The idea of the state charging a sales tax on a whole range of services, such as auto repairs, dry cleaning and haircuts, was a nonstarter in the late 1980s. Brought up again in recent years, it’s been brushed aside in the legislature session after session — until last spring when Illinois faced a record-breaking budget shortfall of more than $11 billion.
As Gov. Pat Quinn threatened deep cuts to human services, the idea of taxing user services — proposed as part of a multifaceted revenue package — progressed in the Senate, where lawmakers approved a compromise version of a near decade-old plan. But the legislation was never called for a vote in the House, where senators who’ve already put themselves in political peril say it must re-emerge if they’re going to readdress the issue.
The same atmosphere causing several other states to look at more service taxes — a structural deficit and a nasty recession — helped the plan gain momentum last spring. But the idea of an expanded sales tax base is nothing new, and it’s rooted in a fundamental change in the country’s economy.
Since the mid-1970s, the national economy has gone from less than 30 percent service-based to more than 43 percent service-based by 2008, according to Illinois’ Commission on Government Forecasting and Accountability’s Service Taxes 2009 report. Over the same period, Illinois’ service industry went from about 32 percent to almost 50 percent of the state’s gross domestic product.
How the state brings in revenue, proponents say, should mirror the shift from goods to services. “It’s a real basic principle. It’s called math,” says Ralph Martire, executive director of the Center for Tax and Budget Accountability. “Your tax system, if it’s going to work using capitalist economic principals ... means it has to be both stable and responsive. ...You want your taxes to grow where your economy grows.”
Most economists agree that a broad sales tax base is best — in theory anyway. “From the standpoint of an economist ... there’s no difference between consuming a good or a service. ... So, theoretically, there’s no reason to tax one and not the other,” says Fred Giertz, an economist with the Institute of Government and Public Affairs at the University of Illinois. The fact that service taxes are less common than taxes on goods is simply a matter of history and tradition, he adds.
Illinois first instituted a sales tax in 1933, when American consumer spending was primarily goods-based. As manufacturers in the 1970s began outsourcing production of those goods to foreign countries, they became less expensive. “It’s a more modern economy,” says economist Richard Dye, also with the institute. “[We can buy] the same goods out of less of our total budget. ... Then we can have extra money to spend on the health club or the hairdresser.”
That shift has affected state coffers. “Sales tax revenues are growing more slowly than the economy as a whole,” says Mike Klemens, spokesman for the Illinois Department of Revenue. Adjusted for inflation, sales tax revenues have remained virtually flat since 1985 and have been declining steadily since fiscal year 2000. In fiscal year 2008, sales tax revenues were about equivalent to those in the mid-1990s and weren’t too far above where they were in 1985.
“Generally, from a policy standpoint, [the service sector] is one of the places where there’s capacity in the state tax code,” Klemens says, adding that “it’s probably not the panacea that it gets trotted out [to be] all the time.”
The Department of Revenue estimates that service taxes could bring in anywhere from $3.7 billion to $6.5 billion. But those figures include medical and legal services — areas that are often excluded for social reasons and that have strong lobbying organizations. Legal services alone would generate between $307 million and $586 million.
With a tax on 17 of 168 possible service categories, Illinois comes in well below the 56 services taxed by the average state, according to the Commission on Government Forecasting and Accountability’s report. It’s that narrow base that expansion proponents say is hurting Illinois’ sales tax revenue stream. On top of a flat growth rate, Illinois’ sales tax — its second largest single source of income — takes a hit with every economic downturn. As the recession continued to wear on the state’s already poor fiscal condition, sales tax revenues dropped by more than $440 million, or by 6.1 percent, in fiscal year 2009.
But that kind of volatility doesn’t have to happen, Martire says. In theory, the narrower a tax base, the more susceptible that revenue is to an economic downturn.
