The 21st Century Taxation Blog

Pyramiding in a tax system refers to the imposition of a tax on a tax. It typically happens with taxes that are imposed on goods or services, such as a sales tax. Pyramiding causes a tax to violate several principles of good tax policy, including transparency, efficiency, equity and neutrality. For example, in California, most food purchased at the grocery store is exempt from the sales tax. However, the price paid for that food includes sales tax paid by all businesses in the production and distribution chain to get that food into the store. When a business pays a tax, it is one of many costs factored into its operations that either goes into the price of what the business sells and/or reduces profits. This effect makes the sales tax fail the transparency principle in that when you buy an item (whether tax exempt or not), the true amount of sales tax included in what you pay is not obvious due to pyramiding; the sales tax paid is definitely more than what is noted on your sales receipt.

As noted in earlier blog entries, the ideal consumption tax would tax all or most forms of consumption. Many states (but not all) exempt food or tax it at a lower rate. California exempts food except for food purchased at a restaurant.

This is a current topic of discussion in Tennessee where the governor and some lawmakers want to decrease the food tax, but need to find replacement revenue. Proposals include increasing the tax on tobacco products and here's an interesting one - a porn or adult materials tax (on sex toys, escorts, and similar items).

15 states do impose sales tax on food.

Why should food be exempt from sales tax?

1. Food is a necessity and similarly to personal and dependency exemptions for income taxes, the food exemption ensures that some basic level of living needs is not subject to tax.
2. The exemption provides tax relief to low-income individuals.

Why tax food?

One of the weaknesses I noted earlier for the California tax system is that its sales tax base is narrow in that not all consumption is taxed and there are many exemptions. Let me elaborate...

California's sales tax was created in 1933 with the Retail Sales Act. The tax was to be imposed on retailers for the privilege of selling tangible personal property. In 1935, the use tax was enacted to complement the sales tax to ensure that in situations where a retailer was not obligated to collect sales tax (such as because it was not located in California), the California consumer would be obligated to pay use tax at the same rate. While the sales tax is imposed upon the retailer (although they can add it onto what the buyer pays), the use tax is legally imposed upon the purchaser.

Because the California sales and use tax rules specifically apply to tangible personal property, sales and purchases of services and intangibles are exempt from the tax. However, there are exceptions. If the service is embedded in the goods or if an intangible (such as a film) can be viewed as really being tangible, they will likely be taxed. The California Revenue & Taxation Code has many rules that explain what taxable tangible personal property means. For example, a restaurant's prices may not be separated between services and food; instead, the entire restaurant bill is subject to sales tax.

One of the most misunderstood tax topics involves application of taxes to anything involving the Internet. Some people believe that no taxes should be applied to the Internet. They may mean that access fees should not be taxed to the payor and/or they may mean that anything you purchase via the Internet should not be taxed. Thus, if you purchase clothes at your local store, it is ok to charge sales tax. If you order clothes from a catolog, it is ok to be charged sales tax. But, if you get the same clothes from a vendor who set up a webpage to handle the sale, it should not be taxed. Such positions are hard to understand. (If you are looking for more information on these positions, you can find several through a Google search.)

While some of the people proposing no tax on anything related to the Internet may just want to see all or most taxes disappear, the statements likely also stem from lack of understanding of use taxes. A 5/23/07 article on CNetnews.com ("Net taxes could arrive this fall" by McCullagh) explains that states are working together to convince Congress that it should allow the states to collect sales and use tax from vendors who are not physically located in their state. The article notes that this would allow states to "collect billions of dollars in new revenue by next year." This does make it seem like a money grab by states with no rationale for doing so.

A common practice in state tax reform is to create a commission to study the problems and identify solutions. Often the commission is also required to get comments from the public. A recent example is Massachusetts where Governor Patrick and legislators formed a 15-member commission to study ways to improve the corporate income tax. This group has a short timeframe in that it was created on April 29, 2007 and the report is due June 15, 2007.

