“OF SALES & SIN” (PART 1) – SALES TAX SEPTEMBER 24TH 2015 DESCRIPTION:

In this episode of the Politi-Cal Podcast—the first entry in our series on consumption taxes—we talk about California’s sales & use tax, including how it works, who pays it, what purchases are affected (or exempt), and why we should think about reform.

TRANSCRIPT:

Picture a typical day in the life of the average Californian.

You start by brushing your teeth, taking a shower, and making a hearty breakfast of eggs, toast, and oatmeal. During your morning routine, you use water from your tap, electricity from your toaster, and gas from your stove, adding a few tiny increments to the cost of your utility bills. But however much of these resources you consume, you won’t pay a dime in sales taxes, because utilities are taxexempt under state law. Nor did you pay any sales tax on the eggs, toast, and oatmeal you just ate, since groceries are tax-exempt, too. After breakfast, you drive to the nearest gas station to fill up your tank. Whatever the price of petroleum happens to be that day, you pay the State of California 30 cents per gallon of gas, plus two-and-a-quarter percent [2.25%] of your purchase price. While your fuel is flowing, you stop in the on-site convenience store to buy a fresh cup of coffee and a hot sandwich for lunch. Unlike groceries, prepared foods like coffee and sandwiches are not tax-exempt, so you pay about eight-and-a-half percent [8.5%] sales tax on your purchase—including a 7.5 percent state rate and a one percent local rate. Shortly thereafter, you drive to work and, before heading into your office, you take quick break to smoke outside. You walk to the nearest convenience store and buy a pack of twenty cigarettes, handing the cashier the cost of the pack plus 87 cents in excise taxes.

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“OF SALES & SIN” (PART 1) – SALES TAX

Sitting at your desk, a few hours of work pass by, and you remember you had to buy two books from two different bookstores online. The first retailer is part of a nationwide chain and has a distribution center in California. So your usual sales tax—eight-and-a-half percent [8.5%]—is applied automatically to your transaction. The second retailer is an independent bookstore based entirely in Arizona. Sales tax is not included in your order, so instead you owe the State of California a use tax on the book. It’s the same rate as the sales tax—eight-and-a-half percent [8.5%]—but you have to submit it separately through next year’s tax returns. After work, you decide to blow off some steam with your coworkers and head to the local bar. Unbeknownst to you, the cost of your drink includes a wholesale tax of anywhere between 20 cents [$0.20] and six dollars and sixty cents [$6.60] per gallon, depending on the type of beverage and the alcohol content. So whatever your drink of choice, you end up sending a few pennies to the state in the course of consuming it. Finally, on your way home, you stop at the drugstore to pick up your prescription, plus a bottle of aspirin. Despite both being some form of medication, you only pay sales tax on the aspirin, since prescription drugs—not over-the-counter drugs—are tax-exempt. On your way out of the store, you spot a Redbox kiosk and to your great excitement, Liam Neeson’s latest rescue movie, “Taken 4,” is available for rent. But just as you’re about to swipe your credit card in the machine, you remember that tangible goods—including DVD rentals—are subject to sales tax, while digital goods—like streaming video—are not. So you decide to save a few cents on the transaction and rent the movie tax-free from iTunes instead. Or maybe, at that point, you just decide to go to bed. Navigating our complicated system of consumption taxes may be enough adventure for one day. … Welcome to the Politi-Cal Podcast, policy in a golden state of mind. My name is Tony Mastria, and today marks the beginning of our series on consumption taxes—simply, taxes on things we purchase. And if the scene portrayed in today’s introduction made your head spin, it’s probably because you’re feeling overwhelmed by how commonly and confusingly consumption taxes can affect our lives. When we talk about consumption taxes, we’re usually referring to taxes in one of two categories: sales taxes and excise taxes. Sales taxes are the amounts you see at the end of most paper receipts. They’re preset percentages added to the cost of your purchase whenever you buy some tangible good, like a burger at a restaurant or a t-shirt at a clothing outlet or a box of paper from an office supply store. Sales taxes are imposed broadly, meaning they’re applied evenly on all physical goods across our economy, with just a few exceptions that are explicitly tax-exempt.

