Sales tax: Definition, how it works and how to calculate it

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What is sales tax?

A sales tax is one that applies to the purchase of goods and services for consumers and to the sale of goods and services for businesses. It’s a type of consumption tax, meaning it taxes people for spending money. It’s categorized as a consumption tax because sales taxes are generally passed along to consumers at the point of sale.

A sales tax is also a type of indirect tax, which means it isn’t paid directly to the government as is income tax. Instead, retailers collect sales taxes from their consumers and then remit them to the appropriate government entity.

Imposed by both state and local governments, sales taxes make up the largest source of tax revenue for states throughout the country.

How does sales tax work?

Sales taxes apply to the sale of goods and services and are a percentage of the total purchase amount. Retailers are responsible for calculating and collecting sales tax at the time a purchase is made. Then, on a schedule set by the state or local government, retailers are required to remit the sales taxes they collect to the government.

Sales tax isn’t collected by the federal government. Instead, it’s imposed by state and local governments. Forty-five states and the District of Columbia impose sales taxes, while another five states have no sales tax. Additionally, 38 states allow local governments to collect sales taxes. Consumers in those states would pay both the state and local sales tax once for each purchase.

Even in those states that have sales taxes, they don’t usually apply to every product or service. Most states don’t charge sales taxes on groceries or prescription drugs. Additionally, some states add clothing and medical devices to the list of items that aren’t subject to sales taxes.

Consumers can also purchase items free of sales tax during what are known as sales tax holidays. A handful of states have a set handful of days each year that are designated as sales tax holidays. These holidays often correspond with the start of the school year, so that families can purchase school supplies and clothing for their children.

What is nexus?

Nexus is an important concept that determines which businesses do, and don’t, have to collect sales taxes in a given state. Prior to 2018, nexus was the major factor in determining sales tax requirements, and companies only had to collect sales taxes in states where they had a physical presence.

Then, in 2018, The Supreme Court decision in South Dakota versus Wayfair changed the way sales tax is collected. Rather than only being required to collect sales taxes in states where they had a physical presence, companies may now be required to collect sales taxes on all purchases, regardless of the state in which the company and consumer are located.

It’s worth noting that this change doesn’t happen automatically. States must pass a law similar to South Dakota’s to require that out-of-state companies collect sales taxes. Until they do, retailers don’t necessarily need to collect sales taxes on purchases if they don’t have a physical presence.

Examples of sales tax

Sales taxes apply as a percentage of the purchase price. Suppose you planned to purchase a $1,000 computer in Wisconsin. The state charges a 5 percent sales tax. Additionally, Wisconsin counties charge an additional 0.5-percent tax, bringing the total sales tax to 5.5 percent.

At the time you buy your computer, you’ll be required to pay the $1,000 for the computer, as well as $55 in sales taxes ($1,000 x 0.055). The retailer will keep the $1,000 for itself, and then set aside the $55 sales tax to send $50 to the state government and $5 to the county government.

How sales tax varies by state

Sales taxes vary significantly from one state to the next. As previously mentioned, 45 states and the District of Columbia charge a sales tax. The five states that don’t impose a sales tax are:

  • Alaska
  • Delaware
  • Montana
  • New Hampshire
  • Oregon

California has the highest sales tax of 7.25 percent, followed by Indiana, Mississippi, Rhode Island, and Tennessee each at 7 percent. Of the states that charge sales tax, Colorado has the lowest at a rate of 2.9 percent, followed by Alabama, Georgia, Hawaii, New York and Wyoming, which each charge 4 percent.

Don’t forget that in many states, your state sales tax isn’t the only one you’ll pay; local governments may also charge sales taxes. When you account for the average combined sales tax, Tennessee, Louisiana, Arkansas, Washington and Alamaba have the highest rates, while Alaska, Hawaii, Wyoming, Wisconsin and Maine have the lowest. Alaska is the only state without sales taxes that still allows local governments to charge sales taxes if they wish.

Sales tax versus value-added tax

The value-added tax (VAT) is another type of tax on the purchase of goods and services. The key difference between the two is that while sales taxes are collected at the final sales of a good or service, VAT is collected at each stage of production.

For example, suppose a product goes through four different stages of production from start to finish. VAT would be charged four different times to account for the change of the value of the product. The VAT is determined by taking the cost of the product at the current production stage and subtracting the cost of materials and any taxes that have already been collected.

The United States is one of few countries — and the only economically advanced country — that doesn’t impose a VAT. More than 160 countries worldwide impose VAT as their primary consumption tax.

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