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in a tax system refers to the imposition of a tax on a tax. It typically
happens with taxes imposed on goods or services. For example, in
, if a business purchases equipment,
generally, it will pay sales tax on that equipment. The equipment
(including the sales tax) is one of many costs factored into the price of
the goods that business sells. Assuming the goods sold are subject to
sales tax, in effect, a tax is paid on a tax. The situation expands when
you consider that the company that manufactured the equipment also paid
sales tax on its taxable purchases and factors that into the prices it
charges for its goods.
degree of pyramiding varies from state to state depending on the types of
sales tax exemptions that exist. For example,
exempts purchases for resale. Several
states also exempt purchases for resale as well as some or all equipment
purchased by certain types of businesses or by businesses operating in
certain areas of the state.
Pyramiding violates several principles of good tax policy, as discussed
later in this report. However, it has been part of the
sales and use tax for years, as it has in
other states. It has not been removed from any state most likely because
the states have come to depend on the revenues generated from this
report notes the likely size of the pyramiding problem, why it should be
eliminated as part of any plan to improve and modernize the sales tax, and
possible ways to address this problem.
The California sales and use tax system results in tax pyramiding where
sales tax is paid on sales tax.
Eliminate pyramiding by making business purchases exempt from sales tax.
Effect of Pyramiding
of revenue generated from pyramiding vary.
estimates that somewhere between 15% and
30% of its gross receipts tax revenue is generated from businesses selling
taxable items to other businesses.
In 1984, the U.S. Treasury Department estimated that about 20% of state
sales tax revenue was derived from taxing producer goods.
AB 2218 (2005-2006) which proposed to exempt manufacturing equipment from
sales and use tax was estimated to cost the state about $698 million per
Eliminate Tax Pyramiding from the Sales and Use Tax
for eliminating pyramiding in the sales and use tax include the following.
- Pyramiding is viewed as
economically inefficient and non-neutral. For example, pyramiding
could encourage a business to be more vertically integrated so that it
creates more of its own raw materials, lessening the transaction taxes
it pays on acquired goods and services. Because the ability to
vertically integrate varies among businesses based on their size and
industry, pyramiding is viewed as inequitable (unfair). In addition,
because the amount of inputs needed varies from business to business
and industry to industry, equity is harmed by tax pyramiding.
Inefficiency results from the pricing effect the sales tax has on
business inputs. In addition, the location of a company�s operations
can affect pricing due to varying sales tax rates and exemptions from
state to state.
- Pyramiding makes the
sales tax less transparent. Buyers assume that the stated sales tax on
an invoice (for example, 8.25% in San Jose) is the total sales tax.
Because of pyramiding, the total sales tax imposed on a taxable item
is actually higher.
- One area where the tax
base should be broadened is to include services (discussed in Report
#2a). Many of the problems of taxing services apply to use of services
by businesses. Often when a business obtains services, they are not
provided to benefit operations in a single state. Thus, some type of
allocation among the states of the amount paid is needed which can
cause complications (and perhaps even double-taxation if states do not
use the same allocation formula). In addition, taxation of services
may lead some businesses to hire employees rather than contract for
services in order to avoid the tax. Such a practice prevents the tax
from meeting the principles of neutrality and equity (since it is
likely larger businesses that can avoid the tax in this manner). Thus,
elimination of pyramiding will eliminate the business taxation
problems that can arise in broadening the sales tax base.
- Many states provide
incentives to manufacturers by offering sales tax exemptions on
equipment. Similar proposals have been introduced in
Elimination of pyramiding would eliminate the need to enact narrow
sales tax exemptions in order to attract businesses to the state.
Elimination of pyramiding should be viewed by businesses as a
significant incentive to relocate to or expand in
biggest obstacle to eliminating tax pyramiding is the reality that
generates revenue from the pyramiding that
has always existed in the sales tax. However, other improvements needed to
sales and use tax could generate the
revenue to offset the revenue generated from pyramiding.
challenge is the perception that making businesses exempt from paying
sales tax on purchases will be a significant tax break to businesses.
