California Tax Policy and the Internet:

Legislative Analyst's Office
January 2000


Subparts Page


The procedures for allocating local SUT revenues are complex and governed by numerous detailed regulations, which can have important effects on local jurisdictions. The sales tax component and the use tax component of the SUT are allocated among local governments using somewhat different methods.

Allocation of the Sales Tax

The state receives revenues from its 6 percent share of the basic 7.25 percent statewide tax rate. Generally, the local SUT portion (based on a 1 percent rate) is allocated to the assigned tax area code for the seller’s principal place of business or place of sale, while the remaining 0.25 percent local share (the transportation tax) is allocated to the corresponding county. If the retail sale cannot be identified with a permanent place of business (in the case of contractors, for example), the tax is allocated to local jurisdictions through a countywide (or statewide) “pool.” Revenue in these pools is allocated based on the proportion that the identified tax for each geographic area bears to the total revenues identified for the county as a whole. For sellers with multiple geographic locations, the tax is allocated to the location of the principal sales negotiations, even if the item is shipped from elsewhere in the state. For sellers with only one place of business in the state, all sales (and the local portion of the sales tax) would be attributable to that county and its tax areas. Collection of local-option taxes by sellers depends on whether the goods are being delivered or sold inside or outside of an area having an optional tax rate, and whether or not the seller has enough business presence in the tax area to require it to collect the tax.

Allocation of the Use Tax

The state also receives revenues from its 6 percent use tax rate. Since the use tax component of the SUT is by nature not identified with a particular place of business, the local portion of the tax is generally allocated to local jurisdictions in the county of use through the countywide pool. The category of sellers generally collecting and remitting use taxes would include construction contractors whose place of business is a job site, out-of state sellers who ship goods directly from a location out-of-state, and in-state sellers who ship goods from an out-of-state location. Use taxes collected from purchasers (for example, automobiles purchased from private parties) are generally allocated to the location of the purchaser’s residence.


There are a number of different factors that appear to have contributed to the SUT not keeping pace with California’s overall economic growth over the past couple of decades, as measured by statewide personal income.

First, services--which are generally nontaxable--have become a much more dominant share of the economy. For example, while services comprised roughly 45 percent of personal consumption expenditure in 1970, they accounted for over 58 percent of consumer expenditures by 1996. Compared to many other states with a SUT, California taxes relatively few services.

Second, the growth of catalog sales, telephone sales, and Internet sales by out-of-state companies which are not required to collect the state’s SUT has created further erosion of the tax base. This type of retail consumption has increased over recent decades and, given the increasing integration of national and international markets, the trend is likely to continue.

Third, the state’s housing construction sector--which is closely linked to SUT performance--has not returned to the levels of activity that were prevalent in the 1970s and 1980s. During those two decades, residential housing starts averaged in excess of 200,000 annually. For the 1990s, in contrast, the annual average declined abruptly to 110,000 units. This is important because the construction of new homes and the furnishings that are acquired for them provide significant stimulus to SUT collections.

Fourth, the component of personal property that is basically informational in nature can be transformed into an intangible form and not be subject to taxation under the SUT. The Internet has increased the opportunities for such transformations to occur. For example, computer software or a database which is sold in prepackaged form and purchased at a store is subject to the SUT. However, the same program or data if downloaded over the Internet would not be taxed.


Reliably estimating the revenue impacts of Internet activity and e-commerce is difficult and subject to considerable error. Thus, although consensus exists that e-commerce is a rapidly growing sector of the economy, estimates of its size vary considerably and are subject to frequent revision. The DOC will release its estimates of e-commerce for the fourth quarter of 1999 in March 2000. Additional estimates of e-commerce will not be released by the DOC until later in the year. Despite the lack of official estimates, it is helpful to look at some of the independent estimates that have been forthcoming for illustrative purposes.

Volume of E-Commerce

Recent estimates have pegged total e-commerce volume in excess of $100 billion for 1999. Estimates of the business-to-consumer retail segment of this total amount range from $20 billion to $36 billion. Based on these figures, we estimate that the 1999 volume of retail e-commerce in California could be on the order of $3 billion to $5.5 billion. Growth estimates also vary considerably, depending on the assumptions used, and tend to be revised frequently as the Internet’s development continues to exceed expectations. Annual growth rate estimates for business-to-consumer e-commerce for the next five years range upwards of 100 percent to 200 percent. While the latest independent estimates vary depending on the methodology used, generally they result in sales volume forecasts for retail e-commerce well in excess of $100 billion by 2003.

