspective, “this is fairly common-sense stuff,” Gardner said. “Everyone is saying this is what needs to be done,” Gardner said. “It’s just politically it hasn’t happened.”

Lawmakers don’t want to tax car repairs, for example. “There are going to be narrow constituencies that oppose these decisions,” Gardner said.

Tom Kavet, the consulting economic expert for the Legislature, said in order to make the sales tax on services more palatable, lawmakers should consider lowering the rate a great deal more. He suggested that they tax everything — including food and medical expenses — and bring the rate down to 1.8 percent. He told House Ways and Means that this would limit the economic disruption caused by the sales tax because there wouldn’t be enough of an a incentive for Vermonters to seek goods and services on the Internet or in New Hampshire.

Kavet said lawmakers could “adjust for regressivity” by offering a tax refund for Vermonters who fall below the poverty line.

“That way you’re only refunding the tax to people who really need it,” Kavet said. “Who in this room couldn’t afford a 2 percent tax on food?”

Editor’s note: Bill Schubart, a member of the Vermont Blue Ribbon Tax Structure Commission, is the president of the Vermont Journalism Trust, the umbrella organization for VTDigger.org.