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States Should Embrace 21st Century Economy by Extending Sales Taxes to Digital Goods and Services


States are losing more and more revenue each year from a failure to require the payment of sales taxes when goods and services are sold and delivered online.  The tax-exempt status in many states of “digital goods and services” — a fast-growing sector of the economy that ranges from movie downloads to online dating services to computer software — costs states well over $300 million per year, and the price tag is rising.  Such implicit tax breaks are inequitable and completely unnecessary, and should be brought to an end.

There is no good reason to exempt digital goods and services whose tangible counterparts are taxed.  Sales taxes do apply to in-store sales of computer software, books, movies, music, and games sold on physical media (paper, CDs, and DVDs) in all 45 states that have sales taxes; many states also tax sales of newspapers, magazines, greeting cards, stock photographs, cable TV, pay-per-view movies, and similar types of information- and entertainment-related goods and services.  Only a minority of states, however, have extended the sales tax to all of these products when they are delivered over the Internet.

In most cases, these tax exemptions exist not for any policy reason but rather because sales tax laws and regulations have not been updated to reflect the Internet age — an oversight that is growing costlier every year.  The failure to tax sales of digital goods and services is particularly problematic when many states are still struggling to bolster their finances after the deepest recession in 75 years slashed state sales and income tax receipts and led to major cuts in education, health care, and other critical services. 

The case for extending state sales taxes to digital goods and many closely related online services is compelling.  Taxing digital goods and services:

  • Would make sales taxes fairer.  The sales tax is intended to be a broad-based tax on household consumption.  People buying digital goods and services are consuming economic resources just as people buying physical goods are, so fairness dictates that they should pay the same amount of tax on each dollar of such spending.  The unfairness of exempting digital products is particularly evident when someone is buying the exact same book or movie and avoids sales tax only because of the technology they use to read or watch it.

    Notes on Terms in This Report

    This report discusses state and local sales taxation of “digital goods and services.”  By this we mean goods and services that are both purchased and delivered over the Internet in digital form.  Of course, computer software, music, and similar items sold on physical disks also exist as 1s and 0s and therefore can reasonably be considered digital goods.  Nonetheless, common parlance in tax policy circles typically uses the term “digital goods” to refer to items that are delivered electronically rather than in physical form, and this report adopts that convention.

    In the interest of readability, this report refers only to state sales taxes.  However, most of the analysis applies equally to local governments’ sales taxes.  If, consistent with the recommendation of this report, states authorize their localities to extend their sales taxes to digital goods and services, states should, to the maximum extent permitted by law, require local tax treatment to mirror the state tax treatment.  This will minimize confusion for consumers and sales tax compliance burdens for sellers.

    Finally — and also in the interest of readability — the report refers only to sales taxes, not to “sales and use taxes.”  Use taxes are the analog of sales taxes that are due on the interstate sale of a taxable good or service.  They are collected by the seller if the seller has a facility and/or employees in the purchaser’s state, but if they are not collected by the seller they must be self- remitted by the purchaser directly to the state revenue department.  References in this report to sales taxes should be understood to encompass complementary use taxes as well.  Most taxable sales of digital goods and services are likely to be interstate sales and therefore subject to use taxes rather than sales taxes.

    Moreover, those avoiding sales tax by buying digital goods are disproportionately upper-income households, since many lower-income households do not have home Internet access (a precondition for consuming information and entertainment in digital form) or, even if they do have Internet access, are less likely to make online purchases.  Sales taxes already consume a larger share of the incomes of lower-income people than those who are better off; exempting digital goods and services forces lower-income households to shoulder an even larger share of sales tax collections.
  • Is necessary to prevent long-term erosion of the sales tax base.  More and more information- and entertainment-oriented products will be delivered over the Internet in digital form as time goes on.  If states do not incorporate these items into their sales tax bases, the tax will be unable to continue financing the share of public services it currently supports.  States will either have to scale back services like education and health care or raise other taxes to compensate.
  • Helps ensure a level playing field for all retailers.  Consumers are shifting from tangible goods and services to their digital equivalents primarily because the latter are more convenient and offer more features.  Still, some of this shift is attributable to the artificial price advantage that the sales tax exemption provides.  States should stop picking winners and losers in this way and let the market determine the relative costs of competing tangible and digital products.
  • Generates needed revenue.  Broadening existing sales taxes to include digital goods and services could make a modest but meaningful contribution to state treasuries, perhaps financing the restoration of some recent service cuts or mitigating additional ones that may still be in the offing in harder-hit states.  The states that are not yet taxing the five major types of digital goods — computer software, movies, music, books, and games — could raise approximately $300 million annually in the aggregate by extending their sales taxes to these items alone.  (This estimate relies on conservative assumptions about how much of the potential revenue sellers would actually collect.)  Tens or hundreds of millions of dollars more could be generated by taxing downloaded goods and services more broadly. 

Taxing digital downloads is not a radical move.  A significant number of state policymakers have accepted the arguments in favor of including at least some digital goods and services in the sales tax base:

  • 33 of the 45 states levying sales taxes, plus the District of Columbia, tax downloaded computer software;
  • 22 of the sales tax states plus the District tax downloaded movies, music, and/or books;
  • Hawaii, New Mexico, and South Dakota tax virtually all digital goods and services, just as they tax most other types of services, while Idaho, Utah, and Washington also have very broad coverage of digital goods and services (extending well beyond software, movies, music, books, and games); and
  • a number of states tax smaller categories of digital goods and services, such as online information databases and electronic greeting cards.

Most of the states that tax digital goods and services do so by listing in statute the types of these products to which the sales tax applies, an approach that most states that begin to tax these items in the future are likely to follow.  The Streamlined Sales and Use Tax Agreement, which more than 20 states have adopted to simplify and harmonize their sales tax codes, provides detailed model language governing taxation of the five major types of digital goods; states that wish to extend their sales taxes to these products should take advantage of this language. 

As states extend their sales taxes to digital goods and services, they should give careful consideration to whether and how to tax these products when one business sells them to another.  Business-to-business sales of digitized movies, books, music, and computer games will almost always be for resale to final consumers, and states need to write their sales tax laws to ensure that such sales are tax exempt in the same way that sales of tangible goods for resale are.  On the other hand, businesses do widely purchase computer software for their own use and states widely tax this software when it is purchased in physical form, so a good argument can be made that it should be taxed when purchased and delivered online.  That said, taxing online computer software raises certain complex administrative and definitional issues — particularly when the software is received as a “cloud computing” service rather than a final purchase of an intact software package.  These issues are currently in flux, and are the subject of state-industry discussions that could lead to model state legislation; for now, states would be well-advised to forgo extending their sales taxes to cloud computing services unilaterally.

Cloud computing issues aside, extending state sales taxes to digital goods and services that households purchase is straightforward and long overdue.  It’s time for the states not yet taxing them to embrace the 21st century economy.