Closing the Digital Divide in State Taxation: A Consumption Tax Agenda

The unexpected public health crisis and economic downturn caused by the coronavirus outbreak has created intense fiscal challenges for state and local governments. States’ costs have increased dramatically as they struggle to fund unemployment insurance, public healthcare, and other costs associated with the pandemic. At the same time, states face a sharp revenue decline as their two largest tax revenue sources — the general sales tax and personal income tax¹ — generate significantly less than projected because of low consumption and high unemployment. In light of these circumstances, some experts have predicted state budget shortfalls exceeding $555 billion over the next two fiscal years — which could be the largest on record for many states.²

Given most states’ balanced budget requirements, they have limited options to address this shortfall without additional federal support: They can reduce spending or increase taxes. As economists have pointed out, “Large cuts would erode the health and social infrastructure needed to continue [combating] COVID-19, increase an already high level of inequality, and exacerbate the economic downturn.”³ Thus, we and many others believe that now is the time for states to shore up their tax bases and to take targeted measures to increase revenue.⁴ Those efforts should include reforms aimed at effectively taxing digital activities to ensure that their tax bases are robust and fit for the modern economy.

More specifically, states should think about three distinct areas of digital tax reform. First, states that have not already done so should expand their consumption tax bases to digital goods and services. Second, state income taxes should apply to companies that exploit states’ markets only digitally. Finally, state income tax bases should be broadened and administered to ensure that they encompass income generated by digital activities, including revenues derived from digital advertising delivered to in-state audiences. This article, the first in a series, focuses on expanding the consumption tax base.

Despite the benefits of digital taxes, we recognize that they are inadequate on their own to overcome the economic fallout of the COVID-19 pandemic, and that the solutions to this problem are multiple. Thus, this article adds to the ongoing work of Project SAFE (State Action in Fiscal Emergencies),⁵ which provides numerous policy recommendations for states to consider as they work to modify their existing taxing and spending program priorities in response to this crisis.

What Are Digital Taxes and Why Should States Enact Them?

Before discussing the merits of state reform related to taxing digital transactions, it is useful to address some confusion in the area. Specifically, there is an ongoing confusion regarding the term “digital services tax” and its widespread use to describe nearly any type of reform in this area of law. As a consequence, DST proposals can be dismissed out of hand based on concerns that are inapt in a particular context. The reality is that there is no universally accepted definition of a DST, which means different things in different contexts.⁶ In practice, DSTs can refer to a wide variety of tax instruments ranging from a consumption tax to a gross revenue tax that targets specified digital activities.⁷ For purposes of this article series, we use digital taxes as a general term to refer to policies that tax digital companies or transactions on par with the how states tax the companies and transactions of the “old economy.”

With that in mind, there are several reasons that states should ensure that their consumption tax bases encompass digital products and services. First, the digital economy continues to experience unprecedented growth, and the global pandemic — with its stay-at-home orders and social distancing requirements — has only accelerated this trend. States that ignore this shift in how consumption occurs will continue to see revenue losses when they can least afford them. In contrast, states that extend their sales taxes to the wide range of digital activities that occur in the current economy will not only shore up their existing taxes, but may also create a potential new revenue source that they desperately need.

Second, and relatedly, the U.S. sales tax system had not adequately adapted to changes in the economy even before the pandemic. With the economy’s digitalization, consumption has long been shifting from the tangible or physical world to the digital world. Our economy also increasingly relies on the sales of services more than the sale of tangible goods, and cloud computing and other technologies are even transforming many goods into services.⁸ However, the sales tax often exempts many of these service-oriented and digital activities from taxation by limiting the base to purchases of tangible personal property and a relatively short list of enumerated services. By expanding the consumption tax base to digital and non-digital services, states can help minimize tax base erosion and modernize their sales tax systems. The current economic crisis is an opportunity to make these necessary updates to the sales tax system.

