Understanding Sales Tax: What Is It, and How Does It Work?

FT Contributor  | 

When you go shopping, the price you pay for items at the register is often more than the actual price you see on the tags. In almost every state, consumers are charged a sales tax on the products and services they purchase, and in some cities, you’re charged an additional local sales tax on top of the state rate.

Because sales tax adds to the cost of what you buy every day (in some cases, significantly adding to the final bill) it’s important to account for this tax in your budget, especially when the combined state and local tax rate can add up to 10% or more of the purchase amount. Sales tax may also have an effect on your annual tax bill, as some states allow deductions for the sales tax you’ve already paid.

Sales Tax Definition

Simply put, a sales tax is a consumption tax levied on the price of consumer goods and services calculated as a percentage of the sale price. The tax is charged by the retailer or service provider when you make a purchase, and then remitted to the state by the business.

Sales taxes are governed by state and local governments, which determine the tax rate, what items are taxable, and how the money is to be collected and remitted. The federal government does not charge any sales tax.

Sales Tax Exemptions

In some states, sales tax is only applicable to certain items, or only when specific spending thresholds are met. For example, in Massachusetts, groceries and prescription drugs are exempt from sales tax, as well as clothing purchases up to $175. In California, all purchases other than groceries and prescriptions are subject to sales tax. Some states also have item-specific taxes on alcohol, cigarettes, gasoline, and certain foods, which are typically much higher than the usual tax rate.

Many states also offer what they call “Sales Tax Holidays,” during which consumers can make tax-free purchases up to a certain amount that would typically be taxed. Often, these periods take place during the month of August and are tied to back-to-school shopping, the intent being to help parents save money on school clothing and supplies. These sales tax “holidays” are often limited to the purchase of specific items or spending thresholds, but some states extend the tax-free shopping to all items.

Sales Tax Across State Borders

Sales tax is similar, but not the same, as a use tax. A use tax is charged when someone purchases an item in a state with no sales tax for use or consumption in a state that charges sales tax.

The use tax rate is the rate that the purchaser’s state charges. For example, if someone in Texas makes a purchase from an online retailer located in New Hampshire, the retailer is required to collect a 6.25% use tax from the purchaser (6.25% is the prevailing sales tax rate in Texas) and submit that money to Texas.

However, it’s not always that simple. Sales and use taxes are complicated by the existence of laws relating to nexuses, or a business’ physical presence within a state. Generally speaking, if a business does not have any physical presence in a state (meaning a brick and mortar location, a warehouse, or sales representative, depending on the individual state laws) then it does not have to collect sales or use tax from customers in that state. The burden then falls upon the consumer to report their purchases to the state and pay the applicable taxes.

Some states, though, have passed laws requiring online purchases to be taxed, regardless of whether the retailer has a nexus in the state. For example, New York has the so-called “Amazon law,” which requires all internet retailers to pay use tax on purchases made by individuals in that state.

Sales Tax Examples

Sales tax is charged as a percentage of the sale price of an item, regardless of whether the item is sold with a discount or coupon. If you purchase multiple items, and some are subject to tax and others are not, you only pay sales tax on the taxable items.

For example, you shop for groceries at a store in Columbus, Ohio. The sales tax rate in Ohio is 6.25%, but Franklin County, where Columbus is located, charges an additional 1.25%, for a total tax rate of 7.5%. Your total grocery store bill is $100, but you spent $12 on cleaning supplies in addition to food. Cleaning supplies are taxable, therefore you’ll be charged an additional 90 cents, making your bill $100.90.

The higher the price of the items you’re purchasing, the more you pay in sales tax. A new washing machine might be $499, for instance, but in New Jersey, you’ll pay $533.93 thanks to the 7% sales tax. On the plus side, you won’t have to pay sales tax on the clothing you wash in the machine, as New Jersey exempts clothing purchases from the additional charge.

Big-ticket items such as cars, boats, and recreational vehicles are also subject to sales tax, in addition to any other taxes such as excise or property tax.

What Is Sales Tax Money Used For?

Sales tax revenues are a substantial part of state and local budgets. The money is typically added to the state’s general fund, which is then allocated as needed to fund schools, roads, public safety, and other services and projects in the state.

