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Tuesday, May 15, 2007

Bringing Sales & Use Tax into the Modern Era

Back in the Depression (the late 1920's), many states added the sales tax to their array of taxes. This was soon followed by the use tax to ensure that when people bought taxable items (even from out-of-state), the sales tax would be paid. In the following decades, as mail order sales grew, the use tax caught more attention from both state and federal legislatures, because it wasn't being collected on many mail order (catalog) sales. This is because if the seller was not located in a state, it was not required to register to collect sales tax. Instead, the buyer, was required to self-assess and pay the use tax (at the same rate as the sales tax). As you can guess, much of this use tax wasn't (and today still isn't) collected.

Congress started studied this back in the 1960s when it reviewed a variety of state tax issues in the famous "Willis Commission" report (Congressman Willis of Louisiana chaired the Special Subcommittee on State Taxation of Interstate Commerce that generated the lengthy report). The report is dated June 30, 1965, 89th Cong, 1st Session. As noted back in 1965 (!) for the sales and use tax: "If the seller is beyond the jurisdiction of the State or otherwise does not collect the tax, the sale is likely to end up tax free. For local businessmen, this raises the specter of competitive disadvantage; for the States it means a loss of revenue." (89th Cong. House Rpt. No. 565, p. 879) In 1992, the U.S. Supreme Court confirmed that indeed, a seller had to have a physical presence in a state before a state could require the seller to collect sales tax. This is the Quill case (504 US 298). So, if you have ever wondered why something you purchased via mail order or the Internet did not have sales tax included, when you certainly would have paid sales tax if you'd gone to your local store to buy the item, this is why - the seller does not have a physical presence in your state and thus is not under the jurisdiction of the state to be required to collect sales tax. However, you, the buyer, still owe use tax. Many buyers (both individuals and some small businesses) don't know this. Thus, much of this tax goes uncollected.

Difficulty in collecting the use tax was just one of the problems Congress found in 1965 with the sales tax. Another one that continues to this day is the complexity for sellers with a physical presence in many states who must deal with the differing sales tax rules among the states and even with the differing rules and rates of local jurisdictions within the states. Today, some states have adopted uniform rules (the Streamlined Sales & Use Tax Act), but not many (California has not adopted this uniform act - that is the topic for another blog entry).

Basically, a few changes are needed to modernize the sales tax, particularly in California (some other states have already taken measures). Here is a brief overview to two possible changes (while the following may not look brief, given the complexity of some of the items involved, it is):

1. Broaden the tax base to include more than just tangible personal property. California, relative to several other states such as South Dakota, Minnesota and New Mexico, taxes very few services and no intangible items such as digital downloads. Adding services consumed by individuals, such as lawn care, hairdressing, legal, and child care, would broaden the tax base. This should allow for a reduction in the rate as well. This would make the law more fair in that more types of consumption would be subject to tax. Sales tax is viewed as regressive in that it usually represents a higher percentage of a lower income individual's expenditures relative to a high income individual. When consumption items that are more likely to be made by higher income individuals are exempt (such as personal services and digital download items), the regressivity (and perceived unfairness) increases. Of course, taxpayers and the businesses that would have to start collecting sales tax, will balk, but many other states tax these services and financial assistance can be provided by the state to help businesses comply.

Digital downloads are another consumption item missing from the California tax base. A few states have expanded their sales tax base to add these items which are the digital equivalent of tangible items that are subject to sales tax. For example, in mid-2006, New Jersey added these items. A few other states have also done so or are considering it. Again, taxpayers will likely not be happy. An argument in favor of taxing the downloads is to preserve the tax base as the items (such as songs) would have been subject to tax if purchased in tangible form (a CD). With a growing amount of tangible consumption becoming digital consumption, the state and local sales tax collections will shrink and they will need to find other sources of revenue, such as raising sales tax rates. Also, whether tangible or digital, consumption occurs and should be subject to sales and use tax. Some people will point to use of technology as a way to reduce the complexity of collecting the tax. For example, when your credit card is charged for an iTunes, it could also be charged at the same time by the tax collector or iTunes could collect it from you (as other retailers do) and send it to the tax collecting agency. Arguments sometimes raised against expanding the sales tax base include complexity for buyers and sellers. Some also argue that the government has no need to collect tax from the digital transaction as it is completed without any cost to the government (a questionable statement and perspective). And of course, some will argue that government spending should just be reduced. But, allowing a tax to be inequitably applied is not a way to effectively and fairly reduce government spending.

2. Find a more efficient way to collect use tax. As noted earlier, many people just don't know about the use tax (even when the state personal income tax form includes a line for it), so it doesn't get collected. Consumers will argue that it is too difficult to keep records of all of their taxable purchases for which sales tax was not collected by the seller. But, there are solutions, such as the following:
a. Do what Maine does and allow individuals to either keep records to calculate their use tax or to use a table that uses their income to estimate what their use tax liabiltiy likely is. The tax is then reported and paid through the state income tax form.

b. Use technology to collect the tax. For example, the CA Board of Equalization, could compensate online vendors to include a mechanism on their websites that when a customer's credit card is charged for the taxable items, it is also charged for the sales and use tax which is immediately collected by the tax agency. Of course, for this to work, states would have to engage in a publicity campaign to educate consumers about the use tax. For goods that are physically shipped, the vendor knows the address of the buyer. For digital items, the vendor could use the credit card billing address, but some folks might use an address in a state without a sales tax. But, there are other ways to find the location of the buyer (other tax records, credit card records, etc.).

c. Eliminate the sales and use tax altogether and replace it with a different tax - a subject for another day for this blog. (I think today, many would prefer to keep a tax like the sales tax because it taxes consumption rather than income, but there are other forms for a consumption tax besides a sales tax. For example, most of the rest of the world uses a value-added tax (VAT) although usually also at the national level, not just the subnational level.)

So, in summary, the California sales and use tax could be modernized by expanding the tax base to cover more types of consumption (services and digital goods). Also, technology and other ideas could be used to improve use tax collection. These measures would be more equitable (fair) than finding revenue by just increasing the already high rate on the sales tax. It would also make the sales tax more neutral so that a decision to buy something digitally or in tangible form wasn't driven by the tax law. It would also recognize that the world has changed (such as by having digital goods and increased ease of buying from vendors who are not located in your state) and tax systems need to change as well.

Related links:
a. My website on e-commerce tax issues

b. A California tax publication on the use tax

c. Center for Budget & Policy Priorities 2003 report on expanding sales tax to cover more services

d. Federal Tax Administrators data on the services taxed by states

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