History and Terminology

This page is intended as background to aid in the review of the issues that arise when we consider a sales tax on digital goods. We begin by clarifying some of the terminology we use on this project, then move on to a brief history of the sales tax and some similarities and differences in how states treat the tax. You can use the links below to jump to a specific section.

State Sales Tax – A brief history

• • • Early Years
    • Mid-20th Century – Federal Restrictions on Sales Taxes
    • Post-Quill Years – State and Federal Initiatives

Sales Taxes – Important Similarities and Differences

• • • Revenue Generated from the Tax
    • Tax Rates Imposed
    • Tax Base

State Sales Tax – Background and Terminology

State sales taxes share a common history and there are many similarities across state sales taxes. But there are also important differences worth noting when reviewing the detailed outline.

NOTE on Terminology: The terms used to describe some types of taxes can be confusing. Therefore, we use the following terms in the following ways:

• • Digital Products – We use this single term to mean digital goods, digital services, or other items.
  • Sales Tax – Often referred to as the “retail sales tax,” and which will be referred to here simply as the “sales tax,” these taxes may vary somewhat in the way they are imposed and the breadth of their base. A few are called “gross receipts taxes,” but they should be distinguished from business activity or true gross receipts taxes, as will be further discussed.
  • Business Activity or True Gross Receipts Taxes – We refer to taxes on gross receipts or gross income that are distinct from typical sales taxes as “business activity taxes” or “true gross receipts taxes.”
  • Excise Tax – The sales tax can also be distinguished from other narrower excise taxes on specific goods and services which may be imposed by states or by local governments.
  • “Seller” and “Sale” – The sales tax is typically imposed on customers but is collected by the person or business making the transaction. Various types of transactions may be subject to the tax. We will generally refer to the person or business collecting the tax as the “seller” and the transaction as the “sale.”

State Sales Tax – a brief history

The history of the sales tax has influenced its development and particular events may have stifled the expansion of the tax base as the economy has changed.

Early Years

Most states adopted their sales tax in the 1930s and ‘40s. Mississippi was the first, converting its true gross receipts tax into a tax with features of a modern retail sales tax in 1932. West Virginia was next, enacting a freestanding retail sales tax in 1933 and also a pure gross receipts tax, the business and occupation tax.[1] The states with broad based sales taxes—Hawaii, New Mexico, South Dakota, and Washington—also enacted those taxes in the 1930s. The latest state to adopt a sales tax was Vermont in 1969.[2]

In general, the 20^th Century saw a trend away from early forms of true gross receipts taxes and toward the sales tax. Most of these sales taxes defined their base to include only sales or transactions involving tangible personal property. To the extent taxes included other items, they typically did so by describing and defining, or “specifically enumerating,” those items. And, over the years, states have generally followed this same specific enumeration approach when expanding their sales tax base, with two exceptions. Florida and Massachusetts attempted to expand their tax to services broadly, but each soon repealed that expansion.[3]

Mid-20th Century – Federal Restrictions on Sales Taxes

State sales taxes long faced both real and potential federal limits, both from interpretations of the federal constitution and from federal statutory law. In the 1960s, the Willis Committee, best known for its study of multistate income taxes after the U.S. Supreme Court’s Ruling in Northwestern States Portland Cement,[4] expanded its work to consider state sales taxes as well.

The Willis Committee proposed sweeping federal reforms and limits, which Congress declined to undertake.[5] But it also noted two specific issues that the states responded to—the lack of a uniform credit against sales tax imposed in one state for taxes already paid in another and the failure of states to accept certificates of other states to support exempt transactions. This led directly to the inclusion of provisions to address these issues in Article V of the Multistate Tax Compact,[6] and to widespread adoption by the states of similar and related provisions.

States may impose sales taxes on sellers although most impose them on the customers. But even these states depend on sellers to collect the tax. Therefore, the ability of states to assert taxing jurisdiction over out-of-state sellers, consistent with the U.S. Constitution, has always been a significant consideration for policymakers in considering what to tax.

The U.S. Supreme Court, in its 1967 ruling in National Bellas Hess,[7] struck down a sales tax on an out-of-state seller. Then, in 1992, the Court upheld that decision in Quill,[8] setting out a physical presence standard for sales tax jurisdiction. This restriction of state tax jurisdiction likely influenced the breadth of the sales tax base.[9]

In addition to these constitutional limits, in 1998, Congress enacted the Internet Tax Freedom Act (ITFA).[10] ITFA had two critical provisions. One imposed a moratorium, now a permanent prohibition, on state taxation of internet access. The other provision, often referred to as the anti-discrimination clause, preempts multiple or discriminatory taxes (not including income taxes) that states might impose on “electronic commerce,” defined to include transactions over the Internet. States seeking to expand their sales tax base to digital products must consider the implications of ITFA, which are further detailed in the outline, below.