Revenue Implications

In estimating potential SUT revenues associated with e-commerce, it is important to note that only a portion of total e-commerce is potentially subject to the SUT. The OECD estimates that roughly 80 percent of the volume of e-commerce transactions is business-to-business in nature. Most of these purchases would not be taxable since they would
(1) represent the purchase of intermediate goods, or (2) involve the purchase of nontaxable business services. Of the portion that would be subject to the SUT, this would generally be paid as a use tax by the business if the sales tax were not required to be collected by the seller. However, as we indicate in the report, businesses which are not registered sellers would typically not remit the use tax on their purchases.

With respect to business-to-consumer retail sales, some consumer purchases over the Internet would not be taxable because they are either (1) not part of the taxable base or (2) statutorily exempted. In addition, there would be some displacement of catalog or telephone order sales which do not now result in SUT payments, and therefore would

not represent a loss in SUT revenues compared to current collections. Finally, businesses with nexus in the state generally would collect the SUT on transactions conducted through the Internet. What remains is the portion of Internet sales of tangible goods that otherwise would have resulted in the remittance of the SUT, and intangible goods that otherwise would have been purchased in a tangible (taxable) form.

Based on these factors, it is estimated that over $1 billion but less than $3 billion of business-to-consumer sales in 1999 would otherwise have resulted in the payment of the SUT if not for Internet activity. Using the average SUT tax rate of 7.9 percent results in a potential total revenue loss to state and local governments in California in the high tens of millions of dollars to the $200 million range. These estimates do not account for
(1) taxes that would have been collected on the sale of a tangible good that was instead purchased in intangible form using the Internet, or (2) purchases by (nonregistered seller) businesses that would otherwise have resulted in the payment of the SUT. In addition, these estimates do not consider an off-setting increase in other new tax revenues because of expanded commercial activity associated with the Internet itself.

As noted in the text, these revenue-loss estimates do not constitute a large percentage of California’s total SUT revenues. They are dwarfed, for example, by potential revenue losses from telephone and catalog remote sales. What is more of a concern to analysts, however, is that the growth of e-commerce could result in major adverse revenue effects on state and local governments in the future. For example, if Internet retail activity continues to expand at its present rate, forgone Internet-related SUT revenues could represent as much as 2 percent to 4 percent of total SUT revenues by 2003. Thus, it is the prospect of these future effects that makes the issue of so much interest today.


Constitutional Standards

Whether or not a state can require a company to collect the sales tax hinges on two Constitutional principles--the due process clause, set forth in the 14 th Amendment to the
U.S. Constitution, and the commerce clause, set forth in Article I, Section 8, of the U.S. Constitution:

Due Process Clause. This clause sets forth guarantees regarding the treatment of parties by the states. With respect to taxation, its standards are concerned with the fairness of the tax burden and whether the taxpayer has minimum contacts with the state that is levying the tax. The due process clause states: “. . . No state shall make or enforce any law which shall abridge the privileges or immunities of citizens of the United States; nor shall any State deprive any person of life, liberty, or property, without due process of law; nor deny to any person within its jurisdiction the equal protection of the laws.”

Commerce Clause. This clause balances a state’s right to tax against the burdens placed on interstate commerce due to such taxing. The commerce clause reads, “(The Congress shall have the power) To regulate commerce with foreign nations, and among the several states, and with the Indian tribes.” The commerce clause is also known as the “dormant” commerce clause, since it does not specifically limit state activities but simply reserves to Congress the power to regulate interstate commerce.

The QuillCase

The current legal framework regarding SUT nexus was set forth in a series of Supreme Court cases, the most recent being a 1992 case entitled Quill Corporation vs. State of North Dakota (hereafter referred to as Quill). The case involved the Quill Corporation, an office supply company headquartered in Delaware, and the State of North Dakota. The Quill Corporation advertised by catalog and telephone in North Dakota, and delivered its products within the state using mail or common carrier, but had no physical presence in the state. North Dakota sought to require the Quill Corporation to collect the SUT on sales orders delivered to North Dakota residents.