That idea is propelling sales tax expansion proposals in other states, too, says Sujit CanagaRetna, senior fiscal analyst with the Council on State Governments. “Obviously you have about two or three things going on,” CanagaRetna says. “Right off the bat, you have an economy that’s still recovering from the great recession. ... Not only did the pie shrink, but you also have an environment where this particular source [of revenue] was shrinking even before the recession came upon us.”
It’s that “double whammy” that several states have tried to avoid by expanding the sales tax — not only in this recession but also in the 2001 economic downturn, CanagaRetna says. “Bottom line, more and more states are going to be forced to look at this as a viable strategy just because of the way the economy has changed.”
Some states have incrementally expanded their sales tax bases with success, but others’ plans have failed. Michigan Gov. Jennifer Granholm is now pushing a major expansion along with a lower rate, despite the fact that a similar plan implemented in 2007 was almost immediately repealed. And when then-Illinois Gov. James Thompson proposed service taxes in 1987, Florida constituents were slamming their lawmakers for an expansion that would be repealed before the year’s end.
“It was never taken very seriously. There was a poor reaction from the public,” says Doug Whitley, now president and CEO of the Illinois Chamber of Commerce but then president of the Taxpayers’ Federation of Illinois and chairman of Thompson’s revenue review committee. “[Florida] really took the wind out of the sails in Illinois.”
More recently, Sen. James Meeks, a Chicago Democrat, pushed service taxes as part of a comprehensive tax and education funding reform measure, Senate Bill 750. The “tax swap” legislation features an income tax increase for individuals and corporations, as well as property tax relief. In the original SB 750, 119 service categories would be taxed, ranging from hairdressing to parking garages to massage services. The expanded sales tax would bring in an additional $2.4 billion, according to Center for Tax and Budget Accountability estimates, which placed the entire reform package at about $7.3 billion of additional funds.
While Meeks calls SB 750 the ideal bill for raising revenues, he couldn’t find enough support for it to pass one, let alone both, chambers. And so entered House Bill 174 to the scene last spring. Among other changes, HB 174 reduced the number of taxable service categories to 39. Projected revenue increases were $500 million to $720 million from the sales tax, out of more than $5 billion in overall increased revenues, according to Martire’s organization.
“[We] scaled it back because the more services you tax, the more people you have here complaining about the fact that they’re being taxed. So we picked the ones we thought people could most support,” Meeks says. “At some point, you have to start looking at what you can pass, not necessarily what’s the best, but what you can pass.”
HB 174 did pass, but only in the Senate. “Now the battleground is in the House,” Meeks says. “I don’t expect to bring it up again until after it passes the House.”
House sponsor Rep. David Miller, a Lynwood Democrat, says that lawmakers attempted to limit HB 174 to include only luxury-type services, such as dating services, pet grooming and tanning parlors. But part of the problem in trying to expand the sales tax is that some services are unintentionally included, he says.
“There’s certain coding, so if you would say, for instance, hair care, then it may have included all aspects of hair care as opposed to some high-end type procedure to be done,” Miller says. “The attempt may have been to consolidate, but actually if that bill is going to move any further, some of the coding issues it was going to tax include industries and services that it was not intended to.”
Those unintentional consequences are part of why the National Federation of Independent Business in Illinois opposes the idea. “[With HB 174] Senate Demo-crats said they tried to look at what they called luxury items, but included in that are ... bowling … laundry. ... It’s not really going after the people who have the ability to pay,” says Kim Clarke Maisch, director of the organization.
“We are adamantly opposed,” she says. “The service tax is one of the few areas where Illinois has a lower tax burden than our neighboring states.”
A service tax might not drive repair shops or movie theaters across state lines, but other types of businesses such as financial trading might respond to a greater tax burden by changing location, Whitley says. “Business services are highly transferable.” And many of those businesses are in Chicago, where sales taxes are already the highest in the nation.
Often, though, the broader-base strategy is paired with lower tax rates, which mean less government influence on consumer choice, U of I economist Dye says. “The higher the rate of a tax, the more there’s a distortion — a higher tax on one item rather than another puts a price on choice.”
