A Policymaking Primer on Digital Taxation

Crafting clear, fair rules for taxing sales of digital products is tricky business, as state legislators and policymakers in Washington and other states can attest. These laws and rules are crucial to get right given that state and local government budgets depend on revenue generated by sales taxes, income taxes, and property taxes—and given the growing embrace of income and property tax relief efforts.

The National Conference of State Legislatures (NCSL) Taxation of Digital Products report equips state legislators with an overview of the issues that arise with legislation on digital taxes. The detailed document examines current methods of taxing digital products and provides a deep look at the approach used by Streamlined Sales and Use Tax Agreement (SST) members.

While the guidance is directed at state legislators, their staff members, and departments of revenue (DORs), the discussions are illuminating for indirect tax teams. Tax leaders can use the report to help inform their advocacy work with state DORs and other tax policymakers. The NCSL encourages state legislatures to consult with business taxpayer groups when drafting digital taxation rules.

If you're not currently engaging with DORs and/or trade groups to influence tax policymaking, you're not alone: roughly the same portion of respondents to a recent Vertex Community webinar indicated that they are actively or semi-actively engaged in tax policy advocacy (43.8%) as those who reported they have limited capacity to participate in advocacy (44.2%). That said, I encourage tax leaders to get involved—your input can help produce more thoughtful and balanced digital tax rules and rates.

The SST Approach: A Menu of Options

The NCSL analysis supports advocates for the SST's approach, which is used by the organization's 24 members along with some non-member states such as Connecticut and Mississippi. Here are notable features of the SST approach:

• States can choose which digital products to tax from a menu of options
• By default, the tax only applies to downloads unless the law specifically states it covers streaming services where access ends when subscriptions expire
• Prewritten computer software is treated separately from other digital products
• States cannot classify digital products as "tangible personal property;" instead, they must pass specific legislation to do so

How Other States Define Digital Products

Other states have created their own methods of taxing digital products:

• Maryland favors a broader approach, defining "digital product" as "a product that is obtained electronically by the buyer or delivered by means other than tangible storage media," which includes "a sale, subscription, or license to access content online."
• New Mexico treats digital goods as intangible property, yet defines these goods, somewhat vaguely, as "a digital product delivered electronically, including software, music, photography, video, reading material, applications, and ringtones."
• Colorado has embraced a more restrictive approach, defining digital products as "any item of tangible personal property that is delivered or stored by digital means, including but not limited to video, music, or electronic books." (This definition, the report notes, has led to litigation, with a court ruling it did not apply to video streaming services.)

The report advocates for the SST approach, emphasizing that clarity is essential when expanding sales tax to digital products. The NCSL also points out that unclear laws create risks for sellers who might collect too much tax (giving rise to customer experience issues or even consumer lawsuits) or too little tax (giving rise to audit risks).

Striking an optimal balance between state revenue needs and business complexities (e.g., the bundling of digital products and services) is not easy. As Vertex Chief Economist and Senior Tax Policy Director George L. Salis points out, the Internet Tax Freedom Act and bundled digital offerings also require careful consideration.