With sales tax revenues down sharply, nexus becomes tool of choice for states
The unprecedented, global, government-enforced economic shutdown is draining the lifeblood of cities and states: sales on sales tax revenue. Sales tax shortfall estimates vary from state to state, but are upwards of $150 billion for fiscal year budgets.
The U.S. economy had been booming until recently, with 2019 GDP hitting $21.4 trillion. The unemployment rate was near a 50-year low in February, and the stock market was hitting record highs. The U.S. consumer was consuming.
Enter COVID-19. Mandatory closures of nonessential businesses have created a full-stop, historic contraction of consumer spending.The impact is staggering, based on the early numbers. Unemployment claims rose by 22 million in April, raising the unemployment rate to 14.7 percent. U.S. consumer spending plunged 7.5 percent in March, according to the Commerce Department, the sharpest monthly drop since 1959. Personal income fell 2 percent, with wages and salaries falling 3.1 percent due to the mass layoffs.
The federal government estimated that GDP shrank at an annual rate of 4.8 percent for the first quarter. Analysts are predicting the GDP will shrink by 40 percent in the current April-June quarter. This drastic drop in consumer spending presents a significant problem for state and local government budgets because general sales taxes comprise nearly 33 percent of general tax revenues.
How will states, who rely heavily on sales tax revenue, make up the shortfall? Many e-commerce and remote retailers are experiencing significantly higher demand for their goods and services because of the social distancing order. While growing fast, it still only represents 11 percent of total retail sales, according to the U.S. Commerce Department. Consumers spent $599.5 billion online in 2019, up 14.4 percent from $523.64 billion in 2018. State governments are eyeing this as a source of revenue.
The most heavily impacted sectors employ 37 million Americans — retail, restaurants, bars, transportation, entertainment (sports, arts and theaters), accommodations and services. These are the exact same industries that supply the bulk of sales tax revenues in the U.S.
Recent estimates project state sales tax revenues dropped by $3 billion in March and will drop by 25 percent in the second quarter. States and cities are desperate. The goods and services that are actually seeing increased demand, such as groceries and digital entertainment, are generally not subject to sales tax.
Seven states in the U.S. don’t impose a state income tax (Alaska, Florida, Nevada, South Dakota, Texas, Washington and Wyoming) and will therefore see an even larger revenue gap. Two other states (New Hampshire and Tennessee) don’t tax earned income, but do tax investment income.
Florida is particularly vulnerable to a reduction in tourism during its peak season and lost $770 million in March . Texas saw a 9.3 percent drop in sales tax revenue in March. Texas is further exposed to the oil industry and the drastic drop in gas demand. Nevada relies on sales tax revenue more than any other state, with general sales taxes representing 55 percent of the state and local own-source general revenue. Nevada has been hit especially hard due to the closure of its vital casino and tourism trade.
Amid stay-at-home mandates, both consumers and brands are shifting their focus to e-commerce. Online transactions through businesses like Amazon, Walmart, Target, eBay, Etsy and other “marketplace” facilitators are still a nascent revenue source of state revenue due to recent legislative changes but are coming into focus as a key tool for the states to make up for lost revenue
Governments are armed with fresh law. South Dakota v. Wayfair, the landmark Supreme Court decision issued on June 21, 2018, ruled that “economic nexus,” with some limitations, is sufficient for a state to enforce its tax regulations on out-of-state, or remote, sellers. The threshold model implemented in South Dakota included a minimum of $100,000 in gross sales or 200 transactions before “economic nexus” was triggered, thereby requiring the business to collect and remit sales tax.
States are implementing Wayfair in various ways. In 43 states, legislation implements the “economic nexus” rules, with some variations. Forty states consider gross sales as the test, while four states consider taxable sales as the pertinent criteria. Thirty-seven states have enacted the $100,000 test on sales, with 26 states implementing both the $100,000 sales or 200 transactions test, and 11 states implementing just the $100,000 sales test.
Realistically, states are poised to aggressively enforce economic nexus laws given the reduction in physical retail. Many audit departments, with the majority of in-state retail businesses shuttered, will shift from auditing local retailers to auditing out-of-state retailers who engage in their state.
The CPA community is stepping up to help retailers avoid potential professional liability. Many retailers are battling to stay alive while others are thriving with an established online presence. Traditional brick-and-mortar companies will be looking to rapidly expand via e-commerce if they want to survive, ensuring they understand economic nexus is critical to their success
State and local audit departments may not engage in aggressive enforcement activities while the COVID-19 pandemic is still occurring. More likely, audit departments will spend the next six months evaluating the best approach to expand their enforcement activities towards remote sellers. Given record losses in sales tax revenue, governments have no choice but to look to the remote sellers for revenue.