In its ruling, the court found that North Dakota could not require the Quill Corporation to collect the SUT, and addressed the two salient constitutional questions raised by the due process clause and the commerce clause:

• For due process purposes, the court loosened the standard established in a previous case (National Bellas Hess vs. Department of Revenue of Illinois) that some minimum physical presence was necessary for a state to require a business to collect the tax. In Quill, the court stated that this earlier requirement was too formalistic and instead adopted a more flexible standard that allows nexus with respect to the due process clause if the seller’s business contacts with the state make it reasonable for the state to require collection of the SUT. Under this test, a business which purposefully avails itself of the benefits of the economic market in a state would meet the due process nexus requirements.

• With respect to the commerce clause requirement, the court applied a test established in an earlier case (Complete Auto Transit Inc. vs. Brady) and retained the “bright line” physical presence nexus requirement with respect to the SUT.

What Does This Mean for States?

While the Quill decision still requires physical presence to establish nexus, it does so only with respect to the commerce clause. The due process clause nexus requirement could be satisfied through something other than physical presence. What this means is that should it so choose--since it regulates interstate commerce--Congress could approve legislation that would allow states to require the collection of the SUT by out-of-state businesses. Some legal observers in fact believe that the court ruled in this manner as a means of encouraging Congress to take legislative action along these lines. To date, however, it has not done so.

The existing legal guidelines requiring physical presence to establish nexus are quite relevant to e-commerce. The Quill decision creates obvious problems for states attempting to require that remote sellers collect the SUT. The court noted that a substantial amount of business is transacted solely by mail and telephone (and now Internet), thus obviating the need for physical presence within a state. While some states have sought to broaden the definition of nexus such that more companies would meet the test, absent Congressional action, it will be difficult for states to require collection of the tax by out-of-state businesses.


One of the major features of Internet technology is its ability to transform vast quantities of information from physical into digital form. The result of this technological capability is that virtually anything whose nature consists of information rather than physical characteristics, can be sold, transferred, or conveyed through the Internet. The process of reducing the item to pure information is referred to as “digitizing” the product, signifying that it is being transformed from a tangible good, which generally would be subject to the SUT, into an intangible good, which is not subject to taxation.

Internet Activity Has Accelerated the Conversion to Intangibles

The process of reducing goods to their pure informational form is not new. Earlier telecommunications-based technologies are used to transform information from physical to digital form. For example, facsimile machines can be used to deliver or sell certain types of information including reports or similar items. However, the development and continued improvement in Internet technology has vastly expanded--in terms of volume and complexity--the ability to engage in such digital conversions.

A Wide Variety of Transformations Are Possible

The process of digitizing has occurred and will continue to occur across a number of different industries. In each case, the intangible, or digitized form, is not subject to the SUT. For example:

• Consumers currently have the ability to purchase music in various digital forms through the Internet. The tangible equivalent of these musical purchases--such as compact discs or audio tapes--would, under normal circumstances, be subject to taxation.

• Computer software and graphics may be purchased over the Internet on a broad basis. The prepackaged equivalents of this software would be taxable under most circumstances.

• Books and other written material may be downloaded through the Internet to individuals or directly to binding companies, in most cases without being fully subject to the SUT.

• Movies and other graphics can be obtained and played directly through the Internet. This use will expand as the technological capabilities of the Internet continue to improve. These would be taxable if purchased in physical form.

• Large-scale databases compiled by businesses, for use by other businesses and individuals, are becoming available through the Internet as the technological capabilities of the medium improve.

It is difficult to ascertain the scope of such product and service transformation. It is also far from clear at what speed such a transformation of many products will occur. Clearly, much of the transformation of many of the products is reliant not only on the technological capabilities of the Internet--for example, the continued development of Internet “broadband” capacity--but also on the willingness of consumers to convert from traditional to new product forms. It is likely, however, that the Internet--and the ongoing improvements to it--will speed up the process of conversion of information-based products to digital forms. As this occurs, many argue it could result in an acceleration in the erosion of the SUT base.

New Tax Administration Challenges Will Have To Be Addressed

The increased use of digitization is likely to require additional regulatory and interpretive actions on the part of the BOE, regarding whether or not products delivered over the Internet are taxable or not taxable. This issue would be raised, for example, if the product being delivered has an exact counterpart in the physical realm. Another manner in which the issue would be joined is if the product delivered were simultaneously accompanied by a physical copy--for example, a software program. Would both be taxed? Would neither be taxed? Or, would only the physical one be taxed?


