21st Century Taxation

The Slow Approach to Closing the Tax Gap

Annette Nellen — Sat, 23 Aug 2008 08:42:00 -0400

The federal tax gap is about $345 billion per year! Reasons for this gap has been studied by the IRS, GAO and others for decades. Many proposals have been made, yet few have been enacted. President Bush's 2009 budget proposal included 16 tax compliance proposals. Some of these have been inserted into tax bills as revenue generators. For example, the proposal to require brokers to include stock basis information on 1099s has been included in a few bills, but not yet enacted.

I call this the "slow approach" to reducing the tax gap: study it continuously, generate lots of ideas for reducing the gap, but avoid comprehensive legislation with a plan for reducing it. Political and budget reasons seem to be the cause for the slow approach. PAYGO has many benefits, but one of them doesn't seem to be to enact legislation that only raises revenue (no new tax breaks). So, we see tax gap proposals come to the table only when revenue is needed to enact new or extended tax breaks.

The recently enacted housing bill is an example. It includes a requirement, effective for 2011, for credit and debit card payment processors, as well as online processors, such as PayPal, to issue 1099s noting the gross amount processed for merchants. This proposal has been in President Bush's budget proposal for the past few years, although calling for IRS regulations rather than a statutory change. The Joint Committee on Taxation estimates that this new reporting requirement will generate over $9 billion over 10 years. That seems like a lot given that unlike cash transactions, there is an audit trail for credit and debit card transactions. I'm guessing that a lot of the revenue estimate stems from online sellers who are not reporting sales despite transaction and activity levels that indicate they are operating a business.

One concern I have is with the long lead time until this new reporting provision is effective (2011). While this lead time is likely due to the need to allow reporters to get their systems capable of filing the 1099s, it also means the many people who don't like this provision have plenty of time to encourage Congress to repeal it.

For more information on the new reporting requirement and the tax gap, please see my short article in the AICPA Tax Insider for 8/14/08. It has more links to information mentioned above.

Beijing's New Polluter Pays Car Tax - Good Idea?

Annette Nellen — Wed, 13 Aug 2008 19:32:00 -0400

Tax systems get used for a lot more than raising revenue for the government. They are also often used to help change behavior and to make prices reflect costs of "negative externalities." If you want to discourage something, raise the tax on it. If you want to encourage something, lower the tax or offer a special deduction or tax credit.

One activity we want to discourage today is greenhouse gas emissions, such as CO2 from burning fossil fuels - like the gas in your car. So, despite some elected officials calling for ways to lower the cost of gasoline, we should really be looking to increase the cost because:

The higher cost will encourage people to drive less or find other ways to use less gasoline.
What we pay for gas at the pump is not the true cost. When we drive and burn gasoline, we cause air pollution, create GHG emissions that contribute to global warming, wear out roads, and cause congestion. These activities have costs - such as cleaning the air or refurbishing roads. When that cost is not included in the price we pay, the government doesn't get the money needed to deal with the problems - the negative externalities of driving.

Beijing seems to have the idea right. It was reported in several news outlets that on August 13, Beijing announced that there would be a much higher sales tax on large cars and a lower tax on smaller cars (see abcnews.go.com)

The US has something similar with the gas guzzler tax enacted in 1978. However, that only applies to new cars so trucks and some heavy SUVs are not covered. You can find a list of covered vehicles from the EPA (here).

A flaw with both approaches is that the tax is only assessed at time of purchase. This doesn't do a good job of tying the tax to the cost of the negative externalities or help modify behavior. Once you've paid the gas guzzler tax, on the purchase of a $350,000 Lamborghini Murcielago, are you going to care how much you drive it every year? On the purchase of an expensive gas guzzling car, is someone even going to notice the up to $7,700 gas guzzler tax tacked onto the price tag? Will it cause someone to not buy the car? Of course, the gas guzzler tax also applies to some less expensive cars and it does seem to have caused carmakers to avoid mass producing cars that are subject to the tax.

Even if you buy the gas guzzler and keep it in your garage without driving it, you owe the tax.

A solution to better encourage less driving of gas guzzlers and discouraging their purchase (and manufacture) would be to have an annual tax on their ownership in addition to a higher gasoline excise tax.

