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National Tax Association
Communications And Organizing Documents (OD-10) REPORT BY THE TAX BASE SUBCOMMITTEE NTA COMMUNICATIONS AND ELECTRONIC COMMERCE
TAX PROJECT:
I. Introduction The Tax Base working group was formed at the February 4th meeting of the Steering Committee (in La Jolla, CA) to address the various questions arising under the topic of "tax base." At that meeting, both Business, Government and Other representatives agreed that the use of uniform definitions and/or classifications of products and services was desirable for purposes of constructing state tax bases. The Steering Committee also appeared to agree that once a uniform system of definitions/classifications is developed, that each state would have the sovereignty to determine which components of the defined list would,or would not, be taxed. (Business stressed that the determination of tax base had to reside with the state, and that local governments had to implement the same tax base). The perceived benefits of this approach include: (1) increased simplification of sales/use compliance for multistate taxpayers and remote sellers, (2) increased simplification of sales/use tax administration, to the extent multistate forms and/or procedures are developed, and (3) a potential increase in uniform taxation of products and services on a multistate basis. The Tax Base working group's members include: Kendall Houghton(chair), Dan Bucks (MTC), Frank Shafroth (NLC), Eliot Goldberg (WSTA), Scott Mackey (NCSL), Kaye Caldwell (CommerceNet), Prof. Robert Strauss (Carnegie Mellon), and Prof. Charles McLure (Hoover Institute). The group has also received valuable input from Harley Duncan (FTA), Jim Eads (COST), Lisa Schoenthaler (NCTA), and Ron Snell (NCSL). At the first conference call of the working group, we considered a number of possible focal points, but narrowed the scope of our investigation to cover two major questions: (1) What possible sources exist for a uniform system of definitions/classifications of products and services, and which source(s) best meet the needs of tax professionals? [We declined to debate whether certain defined products or services "should" be taxed/exempt from tax; this debate is best left to state legislatures, it was felt.] (2) Should questions of tax policy related to the designation of tax base items be addressed, and if so, in what manner? [Our group discussed the merits of uniform exemptions, and several members of the working group felt that there needs to be a mechanism to ensure that policy-driven exemptions such as purchases of business inputs, and purchases by non-profit organizations, can be built into the tax base structured by a state legislature, regardless which defined items are designated as taxable.]
II. Sources for Uniform Tax Base Definitions/Classifications Several potential sources for uniform definitions and classifications of products and services were identified by the group. Each is described below, and materials are attached hereto, which provide more detail on each system. A. United States Harmonized Tariff Schedule (Harmonized System) The United States Harmonized Tariff Schedule (the "Harmonized System") is derived from the Harmonized Commodity Description and Coding System, maintained by the World Customs Organization. The Harmonized System was designed to assist in the application of tariffs (i.e., for tax purposes), and is international in nature; all major trading partners of the United States utilize an identical or nearly identical system (a bonus when dealing with cross-border electronic commerce). The Harmonized System schedule has 22 major subdivisions or sections, each containing one or more chapters; in all, there are 99 chapters containing 8,500 tariff descriptions and corresponding tariff numbers at the eight-digit rate level. Theoretically, for any imaginable item there is only one tariff description that is legally the most correct. Corollary sources are required for proper classification, including six General Rules of Interpretation and four Additional U.S. Rules of Interpretation. The classification process is very complex and time-consuming, but likely to yield an exact result. While the system of classification is very extensive, it is devoted solely to the identification/classification of goods, and does not include services. In addition, the level of detail in classification of taxable goods is excruciating, and may be more information than anyone involved in this project is willing or able to process. To review the Harmonized System, go to the following Web sites:
B. North American Industrial Code System (NAICS) The NAICS system has been designed to replace the Standard Industrial Code (SIC) system of 1987, and it is currently being used by NAFTA countries. The NAICS system utilizes a 6-digit code (expanded from the SIC 4-digit codes) to categorize industries. The numbers refer to industry sectors and subsectors, by reference to a hierarchical production- or supply-based framework, as illustrated below: XX Industry Sector 21 Mining As illustrated by the above example, production-based classifications of goods and services may not be very helpful for sales/use tax base designation purposes; this is because consumption/use is generally viewed as a more relevant criteria for tax policy purposes. On the positive side, the NAICS codes now attempt to identify new and emerging industries, service industries in general, and advanced technology industries. Two sets of material are attached hereto: (1) a background paper on NAICS "Services Classifications," prepared by the Economic Classification Policy Committee, and (2) a summary article on the NAICS system, printed in an FTA publication. To review the NAICS classifications, go to this Web page: http://www.census.gov/ftp/pub/epcd/www/naics.html.