Although most people assume that they are paying a lump sum “sales tax” on their purchases, in some states, the tax rate is actually several different taxes under one umbrella. For instance, in Nevada, only 2% of the total 6.85% sales tax is actually sales tax. The remaining 4.85% is the sum of several different taxes to support schools and specific county initiatives. 

Who Pays Sales Tax?

Generally speaking, sales taxes are only paid by the end-user of an item at the time of purchase. Manufacturers and retailers are typically exempt from sales tax on the raw materials and goods they purchase for resale. Nonprofit organizations are also usually exempt from paying sales tax, provided that they show proof of their nonprofit status at the time of sale.

When you pay sales tax to a retailer for a purchase, the retailer is then responsible for submitting the funds to the state. Retailers must apply for a state permit allowing them to collect sales tax, and then submit the payments on time to avoid substantial penalties.

Types of Sales Tax

Unless you live in a state without sales tax, you expect to pay a little extra on every purchase at the register. Most states charge what’s formally known as a “consumer excise tax” where the retailer collects the tax from the customer and submits it to the state on their behalf. Generally speaking, once the transaction is complete, you don’t give the sales tax another thought, as it’s now the retailer’s responsibility to pay the state.

Although this is the most common type of sales tax, there are two other types: seller privilege taxes and retail transaction taxes. A seller privilege tax is a tax charged to the retailer for the privilege of making sales. Retailers can either pass the tax on to the customer by adding it to the price, or absorb the fee themselves.

Retail transaction taxes are taxes on the retail transaction itself, not the item being purchased, and are usually handled the same way as consumer excise taxes. Retailers cannot pay these taxes themselves, though, and must collect the tax from the consumer.

Sales Tax Deductions

If you itemize your deductions on your federal tax return, you may be able to deduct the state and local sales taxes you paid. However, you can only take the sales tax deduction or the deduction for the state and local income taxes you paid the previous year — not both.

You can use the IRS estimation calculator to determine how much you spent, or keep meticulous records of your purchases to determine how much you actually spent on sales taxes. Usually, though, unless you made some big purchases and live in a state with a fairly high sales tax rate, deducting income taxes often results in a larger deduction.

Sales Tax By State

Most states charge sales tax on purchases, with a few exceptions. In some states, local jurisdictions may charge an additional local sales tax, so the actual tax rate you pay may be higher in some places.

Here’s what you can expect to pay, state by state, as of January 1, 2020:

  • Alabama — 4%.
  • Alaska — 0%.
  • Arizona — 5.6%.
  • California — 7.25%.
  • Colorado — 2.9%.
  • Connecticut — 6.35%.
  • Delaware — 0%.
  • District of Columbia — 6%.
  • Florida — 6%.
  • Georgia — 4%.
  • Hawaii — 4%.
  • Idaho — 6%.
  • Illinois — 6.25%.
  • Indiana — 7%.
  • Iowa — 6%.
  • Kansas — 6.5%.
  • Kentucky — 6%.
  • Louisiana — 4.45%.
  • Maine — 5.5%.
  • Maryland — 6%.
  • Massachusetts — 6.25%.
  • Michigan — 6%.
  • Minnesota — 6.88%.
  • Mississippi — 7%.
  • Missouri — 4.23%.
  • Montana — 0%.
  • Nebraska — 5.5%.
  • Nevada — 6.85%.
  • New Hampshire — 0%.
  • New Jersey — 7%.
  • New Mexico — 5.13%.
  • New York — 4%.
  • North Carolina — 4.75%.
  • North Dakota — 5%.
  • Ohio — 5.75%.
  • Oklahoma — 4.5%.
  • Oregon — 0%.
  • Pennsylvania — 6%.
  • Rhode Island — 7%.
  • South Carolina — 6%.
  • South Dakota — 4%.
  • Tennessee — 7%.
  • Texas — 6.25%.
  • Utah — 5.95%.
  • Vermont — 6%.
  • Virginia — 5.3%.
  • Washington — 6.5%.
  • West Virginia — 6%.
  • Wisconsin — 5%.
  • Wyoming — 4%.

States With No State Sales Tax

As previously noted, several states do not levy a nationwide sales tax. These include:

  • Alaska;
  • Delaware;
  • Montana;
  • New Hampshire;
  • Oregon.

Despite not having a state sales tax, Alaska jurisdictions can charge a local sales tax. Local sales taxes range from 0 to 7.85% in that state.


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