States aiming to increase taxation of digital products, Baker Institute expert says

The old idiom by Ben Franklin, “In this world nothing can be said to be certain, except death and taxes,” remains true — and it applies to the evolving ways Americans consume movies, TV shows, books and music.

Technological advancements that have transformed how people live, work, entertain and learn are pushing state authorities to take a close look at how digital products are taxed, according to Joyce Beebe, a fellow in the Center for Public Finance at Rice University’s Baker Institute for Public Policy. Beebe outlines her insights in a new report, “The Current State of Sales Tax on Digital Products,”  which addresses court cases, administrative actions, congressional proposals and what may lie in the future for this relatively new area of taxation.

One of the problems Beebe points out is the fact that there’s no universal definition of what constitutes a “digital product.” The most commonly cited definition comes from two publications by the Streamlined Sales Tax Governing Board, a multistate effort to simplify sales and use tax collection and administration. According to the Streamlined Sales and Use Tax Agreement (SSUTA) and the board’s rules and procedures, “specified digital products” include digital books and digital audio and visual works. The SSUTA also differentiates between types of software and cloud computing infrastructure and their taxability.

“Although classifying canned software as tangible personal property or taxing software purchases when something tangible changes hands seem like simple rules, the story does not stop here,” Beebe wrote. “The recent proliferation of cloud computing imposes new challenges on the taxability of software.”

Many digital products do not fit into current tax rules because the rules existed long before the digital economy, Beebe said. States know this is a problem but they haven’t reacted uniformly, she said.

“Despite the complex tax treatment of digital products, it is undeniable that the digital economy continues to encompass a larger share of economic activities,” Beebe wrote. “More consumers are streaming or downloading digital products as opposed to purchasing them through tangible means. From a tax revenue perspective, it is natural to expect states to expand their taxing power on digital products.”

In 2019 alone, more than 10 states expanded, considered or proposed digital product taxes. Even states that do not impose sales taxes on digital products may levy other assessments. For example, Florida generally does not levy sales tax on digital products, but it imposes a 7.44% “communication services tax” on video and music streaming services. Chicago also imposes a “personal property lease transaction tax” on cloud computing services at either 5.25% or 9%.

Congress recognizes the complexity of digital goods taxation, and it has tried to solve the problem by crafting legislation decreeing that your state of residence is the taxing authority for your digital purchases, Beebe said. Even though it has been repeatedly introduced, the legislation has not gained much attention, she said.

“Opponents are concerned that this framework is overly wide, does not provide guidance for individual states, and — considering the evolving and amorphous scope of the digital economy — may require frequent revisions,” Beebe wrote. “However, federal preemptions are usually difficult to revise. Furthermore, there are disagreements as to whether Congress is the appropriate authority to address the issue, or if the taxation of digital goods falls within states’ rights.”

According to Beebe, the future is clear: More states are going to tax digital products at a much broader level. The consequences for the lack of consistency in state tax laws and the absence of national guidelines are also clear, she said: State governments would experience reduced compliance and decreased revenue.

On Aug. 14, the IRS published proposed regulations on the classification of cloud transactions and transactions involving digital content. That proposal is for income tax purposes and it was issued mostly in response to concerns about U.S.-based multinational companies underpaying taxes related to cloud services. Nonetheless, it proves that the IRS understands the urgency of the issue, and it highlights the agency’s view about the nature of cloud-based transactions.