How SCOTUS (sort of) modernized the sales tax
It's still not perfect policy but it's a lot better than it used to be.
Happy Finance Friday! This week is the five-year anniversary of the landmark U.S. Supreme Court decision, South Dakota v. Wayfair. The decision overturned a two-decade-old ruling and paved the way for states and localities to collect taxes on remote sales.
You can read about the revenue impact and ongoing complexities of the sales tax in my Route Fifty public finance newsletter from earlier this week. But in this newsletter, I’m going to look at why this ruling was so incredibly important for states and localities and how SCOTUS (and a South Dakota Senator named Deb Peters) achieved something that states had been trying to do for years.
How sales tax revenue shrank
The first modern sales tax was introduced in Mississippi in 1930 and the practice was adopted by 44 other states over the next few decades. (The five states that didn’t are Alaska, Delaware, Montana, New Hampshire and Oregon but localities in some of these states have enacted their own sales tax.)
The idea behind any tax is to capture a small portion of a particular economic activity that’s occurring in a state or locality. With the sales tax, that activity is commerce.
Pro: The sales tax is less volatile than the income tax, which means it can be easier to forecast accurately from year to year.
Con: It’s regressive, meaning it hurts lower-income earners’ bottom line a lot more than it impacts rich people.
Sales taxes apply to the stuff we buy (goods) and in the mid-19th century, the tax revenue stream did a pretty good job of capturing a portion of consumer spending within a state. But as our economy shifted away from goods and more toward technology and services—things which were difficult to tax—states’ reliance on sales tax revenue shrank.
Read the research: The Retail Sales Tax in a New Economy
This evolution created a rare alliance between right-of-center economists and left-leaning think tanks who said that sales taxes should be expanded to services. Economists argued that taxing services would capture more of the tax base and allow governments to lower their overall tax rate to boot. Those on the left said it was a fairness issue and that taxing services would capture more spending among the wealthy.
But when governments tried to expand to services, powerful lobbies squashed those efforts. Florida in 1987 infamously tried to add services to its tax base, passing an expanded sales tax on advertising, legal, accounting and construction, among other things. The backlash was immediate—major corporations like Coca-Cola and Procter & Gamble revoked or reduced their advertising in the state to protest the tax, while business groups canceled at least 60 conventions there. The tax lasted just six months before it was repealed. A similar Massachusetts law in 1990 extended its then 5% sales tax to nearly 600 additional services, but that lasted less than a year before it was repealed.
So, instead of expanding the sales tax, states raised the rates—making it even more of a burden on the portion of their population who can least afford it.
Who is Deb Peters?
Deb Peters served 14 years in the South Dakota state legislature and was the author of the legislation that eventually made its way to the Supreme Court. The sales tax is the whole ball game in a low-population state like South Dakota that doesn’t have an income tax and Peters had been on a crusade for years to modernize it. Peters testified before Congress multiple times to advocate for a national interstate commerce bill that would allow states to collect taxes on remote sellers. But the majority in Congress wasn’t interested.
“Most people who know me know I’m not a patient person,” she told me in 2016. “I can be a little pushy and if things aren’t going my way, I have a tendency to get very frustrated.”
With the support of the National Conference of State Legislatures (NCSL) and in consultation with the governor and state attorney general, Peters wrote and shepherded through legislation that year allowing South Dakota to collect taxes from online sales. Anticipating a lawsuit, the legislation was written in a way that fast-tracks the case through the courts. Other states made smaller moves at the time (such as state departments of revenue issuing rule changes) and the entire effort was orchestrated to work around Congress and force the online retail industry’s hand.
In less than 24 months, the case was argued before the Supreme Court and the rest was history.
A sales tax makeover
Since that ruling five years ago, two other developments have dramatically changed the landscape for modernizing the sales tax.
Modernizing the sales tax = Making the legislative and technological changes necessary to fulfill its original public policy intention of capturing economic activity.
The pandemic and federal relief spending. With money to spend and nowhere to go, consumers’ online shopping spiked in 2020. Thanks to the Wayfair ruling, states and localities were positioned to capture that economic activity.
AI software. Improvements in Artificial Intelligence have helped taxation compliance software keep up (almost seamlessly) with all the weird complexities and differences in sales taxation across tens of thousands of taxing jurisdictions. According to a recent survey by the firm Avalara, 72% of U.S. and U.K. businesses have invested in technology to help manage the calculation and reporting of online sales tax requirements. Top investments: Accounting solutions (55%) and automated tax compliance software (51%).
The result: The sales tax is more fair and does a better job of capturing spending than it has in decades.
I wouldn’t call it fully modernized. States are expanding the sales tax to cover more services (see: Kentucky, 2022) but efforts are still controversial (see: Utah, 2019, and Maryland, 2020). I would argue, however, that Wayfair plus our rapid shift toward online consumption did make it easier to enact taxes on technology services such as subscriptions and software. The wider tax base also helps governments afford more equitable policy decisions such as exempting groceries, diapers and feminine hygiene products from taxation.
The warning: Nearly half of states have cut income taxes, corporate taxes or both since 2021 which means they will rely more on sales taxes that are still—overall—regressive and don’t capture all economic activity.
While sales tax collections have been strong over the last two years, sales revenue growth was slow or flat in many states in the years leading up to the pandemic. And according to the latest figures, sales tax revenues are back in pre-pandemic form. “[S]tates wishing to transition from income toward consumption taxation will eventually need to reckon with long-standing issues facing the sustainability of state sales taxes,” the NCSL warns.