Professional service taxes are poor tax policy.
Taxes on services are bad for state and local economies— they’re difficult for businesses to comply with, are regressive for consumers, and several attempts to implement them in the past have failed. They’re unworkable for many reasons, and states should avoid them. Some states have recognized they are so detrimental that they have constitutionally banned them (Missouri and Arizona).
Taxes on services are complicated for businesses to comply with.
Compliance with a sales tax on services is extremely complicated for businesses large and small, and administration by state and local governments is costly. Due to the multi-state nature of customers and service providers, it is often difficult to determine where, when, and how the services are provided and what services are actually subject to tax. Compliance is particularly burdensome on smaller service providers. What's more, small and emerging firms often must use outside service-providers that would be taxed (such as external legal counsel or tax-filing services), while larger companies with in-house expertise could avoid taxation for such services as a result of vertical integration, further adding to the outsized small-business tax burden.
Sales taxes on service are regressive for consumers.
By nature, the sales tax is regressive. Since sales taxes apply to all taxpayers at the same tax rate, regardless of income level, sales taxes fall harder on lower-income families with less ability to pay. The Institute on Taxation and Economic Policy (ITEP) estimates that the lowest 20 percent of households (based on income) forgo seven percent of their income to pay sales taxes, while the top one percent forgoes less than one percent.
Several states have attempted to tax services, but each tax was repealed shortly after enactment.
Although many states tax a few select services, there is no trend of states successfully and broadly expanding their sales tax base to include professional services. Even at the height of the recent recession, most states looking at a sales tax on professional services rejected the idea as inherently unworkable. There have been multiple examples in recent memory of states attempting a tax on services, but repealing it shortly thereafter:
In 2014, Minnesota enacted a tax on warehouse and storage services. Following the tax's passage, there was a large outcry that the tax would negatively impact the state economy and harm jobs and investment within the state. The tax was repealed prior to its effective date.
In 2013, Massachusetts approved legislation expanding the definition of services to include computer software and design services. The new tax faced immediate backlash from the tech and services community resulting in the Governor signing legislation repealing it two months later.
In October 2007, Michigan enacted a broad tax on services and a taxpayer coalition was quickly formed to repeal it. The group was worried that it would negatively affect jobs. The tax was repealed 17 hours after it became effective.
In 1990, Massachusetts passed a tax on services that applied only to services provided to businesses (that is, it taxed business inputs explicitly). The state repealed the tax two days after it took effect because of the fear of economic harm and potential job loss.
In 1987, Florida passed a sales tax on services. Six months later, they repealed it because it put in-state businesses at a competitive disadvantage to out-of-state counterparts.
Economic theory teaches that business inputs shouldn't be taxed, something that nearly all professional services are.
Economists and public finance experts agree that business inputs shouldn't be taxed under the sales tax. When business inputs are taxed, taxes pile up on one another along the production chain, resulting in double and even triple taxation (with taxes becoming embedded in the purchase price)—a phenomenon known as "tax pyramiding." Tax pyramiding leads to numerous negative economic effects, such as creating arbitrary price differences between similar services, industries, and business. A significant share of professional services are business inputs (that is, business services purchased by other business to be used in the production or provision of another good or service.). The Council On State Taxation (COST) estimates that approximated 42 percent of existing state and local sales tax revenues in the 2016 fiscal year were levied on businesses. Taxing professional services will only exacerbate this problem.