The funds generated from a gas tax increase could be used for environmental research and clean-up, education on how to help the environment, and to provide relief to low-income taxpayers, as well as to some hard hit industries which they retool to use less gasoline. The use of a polluter pays tax to reduce another tax is called a "tax shift."

Another stick to help discourage production of gas guzzlers would be to deny companies the manfucturing deduction for them (IRC Sectoin 199) or impose an excise tax on some part used in these cars.

As federal and some state governments start serious work on reforming their tax systems to make them work better in supporting economic, societal and environmental goals, polluter pays taxes and tax shifts need to be part of that discussion.

States Reaching to Find Sales Tax Nexus

Annette Nellen — Fri, 08 Aug 2008 15:29:00 -0400

In April, New York changed its sales tax law to try to make a few large vendors subject to sales tax collection - most notably, Amazon.com. The new law creates a rebuttable presumption that a vendor is soliciting business and thus required to collect tax if, per an agreement, they compensate New York residents for directly or indirectly referring potential customers. Referrals may be made through a website or other means. The presumption only applies to sellers with over $10,000 of sales to New York customers made via the referrals in the prior four quarters. Sellers may rebut the presumption by showing that the residents did not solicit sales in New York for them. (Bill Summary, p. 10)

Amazon's "Associates Program" causes it to have many associates who may be New York residents. Amazon filed a lawsuit as soon as the law went into effect challenging the new law as unconstitutional. It also started collecting the tax!

Another company that fell under the law change is Overstock.com. Their remedy was to cancel its agreements with its New York affiliates who were helping Overstock.com advertise.

Arguably, the associates who have a link to Amazon or Overstock on their website are third party advertisers, not sales agents or representatives of these companies.

For more information on this law change and vendor reaction, see this short article - Grabbing Remote Vendors.

In a hard to find NY Senate bill - S 8638, senators voted on June 24 to repeal the provision. Here is information from the NY Legislative website:

"STATUS:
S8638 RULES No Same as
Tax Law
TITLE....Repeals provisions of law relating to an evidentiary presumption to facilitate the administration of the sales and use tax


06/19/08	REFERRED TO RULES
06/24/08	ORDERED TO THIRD READING CAL.2231
06/24/08	PASSED SENATE
06/24/08	DELIVERED TO ASSEMBLY
06/24/08	referred to ways and means

BILL TEXT:
STATE OF NEW YORK
________________________________________________________________________

8638

IN SENATE

June 19, 2008
___________

Introduced by COMMITTEE ON RULES -- read twice and ordered printed, and
when printed to be committed to the Committee on Rules

        AN ACT to repeal subparagraph (vi) of paragraph 8 of subdivision (b) of
          section 1101 of the tax law relating to an evidentiary presumption to
          facilitate the administration of the sales and use tax where a person
          making sales of taxable property or services in the state uses resi-
          dents in the state to solicit sales

The People of the State of New York, represented in Senate and Assem-
bly, do enact as follows:

     1    Section 1. Subparagraph (vi) of paragraph 8 of subdivision (b) of
     2 section 1101 of the tax law is REPEALED.
     3    § 2. This act shall take effect immediately."

There appears to be no other action on this proposal. The April law change was estimated to generate $47 million in 2008/2009 and $73 million in 2009/2010 (see links in above article - Grabbing Remote Vendors). That's a lot of money. If this estimate is anywhere close to being accurate, it means that lots of New Yorkers are not self-remitting use tax on purchases they make from the vendors who are subject to the law change. (All states have similar problems - most people don't know what a use tax is or don't keep sufficient records to measure it every year or ignore it.)

All of this illustrates the challenges sales and use taxes face in e-commerce where it is very easy to have a physical location in just one state, but customers in all states. Such a vendor is only legally obligated to collect sales tax from customers in the state where the vendor resides (where they have a physical presence). Customers in other states must self-report their use tax on the purchases.

So, some states modify their sales tax laws to grab remote vendors by trying to connect them to some physical location in the state (such as Amazon's New York Associates). But, there are constitutional restraints that limit this. Given current case law, New York will likely have difficulties defending its law change.

