What Is Sales Tax? Definition, Examples, and How It's Calculated

What Is a Sales Tax?

A sales tax is a consumption tax imposed by the government on the sale of goods and services. A conventional sales tax is levied at the point of sale, collected by the retailer, and passed on to the government.

A business may be liable for sales taxes in a given jurisdiction if it has a presence there, which can be a brick-and-mortar location, an employee, or an affiliate, depending on the laws in that jurisdiction. 

Understanding Sales Tax

Conventional or retail sales taxes are only charged to the end user of a good or service. Because the majority of goods in modern economies pass through a number of stages of manufacturing, often handled by different entities, a significant amount of documentation is necessary to prove who is ultimately liable for sales tax.

Suppose a sheep farmer sells wool to a company that manufactures yarn. To avoid paying the sales tax, the yarn maker must obtain a resale certificate from the government saying that they are not the end user. The yarn maker then sells the product to a garment maker, who must also obtain a resale certificate. Finally, the garment maker sells fuzzy socks to a retail store, which will charge the customer sales tax as part of the price.

Different jurisdictions can charge different levels of sales taxes. Also, states, counties, and municipalities may levy sales taxes of their own. This can make the purchase price of the same item in different locations differ. Sales taxes are closely related to use taxes, which apply to items purchased from outside their jurisdiction.

Use taxes are generally set at the same rate as sales taxes but are difficult to enforce, except when applied to large purchases of tangible goods. An example of a use tax would be when a Georgia resident purchases a car in Florida. The buyer would be required to pay the local Georgia sales tax as though they had bought it there. Comparison shoppers might use the net of tax price to see if buying an item in one location is beneficial over buying it in another location.

Nexus

A nexus is generally defined as a physical presence, but this "presence" is not limited to having an office or a warehouse. Whether a business owes sales taxes to a particular government depends on the way that government defines a nexus.

Having an employee in a state can constitute a nexus, as can having an affiliate, such as a partner website that directs traffic to your business' page in exchange for a share of profits. This scenario is an example of the tensions between ecommerce and sales taxes. For example, New York has passed "Amazon laws" requiring internet retailers such as Amazon.com Inc. (AMZN) to pay sales taxes despite their lack of physical presence in the state.

Excise Taxes

In general, sales taxes take a percentage of the price of goods sold. A state might have a 4% sales tax, a county 2%, and a city 1.5%, so that residents of that city pay 7.5% in total.

Certain items are often exempt, such as food. Others are exempt below a certain threshold, such as clothing purchases of less than $200.

Conversely, some products carry special taxes, known as excise taxes. "Sin taxes" are a form of excise tax, such as the local excise tax of $1.50 New York City charges per pack of 20 cigarettes on top of the State excise tax of $4.35 per pack of 20 cigarettes.

Value-Added Tax

The U.S. is one of the few developed countries where conventional sales taxes are still used. Outside of the U.S., many countries have adopted value-added tax (VAT) schemes. These charge a percentage of the value added at every level of production of a good.

In the example above, the yarn maker would pay a percentage of the difference between what they charge for yarn and what they pay for wool. Similarly, the garment maker would pay the same percentage on the difference between what they charge for socks and what they pay for yarn. This is a tax on each company's gross margins, rather than on the end user.

The main objective of the VAT is to eliminate tax on tax (i.e., double taxation) which cascades from the manufacturing level to the consumption level.

The U.S. system with no VAT implies that tax is paid on the value of goods and margin at every stage of the production process. This would translate to a higher amount of total taxes paid, which is carried down to the end consumer in the form of higher costs for goods and services.

The Bottom Line

A sales tax is a percentage-based tax on finished products at the point of sale. Sales taxes are common in the United States, where each level of government may charge an additional percentage of gross sales. They are less common outside the U.S., where many countries use a value-added tax instead.