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“OF SALES & SIN” (PART 1) – SALES TAX

By comparison, excise taxes are applied narrowly, imposed on a few targeted goods like tobacco, alcohol, and motor fuel. And they’re usually applied, not as a percentage of your purchase price, but as a specific cost per unit. You’ll recall in our opening example that cigarettes are taxed at 87 cents per pack and gasoline at 30 cents per gallon, regardless of whatever these items cost to begin with. Colloquially, excise taxes are often called “sin” taxes because they’re imposed on things that our more puritanical predecessors might have deemed sinful, or at least disreputable. And with that, today we’ll be discussing California’s sales tax, leaving some of our more colorful consumption taxes—including on alcohol, tobacco, and gasoline—to be explored in future episodes. California’s main consumption tax is officially called the “sales and use” tax. As its name implies, the sales and use tax actually includes two separate but complementary taxes that are applied differently depending on circumstance. And we’ll talk about why this distinction exists momentarily. Like most taxes, the sales and use tax is collected to generate revenue to support public services, and it’s not an insignificant source of funding. In recent years, revenue from the sales and use tax has contributed over twenty billion dollars per year to California’s General Fund—about a fifth of the state’s discretionary budget—not to mention the billions more in sales tax revenue that go to nondiscretionary programs and local governments. Because of this outsized influence, it should come as little surprise that sales taxes aren’t a minor expense for individuals either. By some estimates, every resident of California spends over a thousand dollars per year on sales taxes alone. So it goes without saying that any policy discussion about the sales tax should be taken with the gravity it entails, since this necessarily affects a big portion of both our public revenue and our personal spending. So, you might be asking, how exactly does this system work, and where did it come from? California’s sales tax was first established in 1933, followed by the use tax in 1935—both during the early depths of the Great Depression. At the time, the rate was set at 2.5 percent on all tangible goods in our economy. And over the next few decades, the law was periodically amended to make certain goods tax-exempt, including food and utilities in 1943 and prescription medicine in 1961. Although these exemptions have made it easier for Californians to afford basic necessities, they’ve also narrowed the number of sales from which the state can draw revenue. As a result, the officials who helped to carve out these exemptions have also been forced to raise the sales tax rate overall just to keep pace with the level of revenue they had before. It’s an old problem that has a familiar resonance today, given the growth of intangible goods like digital content and professional services. Currently, the state sales tax rate is 7.5 percent, which means that when someone buys one hundred dollars’ worth of taxable goods, that person sends an additional seven dollars and fifty cents to the state. But even this relatively simple figure obscures a much more intricate breakdown of where all the money ends up.

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“OF SALES & SIN” (PART 1) – SALES TAX

Out of that original 7.5 percent, about half—roughly four percent [3.9375%]—goes to the California General Fund. That’s the pool of money we’re typically referring to when we talk about the state budget, and every year, lawmakers allocate money from the General Fund to essentially whichever programs or public services they choose—things like education, corrections, health, human services, and natural resources. Another one percent [1%] of the sales tax, called the “Bradley-Burns” rate, goes to the cities and counties where the tax was first collected. The Bradley-Burns rate, named after the 1955 bill that created it, is basically a lump sum that local lawmakers can use for whatever expenditures they desire—sort of like the state’s General Fund, but at the municipal level. On a related note, another quarter-percent [0.25%] is directed toward county transportation programs. Although it’s a separate amount, this quarter-percent is often referred to as “BradleyBurns for transportation,” since it’s local and mostly discretionary. Another one-and-a-half percent [1.5625%] goes to city and county services affected by realignment, including social services, healthcare, and public safety. Realignment, which took place most notably during the budget-crunch years of 1991 and 2011, occurs when the state shifts certain responsibilities down to the local level, along with some extra revenue to pay for them. Finally, three-quarters of a percent [0.75%] is committed to activities specified by ballot initiatives, including public safety and education. You may remember that in 2012, as part of Proposition 30, California voters approved a quarter-cent sales tax to support local education agencies. And about twenty years ago, in 1993, they did the same with a half-cent increase for public safety—part of Prop 172. And if you add up all these disparate amounts—four percent in the General Fund, one percent for local governments, a quarter-percent for transportation, one-and-a-half percent for realignment, and three-quarters of a percent for voter initiatives—you should—eventually, windingly, and perhaps wearily—reach our total of 7.5 percent. But if you’re like most Californians, you probably pay more than 7.5 percent when you buy things in your area, so you know the story doesn’t quite end there. On average, the sales tax rate throughout the state is closer to about eight-and-a-half percent [8.5%], and that extra percentage point comes from sales taxes imposed at the local level. Local sales taxes are officially called “Transactions & Use Taxes” or “TUTs” and were first authorized by state law in 1969. Unlike the state sales tax, TUTs are applied at the discretion of city and county officials at basically whatever rate these local lawmakers choose, so some jurisdictions impose the maximum rate of two percent, and some don’t impose TUTs at all. So where can you go to find the lowest sales taxes in the state? By definition, no locality can impose a rate lower than 7.5 percent—since that’s the minimum collected by the state—and you can find that 7.5 percent in effect throughout eleven of California’s fifty-eight counties. Aside from Kings County in the San Joaquin Valley, all of these low-tax areas can be found in the northern part of the