States should do a better job educating their citizens about use tax and the benefits to the state (and its citizens) of collecting it. New York law allows individuals to use a table to estimate the use tax owed so they don't need to keep records. Given the revenue estimates attached to the April 2008 law change, compliance must be low. New York should take out some on-line ads to help buyers understand the use tax and how to pay it. In the long run, that would be better than enacting laws of questionable constitutionality that will be challenged in court.

Another option for states is to not allow the state or its agencies to purchase from sellers who do not collect sales tax. Unless a state has perfect recordkeeping (or doesn't require its agencies to pay sales tax), when purchases are made from remote vendors, it is possible that the use tax payment gets overlooked. Also, some schools and home-and-school clubs have Amazon links on their websites. Perhaps those sites should at least be told to include a note about the need to pay use tax (which in most states helps fund schools!).

What do you think states should do to get more of their residents to pay use tax?

Easy Fix to Help Federal and State Budgets (and Health Care)

Annette Nellen — Sat, 02 Aug 2008 21:31:00 -0400

I have written about this topic before - policymakers lament trying to find dollars to help get more people health care, yet millions of workers reap overly generous tax benefits when their employer pays all or part of their health care coverage. These generous tax benefits represent dollars from the federal and state budgets that could be used for other purposes. And, the problem is even worse because having so many insured employees not directly involved in how much their health care coverage costs tends to make them get too much health care at times, which drives up costs for everyone.

Here are prior posts:

On 7/31/08, the Senate Finance Committee held a hearing on Health Benefits in the Tax Code: The Right Incentives.

Each of the three witnesses commented on the exclusion for employer-provided health insurance. Joint Committee on Taxation Chief of Staff Edward Kleinbard noted:

"the current system of providing a generous tax subsidy for employer provided health care with no or little subsidy in the case of insurance purchased outside of the employer market distorts taxpayer and market behavior. The existence of the subsidy reduces the price of the consumption of health care, leading to overconsumption of health care relative to other goods and services for those taxpayers with qualifying plans, and very expensive health care for taxpayers in the individual market. Unlike most tax expenditures, the large subsidy associated with employer-provided health care is subject to few statutory limitations."

The exclusion, measured as a tax expenditure, is one of the largest in the income tax system. It is also an exclusion from Social Security and Medicare taxes. Kleinbard's testimony noted the cost of this tax break for 2007 as:

Income taxes $145.3 billion
FICA $100.1 billion

That's a lot of money!

Most, if not all states also follow the federal exclusion.

The exclusion is an even better deal than a tax deduction because the employee has not spent anything to get the break (ok - except for foregone wages). For example:

Jamie's employer pays $10,000 for Jamie's health insurance coverage. If the employer did not provide this benefit, the employer would likely increase Jamie's salary by $10,000. Under our tax system, having the employer pay for Jamie's insurance is a much better deal than getting $10K more of salary. The $10K is not taxable to Jamie, although the employer deducts it on their tax return. Also, no FICA or Medicare tax is owed by either party on the $10K. If Jamie's marginal tax rate is 25%, Jamie saves $2,500 of taxes. BUT, if Jamie had to include the $10K in income, Jamie would still have a good deal - getting $10K of insurance benefit for $2,500.

The federal government should cut back on this exclusion and better target it so more relief is given to low-income taxpayers. For example, depending on one's income level, an increasing percentage of the health insurance benefit would be included in income.

This would give the federal government funds to help move health care towards universal coverage. It would help states with their revenue problems.

AND - it would bring greater equity to the tax system. Today, it is more likely that higher income workers have health insurance from their employers. When individuals have to buy insurance on their own, there is not tax break.

Also, cutting back on this tax break would mean that employers would have to include the amount of the benefit on the employee's W-2. That would be good because today, most employees probably can't tell you how much the benefit is. This change would also be a good start in moving towards the bigger health care solutions that are needed.

What do you think?

Dealing with the Decline in Gas Tax Revenues Due to the Decline in Driving

Annette Nellen — Mon, 28 Jul 2008 19:51:00 -0400

The Department of Transportion announced today that we drove 9.6 billion fewer vehicle-miles traveled (VMT) in May 2008 compared to May 2007. While that is good for reducing carbon emissions, it is bad for the Highway Trust Fund. When we use less gasoline, less gasoline excise taxes are collected.