Third, properly designed digital taxes can improve the sales tax’s neutrality by reducing the distortionary taxation inherent in the system. Specifically, including digital goods and services in the sales tax base can ensure that both physical and digital consumption are taxed, thereby levelling the playing field between digital and non-digital businesses. With these changes, states can reduce distortions in the market between different types of consumption that frequently result in substantial lost tax revenue, especially given that there is no clear policy justification for discriminating between these different types of economic activities.⁹ Moreover, these base-broadening measures also align with the general goals of the sales tax system to tax consumption.

Finally, despite the digital tax debate, state digital taxes will very likely be enacted at some point. In fact, following the U.S. Supreme Court’s Wayfair ruling,¹⁰ many states have broadened their sales tax bases to online sales, with some even expanding those bases to digital content providers’ activities. From a global perspective, many countries have already expanded their consumption tax systems to digital services and are proposing or enacting digital taxes on the gross revenues of specific digital businesses. Given their significant fiscal challenges and the rapidly expanding digital economy, states should consider broadening their sales tax bases to digital consumption now, rather than waiting, and obtain the benefits from this additional, much-needed revenue source.

The Digital Tax Base

Establishing why states should extend their consumption taxes to digital activities is straightforward, but explaining how is more complicated. In designing and implementing this type of digital tax, several policy considerations and legal restrictions must be explored. One of the first issues for policymakers to consider is how to expand the types of goods and services subject to sales tax in a manner that includes digital transactions. Identifying the types of taxable transactions is difficult for states, given the ongoing evolution of this market and the difficulty of passing legislation in a timely manner. Those challenges have prompted states and some jurisdictions to interpret their existing categories of taxable activities broadly to include digital activities, like the purchase of streaming or cloud-based services.¹¹ Expanding existing law to incorporate new types of transactions is less ideal than having laws that are clearly on point, but we recognize that it may be necessary for states to operate that way in the short term. Legislation takes time to enact, and state revenue authorities are well within their power to clarify how old laws apply to new types of activity.

Over the longer term, however, states should establish new categories of taxable items legislatively instead of trying to fit new transactions into outdated existing categories.¹² The difficulty for states in that regard will be in defining exactly which digital transactions are subject to the consumption tax. Fortunately, states have great models with which to work to start that process. The Streamlined Sales and Use Tax Agreement provides a separate category of potentially taxable activities for “specified digital products,” which encompasses digital goods and services such as electronically transferred digital audiovisual works, digital audio works, and digital books.¹³ This is a good first step, and non-SSUTA states should look to this definition as a starting point.

Unfortunately, despite the tremendous progress that SSUTA has made, the agreement’s approach is not without its shortcomings. SSUTA’s definition of specified digital products excludes many digital activities and allows states to select among enumerated subvarieties of digital goods. SSUTA also does not treat software as a specified digital product, but rather defines it as a separate category and allows states to exempt prewritten software delivered electronically, which further enables member states to vary in how they tax digital activities.¹⁴ This under-inclusiveness and lack of a single unified definition and characterization of taxable digital activities has created a wide divergence in how member states define and tax digital goods, which means that a lot of complexity remains in this area.¹⁵ Given these challenges, further work needs to be done on these issues.

States can also look to the VAT systems imposed worldwide for examples of how to better address digital taxation. Many VAT systems already tax a broad range of services, and many have made progress in taxing digital transactions through various measures, such as explicitly treating digital products as taxable services¹⁶ or introducing electronically supplied services as a separate, broadly defined category of taxable services.¹⁷ For instance, the EU’s definition of electronically supplied services includes “services which are delivered over the internet or an electronic network and the nature of which renders their supply essentially automated and involving minimal human intervention, and impossible to ensure in the absence of information technology.”¹⁸ This definition includes specific examples clarifying that this category of taxable services is broad and encompasses most digitized products, software, and digital services.