C. Bureau of Labor Statistics Expense Categories The Bureau of Labor Statistics (BLS) prepares a listing of 450 or so discretionary expense categories, including goods and services. The BLS data reflect a survey conducted to determine how consumers spend their disposable dollars. Therefore, the survey classifications are much less detailed, and organized, than the NAICS or Harmonized System. (On the other hand, they are more manageable, by reference to level of detail and number of classifications.) To review the BLS Expense Classifications, go to the following Web site: http://stats.bls.gov/csxgloss.htm#expn
D. Other Sources Other sources were suggested for definitions of specific products or services, e.g., the Communications Act of 1934, as amended, was suggested as a source of definitions for telecommunications and cable-related services. None of these other sources provided comprehensive coverage of products or services, however, and hence were not preferred by the group. In addition, we asked to review the Federation of Tax Administrators' compilation of state tax services categories (by reference to existing state tax codes), but that list was not deemed to be as comprehensive or classification-sensitive as other sources.
III. Tax Base Working Group's Recommended Approach Toward Compiling a Uniform Listing of Products and Services After reviewing each of the above-described sources for definitions/classifications, we concluded that none of the sources could, in and of itself, adequately serve the needs of state tax administrators and taxpayers. On the one hand, the Harmonized System is very detailed and product-oriented, but it only classifies goods and ignores services (as is appropriate for a tariff schedule). On the other hand, the NAICS system addresses services as well as goods, but its industrial classifications are production- or supply-oriented, rather than market- or consumption-oriented. The BLS expense categories are neither detailed enough or logically formatted for tax classification purposes. Nevertheless, the Tax Base working group recommends that the NTA Steering Committee endorse an approach that utilizes or adapts an existing third-party source or combination of sources. This is because the process of developing a system of definition/classification is daunting, and the above-described systems took many years to develop and implement. Second, the systems are designed to be comprehensive, and a de novo review of products and services that might conceivably be included in a state's tax base will likely not be as complete. [On the other hand, see below for discussion of need to minimize the complexity of classifications.] If we are to adapt existing systems to our own use, then the Tax Base working group recommends that the system combine features of both the Harmonized System and the NAICS system. At least some of the services categories included in the NAICS (specific inclusions to be determined at a later time) should be included in the menu of products and services from which states construct their tax bases. On the one hand, the orientation of the NAICS is less helpful to consideration of state tax base inclusion/exclusion than the orientation of the Harmonized System. On the other hand, the Harmonized System's level of detail is not conducive to the efficient conduct of tax administration or compliance. It appears, based on information received the working group immediately prior to publication of this paper, that the United Nations is sponsoring an effort to develop a Central Products Classification (CPC) scheme, "based on the physical characteristics of goods or on the nature of the services rendered. CPC provides a framework for international comparison of the various kinds of statistic dealing with goods, services and assets. It covers categories for all products (goods and services) which can be subjects of domestic and international transactions or which can be put into stocks." Cf. URL for United Nations Website (http://www.un.org/Depts/usnd/class/cpcprof.htm). The CPC system is indicated on the Website to be targeted for a 1998 release. Interestingly, the CPC scheme keys off of the Harmonized System, for classification purposes. The United States Census Bureau is also working on a product-based classification of goods and services that it hopes will be ready by the year 2002. This system will probably build on the CPC. The work to build a tax-specific definition and classification system for goods and services is extremely labor-intensive, because choices cannot be made between the NAICS and Harmonized Systems, including their competing definitions for goods, without detailed review of the two systems. In addition, the process requires that consensus be reached regarding the appropriate level of refinement to be achieved in product or service classifications. On the one hand, the classifications must be detailed enough to provide certainty to taxpayers who are trying to ascertain whether a particular item is included in a state's tax base; on the other hand, erring on the side of too much complexity may stall legislative processes, and may encumber tax compliance efforts. For these reasons, the working group recommends that we focus our research and review on the United Nations CPC scheme and the U.S. Census Bureau's efforts to create integrated classification systems for both goods and services. Only if these integrated systems are deemed unsatisfactory by tax administrators and taxpayers should we consider undertaking such an effort ourselves. For purposes of this research, we plan to consult with industry representatives who utilize both the Harmonized System and the NAICS System, and who may have familiarity with the United Nations CPC scheme, to ascertain whether other advantages or disadvantages (either theoretical or operational) pertain to each system that we have not considered.
IV. Other Issues Considered by the Working Group A number of policy issues arise in the context of an examination of the sales/use tax base. While this working group does not herein make any recommendations concerning these tangential policy matters, we felt that several issues are critical and merit consideration by the Steering Committee as a whole. Therefore, we highlight these issues below, and where appropriate indicate options and set forth the perceived pro's and con's of contrasting approaches.