According to Transportation Secretary Mary E. Peters: "By driving less and using more fuel-efficient vehicles, Americans are showing us that the highways of tomorrow cannot be supported solely by the federal gas tax."

Our current federal gasoline excise tax is 18.4 cents per gallon. It is not adjusted for inflation. It has been known for some time that adjustments would eventually need to be made in the rate or HTF funding approach as MPG of cars increased. Various studies have been done to get an idea of the problem and possible solutions to provide more funds for the HTF to maintain and build roads.

In December 2007, the National Surface Transportation Policy and Revenue Study Commission released its study of transportation funding issues and possible solutions. This lengthy report provides background on transportion and highway funding challenges and the results: roads in disrepair, increased congestion, economic losses due to problems of moving goods, and increased safety concerns. The report also looks at existing programs, funding problems and makes recommendations for preventing negative balances in the HTF. The Commission ended in July 2008.

Chapter 5 of the report lays out various recommendations. Some interesting ones include:

Have the revenues from the gas guzzler tax be directed to transportation projects.
Have any gas tax exemptions funded by the General Fund.
Have custom fees related to transportation go to HTF

A few observations:

Carrots versus sticks: It is interesting that higher gas prices led to a drop in consumption. Several state governments have greenhouse gas emission reduction goals, why didn't they just raise their gasoline excise taxes and generate some needed funds while also helping their state to meet GHG emission reduction targets as a way to help meet their goal?
1. How should governments determine when a carrot - such as an income tax credit for purchase of a hybrid fuel car is warranted rather than incentivizing behavior with an added cost, such as a higher gasoline excise tax? Couldn't the federal government have encouraged people to buy hybrids by raising the gasoline excise tax rather than giving away tax credits - and done some good for the federal budget? Of course, there are other costs of higher gas taxes.
2. A problem with incentives is that they can sometimes fund activity that would have occurred anyway. For example, today most hybrid cars have waiting lists - even those without a tax credit.
3. Sticks, such as higher taxes, are hard to implement as evidenced by some policymakers wanting to provide some type of relief for today's high gas prices. There are alternatives to high gas prices - driving less, using public transportation, making sure cars are in good operating condition and not carrying "stuff" that doesn't need to be transported around continually.
Several states have suggested or studied an alternative to tax per gallon - tax per mile traveled. Of course, that is much harder to measure and collect relative to paying per gallon at the pump, but not impossible.
1. Research Triangle
2. Oregon Mileage Fee Concept (2007 final report)
3. California DMV Director (2004)
The gas guzzler tax could be expanded so that it also covers SUVs and the mileage rates modified to cover more "low" MPG cars.

Given tight budgets and plenty of other needs for general fund revenues, other options will need to be found for funding transportation and transit projects, particularly in light of declining gasoline excise tax collections.

What do you think?

The Pressing Need to Rethink Our Existing Tax Rules for Retirement Savings

Annette Nellen — Sun, 20 Jul 2008 18:00:00 -0400

On 6/26/08, the House Ways & Means Committee held a hearing on Individual Retirement Accounts (IRA) due to concern over underutilization and reasons why many small businesses did not offer some type of IRA plan for workers. The GAO report on the topic was highlighted. Subsequent to this hearing, a few other committees held hearing on retirement savings and a report was released by Ernst & Young on people not having enough to live on in retirement.

There are some troubling data and realities about IRA participation and inadequate retirement savings. For example:

For 2004, 79% of all taxpayers were eligible to make an IRA contribution (about 145 million taxpayers). Just 14.7 million taxpayers made a contribution though (about 10%). Participation was highest for taxpayers with $200,000 or more of AGI and that group also made the largest average contribution. For eligible taxpayers with positive AGI, participation was greater among higher income taxpayers. [Bryant, Accumulation and Distribution of IRAs, IRS, 2004]
In 2001, 60% of taxpayers either had assets in or income from an IRA or employer-sponsored plan. Thus, 40% of taxpayers have no retirement accounts although they may have other assets for retirement. (Sailer & Holden, IRS, 2004)

I have more information in a short article - Rethinking IRAs.

