As legislatures convene across the country, the state of New Mexico is being thrust into an unlikely role as a model for states that are looking to increase revenues by broadening their tax bases. North Carolina and Missouri are just two of the many states expected to consider broadening their sales tax bases this year. Ohio and Texas have gone even further by joining New Mexico in adopting a gross receipts tax. Whether taxing services or goods, effective tax rates under a gross receipts tax regime are dramatically-higher than the stated rate.  In New Mexico, for example, because of the gross receipts tax effective tax rates are one-third or more higher in New Mexico than in other states.

Unlike a sales tax, gross receipts taxes like New Mexico’s are taxes on the “privilege” of doing business in the state. Under New Mexico’s system, the taxable amount for a service producing firm is the gross amount — not net after business expenses — and the tax liability belongs to the business instead of the customer. That is, when an entrepreneur sells her service, she has to pay tax on the entire amount received even though a sizable portion of her receipts may be necessary to cover her costs. The more costs she has relative to her receipts, the more burdensome the GRT. High overhead service providers, such as doctors, have been particularly hard hit by this tax in New Mexico. Goods producing firms get off a little easier in that they deduct the cost of any raw materials from the gross amount.

Unlike New Mexico, Ohio and Texas levy their GRT’s at rates of one percent or less. That is a far cry from New Mexico where rates run as high as 7.8%. Hawaii and South Dakota — the only other states that levy broad-based taxes — do so at rates of only 4.5% and 6 percent respectively (South Dakota does not tax income).

In discussing Ohio’s need for a GRT, Republican Speaker of the House Jon Husted commented, “Ohio needs a business tax with a broad base and a low rate. We have only a few businesses pulling the wagon and a lot of people riding in it. Everybody is going to pull the wagon a little bit, and we’re going to benefit everybody.”

Husted and his colleagues in Ohio (and Texas) would be wise to study New Mexico situation so as to understand the problems inherent in GRT’s and to learn from some New Mexico-specific mistakes. All gross receipts taxes, for example, create the problem of “tax pyramiding.” Pyramiding occurs when one business purchases a taxed good or service from another business. So, taxes build upon one another as the entrepreneur gets her roof fixed, purchases accounting help, legal help and so on.

Even more problematic than tax pyramiding is the perverse incentives created under the GRT. In New Mexico, rather than maintaining the tax at relatively low rates across the board, the tendency has been for politically influential industries to carve out specific exemptions for themselves in order to reduce their tax burden. One recent example was the successful effort by managed care firms to exempt their industry from the gross receipts tax. Simultaneously, the gross receipts tax for fee-for-service firms actually went up.

Similar exemptions have been carved out for groceries, the film industry, aviation, and space travel, just to name a few well-connected or sympathetic interests. In the meantime, gross receipts tax rates have risen statewide by nearly a full point in many places. Now, when businesses consider locating in New Mexico, some sort of gross receipts tax exemption is nearly always negotiated. This behavior skews the marketplace, gives politicians undue influence over business activity, and ultimately makes New Mexico’s economy less efficient.

States that are now considering dramatic broadening of their tax bases should look long and hard at New Mexico’s experience before acting. Perhaps such taxes can be adopted with safeguards to protect against higher rates and special-interest carve-outs, but “tax pyramiding” is nearly unavoidable and remains an economically-unattractive outgrowth of broad-based taxation regimes.

Dr. Messenheimer is a senior fellow with the Rio Grande Foundation, a non-partisan, tax-exempt research and educational organization dedicated to promoting prosperity for New Mexico based on principles of limited government, economic freedom and individual responsibility.

Mr. Gessing is the president of the Rio Grande Foundation, a non-partisan, tax-exempt research and educational organization dedicated to promoting prosperity for New Mexico based on principles of limited government, economic freedom and individual responsibility.