Post-Recession State Tax Revenues and Taxation of Digitized Transactions

State tax performance since 2008 shows that effects of recessions on revenues can last five years or more. Policymakers planning for potential revenue shortfalls must consider relatively long time periods. This article addresses two key revenue policy issues. First, it provides a brief summary of state tax revenue performance during the past several years, with a focus on how collections stand relative to their previous peak. This section shows the relative revenue performance for state governments in aggregate since 2008. Second, it describes key sales tax issues associated with the dramatic movement towards digitization and identifies some policy options.

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About the Authors
William F. Fox is a Chancellor’s Professor, the William B. Stokely Distinguished Professor of Business and the Director of the Center for Business and Economic Research at the University of Tennessee. He has served as a consultant in more than 25 countries and 10 U.S. states on a wide range of public policy issues.

LeAnn Luna is an associate professor and holds a joint appointment between the Department of Accounting and Information Management and the Center for Business and Economic Research at the University of Tennessee. Earlier in her career, Luna amassed nearly a decade of corporate experience that included positions with an international accounting firm and private industry.

Revenues are Recovering from the Deep Recession
State tax revenues are rebounding from the worst fiscal recession in modern history. Although regional performance varies considerably, overall state tax revenues expanded rapidly in 2011, and growth continued nearly as strongly into 2012. Last year, inflation-adjusted tax revenue growth was the third fastest since 1998 and 2012 would be the fourth fastest if growth is sustained at the first quarter’s level throughout the year. (see Figure A) After revenues declined by 10.2 percent between 2008 and 2010, 2011 revenues of $755.2 billion are only $26.6 billion under the peak reached in 2008 and are just shy of 2007 collections.1

The decline in revenues is much greater when inflation is taken into account.2 Real revenues fell by 15.4 percent between 2007—the peak in real revenues—and 2010, and they ended last year $91.5 billion below the peak (or 11.4 percent lower than peak real revenues). The 2012 fiscal year nominal revenues for the sum of the states will surely exceed the 2008 maximum, but revenues will remain much lower in inflation-adjusted terms. Only seven states anticipate a revenue decline in 2012, though more than one-half of states expect nominal revenues to rise by less than 5 percent.3

States differ widely in the recovery of revenue. (see Figure B).4 After one year of upturn, nominal 2011 revenue exceeded 2008 collections in only 16 states. Only North Dakota and Oregon had more revenue in 2011 than in 2008 after inflation is taken into account. As a general rule, revenues have recovered better in the upper Midwest, mid-Atlantic and New England regions. Revenues are further from their peak in the Southeast. The biggest declines relative to 2008 are in Alaska, Louisiana, South Carolina and Georgia, whose 2011 revenues are 85 percent of their peak or less.

States have tried a variety of policy responses to the revenue reductions, with rate increases being an important component in some states. Eleven states raised their sales tax rate and seven increased their personal income tax rate since 2008. Six of the 16 states that had higher revenues in 2011 than in 2008 increased one of these two tax rates. Interestingly, five states, including New Mexico, North Carolina, Ohio,5 Oklahoma, and Rhode Island, reduced their personal income tax rate between 2008 and 2011 despite having less revenue than in 2008.6 Both North Carolina and Utah raised their sales tax rates as they lowered their personal income tax rate. North Dakota lowered its income tax rate and Oregon raised its rate.

The corporate income tax experienced the largest revenue decline between 2008 and 2010, followed by the personal income and general sales taxes. Revenue from each tax grew in 2011, but was still lower than in 2008. (see Figure C) For example, sales tax revenue declined by 7.4 percent in the recession, but was only 2.3 percent below its peak in 2011. During 2012, aggregate state sales and personal income tax revenue will likely exceed their 2008 peak,, but corporate income taxes will continue to lag significantly behind pre-recession levels.

Sales Taxation of Digital Goods and Web-Enabled Transactions7
Technological advances are changing the way businesses do business. For example, payroll software was once typically delivered via disk or DVD and downloaded onto company computers for use. Today, that software is more typically downloaded electronically and installed on company desktop computers, installed on a central server accessed by company employees from their desktops or increasingly accessed by users from the “cloud.” Call centers and help desks no longer need a brick-and- mortar location to provide services. Customers calling an 800 number could be routed to desks of employees working from home or to centers located anywhere in the world, depending on call volume, time of day, etc.

These changes in delivery methods have profound effects on the sales and use taxation of digital products and services.

Taxation of Digital Products and Services
Digital products typically consumed by businesses may be subject to sales and use tax if the transaction involves (1) the sale of software, (2) data processing, data storage or canned information, or (3) the digital equivalent to tangible personal property (i.e., “digital goods”). The Streamlined Sales Tax Agreement defines “specified digital products” as electronically transferred “digital audio-visual works” (e.g., movies), “digital audio works” (e.g., ringtones, music) and “digital books.”8

States take several different approaches to taxing software depending on the type of software and how it is delivered. First, some states have never taxed software. Second, some states tax standardized or custom software delivered by a physical medium— such as DVDs—as tangible personal property.9 Third, most states tax standardized or canned software, whether delivered by physical medium or downloaded remotely, as a sale of a tangible product. On the other hand, custom software is often classified as a service and taxed accordingly, depending on the state’s taxation of such services in general. Data services can be taxed as information services or as telecommunication services.