There are several key tax-policy principles that economists and public finance experts typically suggest should be recognized when dealing with tax-policy issues. In the case of Internet-related tax issues, these principles, which include both economic and tax-administration considerations, are among those that can help to guide legislators as they consider and debate various policy options.

Efficiency and Neutrality

This principle holds that taxes should generally be structured in a manner that minimizes their interference with economic decision making. For example, the broaderbased a tax is, the lower the tax rate that can raise a given amount of revenues, and thus the fewer the distortions that will stem from its imposition. This principle would suggest that taxes be applied equally to all similar goods, regardless of the means by which they are purchased.


The equity principle has to do with the relative amounts of taxes paid by different taxpayers having different characteristics, such as their economic well being as measured by income or wealth. Both “vertical” and “horizontal” equity are involved. The former considers the tax treatment of taxpayers in different economic circumstances, whereas the latter considers similarly situated taxpayers. With respect to vertical equity and the Internet, one consideration is the fact that lower-income individuals do not generally have the same access to the Internet as do higher-income individuals, and thus, to the extent that Internet buyers avoid paying the use tax, low-income individuals would be at a comparative disadvantage.

Revenue Sufficiency

This principle involves such basic features of a tax as the adequacy of the revenues it generates, the growth in these revenues over time, and volatility of its revenues over the course of the business cycle. Also involved are the balance and diversity which a tax brings to a state’s overall revenue portfolio.

Administrative Feasibility

From an administrative standpoint, the best taxes are those which impose minimal compliance costs on taxpayers, and minimal enforcement, collections, and other administrative costs on tax agencies. Such taxes tend to be relatively simple, visible and transparent, and ensure that a high degree of compliance and accountability can be attained.


Increased use of the Internet by consumers and businesses, and its increasingly sophisticated technological features, have heightened awareness of issues related to the tangible versus intangible classification of property for SUT purposes. Currently, certain products are subject to the SUT when purchased in tangible form, but exempt when purchased in intangible form--such as when the product is delivered electronically through the Internet. This occurs, for instance, with music, written products, and graphics.

If an effort were made to make the SUT neutral in its application with respect to tangible or intangible manifestations of the same product, either both forms should be taxed or neither should be. Broadening the tax base to include the taxation of intangibles presents quite complex administrative issues. Many of these relate to inability to determine the place of delivery or use of the product for the purpose of assessing the tax and distributing its proceeds. With respect to the sale of intangible goods over the Internet, the seller does not need to know--for purposes of delivery--the location of the purchaser, the location of use, or the number of locations where the goods will be used.

Implementation and Administrative Issues

While taxing intangibles purchased in-state could be accomplished without conflicting with the Quill decision (see Supplement D-4), interstate commerce taxation would require that Congress address the commerce clause issue. In addition, taxing intangibles could entail rather intrusive auditing procedures by the BOE unless the state were to rely on purely voluntary participation by purchasers. Since no geographic destination needs to be specified on the delivery of intangibles purchased through the Internet, a voluntary approach would result in an incentive for taxpayers to indicate a purchase site in a low-or no-tax location.

This compliance issue could be dealt with through the use of “digital certificates,” which provide evidence of the owner's identity during a given transaction in the form of a statement signed by an independent third party. In this manner, a digital certificate allows a vendor and officials from a taxing jurisdiction the ability to determine the correct tax rate. Alternatively, instead of assessing the tax based on the place of delivery, the tax could be assessed based on the billing address of the purchaser. This method would be suitable for credit card or similar purchases, even though it would not necessarily mesh with the actual point of consumption and use. In addition, it would not be effective for purchases using untraceable payment means, such as “cybercash”--an Internet form of physical currency. Using such means of payment would require additional information provided by a firm acting as the financial intermediary for the transaction--a requirement which would raise a number of privacy and administrative issues.

A Fallback Alternative

One proposal to deal with the sale of intangible goods where the purchasers’ location is unknown, is to default to a single basic SUT rate (for example, a national minimum tax rate), where the tax proceeds would either be (1) “thrown back” to the seller’s location or (2) “thrown around” to all other states in proportion to their share of purchases with known destinations. This approach does raise issues with respect to state sovereignty given that states have independently chosen different SUT rates or may not even have a sales and use tax.