Elimination of pyramiding will require taxpayer education to illustrate
that those taxes are ultimately really paid by individuals. Also, pointing
out the hidden nature of the sales tax paid by businesses should also
help. For example, while food purchased at the grocery store is exempt
from sales tax in
, this is not really true because
pyramiding results in prices that include sales tax because sales tax was
paid by the companies in the production and distribution chain that
enabled that food to get to the consumers. Elimination of pyramiding would
make the sales tax more transparent.
another challenge is distinguishing between business and personal
expenditures. For large and established companies, this is rarely a
problem. For closely-held corporations and sole proprietorships, it can be
a problem. Some business owners may be inclined to try to call a personal
purchase a business one so as to avoid sales tax. Also, if an asset is
purchased with the intent of multiple use, such as a car or computer owned
by a sole proprietorship, what mechanism will be put in place to be sure
sales tax is charged on the cost attributable to personal use?
ways to move the
sales tax towards a more efficient and
neutral tax � one without pyramiding, include the following.
- Identify industries
where pyramiding is likely to be greatest (data exists on the likely
number of times certain items are taxed in the production process for
Gradually enact exemptions for taxable items purchased by businesses
in these industries.
These changes should be enacted along with changes in broadening the
sales tax base (see Report #2a). Alternatively,
a refundable credit could be provided to businesses based on the value
of taxable purchases. The credit could be increased gradually each
year, again with the revenue offset by base broadening. The credit
approach would likely be simpler because businesses would not need to
redo their sales tax compliance processes. They would still charge
businesses on their taxable sales until such time that the refundable
credit is equal to 100% of the sales tax collected by businesses on
their taxable purchases.
- Completely eliminate
pyramiding at once (rather than gradually) and replace the revenue by
broadening the sales tax base (with a rate reduction, as noted in
Report #2a) enough to offset the revenue. The benefit of this approach
would be simplification as there would be no need to gradually
increase sales tax exemptions or create a new refundable sales tax
credit. Additional advantages would be reduced compliance costs for
businesses that only sell to businesses and reduced administrative
work by the BOE (due to fewer business sales tax returns filed) which
would provide resources for the BOE to help businesses that must start
collecting sales tax due to the expanded base applicable to consumer
purchases. Also, a benefit of eliminating pyramiding all at once
rather than gradually is that the positive impact to businesses would
be very easy to measure and tax savings might be put into new
investment or lower prices. Finally,
would become the only state to
eliminate pyramiding which might lead businesses to start or expand
operations in the state.
- Replace the sales and
use tax with a value-added tax (VAT). VATs are used in all
industrialized countries except the
A VAT is different from a sales tax in
that pyramiding does not exist. For example, under a credit invoice
VAT (commonly used in the EU), businesses pay VAT on all purchases and
collect VAT on all sales. At the end of each reporting period, a
business adds up the VAT paid and collected and remits the excess of
VAT collections over payments to the government. If instead, payments
of VAT exceed VAT collections, the business receives a tax refund from
the government. In addition to eliminating pyramiding, commonly cited
advantages of a VAT over a sales tax include:
- Improved chance of
collection because the VAT is collected at each stage of production
and distribution, rather than just at the final sale to the retail
consumer. Also, under a credit invoice VAT, each purchaser is likely
to demand an invoice from a seller in order to claim a credit for
the VAT paid. This mechanism can be a self-regulating feature of a
credit invoice VAT that is not present with the sales tax.
- Elimination of the
seller's burden to determine and document whether a buyer is exempt
from sales tax. Under a VAT, unless the item transferred is
zero-rated or the seller is exempt, VAT is charged on the sale of
the good or service; it is up to the buyer to obtain a credit if
they are entitled to one.
- Replace the sales tax
with a different form of consumption tax that consumers calculate on
their own (rather than having vendors compute it and collect it). For
example, consumption can be measured annually as:
Income less savings. An advantage of this system is that it
eliminates various problems with the sales tax such as the
difficulties of collecting the use tax from consumers and pyramiding.
However, additional recordkeeping would be needed for individuals to
track savings, borrowings and repayments.
following chart explains how the elimination of pyramiding would satisfy
the principles of good tax policy. The rating in the last column indicates
how elimination of pyramiding would improve the current system.
Application and Analysis
Similarly situated taxpayers should be taxed similarly.
The Center on Budget and
Policy Priorities notes that pyramiding may pose more of a burden
for low-income taxpayers. Items exempt from taxation, such as food
and utilities, actually have sales tax included in the prices due to
pyramiding, yet the items are described to consumers as tax-exempt.
Larger companies are more
likely to be able to vertically integrate to lessen the impact of
pyramiding. However, the ability to engage in vertical integration
can vary from industry to industry.
Taxpayers should know that a tax exists and how and when it is
imposed upon them and others.
Pyramiding hides the true amount of
sales tax on all purchases, including ones labeled as tax-exempt.