Post-Quill Years – State and Federal Initiatives

After Quill, the states undertook a project to simplify state sales taxes, which led to the formation of the Streamlined Sales and Use Tax Agreement (“SSUTA”) in 2000. The MTC was an early and active proponent of the Streamlined effort.[11] Currently, SSUTA has 23 full and 1 associate members.

Also, in the years following Quill, states also began to consider expansion of their sales tax base to digital products. In addition, some states considered, and a handful of states adopted, general business activity taxes including Ohio, Nevada, and Oregon. In part, this may have been to avoid Quill’s physical-presence standard and to include in the tax base a much broader range of activities than the traditional sales tax.

Around this time there was another initiative to impose federal limits on states—the Digital Goods and Services Tax Fairness Act (“DGSTFA”). First introduced in Congress in 2010, it would preempt taxes on digital goods and services unless imposed on “similar” items and would require sales be sourced according to uniform rules—often to destination. The bill, however, failed to provide the destination state with jurisdiction over the seller. The Congressional Budget Office found the bill constituted an “unfunded mandate” and imposed costs on the states in the form of forgone revenues “totaling more than $3 billion in the first full year and at least that amount in each subsequent year.”[12]

Wayfair and Renewed Interest in Digital Products –

In 2018, the Supreme Court in Wayfair[13] overturned Quill and Bellas Hess, allowing states to require that out-of-state sellers with no physical presence in the state collect and pay sales tax. In response, states have now adopted dollar-based thresholds and/or transaction thresholds into law, plus related rules for determining when out-of-state sellers must collect tax on sales into the state. States have also imposed tax collection requirements on intermediaries, including internet marketplaces, for sales made on their platforms.

Even before Wayfair, it was common for states to look at taxing software and certain digital products that are similar to traditional goods or services. Since Wayfair, interest has grown in taxing other digital products, as well. Two states are conducting studies on taxing the digital economy or digital products—New Jersey and Mississippi—reports to be issued this year. In the last few months, a number of states have considered legislation to expand their sales tax base to include digital products.[14] Also, in 2021, Maryland adopted a tax on digital advertising[15] that has received significant attention and is the subject of litigation. Other states have recently considered similar legislation.[16]

Sales Taxes – Important Similarities and Differences

This section provides information about sales taxes that may be useful when reviewing the detailed outline.

Revenue Generated from the Tax

All but five states—Alaska, Delaware, Montana, New Hampshire, and Oregon—have imposed a state-level sales tax. (In Alaska, the tax is imposed only by local governments.) Even these five states (and their local governments) impose narrower excise taxes on certain goods and services—e.g., fuel taxes, tobacco, and alcohol taxes, lodging taxes, and utility taxes.

The share of tax revenue that each state derives from sales tax varies. A 2020 study found that sales taxes provided 32% of all state tax revenue, slightly less than the revenue provided by state personal income taxes, although, in 16 states, sales taxes are the largest source of tax revenues.[18] According to U.S. census data for more recent quarters, total state sales tax revenue for all states was about 30% of total state tax revenue.[18] This slightly lower percentage may be anomalous, or it may be consistent with the slight but steady relative decline in sales tax revenue that has occurred over the last few decades.[19]

Tax Rates Imposed

Sales tax rates also vary between jurisdictions and depend on both the state rate imposed and any local rates that may be included. Today, the highest combined state and local rate is slightly less than 10%, and the lowest is around 5%. The overall trend in rates, however, is upward, with median state rates increasing about one percentage point over the last decade.[20]

Tax Base

As noted above, while some states impose the sales tax on a broad base, others impose it only on sales or transactions involving tangible personal property (however defined) and certain other specifically enumerated items. Therefore, the relative breadth of the tax base (excluding specific excise taxes) varies from state to state and depending on whether it is measured relative to certain consumption data or personal income. One estimate based on personal income shows a variation ranging from 19% (California) to 94% (Hawaii).[21] Because of changes in the economy, one expert estimated that the breadth of the sales tax base across all states has narrowed by as much as 35% since 2000.[22]