Any attempt by states to broaden the SUT to encompassing intangible products would need to address these significant administrative issues, and probably would require federal legislation unless the system were to be voluntary.


Approaches to Internet-related SUT issues range from declaring the Internet a “tax-free zone,” to abandoning the SUT altogether in favor of a broad-based tax on all consumption. In this supplement, we focus on approaches which leave the SUT basically intact. Options for addressing Internet-related tax issues may be either undertaken by California alone--the state specific approach--or in conjunction with other states--the cooperative approach.


There are four primary ways the state might wish to address Internet-related SUT issues on its own.

Option: Focus Efforts on Expanding Nexus

Current law requires a seller to have physical presence in a state before the state can require it to collect the SUT. California could use one or more of several legal theories in order to justify expanding the definition of nexus. These include the theories of agency, affiliation, economic presence, and presence of intangibles.

Agency Theory. This approach would allow the state to assert nexus over an out-of-state seller based on the in-state activities of the seller’s agent. Some states have used this theory to assert nexus over out-of-state ISPs that use “server farms” within the state. Some have further argued that ISPs act as agents for those whose web sites they carry. Under this view, firms would have nexus wherever their ISP had a physical presence. Some continue this line of reasoning to argue that telecommunications firms act as agents for ISPs, implying that all firms doing business over the Internet would have nexus in all states. Generally, agency theory has met with limited legal success. Even if the approach met with legal success, however, as a practical matter the ease with which agents could move from state to state would likely make it ineffective as a long-term solution.

Affiliation Theory. This theory of nexus involves linking out-of-state sellers with in-state affiliates and subsidiaries based on the dominance or control exercised by the outof-state seller. As a result of such relationships, the in-state affiliate is deemed to be part of the out-of-state corporation. This approach has generally met with limited success, although it may be successful in narrow situations involving holding companies and “dot-com” subsidiaries.

Economic Presence Theory. This theory of nexus is based on the regular and systematic direction of business efforts to a state where it has no physical presence. In the Quill case (see Supplement D-4), the economic presence argument was unsuccessfully used by the State of North Dakota to establish nexus, so its future effectiveness is questionable.

Presence of Intangibles Theory. This approach would base nexus on the existence of intangible property (such as stocks or trade names) within the state. This approach was validated in an income tax nexus case, and states could push to have this approach applied to the SUT. Here again, however, the likelihood of fundamentally altering the legal framework is remote.

Option: Encourage Use-Tax Compliance

Purchasers who buy goods from an out-of-state vendor are technically required to calculate and remit the appropriate use tax on these purchases, which is levied at the same rate as the sales tax would have been had the purchase been made from an in-state seller. The use tax is self assessed and, as a consequence, generally goes uncollected except in cases (1) where a registration requirement exists or (2) if the purchaser is a registered seller with the BOE. Currently, registration requirements are limited to automobiles, boats, trailers, and selected other categories of items. In addition, only retail businesses and selected other concerns are registered sellers. As a consequence, the SUT is typically not collected on a large number of purchases.

Auditing Will Not Solve the Problem. All states with a sales tax have an accompanying use tax (although it is not always levied at the same rate). The use tax is intended to establish tax equity between goods purchased in-state and those purchased out-of-state. While the rationale for the use tax is theoretically sound, the practical limitations with respect to enforcement have largely compromised the tax’s underlying policy goal. Although audits can provide a cost-effective means of encouraging compliance, these are only cost-effective in particular cases involving easily identifiable and expensive items. Since most of the noncompliance associated with the use tax is a result of a large number of purchases by the broad general population, audits are neither a practical nor politically palatable alternative to comprehensively dealing with the SUT compliance problem.

Piggy-Backing on the Income Tax Form Could Be Tried. To make the SUT a more reliable revenue source for local governments and yet still maintain simple and inexpensive collection methods for sellers, California could focus on increasing use-tax compliance by heightening consumers’ awareness of their use-tax liabilities. This increased awareness could be achieved by incorporating a provision for use-tax payments into California’s personal income tax return. A few states, including Connecticut, Idaho, Indiana, Kentucky, Maine, and Wisconsin already employ such an approach. For example:

• In Maine, the state personal income tax return (Form 1040S-ME) instructs the filer as to how to determine use-tax liability, either by applying the use-tax rate to the amount of purchases for which sales tax was not paid (if this amount is known), or by multiplying Maine adjusted gross income by a certain percentage.