Apparently, the Governor believes there are loopholes in the state's corporate tax system and closing them could improve the business climate and possibly lead to a tax rate reduction.

http://www.boston.com/news/local/massachusetts/articles/2007/04/30/patrick_legislative_leaders_agree_
to_study_corporate_tax_code/
http://www.boston.com/business/taxes/articles/2007/05/12/patrick_state_may_cut_firms_tax_rates/

For a list of some of the reports of various tax reform commissions created by states over the past few years, see the state reform link at:
http://www.cob.sjsu.edu/facstaff/nellen_a/txrefupd.html

While a few states are discussing (or using) a gross receipts tax - usually instead of a corporate income tax, it has its flaws. A response to my first gross receipts tax blog entry came from the Tax Foundation, noting 2 helpful reports they have issued on the topic.

I want to spend more time on a few of the flaws they note (which I agree with):

1. The unfairness of not considering the different net margins and types of business that exist - if a business is in a very competitive market (whether temporarily or always), they will be paying tax at a rate equal to a business that may have much more leeway in its pricing model. In contrast, if the tax were based on NET income, the realities of doing business for all types of businesses are reflected in the tax base.

While California does NOT have a gross receipts tax, I'd like to talk about this type of tax because it has received some attention in a few other states in the past few years and very recently in Illinois. (Ohio adopted one in 2005.) If a state is to look at overall improvements to its tax system, it is a tax that should not be omitted from the discussions, particularly to use to replace one or more existing taxes.

A gross receipts tax is imposed on business revenues (gross receipts) in contrast to the traditional income tax which is based on "taxable income." Generally the rate on a gross receipts tax will be much less than for an income tax because the tax base will be higher (for example, taxable income could be negative, but receipts would not be). One advantage then that should immediately come to mind for a gross receipts tax is that it should be simpler than an income tax. Businesses would not have to calculate net income, but instead would just measure their gross receipts (which they already do with an income tax). But, it sounds unfair in that the tax would be owed even if the business doesn't make a profit. BUT -- consider:

a. Simple? While simpler than a net income tax, if some gross receipts are exempt (such as those from sales out-of-state), it might be difficult to identify where some sales occurred (particularly virtual ones).

As mentioned in an earlier entry, the California tax system has some weaknesses. Here is some data supporting some of these oddities.

Volatile personal income tax

The Legislative Analyst Office (LAO) reports that in 2004: "Taxpayers earning annual incomes of $200,000 or more accounted for about 5 percent of returns but more than 55 percent of liabilities. In contrast, taxpayers with AGI of less than $50,000 accounted for over 45 percent of returns but less than 6 percent of liabilities." [http://www.lao.ca.gov/2007/tax_primer/tax_primer_040907.aspx]

And, the personal income tax provides over half of CA's general fund revenues. Thus, the state is really very dependent on the continued high incomes of a few of its citizens. These high income individuals though, often have types of income which are not steady or predictible (like salaries are). For example, they may have capital gains from stock sales or income from stock options. These amounts will not be steady from year to year and in tough economic times, like the dotcom bust of a few years ago, the state tax collections go down. Basically, when the income of CA's top individual income generators goes down, the entire state feels it.

Back in the Depression (the late 1920's), many states added the sales tax to their array of taxes. This was soon followed by the use tax to ensure that when people bought taxable items (even from out-of-state), the sales tax would be paid. In the following decades, as mail order sales grew, the use tax caught more attention from both state and federal legislatures, because it wasn't being collected on many mail order (catalog) sales. This is because if the seller was not located in a state, it was not required to register to collect sales tax. Instead, the buyer, was required to self-assess and pay the use tax (at the same rate as the sales tax). As you can guess, much of this use tax wasn't (and today still isn't) collected.

I am a tax professor at San Jose State University. I am also a part-time fellow in the New America Foundation's California Program where I focus on tax reforms that follow the principles of good tax policy, address existing flaws, and best reflect our 21st-century society and economy .

I have been studying, researching, writing and presenting on the topic of tax reform for several years (see www.cob.sjsu.edu/nellen_a/ for some of my articles and presentations on this topic). I am starting this blog as another way to discuss tax reform, share ideas and comment on ideas that come up in Congress or the California legislature, the press, policy groups and elsewhere. I will supplement the blog discussions with links to legislative proposals, relevant reports of government and public policy organizations, as well as my writings that I'll post to a website - 21st Century Taxation (link below).