Digitized transactions create two unique sourcing issues. The first is determining where the taxable transaction, or consumption of the product or service, occurs. Once a transaction is properly sited to a particular state, the next step is determining whether the seller has nexus in that state and therefore a sales tax collection obligation. In general, software applications or digital goods will be taxed in the state where they are accessed or downloaded by the user, but exceptions do exist and the taxability becomes more complicated when multiple users are located in several jurisdictions.10

States will often tax hosted services (see discussion of cloud computing below) based on where the customer receives the benefit of the service, the principal place of business or at the point of delivery. The Streamlined Sales Tax Agreement uses the following hierarchy to determine where to source digital transactions. The “best” approach is to use the address provided by the customer’s instructions. The “next best” approach is to use the address the seller has for the customer in the seller’s records (e.g., ship to address or billing address).11 Third, is to use the customer’s address obtained during the sale, and finally, to use the address of the seller’s server.

Cloud Computing

Much of the recent growth in digital products is in “cloud computing.” The U.S. National Institute for Standards and Technology developed the following definition of cloud computing.12

Cloud computing is a model for enabling ubiquitous, convenient, on-demand network access to a shared pool of configurable computing resources (e.g., networks, servers, storage, applications, and services) that can be rapidly provisioned and released with minimal management effort or service provider interaction.

Types of Services in the Cloud
For sales tax purposes, cloud computing is best thought of as an alternate delivery method of electronic products and services rather than as a novel set of products. The transaction can take many forms, but with all of them, clients remotely access computing services by linking to a server that is often located in a state other than where the services are consumed. Infrastructure as a service provides clients access to data storage and computing services, such as data backup and storage to business and individual clients. Software as a service vendors provide access to common programs and applications, such as online tax preparation programs. Platform as a Service provides tools to software developers.

Problems with Taxing Services in the Cloud
Delivery of services through cloud computing creates several interrelated problems. A sales tax collection obligation arises on the part of the seller in the state in which consumption occurs if the seller/taxpayer has physical presence in that state.13 For cloud computing, attributing consumption to a particular state can be complicated. Computing services are sold by businesses that can be located anywhere to customers that can access them from anywhere from servers often maintained by third parties. For example, a company headquartered in California may purchase server space and cloud-based software from a company in Pennsylvania. The software company in Pennsylvania contracts hosting services from a third party with servers in Florida, Illinois and Washington. Employees of the California-headquartered company may access the software across the country by connecting to the servers via the Internet directly or by routing the transaction through the client company’s main server in California. A number of questions must be addressed to determine if and where the transaction would be taxable. If the transaction is the sale of a digital product, in which state does the sale take place? Options include where the server is located, the location of the consumer when the software was accessed or the billing address for the parent company. If the sale is deemed to be a service, in which state are the services consumed? Does it matter if the software is licensed on a monthly or annual basis or on a per-use basis? Once it can be determined where the services were consumed, in which states does the software company have nexus and therefore a sales tax collection obligation?14 One guiding practice is that in recent years, states have asserted nexus based on the activities of third-party vendors whose activities benefit the seller.

The sales tax treatment of cloud computing often follows the taxation of analogous products delivered by other means. The first step is to determine what type of good or service is being provided. Most transactions can be characterized as access to services, infrastructure or software. For example, infrastructure as a service, analogous to data storage or processing services, is often taxed consistent with such services offered in a more traditional delivery method. As a result, states differ in how they tax infrastructure as a service. Connecticut, Ohio and Texas tax data storage and processing services if the customer is located in the state.15 On the other hand, Florida treats the transaction as a rental of the computer, or access to infrastructure, and taxes the transaction based on where the server is located. Servers located in another state and therefore not “rented” in Florida are not taxed.

Software as a service and platform as a service provide software services to users without transferring the software to customer computers either via DVD or download. Whether a client accesses canned software through download or the cloud, the nature of the service is the same. Sourcing the transaction, however, is difficult. Assume a California company hosts software that it makes available to clients located in New York and Pennsylvania. Does the transfer and taxable sale occur in California or the state where the clients access the software? Pennsylvania, Kansas and Utah treat the “sale” as occurring in California and therefore not subject to sales or use tax at all. New York takes a different approach and subjects the transaction to New York sales/use tax, even though the software remains housed at all times in California, and then looks to the seller’s nexus to determine whether New York can impose a sales tax collection obligation on the seller.

Electronic commerce combines information services delivered over telecommunication networks and can be classified for sales tax purposes under either umbrella. Some states tax telecommunication services but not information services. Further, cloud computing services are often bundled, with clients receiving access to applications and platforms, data storage and support for a flat fee. In many states, the storage—a service—may not be taxable, but the access to applications—access to software—is taxed. Because the provider charges a flat fee, however, the proper amount of tax may not be remitted to the state.