On 7/10/08, the Joint Economic Committee held a hearing on the shift from defined benefit plans to defined contribution plans, the greater risk upon workers under DC plans, and the greater return DB plans produced. A representative of the venture capital industry noted the importance of DB plans to providing funds for investment.

On 7/16/08, the Senate Special Committee on Aging held a hearing on people not saving enough for retirement, the recent increase in hardship withdrawals from 401(k) plans and the possibility of "automatic IRAs" that allow for payroll contributions to IRAs. Click here for more information on this topic from Chairman Kohl.

The EY report (July 2008) - Retirement vulnerability of new retirees, found that "almost three out of five middle-class new retirees can expect to outlive their financial assets if they attempt to maintain their current pre-retirement standard of living. To avoid outliving their financial assets, middle-class retirees will have to reduce their standard of living, on average, by 24 percent." The report was prepared for Americans for Secure Retirement.

Living longer, inadequate participation in retirement savings, financial illiteracy, greater personal responsibility for managing retirement savings (DC versus DBs), frequent job changes, and retirement tax rules that are skewed to benefit higher income individuals all point towards a retirement savings crisis that will cause people to work longer, put pressure on social programs and children of retirees, and lower our standard of living.

The reality of greater personal responsibility for retirement will require greater financial education in schools, easier options for retirement savings (such as automatic payroll contributions) and modification of existing tax rules to bring greater equity to the system.

What do you think?

Proposed Tax Increases in California: Overlooking the 21st Century

Annette Nellen — Sat, 12 Jul 2008 02:36:00 -0400

California legislators continue to struggle with how to close the $15 billion budget gap even as the year has begun and the budget deadline has passed. On July 8, the Budget Conference Committee developed a plan that restores some proposed cuts and proposed a package of six tax increases. Five of the increases involve the individual income tax and corporate franchise tax while the sixth calls for efforts to collect some of the state's uncollected taxes (reduce the tax gap).

A problem with aiming to close a specified budget shortfall is that it is too easy to look at the amounts various changes could raise and massage it until you hit your needed number. Math wins out over strategy. while the committee has reasons for each of the five tax increases, they are fairly weak, such as - we had these high rates in the past. Why does that mean they make sense for California's economy and society now? What about cutting back on tax deductions, exclusions and credits that are too generous or poorly targeted such that they benefit taxpayers who don't need a benefit? What about shaping our tax laws to support our economic, societal and environmental goals? For example, policymakers are working to find ways to get California to reduce its GHG emissions. So, why not enact a carbon tax?

While a primary purpose of this tax increase package is to help get a discussion going and to push Republicans to come up with an alternative plan, some of these tax proposals could remain. We'll have to see. Here's my thoughts on each of the proposals and if they are moving California's tax system into the 21st century.

Proposal 1: Add two new tax brackets to the individual income tax. The 10% rate would apply to joint returns with income above $321,000 and the 11% rate would apply to joint returns with over $642,000 of income. We have had these high rates before. Without the change, this income would be taxed at 9.3% and 10% if over $1 million.

Comments: California is already a high income tax rate state. Our income tax is very volatile because the bulk of it is collected from a small number of high income individuals. When their income goes down, in essence, the entire state feels it. This is also because the personal income tax is about 50% of our general fund revenues. California law is designed such that, for example, a family of 4, no income tax would be owed until their income was over $44,000. I've got more information on this volatility in a 2007 report.

There are flaws with many of the tax deductions, credit and exclusions in the personal income tax. For example, CA follows federal law in allowing mortgage interest to be deducted on a primary and second residence and on up to $1.1 million of debt. This tax break is worth more to high income individuals. Why is the state subsidizing home purchases beyond the median home price and on a second home as well? This rule is provides too generous of a benefit to high income/wealthy individuals. It should be cut back and perhaps even converted to a tax credit to eliminate its skew to higher income individuals.

Raising the rate rather than fixing the base just leaves Califorrnia labeled as a high tax state, gives high income individuals pause to question if they should live elsewhere, makes tax planning more attractive and continues to leave the base problems for another day.

