Sales tax is an additional cost that a consumer has to bear when they buy goods and services. It goes by another name of consumption-based tax. The consumer has to pay the fee, but it’s collected by a retailer as opposed to the government in many situations.
How it works on a basic level is that when you buy something at the counter, you pay the price of the item. Then, something extra gets added on as a tax. You give the full amount to the shopkeeper, but they have to pass on the sales tax and value-added tax to the government.
Sales tax can be single or multiple-stage tax – where it’s imposed at one level (such as retail) or multiple, such as production and distribution. The most common in the United States is retail sales tax which is a single-stage tax. You only have to pay one charge when you buy something, instead of during several stages of the product’s manufacturing and distribution.
Value-added tax (VAT), also known as goods and services tax (GST) is a multi-stage tax type. A product is taxed in the factory, at the wholesalers, and the retailers. The consumer will have to pay all those taxes because the previous product owners deduct the fee once they make the purchase. They are only paying for added value, which ends up passed on to the consumer.
If you were to find any significant similarities between the two taxes, it would be that you and I – the consumer – end up paying the tax bill. Except how it’s collected and administered differs.
This example below may also help to explain the differences between VAT and retail sales tax.
Let’s say you have a farmer with a pig who sells the pork to a butcher for $100. The butcher then cuts the pig into sections for $300. He adds $200 of value to the initial $100 value. The VAT tax is 10%, so he has to pay 10 percent of that value added.
Ten percent of 200 is $20 in tax. However, because he is selling the pork in the retail market, he also has to consider a retail sales tax of 10%. He now passes $40 of tax on to the consumer.
Retail tax applies to goods and services and has a significant burden on the consumer. VAT tax applies only to the value added to the product before the sale, not the entire cost.
Tax is not a new phenomenon, even though people still grumble about it as if it’s the latest thing with which to annoy consumers. Direct taxes – taxes on people – were the first to apply to compulsory labor in Egypt circa 2600 BC.
In Mesopotamia, landowners had to pay a tithe (levy), which related to grains and other crops they grew on their land. Tomb paintings in Egypt also paid reference to taxes on cooking oil and professions as tax collectors.
During Julius Caesar’s reign, sales tax appeared in Europe. The Government of Rome made everyone pay one percent in sales tax, and it wasn’t long until it took effect elsewhere. Spain’s 10 to 15 percent tax rate came into force in the 18th century, and France saw it in the 17th century – much to the disgust of many. In the 1960s, VAT tax became more valuable in Europe than consumer-based sales tax.
Even though VAT tax appeared in United States studies as early as 1910, it wasn’t until they needed to finance World War II that they brought in federal sales tax. Now, tax is controlled at a state and local level instead of nationwide.
The modern form of tax we see today came about during the Great Depression when the government had to try and make up for state revenue losses. Only five of the 50 states in America do not have a sales tax - Oregon, Delaware, New Hampshire, Montana, and Alaska.
Working out how to calculate tax is far easier than trying to understand how it all works! Follow these four steps below.
1. Identify the sales tax rate. For this example, it’s five percent.
2. Identify the net price of a product. We’ll say it’s a coffee table and it is $150.
3. Multiply your net price by the sales tax rate of five percent.
150 x 0.05 = $7.50
4. Add the tax to the net price to find out the gross amount.
150 + 7.50 = $157.50
If this process looks familiar, that’s because it is identical to calculating a percentage increase. You can also use a sales tax calculator to work it out quickly, as well as to determine a pre-tax price. There are also other convenient calculators that apply to finance, such as for margins and mark-ups.
The majority of the United States operates with a single-stage sales tax at a retail level. It saddles the consumer with the burden of paying the tax bill. The rates are all different depending on the state, with 46 sales tax variations in total. Because of the diversity between state tax laws, a few problems have arisen.
Businesses who deal throughout many states have to devote a lot of time and effort to ensure they abide by each state’s unique tax laws. This increases their administration costs. What’s more, the tax base is shrinking as more people seek electronic services as opposed to products which do not require a sales tax.
Another concern is tax evasion, which grows by the day. This is due to cross-border mail orders as well as an inefficient method for taxing products coming into the United States from overseas.
If you consider how important sales taxes are to each state, these problems will require addressing sooner rather than later. There may be a possibility of federal value-added tax in conjunction with sales tax in the future.
There is also another option in the pipeline which has been looked upon favorably: Streamlined Sales Tax (SST). Each state would unify and simplify their tax laws, establish a central state, and adopt a uniformed approach to tax laws. There would also only be one general sales tax rate per state.
The Streamlined Sales Tax is now available in 24 states, with more looking to take it up in the future. If all states adopt the strategy, it could simplify the entire tax system for the United States of America.
Economists have been arguing for a long time about how choosing between consumption tax or income tax can affect your saving behaviors as a consumer. In the United States, income tax is a federal level tax that forms a significant part of the country’s revenue. In Europe, consumption taxes play this role.
Economists argued that if the United States moved toward consumption taxes, it would cause people to save more money. But if they shifted toward income tax, you would receive less money in your pocket and would, therefore, have less money to devote to a savings account. Others had counterarguments for that, stating that you only pay consumption tax when you spend your savings, so it would not alter your decision to save at all.
A consumption tax could play in favor of economic growth more so than income tax.
Societal Inequality
If the United States moved in favor of a tax law that promoted savings, then it would end up impacting those with low incomes. People who do not earn much spend all of their money on necessities such as food. The people on a higher salary will then benefit as it reduces their tax burden if they are saving.
In states where a tax rate is high, the gap between the rich and poor is more significant. The way to counteract this social inequality would be by reducing tax rates on food, which is what many states have already done.
Price Level Alterations
As soon as a new or adjusted tax law comes into play, consumers and retailers react accordingly. How the new tax is implemented can make all the difference to how much of an impact it has on price levels.
If you raised a sales tax, then the price of goods subject to that tax would increase with it. However, some retailers would be able to mitigate this with competitive pricing between big stores, who want to outdo each other.
Because tax laws and definitions differ from one state to the next, each state offers something attractive for various business types. As a result, some business owners may decide to move their production to another state with a lower tax burden.
An example of this would be if a state had high tax rates and a more challenging tax system, This could drive production costs up. To increase the profit margin, business owners would have no qualms moving somewhere with a more relaxed approach.
This graph shows the 2019 State Business Tax Climate Index with the ten best and worst business tax climates.
Image: Tax Foundation
No one likes paying tax, but it’s something we all have to do. That’s not to say there aren’t ways to reduce the burden of it ever so slightly. What if you’re going to buy a new pickup truck which comes with a hefty price tag?
You can deduct your state or local general sales tax paid annually, or you can deduct the income tax (state, local, and foreign). There will be some limitations, and you can’t do both, but you may be able to deduct the more substantial amount.
If you are going to deduct sales tax, remember to keep your bills and invoices and use an IRS sales tax worksheet to estimate the tax you paid.
