This study details state sales taxation of business purchases and its negative implications for overall state tax policy.
his study was prepared by Ernst & Young LLP for the Council On State Taxation (COST) and its affiliate, the State Tax Research Institute (STRI).1 The study details the extensive state sales taxation of business purchases of intermediate goods and services and its negative implications for overall state tax policy. The study also analyzes the interrelationship between the state taxation of business inputs and the historic failure of states to significantly expand their sales and use tax bases to include a broad range of services, including business-to-business services.
Our findings include:
- Sales tax systems vary in structure from state to state, but they share a common characteristic: they differ significantly from a theoretically ideal retail sales tax. A true sales tax on consumption would impose a uniform tax on all goods and services sold to households, but would not tax business purchases of intermediate goods and services.
Business inputs constitute intermediate goods and services because companies either resell these goods and services or utilize the materials, products, machinery and services to produce other goods or services that are sold to households. In the United States, the ideal consumption tax is turned upside down because virtually all state sales tax regimes under-tax household consumption and overtax business inputs.
- Current sales taxes on business inputs violate several tax policy principles (economic growth, efficiency, equity, simplicity and transparency) and cause a number of economic distortions due to tax pyramiding. Pyramiding results when a sales tax is imposed multiple times on the same value of business input purchases at multiple stages in the production and distribution process leading up to a final sale to consumers. With pyramiding, the effective sales tax rate exceeds the statutory rate and varies in hidden and arbitrary ways across different types of consumer purchases.
- While most states strive to reduce pyramiding of their sales tax through specific exemptions, these efforts are far from complete. In fiscal year (FY) 2017, the current sales tax systems imposed $157.4 billion of taxes on business-to-business sales of products, services and equipment representing 41.7% of total state and local sales taxes. Proposals to extend the sales tax to certain services (without exempting business purchases) would magnify the pyramiding problem because of the high percentage of additional sales tax revenue collected on business-to-business sales.
- A state sales tax on business inputs functions as a tax on in-state production. The economic response to such taxes varies depending on the characteristics of the taxpayer. Companies that sell into competitive national markets (e.g., durable goods) are less likely to pass these taxes forward to customers through higher prices. In contrast, companies selling into localized markets (e.g., locally supplied services) are more likely to pass these taxes forward to customers but may still face reduced demand. In either case, economic activity in the state levying the tax on business inputs may be impacted.
- Many states have proposed expansions of their sales tax bases in response to the growth in the overall proportion of services in the US relative to the sales of tangible goods, which was the original focus of state sales tax. However, virtually all of the significant efforts to revamp state sales tax bases to include a wide range of service categories have failed to exempt intermediate services purchased by businesses. Extending sales tax to additional business-to-business sales would exacerbate the economic distortions that already exist in the current system.
There are many reasons for the failure of wide-scale sales tax base expansion initiatives, but the common denominator has been principled opposition to sales base expansion without an adequate exemption for business inputs to avoid the negative economic impact of sales tax base pyramiding.
Please click here to view the press release about this study.