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“OF SALES & SIN” (PART 1) – SALES TAX

state. Coincidentally, if you recall our most recent episodes on statehood, you may recognize many of these counties as members of the former and future State of Jefferson, including Alpine, Calaveras, Glenn, Lassen, Modoc, Placer, Plumas, Sierra, Sutter, and Trinity. And where can you find the highest sales taxes? By law, no TUT can exceed the state sales tax rate by more than two percentage points, which means the maximum combined rate is 9.5 percent. That’s the rate you’ll find in effect in Alameda County, followed closely by the nine percent rates in Los Angeles County and San Mateo County. But the state has also granted some leniency to eight specific localities, where the sales tax rate is actually ten percent. This includes four cities in Alameda County—Albany, Hayward, San Leandro, and Union City—three cities in Los Angeles County—La Mirada, Pico Rivera, and South Gate—and one in Contra Costa County—El Cerrito. Now, at this point, we should issue two clarifications about the sales tax. First, who exactly is responsible for paying it? And second, what items are subject to it? Contrary to what you might expect, the sales tax is actually not imposed on consumers, but on retailers themselves. As a condition for conducting business in California, retailers are required to remit a certain proportion of their taxable revenue to the state—specifically, 7.5 percent. It’s an amount that stores have traditionally passed on to their customers and is outlined at the end of every paper receipt. Eventually, retailers submit this revenue to the State Board of Equalization, which is responsible for collecting these taxes. So, as consumers, although we cover the sales tax on the store’s behalf, we’re technically one step removed from actually paying it. While the difference between paying sales taxes through a retailer and paying them directly to the state may seem trivial from a buyer’s perspective, this distinction has important consequences for how we obtain goods in California. And it opens up a valuable opportunity for us to talk about the “use” portion of California’s sales and use tax. Unlike the sales tax, which is imposed on retailers, the use tax is imposed on consumers, and it’s intended to cover purchases that aren’t made through conventional channels—like private sellers and retailers that aren’t registered in the state. For example, if you’ve ever bought anything from a website or catalog based somewhere outside California, you may not have been required to pay sales tax during your transaction. And if you’re like me, you may even have considered these occasions to be “freebies”—small bonuses for being a savvy shopper. But unfortunately, taxable goods are not rendered tax-exempt simply by virtue of their origin. Instead, we’re on the hook for paying whatever taxes we would have incurred if we’d bought them locally. In that case, we can either submit this amount directly to the State Board of Equalization or include it on next year’s tax returns. In addition to online shopping, another large category covered by the use tax is auto sales— specifically, private resale of used cars. If you’ve ever bought a car from someone other than an auto dealer, then in course of registering with the DMV, you probably had to pay a tax on your purchase price—the use tax—equivalent to whatever you would have paid in sales taxes if you’d bought from a dealer. And on a related note, even if you’ve only done business with auto dealers before, you might have noticed that the sales tax on your new sedan isn’t necessarily the same tax applied to