Ultimately, we recommend that states continue to work on these issues and move toward more uniform laws regardless of the approach. States should be guided by the retail sales tax’s ultimate objective, which is a broad tax on all retail consumption unless specific exemptions — like those for medicine and groceries — are warranted. The form of transaction, good, or service should not matter. Thus, states should move toward approaches that presumptively tax all consumer transactions in the digital sphere, just like states tax transfers of tangible personal property unless specifically exempted. “The basic principle should continue to be that the substance of the product matters, rather than its form or method of delivery.”¹⁹

At the very least, states should statutorily expand the list of services subject to the sales tax so that it captures both traditional services and a broad range of digital goods and services. Coordinated action would be preferable to states’ current disjointed approaches. And it goes without saying that the same tax rates should apply to these activities as currently apply to tangible personal property. Differential tax rates may not only be prohibited under the Internet Tax Freedom Act, but also undermine the efficiency and equity of the tax system, create arbitrary distinctions between different types of consumption, and undermine the ideal of a broad, neutral tax base. Ultimately, regardless of their approach, as long as states work together to create a uniform definition of goods and services, as SSUTA has sought to do, both taxpayers and tax authorities will likely benefit from a compliance and enforcement standpoint.

Digital Tax Sourcing Issues

Another important consideration in implementing consumption taxes on digital transactions is determining how to source the sale of digital goods or services to the appropriate taxing jurisdiction. Ideally, consumption should be taxed in the jurisdiction where it occurs. To reflect that, most states already use the destination principle for sourcing interstate transactions involving goods.²⁰ Under that principle, the taxing jurisdiction is based on where the goods are delivered rather than where they originate. But even that approach is not conceptually ideal. The jurisdiction that collects the tax is the one where delivery, not consumption, occurs.

Unfortunately, allocating taxing power to the jurisdiction where consumption occurs is impractical, because it would rely on accurate consumer self-reporting. States’ experience with use tax collection demonstrates just how fraught that approach is. States therefore have to rely on tax collection at the point of sale, which means relying on the delivery location to determine the source.

This sourcing issue applies equally to transactions involving digital goods or services. Ensuring that the consumption of those items is taxed in the jurisdiction where they are used can be difficult. But a state’s inability to pinpoint where consumption occurs does not mean that it should revert to origin-based sourcing. Rather, states should generally grant taxing rights to the state where the customer is located. Focusing on the location of the user accessing digital services — rather than the seller’s location — is a better proxy for the place of consumption given the virtual and borderless nature of these digital transactions and the general goals of the sales tax system to tax consumption. States should therefore work toward that end — looking at whether and how their laws characterize these digital transactions and how they are sourced. Under existing laws, some digital transactions might be treated as goods and subject to destination sourcing and others as services subject to other rules. Destination-based sourcing should be the norm.

Of course, adopting this approach means that states need to identify the consumer’s location, and several options exist. The billing address provided by the consumer, the customer’s credit card information, or the internet protocol (IP) address of the device used to download the digital content can be relatively accurate and efficient proxies for the customer’s location. This information may be acquired through the ordering process or automated procedures, which would minimize the burden on suppliers. But states also need to carefully consider ways to reduce manipulation without significantly increasing the burden on sellers. Each of those proxies can be easily manipulated. Taxpayers can use billing addresses that are detached from where a digital product is used, the address used for credit card purposes might similarly be detached from where the digital product is “delivered,” and IP addresses can be changed with ease if one uses a VPN. States should not be paralyzed by these concerns, but they should be aware of them.

Conceptually, another challenge is that the consumption of a digital good or service can easily occur in several different jurisdictions. How should states source purchases of digital goods and services that are used at multiple locations of the customer?²¹ The current sales tax system does not adequately address this issue. States have different approaches, and some do not provide sellers with any guidance. Needless to say, something is better than nothing.