The California Budget Project notes that in an economic downturn, tax increases are better than spending cuts. But I don't see any reason to get that tax revenue in such a way that increases the volatility of tax collections and doesn't help California's economy. I think we need to replace part of the PIT with an environmental (polluter pays) tax and broaden the sales tax base to bring in the items higher income individuals tend to be the buyers of (personal services, entertainment, digital downloads). A polluter pays tax could be a carbon tax, it could be a utility tax on bills above what the average would be for a family of four living in a 1200 square foot house.

This is a poor proposal.

Proposal 2: Suspend use of corporate NOLs for 3 years.

Comment: The committee's write-up describes this as closing a "tax loophole for large corporations." But, corporations of all sizes are allowed to carryonver NOLs and there is no information provided to say that corporations have used the carryover provision in any way other than how intended. Thus, it this is not a loophole.

[Two of the proposals were described as closing loopholes and neither one is a loophole. For more on this - see my op ed in the San Diego Union Tribune (7/11/08)]

Instead of completely denying corporations use of their NOLs for 3 years, it should be more helpful to the business (and the state) to instead provide that in any year, an NOL carryover cannot reduce taxable income by more than 70% (or some other percentage). This means that when a corporation has positive income, it will pay some level of tax even though it has an NOL carryover. It still gets full use of its NOL, it will just take longer to use it.

This proposal could be improved.

Proposal 3: Suspend the indexing of the individual income tax brackets, apparently, just for one year.

Comment: This is a disguised tax rate increase. For example, if an individual's 2008 income goes up due to a cost-of-living raise, they may end up in a higher tax bracket. Even if this is for just one year, it is a disguised tax rate increase. Also, even if the suspension of indexing is just for one year, the effect will last forever because higher rates will kick in at lower income levels and those are the brackets that will be indexed going forward.

This is a poor proposal. There are more transparent ways to generate additional tax revenues.

Proposal 4: Reduce the dependent credit for individuals with AGI above $150,000. A few years ago, to benefit families, the credit amount for dependents was raised to $294 while the personal credit is $94. A key purpose of these credits is to help measure ability to pay.

Comment: This changes was also described as closing a tax loophole for upper-income income. However, it is not a loophole (see article). There isn't really any strong reason why the dollar amounts of these credits should be different. Also, for high income individuals, the amount of the credits is phased out. However, these are high income levels, such as about $150,000 for single taxpayers.

Proposal 5: Increase the corporate franchise tax rate from 8.6% to 9.3%. This rate had been in place a few years ago and so is described as restoring the franchise tax.

Comment: California already has high tax rates. Rather than making them higher, consideration should be given to broadening the tax base and perhaps lowering the rate.

Proposal 6: Increase tax enforcement efforts to help generate about 1.5 billion.

Comment: This is great. It is always good to be sure the tax gap (amount of tax owed, but not collected) be kept to a minimum. Rather than increasing a tax or creating a new tax, see about collecting more of the taxes already on the books.

Given the push to make changes that lead to closing the $15 billion shortfall, math won out over making tax reforms that would help our economic, societal and environmental goals. But, it is likely just a start to further budget debates. We'll see what other tax increases are proposed and which, if any, of the ones from July 8 are continued.

What do you think?

Our Flat World (except for domestic interstate commerce)

Annette Nellen — Thu, 10 Jul 2008 15:44:00 -0400

Ease of cross-border business activity has led to what Thomas Friedman describes as a flat world. However, our quagmire of state nexus rules leaves domestic commerce in a non-flat world.

States tend to take broad approaches in finding multistate sellers subject to income or gross receipts tax in the state. The 1959 federal law known as PL 86-272 provides guidance for sellers and states regarding when a state can impose income tax obligations on a seller of tangible personal property. A lot more businesses today, relative to 1959, sell something other than tangible personal property and so have no federal statute to rely on to know when they may owe income tax in a state.

Some states take the approach that an economic connection is enough - that a physical presence in the state is not needed before a seller is subject to state income tax. And, rules can vary from state to state leading to the possibility of double taxation of some income.

