Tax or Fee: The Label Could Matter

In a blog post earlier this week, I concluded that whether a payment to government service is classified as a tax or a user fee is sometimes arbitrary and that how the payment is labeled is of secondary importance.   Mike Udell of Ernst and Young, a former staffer on the Joint Committee on Taxation, reminds me, however, that labeling could have real consequences.  Mike raises another example from the health reform legislation – the proposed “fee” on sales of pharmaceutical and medical device products.  If the fee were an excise tax, it would be deductible and not included in the gross revenue of manufacturers of these products.  But as a fee, it is not deductible, so income tax collections from these firms are higher than if they could exclude the payments from taxable income.

Another situation in which classification matters is the example in my blog post of charges by localities for trash collection.  Because the charge I pay is a fee for a service, it is not deductible from federal income taxes.  If, alternatively, I paid for trash removal through an increase in my property tax rate, I could include the extra tax payment in my federal itemized deduction for state and local property taxes.  Note that this disparate treatment provides an incentive for states and localities to fund services through taxes instead of user fees – an instance where a “tax” is a better deal for the local rate-payer.

Of course, in the example Mike gives, Congress could generate additional revenue from the affected industries by setting a higher tax rate instead of by labeling the tax a user fee and thereby including it in the firms’ taxable income.  Or it could decree that this “excise tax” is not deductible from income. 

In the case of these charges on pharmaceuticals and medical equipment manufacturers, the proper classification is clear to me; the firms and their customers are not receiving any service in exchange for the payment so it looks very much like a tax.   But maybe, in the spirit of the Malcolm Baldrige quote in my earlier post, another principle applies.  It is, after all, easy to tell a user fee from a tax. A levy is a “user fee” if Congress says it is.