Eroding sales tax revenues: The impact of e-commerce.

• Author: Bruce, Donald
• Position: Fiscal and Economic Indicators

Editor's note: This article was adapted with the permission of the Institute for State Studies, which funded the e-commerce forecast used in this study. The full report, including state-specific data, is available at www.statestudies.org.

A central theme in the debate over the tax treatment of remote sales is the extent to which the inability to tax them has eroded state and local government sales tax collections. Revenue losses from e-commerce generally arise because e-commerce enables a significant increase in remote sales, thereby causing a shift from collecting sales taxes at the point of sale to collecting use taxes for goods used, consumed, or stored in the state. Compliance rates are much higher for sales taxes than for use taxes, and use tax compliance is expected to fall further as a result of e-commerce. Revenue losses are generally the result of tax evasion, not tax avoidance, since the use tax is due even if the sales tax cannot be collected. (1)

This brief extends the authors' earlier report by using updated e-commerce forecasts from Forrester Research, Inc. and more recent data about state and local tax structures. The forecast methodology has not been changed; instead, the authors developed new estimates that are comparable to the earlier forecast. (2) This is especially appropriate since there is little new empirical guidance for many of the underlying assumptions in the earlier estimates. This report contributes to the quantitative estimates of sales tax revenue losses in three ways. First, the effects of e-commerce are placed in the context of general sales tax base trends, since e-commerce is only one of the factors reducing sales tax bases. Second, sales tax revenue losses are estimated through 2011 to provide a forward-looking view of the effects of e-commerce on state tax systems. Third, the authors estimate the increases in sales tax rates that will be necessary to offset declines in sales tax bases.

Sales Tax Trends

Despite varied year-to-year fluctuations in state sales tax bases, the long-term trend has been a decline relative to state personal income. For the average sales-taxing state, the tax base equaled 51.4 percent of the state's personal income in 1979; this proportion had fallen to 42.0 percent by 2000.

The narrowing of sales tax bases is attributable to three major factors. The first is remote sales, including e-commerce, catalog and telephone sales, and cross-state shopping, all of which have expanded rapidly in recent years. The second factor is the shift in consumption patterns toward greater consumption of services and less consumption of goods. Services are much less broadly taxed than goods, meaning the base shrinks relative to the economy as services become more prominent. Third, continued legislated exemptions have narrowed the base in essentially every state. Although some of the recently legislated exemptions (e.g., industrial equipment) are consistent with sound tax policy, they still have the effect of lowering the taxable base.

States have responded to the narrowing tax bases by raising tax rates, though the extent of a direct relationship has not been carefully studied. The median state sales tax rate increased from 3.3 percent in 1970 to 4.0 percent in 1980 and to 5.0 percent in 1990. Fifteen states now have rates at or above 6 percent. The rate increases have allowed states to slightly increase revenues as a percent of GDP since 1986. Local governments in 32 states also are permitted to impose sales taxes, and a pattern of rate increases appears to have occurred at the local level as well. (3)

Estimates of Revenue Losses

To estimate sales tax losses from e-commerce in the context of the broader decrease in sales tax bases, the authors first estimate the trend reduction in sales tax bases that is occurring...