• In Kentucky, the state personal income tax return (Form 740) instructs the filer to apply a 6 percent rate to out-of-state purchases of tangible personal property. The Kentucky Revenue Cabinet routinely conducts use-tax compliance programs as well.

Option: Simplify the SUT Structure by Changing to an Origin-Based Tax

Under this scenario, California could significantly simplify its current SUT structure by specifying that all sales be taxed according to their origin (or source), as opposed to their destination. An origin-based SUT would mean that out-of-state purchases by Californians would be taxed at the applicable rate according to where the sales originated (if the origin state had such a tax). In addition, California would tax all sales of products originating in-state, even if they were shipped out-of-state. (For additional discussion relating to this option, see Supplement D-9.)

Option: Create a Web-Based Tax System to Facilitate SUT Collections

Under this option, the state would use Internet technology to facilitate use-tax collection and ease the cost of taxpayer compliance and BOE enforcement. For example, the state could choose to become an on-line use tax collection agency. To accomplish this, California might have the “order page” of sellers’ web sites link with the appropriate state site. The state’s site would then calculate and collect the tax from the buyer, using the same payment mechanism the buyer uses for his/her purchase. Other alternatives exist under this option, as well.

Under the State Specific Approach, What Should California Do?

Regarding the first, second, and third options, they would either be generally ineffective or result in potential economic disruption. The first option would require a significant expenditure of resources with very little guarantee of a substantial return. Efforts to expand the application of nexus would be likely to be effective only in marginal cases. The second option--encouraging purchaser compliance with the use tax--is unlikely to have a material effect on SUT revenues. Changing to an origin-based SUT, as the third option suggests, would bring with it potential economic distortions. It would transform the SUT from a quasi-consumption tax to a quasi-production tax, thereby potentially causing business relocations.

The state-specific action that the state may wish to investigate is an Internet-based tax collection system. Although it would not directly address nexus issues, it would ameliorate some secondary issues associated with the SUT. Among other things, this approach could: (1) lessen the administrative costs on sellers; (2) sidestep the complexities associated with nexus issues; and (3) result in a fairer, more economically neutral application of the SUT. Even with this system, tax neutrality and equity concerns would likely persist, since out-of-state retailers would not be obligated (under existing law) to collect the tax, but “main-street” retailers still would be required to do so.


Under this second general approach, the state would attempt to enter into agreements either with other states, the federal government, or both. There are three basic versions of this policy approach.

Option: Establish a Federal Collections Function

This option would require a rather dramatic administrative restructuring of the SUT by specifying a federal agency to collect the tax. Under its constitutional ability to regulate interstate commerce, federal legislation could require that sellers of products across state lines collect and remit to the federal government the SUT. These revenues could then be allocated back to individual states. For the sake of simplicity, agreements would likely need to be reached regarding definitions of products, products to be taxed, the rate of tax to be used, as well as other administrative issues.

Option: Reciprocal Agreements Between Individual States

This approach would call for California to establish cooperative agreements with individual states that would require companies operating in them to collect the appropriate SUT taxes on shipments to California, and visa versa. For example, California companies shipping goods to New York would be required by California to collect New York’s SUT. This would in turn be remitted to California and netted against the SUT paid by New York sellers of goods shipped to California. This approach would avoid the tax-generated movement of production associated with the origin-based tax.

Option: A Multistate Agreement

Under this alternative, California would develop with other states a multistate agreement that would establish a means to facilitate collection of the SUT by out-of-state sellers. The states participating could initially develop a voluntary collection and remittance system. An effective agreement that did not interfere with interstate commerce activities could encourage Congressional action to resolve the out-of-state sales issue. As part of this process, efforts should be made to minimize SUT collection and compliance burdens on sellers. This approach to Internet-related SUT revenues would

enable California to streamline its SUT collections activities, encourage compliance in a cost-effective manner, as well as manage the overall multistate SUT structure. It also would avoid reliance on the federal government in dealing with SUT revenue issues.

Under the Cooperative Approach, What Should California Do?

In our view, the multistate agreement makes the most sense here. With respect to the other alternatives, pursuing a federal collections approach would involve a significant sacrifice of state sovereignty, and state-by-state agreements would not be all inclusive, and therefore not fully address the problem.