The 1959 law needs to be updated. It was intended to be temporary (!), but was never updated. Congress has looked at a few possibilities over the past several years, but nothing has come close to enactment.

For more on this issue that presents a challenge to interstate commerce, see my short article - Not Flat: State Income Tax Nexus.

Taxing Digital Products - Let's Also Use the Technology to Modernize Collection

Annette Nellen — Mon, 23 Jun 2008 12:47:00 -0400

When today's forms of taxes were created decades ago, there wasn't any technology to consider in making computations and collection easy. But that is not true today. While some states are slowly modernizing their laws to address new ways of living an doing business that are partly due to changes in technology, the technology as a tool of tax compliance and administration is often overlooked.

Tennessee enacted various tax law changes which the governor signed on June 5, 2008, including expanding its sales tax to include most digital goods provided the tangible equivalent is something already subject to sales tax. [SB 4173 enacted as Public Chapter Number 1006]

"The retail sale, lease, licensing, or use of specified digital products transferred to or accessed by subscribers or consumers in this state shall be subject to the tax levied by this chapter on the sales price or purchase price thereof at a rate equal to the rate of tax levied on the sale of tangible personal property at retail by the provisions of § 67-6-202."

The law defines various types of digital goods and notes a few exemptions. To determine where the buyer resides, the new law provides:

"(g) The tax imposed by this section shall apply to retail sales in this state, indicated by the residential street address or the primary business street address of the subscriber or consumer."

Thus, Tennessee joins New Jersey, Nebraska and a few other states that have modernized their sales taxes to include today's forms of consumption, although they don't also address using the technology for collection ease. For equity reasons and continuation of the tax base, as forms of consumption progress beyond what yesterday's legislators ever envisioned, such as the digital equivalent of tangible goods, including software and music downloads, a state needs to update its laws.

First - why include digital downloads in the sales tax base? As a consumption tax, there is no reason to tax a song sold on a CD that you'll play in your CD player, but not one downloaded online onto your MP3 player or computer to listen to. The result in both situations is the same - you enjoy the music. And both forms are consumption which is what a sales tax is designed to tax.

One argument sometimes voiced about including digital downloads in the sales tax base is that you may not know the location of the buyer. But, unless the song is free (in which case it is unlikely to be taxed unless it was bundled with something else that is taxable), the consumer is using a credit card which includes their address. While the credit card user could have the card registered in a different state, it is unlikely and there are ways to still require the user to let the credit card company know where the cardholder is located.

Another argument against taxing digital goods is that it will hurt Internet companies. This is a distractor argument. The sales tax is paid by the consumer, although collected by the seller if the seller has a physical presence in the state (if not, the buyer pays use tax on their own). Will people stop buying digital downloads because of sales tax? It seems unlikely because if they really want the product, their alternative is to buy the taxable tangible equivalent. Also, retailers of tangible personal property have been collecting sales tax for decades and they seem to be able to remain in business. Certainly, moving something from being non-taxable to taxable is shocking at first, but people will get used to it. If the states that are modernizing their laws to comport with today's ways of consuming and doing business help explain why the change is needed - equity, fairness, neutrality, to keep state tax bases from eroding, consumers are more likely to understand. And, the sooner the states update their laws, the better because the longer the delay, they are really indirectly educating consumers that digital consumption is not subject to sales tax.

Many states with sales tax, added it in the 1930s when digital goods were not in existence. So, most laws were written to apply to the key type of consumption - tangible personal property. If states had originally written their laws to apply to consumption of goods without using the word "tangible", digital downloads would have been taxable from the start and I don't think consumers would have questioned it. After all, if you pay sales tax on your music CD, why wouldn't you also pay it when you download the music onto your MP3 player to enjoy.

Another issue sometimes raised is the cost to vendors of collecting the tax on digital items. This is also a distractor in that other vendors have been incurring costs for decades to collect sales tax on the tangible items they sell. I do think though that vendors should recieve some relief for these costs, something very few states do today. I also think this is an area where technology could be better used to collect the tax. Again, when sales taxes were enacted decades ago, the use of technology to collect the tax was primarily paper and pencil.

