Five years after the Wayfair ruling, states' reliance on the sales tax grows

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Welcome back to Route Fifty’s Public Finance Update! I’m Liz Farmer. Five years ago this week, the U.S. Supreme Court issued one of the most significant rulings for state and local government finance ever. The court’s decision in South Dakota v. Wayfair overturned a two-decade-old ruling and paved the way for states and localities to collect taxes on remote sales.

Calling the old precedent “flawed” and "removed from reality,” the 5-4 decision did away with the notion that governments can only collect sales taxes on purchases made from retailers with a physical presence in the state. In doing so, the court overturned two previous rulings that predated the world of e-commerce and agreed with South Dakota that an economic presence—not a physical one—should be the basis for taxing a sale.

The timing of the 2018 decision was fortuitous, coming just ahead of the pandemic when state sales tax revenues would skyrocket as consumers turned to online shopping amid stay-at-home orders. Thanks to that shift and federal stimulus money, state sales tax revenues jumped by 10% in fiscal 2021 and by nearly 14% in 2022. 

Now, as other types of revenue are slowing significantly, sales taxes are holding steady. According to the latest figures from the Urban Institute, inflation-adjusted state tax revenues fell by nearly 6% through the first 10 months of the 2023 fiscal year. The decrease is entirely driven by falling corporate and personal income tax revenue. Sales tax revenues, on the other hand, inched up by one-tenth of a percent. 

“As consumers have slowly shifted to spending more on services and less on goods, the Wayfair decision has helped states maintain strong levels of sales tax collections,” noted Brian Sigritz, director of state fiscal studies for the National Association of State Budget Officers.

While there’s no way to determine the exact revenue impact of Wayfair, it’s well into the billions. A U.S. Government Accountability Office report last year found that states collected at least $23 billion from remote sellers in 2022. Before the pandemic shopping surge, the 2019 total was just under $7 billion. And before the ruling and most remote sales tax laws took effect, the total was half that amount.

Sovos, a consulting firm that sells sales tax solutions, recently released a report that found a 3.4% increase last year in the number of local jurisdictions that implement a sales tax. In addition, sales tax revenue as a share of state budgets, continues to grow.

“The ability to collect from e-commerce at the precise moment when e-commerce spiked I think changed the way a lot of states look at the sales tax,” said Chuck Maniace, author of the report and the vice president of regulatory analysis and design at Sovos. “To me, that’s why we’re seeing this increased reliance.”

Still a Burden on Businesses

But while states and localities increasingly turn to the sales tax, businesses are struggling to keep pace. 

The ever-evolving updates to sales tax rates and what can be taxed means businesses need to keep track of rate increases, state sales tax holidays, legislation that extends the sales tax to more categories and bills that exempt it from things like groceries or feminine hygiene products. 

Even the same product is treated differently from state-to-state. Pennsylvania, for example, exempts clothing, except for formal apparel, items made from fake fur and athletic apparel, while New York state exempts clothing sold for less than $110. Definitions of products get complicated as well. Some states tax dried fruit  as if it is candy because the products contain added sugar. Other states define dried fruit as groceries, and exempt them from taxation.

Some 24 states are members of the Streamlined Sales and Use Tax Agreement, an initiative established well before Wayfair and aimed at simplifying business compliance with state and local sales taxes. Businesses that register with SSUTA and sell to member states can have their software-related costs reduced and certain remote sellers can even have them eliminated.

But the initiative has only gained one new member since the ruling and large states like California and New York are not part of it. Scott Peterson, vice president of U.S. tax policy and government relations at Avalara, thinks that it hasn’t gained more momentum because becoming a member could create too many changes to a state’s sales tax structure and hurt revenue. 

Peterson, who previously served as the executive director for the SSUTA Governing Board, remembers when it took the group a year to come up with a suitable definition for candy. The final definition specifically excluded wheat products, which meant states had to drop things like Twix bars and Kit Kats from taxation. “That’s honestly what keeps most states out,” he said. “They can’t deal with the taxability changes.”

What’s more, compliance costs can be significant given the increased exposure to state audits. This is particularly burdensome for smaller businesses. In a separate report last year, the GAO noted that large organizations generally just incur an increase in their compliance software costs. 

“In contrast,” the report said, “a small business with about $20 million in annual gross receipts told us it incurred start-up costs of about $8,000 to purchase new tax collection software and $43,000 to integrate the software with its existing systems. Another business with about $42 million in annual gross receipts reported spending about $200,000 on software integration.”

No Simple Solution

The GAO recommended that Congress work with states to “establish parameters” that “balance state interests with the need to address multistate complexities.” 

At a Senate Finance Committee hearing held earlier this month, committee members appeared to sympathize with small businesses. “Family-owned furniture makers, tool and die shops, clothing boutiques—they shouldn’t be forced into spending big on sales tax consultants and software,” said Oregon Sen. Ron Wyden, the committee chair. “This committee has a bipartisan interest in helping small businesses get ahead, and this is an opportunity for us to lower their costs and save a lot of headaches.”

But observers in the industry like Maniace and Peterson doubt that Congress will intervene in an area that’s long been under the control of states. They believe that states will continue to whittle away at the issues themselves. 

Alabama and Texas, for example, have created a way for remote sellers to pay a single blended rate sales tax given that they both have a lot of local taxing jurisdictions. Other states have simplified the threshold that determines whether a remote seller has an economic nexus in that state. 

Meanwhile, legislatures continue to adjust sales tax laws and many states are turning to an expanded sales tax in favor of reducing their income tax rate and achieving other policy objectives.

“Wayfair did not create complexity,” Peterson said. “It exposed everyone to the complexity that was already there.”