A. Enumeration/Exclusion Approach to Defining Tax Base States currently use two methods to determine whether specific goods and services are subject to the sales and use tax. Under the enumeration approach, goods are presumed to be exempt unless specifically listed in the statute or administrative rule. Under the exclusion approach, goods and services are deemed taxable unless specifically excluded by statute or administrative rule. The enumeration approach puts the burden on the legislature and the state tax administrative agency to take affirmative action to add new products and services to the tax base, while the exclusion approach assumes that goods and services are taxable unless specifically exempt by statute or rule. Under a uniform national system for classifying goods and services, states could employ either method for delineating taxable goods and services. B. Purchases by Businesses and Exempt Organizations The working group also discussed the issue of purchases of taxable items by exempt organizations, and business purchases of taxable items that are incorporated into other products or consumed in the production process. Currently, there is very little uniformity among states in their treatment of such purchases. The working group believes that a uniform, simplified sales tax collection system should develop procedures to address these issues while respecting the right of states to set rules for business and exempt organization purchases.
The sales tax is intended to be a tax on final consumption. When businesses purchase good that are resold, including inputs that are incorporated into other products or consumed in the production process -- and, indeed, any time they make taxable purchases, the possibility of double taxation, or pyramiding, exists. States have developed rules that provide exemptions for businesses that purchase taxable items that are resold or incorporated into products later sold at retail. In addition, some states exempt from the sales tax goods that are used or consumed in the production process -- fuels, utilities, or manufacturing machinery, for example. However, states vary in how much taxation of business purchases they allow in their sales tax structure. Studies by KPMG Peat Marwick, state tax departments, Professor John Mikesell, Raymond Ring and others have produced estimates that between 18% and 65% of the initial incidence of the sales tax falls upon businesses, with an overall average of about 40%. However, this 40% figure does not represent the degree of pyramiding in state sales taxes. In some instances, business inputs are taxable and final sales are not. For example, purchases of paper and computer products by an accounting firm may be taxable business inputs while accounting services are exempt from the sales tax. In this example, there is no pyramiding. The working group believes that a simplified sales tax structure can effectively address this issue by developing uniform definitions for exemptions of business purchases. Under current practice, most states exclude:
In the context of communications and electronic commerce, the question may arise whether "sales for resale" should be clarified to include sales of both goods and services. If a state chooses, it could expand the listed exemptions to include categories where there is not an established current practice (e.g., exempt telecommunication services purchased by an Internet service provider), or it could clarify that it is adapting the above-listed categories to the services or communications/electronic commerce context. The working group believes that states should have the option of deciding whether to grant these exemptions. State policy makers are in the best position to determine which business purchases should be exempt from taxation. Yet the working group believes that simplification would be enhanced if, as in the case of the definitions of potentially taxed (or excluded) products discussed above, there were a uniform "menu" of possibly exempt business purchases from which each state could choose. The working group is seeking to develop such a menu. States could issue uniform exemption certificates that remote sellers could use to determine whether taxes should be collected. Such uniform certificates would be valid in all states. (This task appears to be reserved to another of the working groups.) An alternative approach suggested by one member of the group would be to develop "baseline" business purchase exemptions that all states could agree upon (e.g., two of the four categories listed above). States granting additional any tax exemptions could institute a mechanism whereby firms pay the sales tax and then claim a refund for same, with respect to those purchases that are not uniformly granted an exemption.
Some states have blanket sales tax exemptions for non-profit or charitable organizations. Most states use the IRS 501(c)(3) designation to determine eligibility, but some states specifically list exempt organizations in statute. The working group believes that a uniform exempt organization registration and verification process could be developed. This process would allow vendors to verify the exempt status of organizations purchasing goods and services from remote sellers, while states would retain the authority to designate exempt organizations.
Many economists believe that a pure sales tax should apply only to final purchases. The New Mexico gross receipts tax, for example, may closely approximate the economists' ideal sales and use tax, by providing an invoice credit system that prevents pyramiding and double taxation. In this respect, the New Mexico gross receipts tax (a form of vendor sales tax) comes closest to the transaction-style value added tax. Most states, however, have implicitly rejected the VAT in favor of a sales tax that does not exclude all sales to businesses. The imposition of rules to require states to exempt all business purchases from the sales tax would be a dramatic departure from current state tax policy. It would create significant fiscal issues for some states and could undermine support for movement toward uniform definitions of state tax bases. For this reason, the working group acknowledges that states want continued flexibility to determine how business purchases should be treated under the sales tax. [NOTE: All attachments referred to in the text of this report will be provided to attendees at the April 23/24th meeting of the Steering Committee, in Salt Lake City.]
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