But taxing services that weren’t taxed before still means higher costs to consumers for those services, and sales taxes are regressive, Clarke Maisch says. She suggests a situation of a middle- or low-income Illinoisan in need of car repairs. “Labor is usually the most expensive part. [With a service tax] there is a significant increase to consumers, and it’s the small business owner who’s at the front line who has to explain why their service [cost] just went up.” HB 174 does not include a tax on automotive repair, although its predecessor, SB 750, did.
For businesses that use other services to produce an end product, a common concern is pyramiding, a layering of taxes eventually passed on to consumers. “I know that that was one of their intentions on [HB] 174,” Clarke Maisch says about lawmakers’ attempt to remove business- to-business services from the proposed legislation. “It’s almost impossible to achieve because ... it might say something innocuous, but when you drill down, there are hundreds of services under those codes. ... It’s hard to say with 100 percent certainty that we don’t have any business-to-business transactions.”
Martire insists that pyramiding would not happen under the proposed legislation. “The only thing we propose taxing is final services to consumers,’’ Martire says. He says a business might be that final consumer in some instances, but those incidents would be similar to a company purchasing software off a shelf.
Regardless, service taxes worry businesses. Eighty-two percent of Illinois’ National Federation of Independent Business members opposed service taxes in a poll taken early last year. Lawmakers often cite that kind of strong opposition as a reason why an expansion hasn’t passed. “You have a lot of strong lobbying for those services that don’t want to be taxed,” Meeks says.
Upcoming elections can also influence a lawmaker’s decision. “If you decide to make a political point of pointing them out, you have hundreds of examples [of a tax increase] ... with one ‘yes’ vote,” says Todd Maisch, vice president of government affairs for the Illinois Chamber of Commerce.
“Political marketing often trumps tax philosophy and tax policy,” says Whitley, whose organization opposes service taxes. He adds that any broad-based, low- rate and uniform policy may appear sound, but its merits are easily eroded over time by exemptions and credits. It may be a great concept, he says, but “being able to have the political will and fortitude to protect that philosophy is another matter.”
Taxing districts: Illinois has more than any other state
By a wide margin, Illinois tops the nation in the number of local governments within its borders. While some elected officials call for consolidation and more efficiency, others insist Illinois’ current system allows for a more democratic and accountable set of governments.
With 6,994 local taxing bodies under its umbrella, Illinois outpaces Pennsylvania, which ranks second among the states for the most local governing entities, by more than 2,100 local governments, according to the U.S. Census Bureau.
Illinois’ large number of taxing districts is a huge problem, proponents of government consolidation say.
“The bottom line is, with America in its deepest economic trouble since the Great Depression and taxpayer anger at an all-time high, we have got to rein in these rogue taxing bodies and pare down the government, not only to save money but to provide more coordinated, or better coordinated, systems of government,” Sen. Kirk Dillard says. During his 2010 run for governor, the Hinsdale Republican proposed establishing a panel to recommend ways to consolidate Illinois’ local government structure.
This spring, Marengo Democrat Jack Franks sponsored a bill, which had not been called for a vote as of press time, that would allow for the study of consolidating Illinois’ layered governments. He says tradition contributes to the difficulties of consolidating local governments.
“Change is hard in any organization. Overcoming inertia oftentimes is the most difficult thing to do,” Franks says.
Indeed, townships, one of the most controversial forms of local government, have existed in the United States since the early days of the pilgrims. However, townships weren’t adopted in Illinois until 1850, more than 30 years after statehood, according to Township Officials of Illinois. Now, 85 of Illinois’ 102 counties contain township governments.
“It is the democracy, the basic democ-racy, that our residents enjoy. Our township [residents] can have a direct say in their local government,” says Bryan Smith, executive director of Township Officials of Illinois. “It’s probably the one form of government that if they have a specific need in a community, the township is the best able and equipped to respond to that need.”