For example, most food purchased at the grocery store is
�tax-exempt.� However, the store pays sales tax on its taxable
purchases (although sales for resale are exempt) and factors that
cost into the price of groceries. In addition, manufacturers and
distributors of the food paid sales tax on their taxable purchases
and factored that cost into the prices they charge the grocery
store. Elimination of pyramiding will greatly increase the
transparency of the sales tax because the true amount of the tax
will be the amount indicated on the sales receipt given to the
The tax rules should clearly specify when the tax is to be paid, how
it is to be paid, and how the amount to be paid is to be determined.
Elimination of pyramiding
will result in the elimination of special exemptions that only apply
to business purchases. Such exemptions can sometimes cause problems
for sellers and buyers in determining if a particular exemption
applies. With the elimination of pyramiding, all businesses
purchases will be tax exempt; no special definitional rules would be
A potential problem with
the elimination of pyramiding is that some individuals will attempt
to label some personal purchases as business purchases so the seller
will not charge sales tax. The BOE will need to increase enforcement
efforts to avoid this and the legislature should include harsh
penalties for intentionally misclassifying the purpose of any
+ / -
A tax should be due at a time or in a manner that is most likely to
be convenient for the taxpayer.
Elimination of pyramiding will result in
businesses no longer paying sales and use tax. It will have no
effect on the timing of payment by non-business taxpayers.
The costs to collect a tax should be kept to a minimum for both the
government and taxpayers.
Elimination of pyramiding will remove
sellers from the tax system who only sell to other businesses. This
will reduce the compliance costs of some businesses and
administrative costs of the BOE. Compliance costs for businesses
with taxable sales will also be reduced because when they sell to a
business, there will be no need to obtain a resale certificate or
review the Revenue & Taxation Code to see if the sale is exempt.
The tax law should be simple so that taxpayers can understand the
rules and comply with them correctly and in a cost-efficient manner.
Removal of many taxpayers
from paying a tax and reduction in return filings will make the law
simpler. There will no longer be a need to interpret rules on
exemptions because all sales to businesses would be tax-exempt.
A tax should be structured to minimize non-compliance.�
A concern with exempting
all purchases by businesses is that some individuals will tell
sellers that a personal purchase is really for their business to
avoid sales tax. Additional administrative procedures will be needed
at the BOE to address these situations and new enforcement
mechanisms likely needed in the law. If elimination of pyramiding is
accompanied with a broadened base, all businesses would have to be
registered sales tax collectors (because everything they sell,
unless they only have business customers) would be subject to sales
tax. The broadened base will help to identify more businesses in the
BOE database; but will not be enough to address this problem.
Increased penalties for evading the sales tax would likely help
Appropriate Government Revenues
The tax system should enable the government to determine how much
tax revenue will likely be collected and when.
data on purchases by businesses and consumers is available and
revenues can be estimated. Pyramiding should not have an appreciable
effect on revenue estimation although prices could go down and more
businesses could enter the state. Given the significant revenue
generated today from tax pyramiding, it can only be eliminated with
offsetting tax increases. However, other improvements needed to the
sales and use tax system can provide that revenue and elimination of
pyramiding by making all business purchases tax-exempt, may increase
business activity in the state which would increase other tax
Purpose and Goals
The effect of the tax law on a taxpayer�s decisions as to how to
carry out a particular transaction or whether to engage in a
transaction should be kept to a minimum.
of pyramiding will remove the sales tax from business decisions as
to whether to purchase goods or to manufacture them in-house. The
change should not have any effect on consumer purchase decisions.
Growth and Efficiency
The tax system should not impede or reduce the productive capacity
of the economy.
of pyramiding should make the system more efficient in that tax will
not be charged on a tax.
and Fleenor, Tax Pyramiding: The Economic Consequences of Gross
Receipts Taxes (Dec. 2006), The Tax Foundation; available at http://www.taxfoundation.org/files/sr147.pdf.
Michael, �Expanding Sales Taxation of Services: Options and Issues,� State
Tax Notes, 7/21/03. Also available at http://www.cbpp.org/3-24-03sfp.htm.
Charles, �Sales Tax Exemptions for Business Purchases and Economic
For example, AB 2218 (2005-2006) would exempt manufacturing equipment
from sales and use tax. In its analysis of the bill, the Committee on
Appropriations noted that the revenue loss could be offset with base
broadening. �A more pragmatic approach might be to offset the state
General Fund revenue loss of nearly $700 million annually by
broadening the sales and use tax base to include certain services.