Taxing Professional Services: Beating South Dakota At Their Own Game?

Minnesota is used to feeling economic pressure from South Dakota. Remember these ads (via MPR)?

Whether MN's competitive disadvantage on business friendliness is real or perceived is up for debate. One of the more controversial ideas in Governor Dayton’s proposed FY 2014-2015 budget is an expansion of the state sales tax to include business-to-business services (also called professional services) such as accounting and legal services. Interestingly, Minnesota’s business-friendly neighbor to the west, South Dakota, already has a 4% state sales tax on professional services. While the Governor is set to issue a revised budget proposal in the next week or so to reflect the smaller projected deficit, he has indicated that he will not withdrawal his sales tax expansion. Dayton’s proposed sales tax would bring Minnesota’s overall rate closer to South Dakota’s (see Tax Foundation map below).

But let’s go beyond the rhetoric and look at what some scholars have found on the tax incidence and economic impacts of taxing professional services. Sadly, we are not awash in research on the impacts of taxing professional services. This is probably because only three states currently have such a tax (so there’s not a lot of data out there), and the tax is vigorously opposed by strong interest groups, including CPAs and lawyers (so such proposals are often killed on political rather than purely economic merits). 

That said, probably the best study on this type of tax, published in the National Tax Journal in 1991, used a natural experiment in Florida’s short-lived sales tax on all services to show that the tax actually was slightly less regressive than a general sales tax on commodities. The key impact on incidence resulting from a tax on services is tax pyramiding (discussed earlier in this blog), which they found resulted in a slightly more proportional tax incidence. A political analysis of the Florida’s experiment with a sales tax on services shows that the tax failed purely on political grounds rather than administrative, legal, or economic grounds.

And, in case you’re wondering, New Mexico and Hawaii are the other two states, besides South Dakota, which tax professional services. What do all three of those states have in common? Their main urban areas are relatively isolated geographically, meaning there would be less of a concern that businesses will try to avoid the tax by hiring out-of-state professionals. Perhaps the greatest fear of a tax on professional services is that it will encourage this highly mobile class of people to locate elsewhere. State legislatures will need better research on professional service sales taxes if they have even a hope of passing such a law.