Common Exemptions –

Most states have attempted to reduce what is sometimes called sales tax “pyramiding” or “cascading” on business-to-business (“B2B”) transactions by granting exemptions for purchases made for resale or purchases of manufacturing or processing inputs or other business inputs. In some cases, however, imposing tax on B2B transactions may be considered justified where there is no tax imposed on the ultimate consumption.[23] Most states have also attempted to reduce the regressivity of sales taxes. Methods include exempting certain essential purchases, such as food, tax “holidays,” providing credits tied to income, or expanding the tax base to include certain services purchased by higher-income households.[24]

Adaptability (or Lack of It) –

The inability of the state sales taxes to adapt to changes in the economy—reflected in rising tax rates imposed on a narrowing base relative to consumption—is often cited as critical to the tax’s future.[25] Experts have, for decades, noted the failure of sales taxes to keep up with the digital economy, to the point where one noted expert has opined:

“. . .the tax, as it currently functions, is an anachronism that reflects its origins in the Industrial Age nearly 70 years ago; since the [retail sales tax or RST] was created without a firm conceptual basis and “just growed,” it is not surprising that it is defective—or that e-commerce magnifies its defects. But the problem may be deeper than this; even if reformed, the RST may simply not be suitable to serve as the most important source of tax revenue of state and local governments in the twenty-first century.”[26]

Structure and Common Elements –

Sales taxes have a certain structure and common elements, but also some deviations that may affect efforts to develop an approach to taxing digital products.

• • • Legal Imposition of Sales Tax – In most states, the tax is imposed on the customer but must be collected by the seller (or certain intermediaries). A seller who fails to properly collect the tax typically becomes legally obligated to pay it. A minority of states legally impose tax on the seller.
    • Imposition of Use Tax – The sales tax is invariably imposed with a complementary tax called the “compensating use tax,” or “use tax.” This tax is imposed on the customer and may be collected by the seller, or paid directly by the customer. The use tax, which is imposed only on purchases from out-of-state sellers, does not violate the Constitution if it is imposed with an “identifiable and substantially similar tax on intrastate commerce.”[27]
    • Tax Rates – Most but not all state sales taxes are imposed by both state and local governments. The tax rate on a particular transaction will be a combination of the state and any local rates applicable.
    • State Tax Base – Most sales tax laws provide for general imposition of the tax on all sales or transactions involving tangible personal property, but may also include other specifically enumerated items and specific services. A handful of states impose tax on gross receipts or broad categories of transactions.
    • Local Tax Base – In most states that have tax imposed by local governments, the local tax base is identical to the state tax base. But in a handful of states, local government tax bases may not be identical.
    • Separate Statement of the Tax – In most but not all states, the seller must separately state the tax being charged to the customer. In part, this facilitates the customer’s determination of whether use tax is due.
    • Exemptions – As noted above, states typically provide a number of exemptions. Many of these exemptions address B2B transactions to reduce tax pyramiding or address the inherent regressivity of the tax. Others may single out particular industries or activities for tax benefit. There is a wide variation in the types of exemption states offer and even similar exemptions may rely on slightly different defined terms or requirements.
    • Sourcing – Since rates vary by state or local jurisdiction, it is necessary for transactions to be sourced to particular jurisdictions. In the past, sourcing rules varied considerably. Most states today use destination-based sourcing, although there are some exceptions, and sourcing of certain items, like services and digital products, is more complicated than sourcing transactions involving tangible personal property. States that are members of the SSUTA must conform to uniform sourcing rules.
    • Credit for Tax Paid – Customers who may owe use tax in a particular state for items acquired outside the state can claim a credit against that tax for sales or use tax properly collected or paid to another state. State credits, however, may not completely eliminate double taxation. A particular transaction may be subject to two (or more) simultaneous sales tax impositions. In some states, the credit for tax paid may not apply in such cases.
    • Documentation – Sellers and customers must keep proper documentation to show that any exemptions claimed are valid or that tax paid is computed at the proper rate. States typically provide a standard form or certificate for customers to give to sellers, asserting the transaction would meet the exemption criteria, on which the seller can then rely. If the customer fails to qualify, then the use tax may be imposed.
    • Streamlined States – The members of the SSUTA must conform their laws to that agreement. SSUTA imposes requirements involving definitions, imposition, and sourcing. It contains definitions of certain “specified digital products,” “digital audio-visual works,” “digital audio works,” “digital books,” and “computer software.” SSUTA also provides: “Nothing in this section or the definition of “specified digital products” shall limit a state’s right to impose a sales or use tax or exempt from sales or use tax any products or services that are outside the definition of “specified digital products.” See Section 332 of the SSUTA.

