States likely to turn to digital taxes to cover mounting shortfalls

Apr 24, 2020
State & local tax

In addition to the health consequences and the devastation to the private sector economy, the COVID-19 pandemic has wreaked havoc on state public finances. The near global economic shutdown has led to billions of dollars of lost state tax revenue. Losses vary by state as, for example, it has been reported that Missouri faces a $500 million shortfall while New York is expecting to miss revenue expectations by several billion dollars. The economic crisis has affected all types of taxes, but the two most significant sources of state tax revenue, the general sales tax and the personal income tax, have fallen precipitously. Pressure on state finances will continue to mount, as personal consumption remains low and unemployment increases.

It is certain that state governments will need to raise additional tax revenue. Almost every state must balance its operating budget. These balanced budget requirements are set by statute or constitution; states do not have discretion. With significant projected budget deficits, states will either have to raise tax revenue, cut spending, or some combination. States will quickly exhaust rainy day funds and most states will reduce spending to some extent. However, it is unlikely that state spending cuts could significantly reduce the current and anticipated deficits. States will have to raise additional tax revenue.

Making up almost a third of all state tax collections, the sales and use tax has been a stable and predictable tax for the last decade. According to U.S. Census data on historical state tax collections, beginning in the second quarter of 2010, sales and use tax collections rose on a year-over-year quarterly percentage basis through at least the fourth quarter of 2019. Not only has there not been a quarter of state collections less than the same quarter a year before, but the pattern of collections has been consistent. Sales and use taxes are popular sources for increased tax revenue through piecemeal base expansion, the elimination of exemptions, and, although both rare and highly unpopular with voters, rate increases. Accordingly, base expansion to include the low-hanging fruit of untaxed goods and services may be a popular move by state legislatures hoping to solve coming deficits, and digital goods and services are the most likely target.   

Why transaction taxes on digital goods and services?

There are several reasons that new or increased transaction taxes on digital goods and services will be an attractive option for many states. What is likely to be the most telling, though, is that the COVID-19 crisis has greatly reduced all discretionary consumption except electronic goods and services. People may not be shopping in malls or buying cars, but they are buying entertainment, consuming the news, subscribing to video game services through multiple platforms, participating in online training and otherwise increasing their time on, and interaction with, the internet. This sector of the economy has been sheltered from the devastation of the pandemic, largely because digital goods and services are, by nature, remote and consumable from home.  And, where there is money, there is an opportunity to tax.

Currently, 29 states and the District of Columbia subject some digital goods and services to sales tax. However, the tax base of electronic products varies greatly in these states. Some states tax digital goods and services broadly, while others impose the tax on a narrow list of digital products like books and music, but largely exclude digital services. Moreover, other states have imposed lower tax rates on certain digital goods and services. The remaining 16 states with a general sales tax exclude all digital good and services from tax. These states could significantly increase their sales tax revenue by expanding the base to include digital goods and services.

What will new digital goods and services taxes look like?

States will likely consider several options when contemplating taxation of digital goods and services. Much like the adoption of digital goods and services taxes over the last ten or so years, taxing digital products, such as books, movies, and music may be an early step for those states currently excluding all digital goods and services. States that limit their current tax base to digital products may begin to expand to services, including streaming services, advertising, subscriptions, information services and expanded data processing services.

Moreover, some states may try to subject some digital goods to a gross receipts tax. Just before the current crisis, the Maryland legislature passed a gross receipts tax on digital advertising. There have been proposals to tax digital advertising in New York and Nebraska this year as well.

Taxing digital goods and services creates numerous policy, legal, and administrative issues. Defining digital goods and services is not always easy. Sourcing, i.e., determining what jurisdiction and what tax rate a digital product is subject to, is often a complex analysis. Other states may not need new legislation, opting instead to revoke or replace previously issued guidance and rulings on the characterization and taxation of digital goods and services. From a policy perspective, states must wrestle with exempting business purchases of digital goods and services–currently only provided in a few states. States have largely been unable, or unwilling, to discern business from personal consumption for purposes of sales tax. In many cases, taxing digital goods and services could run afoul of the Internet Tax Freedom Act which prohibits states from taxing electronic goods and services if similar non electronic goods and services are not taxed.


There is a strong possibility that states will enact new or expanded consumption taxes on digital goods and services in the wake of the COVID-19 crisis. Companies selling or buying digital goods and services should be aware of this possibility, and should be ready to act to expand their current digital goods and services sales and use tax compliance process. They should also know the ramifications, from both a cost and compliance perspective, of such taxes. The RSM U.S. State and Local Tax group can assist both buyers and sellers of digital goods and services to prepare for the likelihood of additional taxes.

Other state considerations for the COVID-19 pandemic can be found in RSM’s State tax planning in response to economic distress. For more information on the coronavirus, please see RSM’s Coronavirus Resource Center which includes related and frequently updated developments.

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