How State Sales Taxes Work

Calculating the Pain

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:

  • Alaska does allow local governments to levy sales taxes, and many do.
  • Delaware does impose a tax on businesses' receipts, at a lower rate (a maximum of 2.07 percent) than sales taxes in other states.
  • New Hampshire imposes excise taxes on hotel rooms, some restaurant meals and communications services. For practical purposes, these excise taxes work like sales taxes.
  • Montana levies a 4 percent tax on rental vehicles.
  • Oregon imposes small taxes on cigarettes and gasoline.

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.