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State sales taxes on business purchases deemed too high in new study

State sales taxes on business-to-business purchases accounted for 41.7 percent of state and local sales taxes, according to a new study by Ernst & Young.

The study was done on behalf of the Council On State Taxation, or COST, a trade group pushing for lower taxes on businesses, and its affiliated State Tax Research Institute. It contends that the tax on “business inputs” creates “pyramiding” by taxing business-to-business transactions multiple times before final consumption takes place.

“State sales taxes apply to 21 percent of household consumption while taxing all business inputs, which would be exempt under a true consumption tax,” said COST president and executive director Douglas Lindholm in a statement. “These taxes on business inputs have economic consequences, and are not transparent in the total tax imposed on goods purchased by consumers. These issues have presented challenges when states have attempted comprehensive base-expansion legislation due to the proposed inclusion of business purchases in their sales tax bases.”

State and local sales tax collections chart

The comparative percentage of state sales tax collections has remained relatively steady over the past 15 years. State sales tax collections on business inputs (that is, business-to-business purchases) in fiscal year 2003, the first year the study was released, totaled 42. 8 percent of all state and local sales taxes.

Overall state and local sales taxes generated $377 billion in 2017, of which businesses paid $157 billion. At the state level, sales taxes accounted for 29.5 percent of total tax collections. State sales taxation on business inputs differed significantly by state, ranging from 32 percent in both Idaho and Indiana to 60 percent in New Mexico thanks to differences in state economies and sales tax systems.

“Most efforts to revamp the state sales tax bases over the past three decades to tax more services have failed to exempt the intermediate services purchased by businesses, exacerbating the economic distortions already created by state sales tax systems,” stated Andrew Phillips, a principal at Ernst & Young LLP and with EY’s Quantitative Economics and Statistics (QUEST) practice. “These issues are magnified when sales tax is extended to more services without exempting business purchases.”

Many states have been moving to levy taxes on more types of services. Purchases of services accounted for 31 percent of total input purchases by businesses, and several types of services are mainly purchased by businesses, resulting in greater “pyramiding” of taxes, according to the study.

Taxation of business purchases varies according to the kind of business and industry, and there can be other factors such as the general taxability of different types of goods and services, the amount purchased by businesses, and the degree to which goods and services receive specific exemptions. Among the major types of business purchases, those that appear to be taxed the most are:

  • 47 percent of business purchases of utility services are subject to tax;
  • 36 percent of business purchases of information services are subject to tax; and
  • 20 percent of business purchases of manufactured goods are subject to tax

In comparison, the types of purchases that are least commonly taxed when purchased by business are:

  • 2 percent of business purchases of transportation services and construction services; and
  • 1 percent of business purchases of financial services.

The study argues for a different approach to state sales taxes on businesses. "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," said the report. "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."

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