Sales Tax

What Is a Sales Tax?

A sales tax is a consumption tax imposed by the government on the sale of goods and services. A conventional sales tax is levied at the point of sale, collected by the retailer, and passed on to the government. A business is liable for sales taxes in a given jurisdiction if it has a nexus there, which can be a brick-and-mortar location, an employee, an affiliate, or some other presence, depending on the laws in that jurisdiction. 

Understanding Sales Tax

Conventional or retail sales taxes are only charged to the end user of a good or service. Because the majority of goods in modern economies pass through a number of stages of manufacturing, often handled by different entities, a significant amount of documentation is necessary to prove who is ultimately liable for sales tax. For example, say a sheep farmer sells wool to a company that manufactures yarn. To avoid paying the sales tax, the yarn maker must obtain a resale certificate from the government saying that it is not the end user. The yarn maker then sells its product on to a garment maker, which must also obtain a resale certificate. Finally, the garment maker sells fuzzy socks to a retail store, which will charge the customer sales tax along with the price of said socks.

Different jurisdictions charge different sales taxes, which often overlap, as when states, counties, and municipalities each levy their own sales taxes. Sales taxes are closely related to use taxes, which applies to residents who have purchased items from outside their jurisdiction. These are generally set at the same rate as sales taxes but are difficult to enforce, meaning they are in practice only applied to large purchases of tangible goods. An example would be a Georgia resident who purchases a car in Florida; she would be required to pay the local sales tax, as though she had bought it at home.

Whether a business owes sales taxes to a particular government depends on the way that government defines nexus. A nexus is generally defined as a physical presence, but this "presence" is not limited to having an office or a warehouse; having an employee in a state can constitute a nexus, as can having an affiliate, such as a partner website that directs traffic to your business' page in exchange for a share of profits. This scenario is an example of the tensions between ecommerce and sales taxes. For example, New York has passed "Amazon laws" requiring internet retailers such as Amazon.com Inc. (AMZN) to pay sales taxes despite their lack of physical presence in the state.

Excise Taxes

In general, sales taxes take a percentage of the price of goods sold. For example, a state might have a 4% sales tax, a county 2%, and a city 1.5%, so that residents of that city pay 7.5% total. Often, however, certain items are exempt, such as food, or exempt below a certain threshold, such as clothing purchases of less than $200. At the same time, some products carry special taxes, known as excise taxes. "Sin taxes" are a form of excise tax, such as the local excise tax of $1.50 New York City charges per pack of 20 cigarettes on top of the State excise tax of $4.35 per pack of 20 cigarettes.

Value-Added Tax

The U.S. is one of the few developed countries where conventional sales taxes are still used (note that, with limited exceptions, it is not the federal government that charges sales taxes, but the states). In most of the developed world, value-added tax (VAT) schemes have been adopted. These charge a percentage of the value added at every level of production of a good. In the fuzzy sock example above, the yarn maker would pay a percentage of the difference between what they charge for yarn and what they pay for wool; similarly, the garment maker would pay the same percentage on the difference between what they charge for socks and what they pay for yarn. Put differently; this is a tax on the company's gross margins, rather than just the end user.

The main objective of incorporating the VAT is to eliminate tax on tax (i.e., double taxation) which cascades from the manufacturing level to the consumption level. For example, a manufacturer that makes notebooks obtains the raw materials for, say $10 which includes a 10% tax. This means that he pays $1 in tax for $9 worth of materials. In the process of manufacturing the notebook, he adds value to the original materials of $5, for a total value of $10 + $5 = $15. The 10% tax due on the finished good will be $1.50. Under a VAT system, this additional tax can be applied against the previous tax he paid to bring his effective tax rate to $1.50 – $1.00 = $0.50.

The wholesaler purchases the notebook for $15 and sells it to the retailer at a $2.50 markup value for $17.50. The 10% tax on the gross value of the good will be $1.75 which he can apply against the tax on the original cost price from the manufacturer i.e. $15. The wholesaler's effective tax rate will, thus, be $1.75 – $1.50 = $0.25. If the retailer's margin is $1.50, his effective tax rate will be (10% x $19) – $1.75 = $0.15. Total tax that cascades from manufacturer to retailer will be $1 + $0.50 + $0.25 + $0.15 = $1.90.

The U.S. system with no VAT implies that tax is paid on the value of goods and margin at every stage of the production process. This would translate to a higher amount of total taxes paid, which is carried down to the end consumer in the form of higher costs for goods and services.