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“OF SALES & SIN” (PART 1) – SALES TAX

other items sold in the dealership’s locale. Instead, much like the use tax, sales taxes on automobiles are based on wherever you intend to use the car—i.e., the jurisdiction where you end up registering it. So, in case you were thinking of buying a car in Kings County, driving it to your home in San Leandro, and pocketing the difference, just know you’re only wasting money on extra gas. Now, as you probably deduced from these examples, the sales tax and the use tax apply to the same goods at the same rates, and they’re only applied interchangeably depending on circumstance— never both at the same time. So, in theory, this complementarity should render them fairly easy to administer. The issue, though, is that, unlike the sales tax, the use tax suffers from a severe publicity problem. While we encounter and oblige by the sales tax every day—every time we buy something in a store or restaurant—most Californians aren’t even aware that the use tax exists, and even fewer understand how to comply with it properly. It’s a cumbersome process that requires consumers either to calculate the tax themselves from each purchase individually and send it to the state through a process separate from the actual sale or to keep a meticulous catalogue of all these purchases over a twelve-month period and include them in their personal tax returns the following year. Frankly, it sounds like a lot more trouble than it’s worth, and it seems that most Californians tend to feel this way. Because of the system’s added effort and generally poor understanding, some estimates say there may be as much as a billion dollars in public revenue from the use tax that goes uncollected every year—which would be at least a twenty percent increase in its current size. The question you’re probably asking then is why the state doesn’t just develop a system for collecting the use tax automatically, the way it does with the sales tax? Well, the frustrating reality is that this issue is largely beyond the control of individual states, including California. The Commerce Clause of the U.S. Constitution grants the federal government exclusive jurisdiction over interstate commerce, and according to the Supreme Court, that includes the collection of taxes across state lines. So legally, California cannot impose taxes on retailers that don’t have a physical presence in the state. A few years ago, the U.S. Congress sought to ease these restrictions and grant states more flexibility in this area, but the issue has since atrophied on Capitol Hill. And until Congress decides to confront this dilemma again, it leaves California with little recourse but to bolster awareness efforts and hope this spurs greater compliance. So, now that we’ve covered the question of “who”—as in, who pays?—let’s talk about the “what”. By definition, all tangible goods sold in California—or sold for use in California—are subject to the sales and use tax. So, for the most part, anything you can buy in a store and hold in your hand is eligible for taxation under state law. Over time, however, lawmakers have singled out specific products to be explicitly tax-free, including groceries, utilities, and prescription medicine. There are over 70 specific exemptions listed by the State Board of Equalization, but most of these tend to fall into a few broad categories, like personal necessities, business inputs, and items sold for the benefit of certain charities and causes. The way the law is written, though, lends itself to some interesting divergences in what ends up being taxed and what doesn’t. Because California exempts what it calls “food for home consumption,” groceries are not subject to sales tax, but prepared foods—like salads, sandwiches,

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“OF SALES & SIN” (PART 1) – SALES TAX

