What are “digital goods” and why are some states trying to tax them?

“Digital goods” are electronically delivered items such as downloadable music, movies or books, downloadable or online games, as well as computer software or online information services.    In order to create additional sources of revenue in this tough economic environment, some states are attempting to impose a new sales or use tax on digital goods. 

Historically, every state with a sales tax imposed that tax on the retail sale of tangible goods; a few states have also taxed limited consumer services (typically those personal services performed in a single location.)  As states search for revenue to solve budget problems, a number of them have considered expanding their tax base to digital goods.  In doing so, the technical and policy issues of taxing the digital world should be carefully considered.   

Do all states tax digital goods?

No.  Forty-five states, the District of Columbia, and Puerto Rico impose a sales tax on tangible personal property.  Less than one-third of those states tax digital goods. 

Why would a state want to impose a new tax on digital goods?

As state budget problems worsen, the search for tax revenue has led a number of revenue departments to recommend taxing the digital world.  This new source of revenue offers the promise of immediate revenue.  Unfortunately, this short sighted approach ignores the real economic and policy issues imbedded in taxing the digital world.  Rather than encourage economic development and job creation, imposing tax on digital products would discriminate against in-state businesses and would cause companies able to locate their digital businesses elsewhere to do so.  Where supporters of these tax increases assert that they favor similar treatment of products regardless of the medium through which such products are sold, the reality is that a broad imposition of tax on digital products and services go far beyond “leveling the playing field” and include a litany of additional tax increases cloaked under the auspices of “fairness.”  In addition, digital goods tax proposals, unless carefully drafted, usually result in tax pyramiding by imposing tax on business purchases and sales. 

Who pays this new tax?

Individual consumers downloading digital goods, as well as, some businesses involved in business-to-business transactions.

How would this impact consumer?

Consumers would be required to pay sales or use tax on all purchases of digital goods.  The tax would be collected when a consumer uses a credit card or other payment mechanism to purchase the item.

How would this impact consumers and businesses?

In-state businesses that sell digital goods would be required to collect the tax from in-state consumers, which creates a compliance burden on those businesses by requiring them to file tax returns and so forth.  Notably, those in-state companies would be put at a competitive disadvantage vis-à-vis out-of-state competitors, the latter of which would not be obligated to collect and remit sales taxes on their sales.  As such in-state consumers looking to increase their purchasing power naturally look to out-of-state sellers that are not required to add on tax to each and every purchase of digital goods.

What are the unintended consequences of taxing digital goods?

A new tax on digital goods indirectly promotes the illegal acquisition or “piracy” of those items.  Since the new tax would effectively increase the price of digital goods, the new tax encourages consumers to look for lower-priced or untaxed items offered by “digital pirates.”  Piracy, in turn, increases the price of digital goods for persons who make legal purchases. 

A new tax on digital goods impedes “green” technologies that significantly reduce the carbon footprint of their tangible counterparts as a result of the elimination of packaging and transportation.