Bill Leonard fears his consulting firm's customers would sidestep the governor's proposed sales tax, usually at his expense.

One major client has an office in New York state, where it could hire consultants free of sales tax. Customers in Minnesota could shift work from Leonard's business to their own departments.

"Their decision may be to do it internally, use employees versus using a consultant," said Leonard, whose firm, Charter Solutions, employs 70 people. "[Or] they could do the work outside of the state of Minnesota."

In either case, Leonard would lose business, and the state would get less from the tax.

Gov. Mark Dayton is seeking to collect $2.2 billion in new taxes on sales between companies, but many in the business community say he shouldn't expect to get that much. If approved, the sweeping new levy on business-to-business services will set off a mad dash of firms jockeying to avoid the tax, executives and economists say. Some companies will succeed, cutting into the actual return for Minnesota.

"The revenue will be lower," said Robert Eperjesy, director of state and local tax for Wipfli in Edina. "The governor just proposed a 5.5 to 6.15 percent tax increase to a lot of businesses, and that's going to affect spending."

The governor's office referred questions to the Department of Revenue, which agreed its projections do not take into account the ways business will try to avoid the tax. Other elements of Dayton's plan, however, would help stimulate growth that could replace the revenue lost when firms find ways to deflect the tax, said Susan Von Mosch, assistant commissioner of tax policy for the department.

"There are other provisions within the governor's budget, such as the lower corporate tax rate, that could also spur additional [economic] activity," Von Mosch said.

Different principles at work

Dayton offered a broad defense of his budget proposal Wednesday in his State of the State speech, asserting that his plan would bring fairness to the state's tax system. He did not mention the sales tax or the tax on business-to-business services.

The governor's budget overhaul seeks to erase a $1.1 billion budget deficit, hand homeowners a property-tax rebate and boost funding for education. The plan also has components that the business community supports, such as lower corporate taxes and a lower state sales and use tax rate (5.5 percent, down from 6.875).

To cover the costs of his plan, Dayton proposes to raise income taxes on the wealthy and dramatically expand the sales tax base to include a wide range of services. "No one likes paying more taxes, even when necessary to make them fair," Dayton said during his speech Wednesday.

Most economists view broadening the base to include more consumer services as good tax policy. A sales tax applied to business purchases of services, however, is a concept that some states have flirted with over the years but few have implemented.

"He's doing two things here, one of which is consistent with tax policy principles and one of which isn't," said Laura Kalambokidis, an economist at the University of Minnesota who specializes in taxation. "He's making a tradeoff."

Only Hawaii, New Mexico and South Dakota collect sales tax on professional services. They've been doing so for decades, and sales tax revenue has become a crucial component of their budgets. The tax is offset, to some degree, by other business-friendly policies. Hawaii and New Mexico have relatively low corporate and property tax rates, while South Dakota has no state income tax.

In 1987, Florida's Legislature extended its sales tax to professional services, including advertising, legal, accounting and construction services. Under a firestorm of criticism led by national advertisers, lawmakers repealed the tax six months later. This week, Republican Ohio Gov. John Kasich waded into the same political waters, proposing a similar expansion of the sales tax in his state.

Dayton's sales tax proposal specifically would hit law firms, marketing outfits, accountants, public relations firms, advertising agencies and IT companies. Media companies like the Star Tribune would be affected, as would small businesses that depend on outside firms for help running their business.

Large vs. small firms

Sid Larson, manager of the Franklin Street Bakery, pays hundreds of thousands of dollars for warehousing, legal, accounting, transportation and other services. He sees no way his company can avoid the tax.

"We're bakers, we're not experts at transportation," Larson said. "We're not lawyers, so we're not going to do that for ourselves, so that 10 grand or whatever we're going to spend on lawyers this year, we're going to get taxed on it."

Tax on businesses tilts the market in favor of large firms that do legal or accounting internally, economists say. Small firms like Franklin Street Bakery, which can't hire staff attorneys or accountants, are put at a disadvantage.

"It reduces economic growth, because you're moving people away from the decisions that are economically most beneficial," Kalambokidis said. "You're favoring companies that are organized in a particular way."

In an ideal world, economic considerations, not taxes, would drive people's decisions, Kalambokidis said. But no existing tax system manages to raise revenue without creating economic distortions.

"There are other principles of tax policy, like raising revenue and fairness and simplicity," she said. "Those are always in tension with one another."

The chief objection to sales taxes on businesses is what economists call tax "pyramiding," the repeated taxation of a good or service through the supply chain, which ends up compounding the costs that get passed along to the consumer.

Take, for example, a loaf of bread, said John Spry, a business and economics professor at the University of St. Thomas. Bakeries and grocery stores spend money on advertising, marketing and information technology, and would have to pay sales tax on each of those services.

"Those things would be baked into the price of bread," Spry said. "It doesn't show up on the receipt, but you're paying it."

Taxing business-to-business services is not a new concept, and it's tempting for state governments because it's a hidden tax, one that consumers believe they're not paying, said John Mikesell, an economist at the University of Indiana who studies taxation. But whether they realize it or not, consumers do end up paying the tax, he said.

"Politicians can say, 'Ah, we're going to put a tax on business, and therefore you people are getting away scot-free,'" Mikesell said. "And it's a lie."

Adam Belz • 612-673-4405