Better Use of Technology:

Today, the sales tax could be collected by the state tax agency at the same time the buyer's credit card is billed for the item. This would enable the state tax agency to get the money sooner, there would be no need for the vendor to file any reports and it would still be transparent in that the buyer would see the sales tax charge when they buy the item. Checks and balances could still be in place in that in auditing a vendor, the state agency would primarily review the system for charging to see that it works as intended and check a sample of transactions to be sure the collected tax was charged by the correct state tax agency.

This sales tax billing system could also be used for tangible goods. Whenever the credit card is charged, the sales tax portion gets charged by the state tax agency. The credit card or other payment card would just need to have the customer's state noted or they could be asked at the register (already, many stores ask for a zip code - apparently for marketing purposes).

Let's truly act like we're in the 21st century and not only modernize sales tax to apply to the digital equivalent of tangible consumption, but use technology to make it easier and more cost effective for vendors, consumers and state tax agencies.

[For further information, see my 21st Century Taxation website.]

Health Care Spending versus Extending 2001/2003 Tax Cuts - Tough Issues

Annette Nellen — Fri, 20 Jun 2008 21:00:00 -0400

On June 16, the Senate Finance Committee sponsored a Health Reform Summit. The presentations focused on costs and possible improvements to the delivery and insurance system.

CBO Director Peter Orszag's first part of his testimony helps put the immense financial problems facing us in the next few years in perspective. He says:

"The single most important factor influencing the federal government’s long-term fiscal balance is the rate of growth in health care costs. The Congressional Budget Office (CBO) projects that, without any changes in federal law, total spending on health care will rise from 16 percent of the gross domestic product (GDP) in 2007 to 25 percent in 2025 and 49 percent in 2082, and net federal spending on Medicare and Medicaid will rise from 4 percent of GDP to almost 20 percent over the same period.1 Many of the other factors that will play a key role in determining future fiscal conditions— including the actuarial deficit in Social Security and a decision about extending the 2001 and 2003 tax legislation past its scheduled expiration in 2010—pale by comparison over the long term with the impact and challenges of containing growth in the cost of federal health insurance programs."

And he didn't mention the cost of AMT reform. As noted in my last blog entry - the dollars involved in both tax and health care reform are so immense that the discussions need to be better merged in some way. Otherwise, it might be a race to see which issue gets solved first - finding a way to extend all or part of the 2001-2003 tax cuts or finding ways to address health care spending. Also, there are a lot of health care dollars in the tax law that could be used for either tax reform or health care reform. It seems that the Senate Finance Committee may be going in that direction given that they have held information hearings on both topics to help get ready for work needed in the 111th Congress.

Another link between tax and health care reform is that the increaing cost is hurting the ability of US employers to compete due to the decades old (and odd) linkage of health insurance and employment. One reason cited for business tax reform is to help companies to be more competitive in the global market place. But it isn't just a high tax rate that is a problem, it is health care spending (and for some companies today with an effective tax rate well below 35%, exploding health care costs might be a bigger concern). Craig Barrett, Chairman of Intel, also testified at the Health Reform Summit. He stated:

"Without providing some major fixes, US business will continue to export jobs directly as a result of healthcare costs. I conclude that healthcare is pricing itself out of business, and in the process is just going to drive CEOs to make decisions to put resources elsewhere where the healthcare cost is much more affordable."

That will certainly make our problems even worse if we lose jobs.

Mr. Barrett also expressed concern that the health care debate wasn't focused sufficiently on how to control escalating costs, but instead tended to look at who should pay. He said:

"Sadly, the current debate typically centers on “who pays”? This leads to endless discussion on which financing mechanism to utilize to increase the funds deemed necessary to change our healthcare system. While entertaining, it does not address the inherent problem in the current model; namely the excessive costs."

These two reform efforts are extremely challenging due to their magnitude, but also very crucial. Even if the 2001-2003 tax cuts expire, there is still the AMT problem to fix which is also costly. How to approach solving these difficult issues are good questions to ask of candidates for Congress and President this year. I proposed a few questions on these budget matters a few months ago.

What would you want to ask the candidates?

What do you think can be done to address the enormous fiscal challenges that lie ahead?