How State Sales Taxes Work

A sales tax is classified as a consumption tax. An income tax goes after the money you earn; a consumption tax targets only the money you spend [source: Froomkin]. Some economists argue that state sales taxes aren't true consumption taxes. That's because most states have lots of exemptions -- sales of some goods and most services aren't taxed. Also, often businesses have to pay the sales tax on things they buy, although the businesses aren't the final consumers. Many foreign countries use a different sort of consumption tax -- known as a Value Added Tax (VAT) -- that gives a tax credit to businesses when the goods reach the consumer.

Whether you call it a sales tax or a gross receipts tax, it's usually tacked onto the price of an item. The consumer pays the tax to the retailer, who's responsible for keeping records and sending the revenue to the state at regular intervals.

Consumers in most states don't care about the fine distinctions. A sales tax feels like a consumption tax to them. How much does it hurt?

First, there are the tax-free states:

Then, there are the other 45 states. Some, such as New Mexico, don't call it a state sales tax on buyers, but rather a gross receipts tax of 5 percent on businesses, but since businesses routinely pass the tax on to consumers, it works the same way.

Your home state determines what you pay. California leads the nation with a state sales tax of 8.75 percent. On its heels are Indiana, Mississippi, New Jersey, Rhode Island and Tennessee at 7 percent. Next highest are Minnesota at 6.875 percent, Nevada at 6.85 percent, Washington at 6.5 percent, and Texas and Illinois at 6.25 percent.

On the low end is Colorado, with a 2.9 percent state sales tax. Next are seven states with 4 percent sales taxes: Alabama, Georgia, Hawaii, Louisiana, New York, South Dakota and Wyoming [source: Tax Policy].

How did the sales tax become so important to state governments? You'll find a brief history on the next page.

Who's responsible for the state sales tax? Some say Kentucky came up with the precursor of modern state sales taxes back in 1930, when it imposed a tax on retailers. Four years later, Kentucky revised that to a 3 percent flat sales tax. In 1936, Kentucky scrapped the sales tax until 1960. Other sources point the finger at Mississippi, which started a state sales tax in 1930.

One thing is clear, however: The Great Depression inspired desperate state governments to try sales taxes. Two dozen of the states that use sales taxes today started in the 1930s. Six more joined the trend in the next decade. Five states got on the bandwagon in the 1950s, and in the 1960s, 11 more imposed the tax. The last state to do so was Vermont, in 1969 [source: Fox].

Back in the 1930s, the U.S. economy largely had to do with selling goods. Legislators didn't like the idea of taxing people's labor. That's how sales taxes came to focus on goods rather than services [source: Duncan].

Sales taxes are vitally important to state budgets. In 1970, sales taxes became the largest single source of revenue for state governments. Since the late 1990s, personal income tax revenues have brought states more money than sales taxes, but these taxes still amount to a big chunk of the money that comes into states' budgets. In fact, some states raise nearly 60 percent of their tax revenue from sales taxes [sources: Fox and Duncan].

The many states that count on sales taxes for a lot of income may face trouble down the road. Whenever the economy turns down, legislators are tempted to raise the sales tax. Often, temporary increases are rolled back when times get better. But then something happens, and the tax goes up again. "The trend is clear, and that is upward," says journalist and author Paul T. O'Connor [source: O'Connor].

A lot has changed since the 1930s, however. A far greater share of the economy now is based on services rather than goods, but services historically haven't been taxed. In recent years, states have been moving toward taxing services, but changes in tax law are controversial and tough to accomplish. In March 2010, for example, Michigan Gov. Jennifer Granholm sparked an outcry when she proposed cutting the state's sales tax rate from 6 to 5.5 percent and imposing the reduced tax on a number of specific services, including legal services and landscaping [source: Hornbeck].

Do consumers ever get a break from sales taxes? Read on for some good news.

In the 1990s, a few states came up with an idea that would spread like wildfire. They would suspend the collection of state sales tax on certain items for a weekend in August to give parents a break on back-to-school purchases like backpacks, supplies and clothes for their children. It was a win-win situation for many retailers and shoppers. The retailers came out ahead because the tax break encouraged a lot of shopping. And the parents saved money.

For 2010, at least 15 states have sales tax holidays scheduled. They range from one day to one week [source: Taxadmin].

Sales tax holidays usually are targeted toward certain items. They often have upper limits on the price of items that can be bought tax-free. Back-to-school sales tax holidays are popular, but they aren't the only kind. Several states have recently started tax holiday weekends for appliances with the federal Energy Star efficiency rating.

Some sales tax holidays appear to be designed to influence behavior as well as to save shoppers' money. Louisiana and Virginia, for example, have tax holiday weekends for hurricane preparedness items. Louisiana also has a tax-free weekend for the sale of ammunition, hunting supplies and guns in honor of the Second Amendment.

In Vermont, the Legislature approved two one-day sales tax holidays in 2009, during which people can buy anything costing $2,000 or less tax-free. When shoppers turned out in droves on one of those holidays, March 6, 2010, retailers said it gave them a needed boost in a down economy. One speculated that the sales tax holidays encourage shoppers to buy locally rather than online [source: WCAX]. Buying online can be an easy way to avoid state sales tax. (Consumers are technically required to pay any sales taxes directly to the state -- even when the online store doesn't collect it -- but this rule is rarely enforced.) When tax isn't an issue, buying locally becomes more attractive because it's quicker and there are no shipping costs.

There's a catch, though: Sales tax holidays can be a victory for retailers and shoppers. But they're not great deals for the states that are losing the tax revenue. Some states have repealed tax holidays when the economy worsened. Others require that legislators authorize the holiday every year or two, and in some states such as Florida and Massachusetts, they've decided not to. New York, which was one of the first states to have a tax holiday, did away with the holiday in favor of removing state sales tax on clothing and shoes costing $110 or less year-round.

State sales taxes are a widely used fact of life in the U.S. But are they a good idea? Read on for some criticisms.

Many observers say that Americans accept sales tax more willingly than they do other taxes [source: Duncan]. We pay it in small amounts, we're used to it and there's no paperwork for the consumer.

The main criticism of sales taxes has to do with fairness and social justice. Sales taxes are regressive, meaning that they hit the poor harder than the rich. Poor people have to spend a larger percentage of their income just to get by. Richer people can save more of their income or use it in other ways that don't involve paying sales tax [source: Froomkin].

But that's not the only rap on sales taxes:

Sales taxes aren't the perfect way for states to raise revenue. And if states are going to continue to rely heavily on sales taxes, they'll have to figure out how to deal with changing times. But shoppers should know that state sales taxes won't disappear anytime soon.