and freshly brewed coffee—usually are, even if they’re purchased in the same grocery store. I say “usually” because some prepared foods could be tax-exempt, under the right circumstances, but such a determination is rarely clear-cut. For example, hot foods are always taxable—no matter what—and foods eaten inside a store or restaurant are always taxable—no matter what. But cold foods taken to-go are not taxable—that is, unless they’re purchased in combination with some other item that is taxable, in which case the cold portion of the meal gets taxed, too. Don’t try to memorize the particulars of this delicate, labyrinthine arrangement. The bottom line is that it’s complicated, and anyone attempting to decipher California’s arcane sales tax law should be ready to confront this type of complexity. As we saw in the introduction, California’s tax on tangible goods also creates an implicit exception for digital goods like e-books, music files, and streaming video, but this is less of a conscious policy decision than it is a consequence of history. Most of the laws surrounding California’s sales and use tax were developed decades before the advent of the Internet, so the notion that Californians would pay sales tax on anything they couldn’t see and feel would have been inconceivable at the time. Even today, the idea of taxing something we’ve gotten for free for so long probably feels foreign to us. But over time, as weight of our economy and the bulk of our spending continue to shift to the cloud, we’ll begin to see our consumption of physical and digital goods as simply two sides of the same coin. And when that happens, the legal distinction we’ve created between these two will appear increasingly arbitrary, inexplicable, and, in my estimation, untenable. Sooner or later, we’ll be forced to confront this issue head-on. But the greatest question that remains unresolved in this area may be how California’s sales and use tax can—or should—be extended to include services. As our disposable income has gradually increased over time, Californians have spent a greater and greater share of their earnings on service providers—people like attorneys & accountants, doctors & dentists, mechanics, hairdressers, gardeners, carpet cleaners, and tattoo artists. Again, it probably feels unintuitive to pay sales tax on something that doesn’t physically change hands. But, as with digital content, the legal separation between tangible goods and intangible services is as much an accident of history as it is a case of conscious neglect. At the time our laws on consumption taxes were written, Californians simply didn’t have the money to afford these types of services, so for all but the most affluent consumers, service providers like tailors, lawyers, and landscapers simply weren’t on the economic menu. Fortunately, things are different today, and most of us can afford at least some measure of personal service from each of these occupations. But this positive development in our general wellbeing has also opened up a thorny new debate in our conversations on public finance. As our share of spending on things like digital content and professional services goes up, our spending on tangible goods goes down by comparison, and this process creates an increasingly narrow slice of our economy that’s actually taxable. What this means is that as lawmakers are confronted with a shrinking tax base, they’re obliged to raise rates just to generate the same amount of revenue they had before—revenue that supports public services we all use and value, like education and public safety. Even the most cynical political observers can admit, that’s not

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“OF SALES & SIN” (PART 1) – SALES TAX

necessarily malice or incompetence on the part of our elected leaders; it’s just math. Now, it may come to pass that we, as a society, agree to this arrangement—taxing tangible goods at higher and higher rates rather than face the possibility of adding any additional tolls to intangible goods and services. But we should recognize the tradeoff in this decision, and that bring us to the social implications of the sales and use tax. Like most consumption taxes, the sales and use tax is naturally regressive, which means it tends to fall harder on lower-income Californians than it does on those higher up the economic ladder. Now, at this point, you may reasonably ask how it is that a tax applied at the same rate to everyone could have a disproportionate impact on one group or another. Well, the reality is that lower-income taxpayers—in California and elsewhere—spend a much greater portion of their income on tangible goods. That’s because, when you’re living paycheck-to-paycheck—or close to it—most of that money goes toward buying the bare necessities, and most bare necessities—like food, shelter, and clothing—tend to take a physical form. By comparison, professional services and digital content can be a relative luxury or, at most, a rare indulgence. As a result, a much greater share of spending by low-income residents is inherently subject to the sales tax. Lawmakers have attempted to mend this discrepancy by introducing some measure of progressivity into the system, which is where most of our exemptions come from. But in the long run, it may be impossible to close this gap entirely without rethinking our approach to how we tax the things we consume. And it’s worth keeping in mind that incorporating digital content and professional services would substantially broaden our tax base, extending well beyond the tangible goods we’ve relied on for so long. In theory, this would allow lawmakers to generate the same amount of revenue while actually lowering the rate on everything bought and sold in our economy. So it’s not only lower-income Californians who stand to benefit from a sensible change in tax policy—truly, it’s all of us. … That’s our show for this week. Thank you for joining me on the first entry in our series on California’s consumption taxes. In the coming weeks, we’ll also be looking at taxes on tobacco, alcohol, and gasoline. We won’t cover them all in a row—even a wonk like me can only take so much public finance at one time—but they’ll be out there eventually, and I hope you’ll tune in to hear them. If you haven’t done so already, remember you can subscribe to the show using your favorite podcast service, including iTunes, Soundcloud, and Stitcher, and keep the conversation going on social media by liking our page at Facebook.com/politicalpod and following us on Twitter and Instagram at @politicalpod. For everything else, you can explore the show in depth anytime at your leisure by visiting politicalpod.org. Thanks for tuning in, and I’ll see you next time.

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