Recent rulings rely on the “true object test” to make a taxability determination on the bundled transaction.16 States may also split the transaction into its component parts and assign a part of the purchase price to each function. Massachusetts held that fees charged for access to a database were nontaxable but “add-ons” were deemed taxable use of the software. Thus, a customer can search a database tax-free, but when new tools are purchased, it becomes software subject to sales tax.17

Court battles can result from disagreement over which components are taxable and where. In one example, the taxpayer separately stated charges for hardware, software and a service that collects, manipulates and transmits data so that only parts of the transaction were taxable.18 The department of revenue concluded the entire transaction was taxable because the transmission of data was equivalent to a taxable communication service. But the court ruled in favor of the taxpayer, acknowledging the validity of separating the system into its parts.19

Click-Through Nexus Laws
States have taken a number of approaches to collecting sales tax due on other forms of remote transactions. In 1982, the Quill decision provided the bright line physical presence nexus standard regarding sales and use tax, though federal legislation requiring use tax collection by remote sellers has also been recently introduced.20 New York was the first state to enact click-through nexus—also known as “the Amazon Law”—in 2008, asserting nexus for vendors with certain third-party e-commerce relationships. The law seems to target large e-commerce venders such as and to enforce use taxes on their e-commerce sales.21 The constitutionality of some of the Amazon laws remains unclear.22 And in LLC v. N.Y. Dep’t of Taxation & Fin. (N.Y. App. Div. Nov. 4, 2010), the appellate court remanded the case back to trial court to determine whether in-state representatives were soliciting business or merely advertising on Amazon’s behalf.

Arkansas, California, Connecticut, Illinois, New York, North Carolina, Rhode Island Texas and Vermont have enacted click-through nexus statutes.23 Click-through nexus legislation is under consideration in several states—including Arizona, Massachusetts, Michigan, Mississippi and South Carolina. Colorado and Oklahoma—require greater use tax reporting and a number of other states have asserted click through nexus authority without specific legislation.

As an indication of the stakes in this controversy, both Amazon and Overstock have often responded to newly enacted click through statutes by ending nexus-creating affiliate programs in those states.  


1 Revenue data are taken from the U.S. Bureau of the Census. Note that the 2011 data are estimated from the quarterly tax collections data and the earlier years are taken from the annual tax collections. Some differences exist between these two data series. For example, the quarterly data are generally based on cash received during the year and the annual data allow for adjustments such as for accruals.
2 Revenues were adjusted using the state and local government deflator that is prepared by the U.S. Bureau of Economic Analysis.
3 See, NCSL Fiscal Brief: Projected State Tax Growth in FY 2012 and Beyond, Dec. 6, 2011.
4 Figure B compares all states with 2008 revenue, though the year may not have been the peak revenues in every case.
5 Ohio’s rate decrease was enacted in 2006.
6 In addition, several states temporarily raised their rate and lowered it back by 2011.
7 Much of this section is drawn from presentations by staff from Ernst & Young and Deloitte.
8 As new technologies develop, this definition will likely evolve. For example, is an iPhone application considered a “specified digital product”?
9 Digital goods as defined by the Streamlined Sales Tax Agreement are taxed as tangible property if the state elects to do so. Further, some states impose sales tax on the sale of streaming digital products. For example, Washington taxes streamed digital goods, but New Jersey does not.
10 The simplest example is of a network license bought by a company headquartered in one state, but with employees who are authorized to use that software scattered across the country.
11 This will likely not be very accurate as the billing address may be the corporate headquarters and not where the service is actually being used.
13 See Quill Corp. v. North Dakota, 501 U.S. 298 (1992).
14 For a helpful discussion of the often conflicting state approaches to the taxation of cloud computing, see Houghton, Kendall, and Luongo, Maryann, “No Improved Visibility
for Cloud Computing Taxation,” State Tax Notes, (July 4, 2011), 69–74.
15 Martin I. Eisenstein and Barbara J. Slote. “Let the Sunshine In: The Age of Cloud Computing.” State Tax Notes, (Nov. 28, 2011), 573–582.
16 The test is also called the “real object test,” “the essence of the transaction test,” and the “essence of the relationship test.” (BNA State Tax portfolio)
17 See Revenue Information Bulletin 11-010 (May 23, 2011).
18 See Qualcomm, Inc. v. Department of Revenue, Washington Supreme Court (March 10, 2011).
19 The court looked at the true object and found the service to be an information service rather than a telecommunication service.
20 The Main Street Fairness Act (see also S. 1452), H.R. 2701; The Marketplace Equity Act, H.R. 3179; and The Marketplace Fairness Act, S. 1832.
21 Basis for the law originates in Scripto, Inc. v. Carson (362 U.S. 207 1960), which addressed agency nexus and dealt with live agents.
22 See “Lobbying Congress: ‘Amazon’ Laws in the Lands of Lincoln and Mt. Rushmore,” by Edward Zelinksy, State Tax Notes, May 23, 2011, pp. 557–567.
23 Vermont’s law is only in effect if 15 other states enact an Amazon law. California’s law was stayed until 2012, subject to passage of a federal bill.


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