Smith says Illinois’ 1,432 townships often provide services, such as offering emergency food and shelter or hosting job fairs, that other government entities aren’t able or don’t want to provide. “Especially with the downturn in the economy, more and more people are turning to their township governments.”
But the bulk of Illinois’ local governments come in the form of 3,249 special districts, which include library, park, fire protection, sanitary sewer and mosquito abatement.
Many of those single-purpose districts formed because of borrowing limits, says Northwestern University law school professor Dawn Clark Netsch, former comptroller and delegate to the 1970 Constitutional Convention, where Illinois’ numerous local governments were a topic of debate.
The 1870 Constitution limited local governments’ debt capacity, but as society progressed and residents required such services as utilities and water treatment, “those debt limits just didn’t keep up with the changing condition,” Netsch says. Municipalities couldn’t borrow enough to pay for new capital expenses without limiting their borrowing power for other established needs, so they asked the Illinois legislature to create special districts with their own taxing power.
The 1970 Constitution sought to change that and allowed for communities to abolish townships by way of referendum.
Netsch says that some units of local government continue to exist because those outside urban boundaries feel that their taxes would otherwise go to programs they don’t need or use, such as services for the poor.
“Many people prefer to live in unincorporated areas,” says Marion Mayor Robert Butler, a 1970 Constitutional Convention delegate who served on the local government committee. “For whatever reason, they like to be more in a rural setting than an urban-type setting. ... You don’t pay city taxes when you’re in an unincorporated area. Sometimes the city tax might be considered onerous to them.”
Boundary issues have also contributed to Illinois’ high number of special districts, Netsch says. A water district or transportation service, for instance, might serve more than just those inside city borders.
Or, a smaller community might be forced to create a new district if it’s too far away from an existing district. “People will set up a sewer district because they are not a part of a city or a village government where city sewer facilities are available,” Butler says.
“[Special districts] do serve a purpose, and there’s no question people would not have these various services if they did not have a district set up,” Butler says, adding that inefficiencies do exist. “When you have layer upon layer of units of government, you’re probably duplicating in some fashion, [and] your costs are going to be higher,” he says.
The Illinois Municipal League remains neutral on the subject of consolidation or elimination of townships and special districts, but says municipalities are sometimes open to the idea. “Cities and counties have both expressed willingness to take on additional functions, but generally speaking [those officials] haven’t wanted to force other units of government to give up their powers,” Larry Frang, league executive director, says. He adds that the local governments he represents already have tight budgets and plenty of responsibilities, which keep them from actively pursuing or encouraging consolidation.
Nancy Krumwiede, president of the Illinois Association of County Officials, says multiple layers of government can cause some residents confusion, but they also allow more people to have a direct say in government.
“There are so many different voices in government that can be heard,” she says. “It’s not just a core group making the decisions.” Krumwiede adds that consolidation in some instances would pose challenges to the people those governments serve if they are forced to travel long distances to meet with officials or acquire services.
While advocates for maintaining particular taxing bodies say they are more democratic, Dillard says they can harbor “dynasties” and “nepotism.”
“The closures haven’t happened, sadly, because of politics,” Dillard says. “The minute we try to consolidate school districts, or even harder yet, get rid of units of local government, people who are generally politically connected are going to come flooding legislators’ offices saying, ‘You can’t do that.’’’
Franks calls many of Illinois’ districts a form of “fiefdom,” while Illinois Policy Institute CEO John Tillman says Illinois’ numerous governments are an avenue ideal for “special insiders,” “deal making” and “favors.” The thousands of governmental units in Illinois create thousands more taxpayer-funded jobs held by people who become advocates “to maintain the status quo.”
Some areas may need townships and special districts, Franks says, but more populous areas sometimes double their efforts when one governmental entity has grown to fully encompass another.
Franks says: “One size does not fit all. But I also know that we need to have this discussion.”
Illinois Issues, May 2010