The focus of the multistate approach should be to: (1) establish one SUT rate per state or develop a means to track SUT rates, (2) standardize definitions of taxable and nontaxable items, and (3) establish exemptions for small sellers, as discussed below. Generally, this approach would involve simplifying and minimizing variations in existing SUT systems and coordinating collection efforts. A voluntary system along these lines has been proposed by the National Governor’s Association and National Conference of State Legislatures and endorsed by other state and local government associations.

Establish One SUT Rate Per State or A Tax Rate Tracking System. There are about 6,500 individual SUT taxing jurisdictions nationally. Vendors find it difficult and expensive to keep track of all of the different SUT rates their buyers represent, since they can frequently change and vary according to the city and county involved. Given this, one approach could be to establish one SUT rate per state, at least for out-of-state sales. Alternatively, states could develop a tax tracking system which would allow for local variation in tax rates, but place limitations on the frequency with which rates could change.

Establish Uniform Product Definitions. Many states exempt from the SUT certain categories of goods. However, there is no consistent product definition for these goods among the states. Establishing consensus product definitions among states could lead to increased compliance and would reduce administrative costs.

Establish Rules for Special Sales. States have varying SUT requirements for sales to exempt organizations and sales for resale. As part of the process to standardize treatment of sales by different states, any agreement should result in a process that adequately simplifies these varying administrative rules. There could also be exemptions for small businesses with annual sales less than a threshold amount.

Of course, there would be some drawbacks associated with the cooperative approach. For example, participation in a multistate agreement could mean that California

would lose some degree of state sovereignty. It also is open to question whether such an approach can function effectively, given the high degree of interstate cooperation required. Some states, for example, may have incentives not to cooperate because they want to attract business by not enforcing the SUT. There may also be cost considerations, since it would be important that the amount of additional SUT revenues collected cover the cost of administrative and collection activities.


Sales and use taxes are collected on the basis of either product origination, called the origin basis, or on the basis of the destination of the goods (or location of the purchaser), known as the destination basis. Under the former system, exports for a geographic region are taxed while imports are exempt. Conversely, under the latter system, imports are taxed while exports are exempt. In California, as in virtually all states with a sales and use tax, the tax generally is a destination-based tax, with the tax being assessed according to the rate in effect where the goods are delivered. In practice, however, although the tax is conceptually intended to be purely destination based, the tax is usually levied based on the place of purchase or delivery rather than the place where it is actually used or consumed.

The application of the destination principle to the SUT varies somewhat for the purposes of interstate and intrastate commerce.

The Case of Interstate Sales

The “destination basis” means that for goods shipped from California to other states, no California SUT is collected. This is because the goods are not delivered in the state (although a tax may be collected by the destination state). For those goods shipped from other states to California, the destination basis would result in a California use tax liability. However, as discussed elsewhere in this report, the ability of states to require outof-state sellers to collect and remit the tax is generally limited by law to certain situations, and voluntary remittances by purchasers are seldom made. As a result of these constraints, for many goods purchased from out-of-state, no SUT is collected.

The Case of Intrastate Sales

For commerce that occurs within the borders of California, the SUT is generally (but not strictly) destination based. Purchases made in one county are taxed based on that county’s rate and the taxes allocated to that county. On the other hand, purchases made in one county but delivered to another county are taxed based on the county rate where the sale is made, even though the goods are delivered elsewhere. Certain other inconsistencies occur as well, depending upon the location of the sale and the business structure of the seller. For example, for sellers with one place of business in California, all sales are considered to occur at this location, even if they are shipped elsewhere in the state (thereby suggesting an origin basis for the tax). The determination of where a sale occurs (that is, its “situs”) affects both the rate of tax as well as which local jurisdiction receives the associated tax revenues.

The Rationale for Destination Basis

The destination basis for the SUT is linked to the rationale for SUT itself. The tax was originally conceived of as a levy on the purchase (or use) of a good, rather than its production, since private consumption was deemed to be a better proxy for consumption of the benefits of public services than was production. On this ground, the destination basis of the tax is generally perceived by taxing authorities as a more appropriate model for taxation than an origin-based one. An origin-based tax, in contrast, is effectively a tax on production rather than consumption. One ramification of the destination basis is that it can result in favorable revenue effects for retail-based relative to manufacturingbased economic areas and taxing jurisdictions.

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