One approach is to source digital transactions to a single location. For example, under the SSUTA, a general sourcing rule that encompasses digital transactions sources sales to the location where the product is received by the purchaser, if known by the seller. Even if digital goods are consumed in multiple jurisdictions, SSUTA often sources the transaction to the location where the purchaser takes possession or first makes use of digital goods.²² However, from a policy standpoint, sourcing a sale of products or services to a single jurisdiction is inappropriate when consumption may concurrently occur in multiple jurisdictions. Doing so fails to grant taxing rights to the jurisdiction of consumption, may result in multiple taxation if states do not adopt a uniform sourcing rule, and is likely to result in manipulation.²³ This is especially problematic for digital activities because they are “highly mobile and purchasers can access them simultaneously from multiple locations.”²⁴ As a result, states need to carefully consider how to allocate the taxing rights to the correct states under these circumstances, and develop a uniform sourcing rule that provides sellers clear guidance as to how to source these transactions to the appropriate place of consumption.

But again, perfect need not be the enemy of good. Taxing the consumption of digital goods and services based on a single-location sourcing rule is preferable to not taxing that consumption at all. States should first seek to expand their tax bases using simple, administrable rules. They should then work together to harmonize their approaches based on best practices. In that vein, working within the SSUTA or with the Multistate Tax Commission would be valuable for states and for taxpayers participating in this market.

One potential approach to address this issue is to shift the obligation to collect the tax to business purchasers rather than the seller. Many countries have adopted that approach for VAT purposes, and this approach was originally adopted — but has since been repealed — by the SSUTA.²⁵ Shifting the compliance obligation in that way better facilitates the accurate apportionment of sales taxes among multiple jurisdictions of consumption because the obligation falls to the party with the requisite knowledge. This may be practical for business consumers, as they already have use tax responsibilities for purchases of tangible goods. It is less practical for individual consumers, so this is not a one-size-fits-all solution. As we know, states received very little revenue from individual use tax remissions, which spawned much of the debate that preceded Wayfair.

This discussion necessarily begs the question whether and when business purchasers should be paying consumption tax on digital inputs at all. Unlike a VAT and its application at each stage of production, a conceptually pure retail sales tax excludes these intermediate transactions from the tax system. Ideally, then, all business purchases would be exempt in one fashion or another. The stark reality, however, is that business purchases currently make up a significant percentage of the state consumption tax base. Absent more fundamental reform, excluding digital purchases would therefore give them a tax-advantaged status as compared with their physical peers. In the short term, states should focus on creating parity between types of consumption. Long term, they should focus on places where they can modify their tax systems to become closer to the ideal across transaction types.

Administrative Issues

In adopting taxes on the consumption of digital goods and services, policymakers also need to address several administrative concerns. Specifically, sound tax policy requires lawmakers to minimize the costs of administering, enforcing, and complying with this new digital tax. In this digital era, compliance and enforcement costs are likely to be significant. The virtual and borderless nature of the digital economy means that more suppliers are likely to be involved in high-volume, low-value cross-jurisdictional online sales. As a result, more suppliers will have to comply with multiple jurisdictions’ divergent sales tax laws, and tax authorities will face an increased enforcement risk in ensuring these numerous suppliers comply with their sales tax obligations.

Developing a solution to this challenge is essential, because even if states do not implement digital taxes, they will nevertheless have to confront these issues. With the Wayfair decision, which allows states to impose tax collection duties on remote sellers on the basis of economic nexus, suppliers are already facing onerous compliance burdens in trying to calculate and remit the appropriate amount of sales tax to the correct taxing jurisdiction. In addition to the lack of clear and consistent state guidelines on taxing digital goods, the lack of uniformity between states’ tax bases, definitions of taxable goods, tax rates, filing procedures, and thresholds for compliance in many cases contributes to these compliance costs. This situation has likely resulted in reduced compliance, lost tax revenues, and increased enforcement risks.

Potential solutions exist to reduce these compliance and enforcement challenges. As a starting point, it is critical that states continue to harmonize their sales tax systems to achieve interstate uniformity in their sales tax bases, definitions of items, sourcing rules, and administrative procedures.²⁶

The SSUTA is a commendable start in seeking to satisfy these goals. But more needs to be done to increase the number of member states; implement a clearly stated, broader, and uniform definition of digital transactions; and provide clear sourcing rules based on the destination principle.²⁷ Minimizing the inconsistencies among states in this manner would improve the simplicity and efficiency of the current system, thereby reducing compliance costs and improving enforcement.