 Citations

[1] John L. Mikesell and Sharon N. Kioko, “The Retail Sales Tax in a New Economy,” presented at the Municipal Finance Conference, July 16-17, 2018 (“Mikesell”), p. 3.

[2] Liz Emanuel and Richard Borean, “When Did Your State Adopt Its Sales Tax?,” July 11, 2014 (“Emanuel”).

[3] Hellerstein, Hellerstein & Appleby, State Taxation, Thomson Reuters/Tax & Accounting, 3rd ed. 2001 & Supp. 2022-1, ¶12.05.

[4] 358 U.S. 450.

[5] See Jerome R. Hellerstein, “Federal Legislation on State Taxation of Interstate Commerce: Key Areas of Controversy,” William & Mary Annual Tax Conference, 626 (1966).

[6] Article V provides that purchasers liable for a use tax on tangible personal property are entitled to full credit for the combined amount or amounts of legally imposed sales or use taxes paid with respect to the same property to another state and any subdivision thereof. It further provides that whenever a vendor receives and accepts in good faith from a purchaser a resale or other exemption certificate of a state or subdivision taxing author the seller will be relieved of liability for a sales or use tax with respect to that transaction. See the Compact.

[7] 386 U.S. 753.

[8] 504 U.S. 298.

[9] A number of experts have commented on the influence that the lack of tax jurisdiction over out-of-state sellers had on policy-makers decisions about whether or not to expand the tax base. See, for example, Mikesell, supra FN 1, .

[10] See 47 U.S.C. §151 note.

[11] See MTC Resolution No. 02-01, Improving State Sales Taxes to Achieve Fairness and Simplicity;  Resolution No. 01-10, Resolution Supporting the Proposals and Work of the Streamlined Sales Tax Project; and Resolution No. 00-2, and Resolution in Support of the Streamlined Sales Tax Project; available at https://www.mtc.gov/The-Commission/Policy-Statements-Resolutions.

[12] Congressional Budget Office Cost Estimate H.R. 1860, Digital Goods and Service Tax Fairness Act of 2012, Sept. 14, 2012.

[13] 138 S.Ct. 2080, 585 U.S. __ (2018).

[14] See, for example, Georgia HB 594 and Kansas HB 2230.

[15] Md. Code, Tax-Gen. § 7.5-101 et. seq.

[16] See, for example, Indiana SB 372; Massachusetts bills H. 2894, H. 2928, H. 3081, H. 4042, New York A734, S1124, S302, S4959; and Washington HB 2107.

[17] “How States Raise Their Tax Dollars,” PEW, May 13, 2021.

[18] See information available on the U.S. Census Data website, https://www.census.gov/programs-surveys/stc.html. All state excise taxes generate 13% of total state tax revenues. Common state excise taxes include fuel taxes at around 4% of total taxes and insurance premiums taxes at around 3%. Local governments also impose excise taxes, most notably hotel accommodations and related taxes.

[19] See Vivien Lee and David Wessel, “The history and future of the retail sales tax,” Brookings, July 16, 2018 (“Brookings”).

[20] See John L. Mikesell, “State Retail Sales Taxes in 2018,” Tax Notes State, Sept. 30, 2019, p. 1339.

[21] See Jared Walczak, State Sales Tax Breadth and Reliance, Fiscal Year 2021, May 4, 2022, Tax Foundation.

[22] Id.

[23] See William F. Fox and Leann Luna, “How Broad Should State Sales Tax Bases Be? A Review of the Empirical Literature,” State Tax Notes, Sept. 4, 2006, P. 639.

[24] See, for example, “Who Pays? 6th Edition,” Institute for Taxation and Economic Policy, 2018; and Michael Mazerov, “Expanding Sales Taxation of Services: Options and Issues,” Aug.10, 2009.

[25] See, for example, Brookings, supra FN 17; and Mikesell, supra FN 1.

[26] Charles E. McLure, Jr., “Rethinking State and Local Reliance on the Retail Sales Tax: Should We Fix the Sales Tax or Discard It?,” 2000 BYU Law Rev. 1, Art. 11, Mar. 1, 2000 (“McClure”).

[27] See Associated Industries of Mo. v. Lohman, 511 U.S. 641 (1994).