To improve the tax administration of this system, states should increase their coordination and cooperation on these issues. Under the current system, sellers generally must register in states where they have nexus — then calculate, collect, and remit the sales tax to the appropriate taxing jurisdiction while taking into account the different sales tax laws of the numerous jurisdictions where they have customers. But with businesses having customers in multiple jurisdictions in the growing digital economy, the current registration-based system puts additional compliance burdens on suppliers who operate in multiple states. Those compliance burdens can also be particularly onerous for smaller vendors. States should consider whether and how to reduce those burdens by trying to simplify and reduce the number of registrations and sales tax filings that they require of sellers.

For instance, the SSUTA has a streamlined sales tax registration system, which is a centralized registration system that allows sellers to register with any member state by completing a single form. The SSUTA also requires member states to provide sellers the ability to satisfy their sales tax obligations through a simplified return that may be filed electronically using a standardized transmission process. Also, the SSUTA allows sellers to use certified tax calculation software or a certified service provider to help them satisfy their obligations to calculate and remit the numerous sales taxes due. These measures can help simplify the filing process and reduce costs. So at a minimum, states should consider adopting these measures.

Another approach that states could consider would be to adopt measures similar to the registration and clearinghouse system implemented in the European Union through the mini one-stop shop regime.²⁸ Under such a regime, sellers would register in one jurisdiction instead of registering in all jurisdictions where they have customers. Later, in each taxable period, sellers would access a standardized form on the state of registration’s website to report and remit the tax due for sales to customers in all states. The state of registration would then remit the tax to other states according to uniform sourcing rules based on the destination principle.²⁹ Adopting this type of system would benefit businesses by allowing them to not only satisfy the registration requirements of all states by registering in just one state, but also to file sales tax returns and remit sales taxes to just one state. This type of system has experienced considerable success in the European Union and would significantly reduce the complexity and costs of sales tax compliance as well as improve enforcement efforts by states. Enhancing the use of technology can also reduce costs, improve compliance, and allow for more targeted enforcement measures by states.³⁰

Finally, policymakers should minimize any potential legal and constitutional challenges to their digital tax reforms. In particular, states need to remain aware of the Internet Tax Freedom Act, a federal statute that prohibits states from imposing “multiple or discriminatory taxes” on electronic commerce. To address this issue, a state should ensure — as we recommended — that its sales tax base encompasses both the digital and nonelectronic version of a good or service. Doing so would likely eliminate any legal challenge on these grounds while promoting sound tax policy. States should also consider drafting new legislation that clearly encompasses these digital goods and services, rather than attempting to tax digital transactions using existing sales tax categories, which would help minimize litigation and improve the clarity of the tax law.³¹ Moreover, states should put in place appropriate thresholds and take other measures to alleviate the compliance burden on small businesses to reduce the risk of violating the due process and dormant commerce clauses.

Conclusion

Expanding the consumption tax base to digital consumption is a relatively easy way for states to raise essential tax revenue as they cope with the pandemic and its accompanying economic downturn. Although a digital tax is an imperfect solution and requires overcoming some practical and legal issues, implementing one on consumption is better than the alternative of maintaining the status quo. Under the current patchwork of state laws, digital activities either escape taxation or are only partially and inconsistently taxed. This complex system can place onerous burdens on suppliers, results in governments losing out on a growing revenue stream, contributes to discriminatory and multiple taxation, and does not reflect the economic realities of the digital era. Given the current situation and the tough times ahead, it is worthwhile for states to implement digital taxes on consumption now.

The digital tax debate is far from over, and expanding the consumption tax base is just the first step. The wide range of attention being paid to DSTs and their various forms should not detract from this basic point: A broad, neutral, and strong state tax base is one that includes digital transactions.